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Module 30:Long-run Implications of Fiscal Policy:Deficits and the Public Debt
Module 30:Long-run Implications of Fiscal Policy:Deficits and the Public Debt
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Fiscal Policy Revisited
• Recessionary Gap– The gap that exists
whenever equilibrium real GDP per year is less than full-employment real GDP as shown by the position of the LRAS curve.
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Fiscal Policy Revisited
• Inflationary Gap– The gap that exists
whenever equilibrium real GDP per year is greater than full-employment real GDP as shown by the position of the LRAS curve.
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Fiscal Policy Revisited• Fiscal Policy—the discretionary changes in
government expenditures and/or taxes in order to achieve the national economic goals of:– High employment (low unemployment)
– Price stability
– Economic growth
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Fiscal Policy Revisited
• Assume there is a recessionary gapExpansionary fiscal policy can
close the recessionary gap.Increase government spending
Decrease taxes
Direct and indirect effects cause the aggregate demand curve to shift outward.
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Fiscal Policy Revisited
• Assume there is a inflationary gapContractionary fiscal policy can
close the recessionary gap.Decrease government spending
Increase taxes
Direct and indirect effects cause the aggregate demand curve to shift inward.
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• Other things equal, expansionary fiscal policies (i.e. government purchases of goods/services, higher government transfers, or lower taxes) reduce the budget balance for that year.
• Other things equal, contractionary fiscal policies (i.e. reduced government purchases, lower government transfers, or higher taxes) increase the budget balance for that year.
The Budget Balance
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• Budget Balance
– The difference between the government’s tax revenue and its spending in a given year.
• Government Budget Deficit
– Negative budget balance
• Government Budget Surplus
– Positive budget balance
The Budget Balance
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The Budget Balance—Federal Government Deficits and Surpluses since 1940
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The Federal Budget Deficit Expressed as a Percentage of GDP
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The Business Cycle and the Cyclically Adjusted Budget Balance
Historically, the budget tends to move into deficit when the economy experiences a recession, but the deficits shrink or turn into surpluses when the economy is expanding.
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The Business Cycle and the Cyclically Adjusted Budget Balance
The relationship is even clearer if we compare the budget deficit as a percentage of GDP with the unemployment rate.
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• In assessing budget policy, we need to separate movements in the budget balance due to the business cycle…
– Caused by automatic stabilizers.
– Effects are temporary and tend to be eliminated in the long-run.
The Cyclically Adjusted Budget Balance
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• …from the movements in the budget balance due to discretionary fiscal policy changes.
– Caused by deliberate changes in government purchases, transfers or taxes.
– When we remove the cyclical effects, this sheds light on whether the government’s taxing and spending policies are sustainable in the long-run.
The Cyclically Adjusted Budget Balance
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• It is an estimate of what the budget balance would be if real GDP were exactly equal to potential output.
The Cyclically Adjusted Budget Balance
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• Politicians are always tempted to run deficits because this allows them to cater to voters by cutting taxes without cutting spending or by increasing spending without increasing taxes.
• Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.
Should the Budget Be Balanced?
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1. In the short run, deficits can have two potentially damaging effects on the economy
a. If the economy is at full employment, a government deficit is inflationary.
b. Deficits raise interest rates which can retard growth in investment and housing activities.
2. In the long run, deficits can add to a rising government debt.
Problems Posed by Government Deficits
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• For 2012, the U.S. federal government had total debt equal to $16.43 trillion.
1. A large federal debt puts financial pressure on future budgets
2. If a large portion of the debt is held by other countries, then foreigners have a large claim on U.S. resources
• About half our “public debt” is owned by foreign investors, the largest of which were China and Japan at just over $1.1 trillion each.
3. If the national debt rises at a rate faster than GDP, then this can have negative ramifications for the future growth potential of the U.S.
Problems Posed by Rising Government Debt
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• Although we haven’t balanced deficits with surpluses, these deficits have not led to runaway debt.
• To assess the ability of governments to pay their debt, we often use the debt-GDP ratio– If the government’s debt grows more slowly than
GDP, the burden of paying that debt is actually falling.
– Although the federal debt has grown in almost every year, the debt-GDP ratio fell for 30 years after the end of WWII.
Deficits and Debts in Practice
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• Comparing panels (a) and (b), you can see that in many years the debt-GDP ratio has declined in spite of government deficits.
Deficits and Debts in Practice
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• Still, a government that runs persistent large deficits will have a rising debt-GDP ratio when debt grows faster than GDP.
Deficits and Debts in Practice
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• Our deficit for 2012 was $1.089 trillion
• Our public debt at the end of 2012 was $11.59 trillion.
• Our GDP for 2012 was $15.86 trillion.– Budget deficit as a percent of GDP: 6.8%
– Public debt-GDP ratio: 73%
• A recent study reported that among the 20 advanced countries studied, average annual GDP growth was 3–4% when debt was relatively moderate or low (i.e. under 60% of GDP), but it dips to just 1.6% when debt was high (i.e., above 90% of GDP).
Deficits and Debts in Practice
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• Despite our steady debt-GDP ratio, some experts on long-run budget issues view the situation in the U.S. with alarm due to implicit liabilities.
– Spending promises made by governments that represent a future debt but are not included in the usual debt statistics (i.e. transfer payments).
– Social Security, Medicare and Medicaid currently account for almost 40% of federal spending.
Implicit Liabilities
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• For this reason, many economists argue that the total federal debt of $15 trillion, the sum of public debt and government debt held by Social Security and other trust funds, is a more accurate indication of the government’s fiscal health than the smaller amount owed to the public alone.
Implicit Liabilities