chapter 16 fiscal policy and the government budget · pdf filechapter 16 fiscal policy and the...

Chapter 16

Fiscal Policy and the Government

Budget

Copyright ©2015 Pearson Education, Inc. All rights reserved. 16-2

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• To examine the relationship between the government budget and the growth of government debt

• To understand the long- and short-run economic effects of budget deficits, tax cuts, and increased government spending


The Government Budget

• The government’s budget is affected by:

– Government spending (outlay)– Tax revenue (income)


Government Spending

• Major components of government spending:

1. Government purchases (G), which consist of i) government consumption—spending on other goods and services (GC), and ii) government investment—spending on capital goods like highways and school (GI), so that G=GC+GI

2. Transfer payments (TRANSFERS): direct payments to individuals, e.g., unemployment insurance benefits, social security benefits and Medicare, which are known as entitlements as they are set by earlier legislation

3. Net interest payments (INTEREST): interest payments to holders of government debt like U.S. Treasury bonds, less interest paid to the government for debts such as student loans


Revenue

• Major components of tax revenue (TAXES):

1. Personal taxes: income and property taxes2. Contributions for social insurance, like

Social Security taxes3. Taxes on production and imports, like sales

tax and taxes on imports (tariffs)4. Corporate taxes: taxes on the profits on

businesses


THE GOVERNMENT BUDGET,


Budget Deficits and Surpluses

• The formula for the government spending is:

Deficit = spending - tax revenues= (G + TRANSFERS + INTEREST) - TAXES


Government Budget Constraint

• The government budget constraint for financing its deficit is:

Deficit = change in amount of debt (bonds) in the hands of the public

= ΔB


Size of the Government Debt

• In most countries, the government runs a deficit, so that the amount of worldwide government has been growing over time

• Growth of U.S. government debt over time:– The United States finances its government

deficits primarily by selling bonds, so that is a correlation between budget deficits and the stock of government debt as a percentage of GDP

– The debt-to-GDP ratio, the amount of debt relative to nominal GDP, reached 99% by 2012


FIGURE 16.2 U.S. Federal Deficit and the Size of U.S. Government Debt Relative to GDP, 1940-2013 (a)

Source: Economic Report of the President, Table B-79 at www.gpoaccess.gov/eoptables09.html


FIGURE 16.2 U.S. Federal Deficit and the Size of U.S. Government Debt Relative to GDP, 1940-2013 (b)

Source: Economic Report of the President, Table B-79 at www.gpoaccess.gov/eoptables09.html


International Comparison: The Size of Government Debt

• In 2011, many countries, particularly Japan and Greece, had much higher debt-to-GDP ratios in excess of 100%, while other countries, such as Australia and Luxembourg, had low debt-to-GDP ratios of less than 50%


International Comparison of the Relative Size of Government Debt


Sovereign Debt Crises

• A sovereign debt crisis is a collapse in the market for country’s government debt

• The crisis can occur if the debt-to-GDP ratio rises to the point where investors become concerned about the probability of default by the sovereign government:


Policy and Practice: The European Sovereign Debt Crisis

• Economic contraction in many European countries during the financial crisis of 2007-2009 led to surges in government deficits and the debt-to-GDP ratios

• In 2012, Greece’s debt-to-GDP ratio climbed to 160% from about 100% in 2009

• The sovereign debt crisis spread to Ireland, Portugal, Span, and Italy


Fiscal Policy and the Economy in the Long Run

• Why High Government Debt Is Not a Burden

1. Spending in government capital like highways and schools, and human capital like education, will increase the economy’s future productivity, so that additional tax revenues will go toward paying down the government debt

2. Because government debt is financed by government bonds, bond holders will eventually be repaid with future tax payments


Fiscal Policy and the Economy in the Long Run (cont’d)

• Why High Government Debt Is a Burden

1. Reduction in national saving2. Value of government capital investment3. Indebtedness to foreigners4. Redistribution effects5. Debt intolerance6. Negative incentive effects



• Why High Government Debt Is a Burden1. Reduction in national saving

– Because national saving (NS) based the uses-of-saving identify is:NS = (Y - T - C) + (T-G) = I + NX

Private saving Gov’t saving– Crowding out occurs when a reduction in national saving as

a result of budget deficits means lower private investment (I)2. Value of government capital investment3. Indebtedness to foreigners4. Redistribution effects5. Debt intolerance6. Negative incentive effects



• Why High Government Debt Is a Burden1. Reduction in national saving2. Value of government capital investment

– Most government spending is for government consumption like on medical care and military personnel, not capital stock

– Government investment even in capital is viewed as wasteful (“pork”) spending and unproductive

3. Indebtedness to foreigners4. Redistribution effects5. Debt intolerance6. Negative incentive effects



• Why High Government Debt Is a Burden1. Reduction in national saving2. Value of government capital investment3. Indebtedness to foreigners

– National saving can lower net exports (in addition to investment) and thus increase indebtedness to foreigners

– The largest holders of U.S. government debt are now the Chinese

4. Redistribution effects5. Debt intolerance6. Negative incentive effects



• Why High Government Debt Is a Burden1. Reduction in national saving2. Value of government capital investment3. Indebtedness to foreigners4. Redistribution effects

– Because the people paying taxes may not be the same people who hold government bonds, so that rising government debt involves a transfer of wealth in the future to government bondholders, who tend to be richer

5. Debt intolerance6. Negative incentive effects



• Why High Government Debt Is a Burden1. Reduction in national saving2. Value of government capital investment3. Indebtedness to foreigners4. Redistribution effects5. Debt intolerance

– The fear of debt repudiation—failure of paying it back—may rise as government debt gets very large

– Some countries may experience debt intolerance with a high likelihood of default even at low debt-to-GDP ratios

6. Negative incentive effects



• Why High Government Debt Is a Burden1. Reduction in national saving2. Value of government capital investment3. Indebtedness to foreigners4. Redistribution effects5. Debt intolerance6. Negative incentive effects

– Raising taxes to pay down the debt involves distortions, such as a lower incentive to work due to higher income tax, and few capital stock investment due to a higher capital gains tax

– Tax wedges—the difference between what people earn before and after taxes—reduce the efficiency and economic growth over time


Fiscal Policy and the Economy in the Short Run

• As we learned, expansionary fiscal policy, either a cut in taxes or an increase in government spending, raises aggregate demand

• According to our aggregate demand supply analysis, if aggregate output falls below its potential YP, then expansionary fiscal policy can cause a shift of the AD curve to the right so that aggregate output rises back up to potential while inflation also rises


FIGURE 16.4 Fiscal Policy Expansion and the Economy in the Short Run


Expenditure and Tax Multipliers

• The expenditure multiplier is the change in equilibrium output given a change in government purchases:

• The tax multiplier is the change in equilibrium output given a change in taxes,

• It is always less in absolute value than the expenditure multiplier because the initial change in spending occurs through consumption expenditure

/ 1 / (1 )Y G mpcD D = -

/Y TD D


Expenditure and Tax Multipliers (cont’d)

• Some economists argue that the expenditure multiplier may be smaller than

because:1. Real interest rates may rise when government

purchases rise, resulting in crowding out on investment, consumption spending, and net exports

2. If households and businesses anticipate that larger government deficits will lead to higher taxes in the future, then they will reduce their spending to pay for the anticipated tax increases


Policy and Practice: The 2009 Debate Over Tax-Based Versus Spending-Based Fiscal Stimulus

• When the Obama administration proposed a fiscal stimulus package to jump start the economy in 2009, there was a vigorous policy debate:– Republicans favored tax cuts on the grounds that they

would stimulate spending and reduce tax distortions– Democrats favored increases in government spending

because they would raise aggregate demand directly, and they would raise government investment in physical and human capital

– Christina Romer of the Council of Economic Advisors argued that the expenditure multiplier was 1.5, which was larger in absolute value than the tax multiplier

– Other economists came up with the opposite conclusion on the relative sizes of the expenditure and tax multipliers


Fiscal Multipliers at the Zero Lower Bound

• When the policy interest rate reaches the zero lower bound, a kinked AD curve occurs

• Two cases for the effects of expansionary fiscal policy on aggregate output depends:

1. Initially, the short-run AS curve intersects the AD curve where the policy rate is above zero

2. Initially, the short-run AS curve intersects the AD curve where the policy rate has hit the zero lower bound


FIGURE 16.5 Fiscal Expansion and the Zero Lower Bound


Fiscal Multipliers at the Zero Lower Bound (cont’d)

• Results: The fiscal multiplier is substantially larger when the policy rate has hit the zero lower bound than when it has not


Aggregate Supply and Fiscal Policy

• A cut in the payroll tax (e.g., Social Security tax) acts just like a temporary positive supply shock

• The tax cut lowers the wage cost of production, decreasing aggregate supply, so the short-run aggregate supply curve shifts downward and to the right

• The tax cut also increases disposable income and thus consumption expenditure, shifting the ADcurve rightward

• Suppose aggregate output is below its potential YP, then a payroll tax cut would raise aggregate output back to YP, while inflation may rise or fall


FIGURE 16.6 Effect of a Temporary Payroll Tax Cut


Supply-Side Economics and Fiscal Policy

• Supply-siders emphasize the positive effects of tax cuts on aggregate supply

• They believe permanent cuts in tax cuts not only raises aggregate demand but also have a permanent positive effect on aggregate supply because they induce more investment and greater work effort

• Rightward shifts in both AD and LRAS curves make the cuts in tax cuts highly expansionary


FIGURE 16.7 Supply-Side Tax Cuts


Balancing the Budget: Expansionary or Contractionary?

• Balancing the budget may have beneficial future effects that will influence the behavior of households and businesses today

• A sustained cut in the budget deficit, either from a decrease in government spending or higher taxes, implies that future taxes will be lower

• Because lower taxes will increase capital formation and decrease distortions in the economy, measures to balance the budget can act just like a permanent positive supply shock


Policy and Practice: Two Expansionary Fiscal Contractions: Denmark and Ireland

• In 1982, the government of Denmark began a program to lower its budget deficit by 15% of GDP over the next 4 years: Instead of an economic contraction, real GDP remained high as consumer spending and investment rose

• In 1987, the government of Ireland launched a program to bring down its deficit by 7% of GDP: The Irish economy began to boom

• Both episodes support that fiscal retrenchments can be expansionary because they lower future taxes and raise aggregate demand and long-run aggregate supply


Policy and Practice: The Debate Over Fiscal Austerity in Europe

• European countries experiencing the sovereign debt crises have been required to reduce their budget deficits as a condition for financial assistance

• Arguments for austerity are:

– Improved budget conditions lower interest rates and thus stimulate aggregate demand

– Investment spending increases due to less uncertainty– Lowered future taxes to finance current budget deficits

encourage household and business spending


Policy and Practice: The Debate Over Fiscal Austerity in Europe (cont’d)

• Arguments against austerity are:

– The effect of tight fiscal policy is subject to a high fiscal multiplier due to the policy rate’s zero lower bound

– The budget deficit may not decline when declines in economic activity reduce tax revenue

– Declines in economic activity will reduce nominal GDP, and thus a rising debt-to-GDP ratio


Budget Deficits and Inflation

• Expansionary fiscal policy that increases the budget deficit leads to higher inflation in the short run

• In the long run, inflation will not rise as long as monetary policy focuses on price stability and takes steps to keep inflation under control

• However, large budget deficits make it difficult for central banks to control inflation in the long run


Government-Issued Money

• Bonds to be issued to finance a budget deficit can be sold to either private investors or to the central bank:

Deficit = ΔB= ΔBinvestors + ΔBcentral bank


Government-Issued Money (cont’d)

• If the central bank pays for the bonds by printing money, or monetizing the debt:

ΔBcentral bank = ΔM

then: Deficit = ΔB = ΔBinvestors + ΔM

• Seignorage is the revenue the government receives from this issuance of currency.


Government-Issued Money (cont’d)

• The inflation rate p in the long run will move closely with the growth rate of the money supply:

p = ΔM/Mwhich means that large budget deficits financed by printing money lead to high inflation


Revenue from Seignorage

• Multiplying both sides of the both equation by M:

• Seignorage (in real terms) can be realized by dividing both sides by the price level, P:

which is the inflation rate p multiplied by the amount of money balances, M/P

• Seignorage is an inflation tax because the resulting higher inflation lowers the real value of money balances for their holders

M MD = p ´

/ ( / )M P M PD = p´


Interaction between Monetary Policy and Fiscal Policy

• Monetary policy => Fiscal policy

policy rate ↑=> cost of borrowing ↑ => budget deficit ↑ => government debt ↑

• Fiscal Policy => Monetary Policy

government debt ↑ => risk premium ↑=> interest rate for borrowing ↑


Government Debt andFinancing for Budget Deficit

• Domestic borrowing => interest rate=> crowding-out for private sector

• Printing money => inflation

• Some Unpleasant Monetarist Arithmetic

high government debt => borrowing (not printing money) =>

higher reel interest rate =>higher government debt

chapter 16 fiscal policy and the government budget · pdf filechapter 16 fiscal policy and the...

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