Fiscal Policy, Deficits, and Debt
Chapter 30
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
30-2
Chapter Objectives
• Purposes, tools, and limitations of fiscal policy
• Built-in stabilizers and the business cycle
• The standardized budget and U.S. fiscal policy
• U.S. public debt
30-3
Fiscal Policy
• Council of Economic Advisers (CEA)
• Discretionary fiscal policy–Eliminate recessionary or
inflationary gap–Countercyclical
• Nondiscretionary fiscal policy–Passive or automatic
30-4
• Expansionary fiscal policy–Increased spending and/or lower
taxes–Budget deficit
• Contractionary fiscal policy–Lower spending and/or higher
taxes–Budget surplus
• Policy options?
Fiscal Policy
30-5
Expansionary Fiscal Policy
Real Domestic Output, GDP
Pri
ce L
evel
AD2
RecessionsDecreaseAggregateDemand
AD1
$5 Billion AdditionalSpending
Full $20 Billion Increase in
Aggregate Demand
AS
$490 $510
P1
30-6
Contractionary Fiscal Policy
Real Domestic Output, GDP
Pri
ce L
evel
AD3
Reduce Demand Pull
Inflation
AD4
$5 Billion Initial Decrease
In Spending
Full $20 Billion Decrease in
Aggregate Demand
AS
$510 $522
P1
30-7
Built-In Stability
• Automatic stabilizers–Taxes and transfers
• Economic importance
• Tax progressivity–Progressive tax system
–Proportional tax system
–Regressive tax system
30-8
Built-In Stability
G
T
Deficit
Surplus
GDP1 GDP2 GDP3
Real Domestic Output, GDP
Go
vern
men
t E
xpen
ses,
Gan
d T
ax R
even
ues
, T
30-9
Evaluating Fiscal Policy
• Standardized budget –Full-employment budget
• Cyclical deficit
• Recent U.S. fiscal policy
• Budget deficits and projections
• Social security considerations
30-10
Evaluating Fiscal Policy
G
T
GDP2 GDP1
Real Domestic Output, GDP
Go
vern
men
t E
xpen
ses,
Gan
d T
ax R
even
ues
, T
(Year 2) (Year 1)
$500
$450
ab
c
Cyclical deficitFiscal policy neutral
30-11
Evaluating Fiscal Policy
G
T1
GDP4 GDP3
Real Domestic Output, GDP
Go
vern
men
t E
xpen
ses,
Gan
d T
ax R
even
ues
, T
(Year 4) (Year 3)
$500
$450
de
f
$475
$425 g
T2
h
Standardized deficitExpansionary fiscal policy
30-12
(1)Year
(2)Actual
Deficit (-) orSurplus (+)
(3)StandardizedDeficit (-) orSurplus (+)
Budget Balances as % of GDP
1992199319941995199619971998199920002001200220032004200520062007
-4.5%-3.8%-2.9%-2.2%-1.4%-0.3%+0.8%+1.4%+2.5%+1.3%-1.5%-3.4%-3.5%-2.6%-1.9%-1.3%
-2.9%-2.9%-2.1%-2.0%-1.2%-1.0%-0.4%+0.1%+1.1%+1.0%-1.2%-2.5%-2.4%-1.9%-1.8%-1.4%
Source: Congressional Budget Office
30-13
Standardized Budget Balance
Percentage of Potential GDP, 2007
Source: Organization for Economic Cooperation and Development
Denmark
New Zealand
Ireland
Canada
Norway
France
United States
United Kingdom
Japan
-6 -4 -2 0 2 4 6Deficits Surpluses
30-14
Federal Budget BalanceActual and Projected, Fiscal 1994-2014
Source: Congressional Budget Office
$300
200
100
0
-100
-200
-300
-400
-500
Bu
dg
et D
efic
it (
-) o
r S
urp
lus,
Bill
ion
s
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Actual Projected (as of March 2008)
30-15
• Problems of timing–Recognition lag–Administrative lag–Operational lag
• Political considerations• Future policy reversals• Offsetting state and local finance• Crowding-out effect• Current thinking on fiscal policy
Problems, Criticisms, and ComplicationsFiscal Policy Issues
30-16
The Public Debt
• National or public debt $9.01 trillion
• Ownership–U.S. securities–53% owned by federal government
and Federal Reserve–47% held outside the federal
government and Federal Reserve
30-17
Debt Held by theFederal Government
and FederalReserve (53%)
Debt Held OutsideThe FederalGovernmentand Federal
Reserve (47%)
FederalReserve
U.S.Government
AgenciesU.S.Individuals
ForeignOwnership
U.S. BanksAnd otherFinancial
Institutions
Other, IncludingState and LocalGovernments
Source: U.S. Treasury
9%
7%
25%
8% 7%
44%
The Public Debt
Total Debt: $9.01 trillion
30-18
Debt and GDP
Federal debt held by the public, percentage of GDP
Source: Economic Report of the President, 2006
Per
cen
t o
f G
DP
Year
50
45
40
35
30
25
20
15
10
5
01970 1975 1980 1985 1990 1995 2000 2005
30-19
Debt and GDPPublicly Held Debt: International Comparisons
As a Percentage of GDP, 2007
ItalyJapan
BelgiumHungaryGermany
United StatesUnited Kingdom
FranceNetherlands
CanadaSpain
Poland
0 20 40 60 80 100
Source: Organization for Economic Cooperation and Development
30-20
Debt and GDP
• Interest charges–Primary burden–1.7% of GDP 2007
• False concerns–Bankruptcy–Refinancing–Taxation–Burdening future generations
30-21
Debt and GDP
• Substantive issues–Income distribution–Incentives–Foreign-owned public debt
• Crowding-out effect revisited–Burden on future generations–Public investment as an offset–Graphically
30-22
Crowding Out
5 10 15 20 25 30 35 400
2
4
6
8
10
12
14
16
Rea
l In
tere
st R
ate
(P
erce
nt)
Investment (Billions of Dollars)
ID1
ID2
a
b c
Interest RateRise WillDecrease
Investmenta to b
Crowding-Out Effect
A Large Public Debt to Finance Public Investment Will Cause…
If Public SpendingSpurs More Private
Investment WillIncrease to ID2
30-23
The Leading Indicators
1. Average workweek2. Initial claims for unemployment
insurance3. New orders for consumer goods4. Vendor performance5. New orders for capital goods6. Building permits for houses7. Stock prices8. Money supply9. Interest-rate spread10.Consumer expectations
Source: The Conference Board
30-24
Key Terms
• fiscal policy• Council of Economic
Advisers (CEA)• expansionary fiscal
policy• budget deficit• contractionary fiscal
policy• budget surplus• built-in stabilizer• progressive tax system• proportional tax system
• regressive tax system• standardized budget• cyclical deficit• political business
cycle• crowding-out effect• public debt• U.S. securities• external public debt• public investments
30-25
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