KRUGMAN'SMACROECONOMICS for AP*

30

Margaret Ray and David Anderson

ModuleLong-run Implicationsof Fiscal Policy: Deficitsand the Public Debt

What you will learnWhat you will learnin thisin this ModuleModule::

• Why governments calculate the cyclically adjusted budget balance

• Why a large public debt may be a cause for concern

• Why implicit liabilities of the government are also a cause for concern

• Deficits

• Surpluses

• Good? Bad?

The Budget BalanceThe Budget Balance

The Budget Balance as aThe Budget Balance as a Measure of Fiscal Policy Measure of Fiscal Policy

• Sgov = T - G - Transfers

• Expansionary policies reduce budget balance

• Contractionary policies increase budget balance

• G has a greater impact than T or Transfers

• Changes in budget balance are often result, not cause, of economic fluctuations

The Business Cycle and the Cyclically The Business Cycle and the Cyclically Adjusted Budget BalanceAdjusted Budget Balance

• Strong relationship between budget balance and business cycle

• Cyclically adjusted budget balance

The Business Cycle and the Cyclically The Business Cycle and the Cyclically Adjusted Budget Balance (Continued)Adjusted Budget Balance (Continued)

Should the Budget Be Balanced?Should the Budget Be Balanced?

• Political motivation for running deficits or balancing the budget (deficits cater to voters)

• Economists argue against balanced budget rule in favor of cyclically balanced budget (automatic stabilizers would be compromised)

• Limits on deficits as a compromise

Deficits, Surpluses, and DebtDeficits, Surpluses, and Debt

•When spending exceeds tax revenue, government borrows (crowding out threatens investment) (increasing payment to interest threatens future budgets)

•Fiscal years

•Public Debt

Problems Posed by RisingProblems Posed by Rising Government Debt Government Debt

•Government competes with private sector for investment funds

•Financial pressure on future budgets

•Possibility of Default

•Monetizing the Debt (issuing of T-bonds)

•Cyclical budget

Deficits and Debt in PracticeDeficits and Debt in Practice

•Debt-GDP Ratio

Implicit LiabilitiesImplicit Liabilities

•Implicit Liabilities (spending promises made by the gov, not included in debt statistics)

•Social Security

•Demographics (Baby boomers retiring—stop paying taxes and start collecting beneftis)

•Medicare

•Medicaid

ModuleMonetaryPolicy and the Interest Rate

•KRUGMAN'S•MACROECONOMICS for AP*

31

Margaret Ray and David Anderson

What you will learnWhat you will learnin thisin this ModuleModule::

• How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output

• Why monetary policy is the main tool for stabilizing the economy

Monetary Policy and the Interest Monetary Policy and the Interest Rate: Targeting the Fed Funds RateRate: Targeting the Fed Funds Rate

Expansionary Monetary PolicyExpansionary Monetary Policy

The Economy

The Money Market

1) Open Market purchas

e

2) Lowers the

interest rate

3) Which increases

demand for money for investment

Contractionary Monetary PolicyContractionary Monetary Policy

The Economy

The Money Market

1) Open Market salse

2) increases

the interest

rate

3) Which decreases

demand for money for investment

Monetary Policy in PracticeMonetary Policy in Practice• Fed policy and the output gap

• Taylor Rule (setting the Fed Funds Rate that takes into account both inflation rate and output gap)

• Fed Funds Rate = 1 + (1.5 x inflation rate) + (0.5 x output gap)

OR

• 1+(1.5 X π%)+(0.5 X Output Gap) Stanford Economist, John Taylor

Inflation TargetingInflation Targeting

• The Fed and Inflation (prefers inflation of about 2%)

• Inflation Targeting (used by “other” central banks—more accountability and transparency—everyone knows the goal and if the bank doesn’t succeed, it comes under scrutiny)

• Inflation Targeting v. Taylor Rule (Infl Targ more forward-looking than backward-looking as the Taylor Rule)

• Inflation Targeting v. Fed discretion