Transcript Fiscal policy - McGraw Hill Higher Education - McGraw

Chapter 12
FISCAL POLICY AND THE NATIONAL DEBT
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Learning Objectives
After this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Analyze the recessionary and inflationary gaps.
Calculate and apply the multiplier.
List and discuss automatic stabilizers.
Assess discretionary fiscal policy.
Distinguish between budget deficits and surpluses.
Discuss fiscal policy lags.
Define and differentiate between the crowding-out and crowding-in
effects.
Assess the success of fiscal policy measures in ending the Great
Recession.
Discuss and analyze the national debt.
Explain why the recovery from the Great Recession will be “jobless.”
Explain predictions for federal budget deficits in the future.
12-2
Fiscal Policy
 Definition: the manipulation of the federal budget to
attain price stability, relatively full employment, and
a satisfactory rate of economic growth.
 Two sides to federal budget: Government spending
(outlays) and federal tax revenue.



Focus on level of Government spending (G), not how the funds
are allocated.
Focus on level of tax revenue (T), not using tax policy to
reward certain behavior (e.g., home ownership).
Both are responsibility of Congress and President.
12-3
Three Options for Fiscal Policy
 Balanced Budget: G = T
 Government expenditures equal tax revenue for the fiscal year.
 Budget Deficit: G > T
 Government spending is greater than tax revenue for the fiscal
year.
 Government borrows difference by issuing Treasury bonds.
 Budget Surplus: G < T
 Government spending is less than tax revenue for the fiscal
year.
 Before Keynes, economists argued government
should always balance its budget. There was NO
active fiscal policy.
12-4
Putting Fiscal Policy into Perspective
 John Maynard Keynes invented fiscal policy.
 Problem in Depression was inadequate Aggregate
Demand for output (real GDP).
 Equilibrium stuck below full-employment level:




C stays low because consumers are unemployed or cutting back.
I stays low because businesses have low profit expectations and no
incentive to expand inventories or production.
The only component of AD that the government can control is G.
Increase G to increase AD.
Or, by cutting taxes (T), government can hope consumers and
businesses will spend additional income.
 Running a budget deficit could jump-start the economy.
12-5
Modeling Fiscal Policy Using Aggregate
Expenditures
 Equilibrium GDP tells us the level of production and
spending in the economy.

Aggregate Demand equals Aggregate Supply.
 Full-employment GDP tells us the level of spending
necessary to reach full employment.


If plant and equipment is operating at between 85 and 90% of
capacity, that’s considered full employment.
If approximately 5% of labor force is unemployed, that’s
considered full employment.
 Fiscal policy is used to push equilibrium GDP
toward full-employment GDP.
12-6
Recessionary Gaps and Inflationary Gaps
 Recessionary Gap occurs when equilibrium GDP is
less than full-employment GDP.


Inadequate Aggregate Demand (C + I + G + Xn)
Fiscal Policy solution is to run a budget deficit (raise G or lower T).
 Inflationary Gap occurs when equilibrium GDP is
greater than full-employment GDP.



Excess Aggregate Demand sparking inflation
“Too many dollars chasing too few goods.”
Fiscal Policy solution is to create a budget surplus (decrease G or
raise T).
 Budget deficits are only appropriate during recessions.
12-7
Questions for Thought and Discussion
 Which do you think is easier politically for members
of Congress and the President to do—raise taxes or
lower taxes?
 Which do you think is easier politically for members
of Congress and the President to do—increase
government spending or cut government programs?
 Given your answers, which is easier politically to
do—use fiscal policy to fight recessions or inflation?
12-8
Graphing a Recessionary Gap
When the full-employment
GDP is greater than the
equilibrium GDP, there is a
Recessionary gap. How much is
it?
$7 trillion – $6 trillion = $1 trillion
Note that the Recessionary
gap is less than the gap in
output on the horizontal axis.
12-9
Graphing an Inflationary Gap
When the full-employment
GDP is less than the
equilibrium GDP, there is an
inflationary gap. How much
is it?
$1,200-$1,000=$200 trillion
Note that the inflationary
gap is less than the excess
output on the horizontal axis.
12-10
Summary of Graphs
 Recessionary Gap:
 Difference between full-employment GDP and equilibrium
GDP is $2 trillion.
 Recessionary gap (inadequate spending) is $1 trillion.
 Inflationary Gap:
 Difference between full-employment GDP and equilibrium
GDP is $500 trillion.
 Inflationary gap (excess spending) is $200 trillion.
 Why is gap in spending less than gap in output?
 Multiplier effects
12-11
The Multiplier and Its Applications
 Any change in spending (C, I, or G) will set off a
chain reaction, leading to a multiplied change in
GDP.
C + I + G + Xn
GDP
Size of multiplied change depends on MPC and MPS.
12-12
Calculating the Multiplier
Remember: MPC + MPS = 1, therefore, MPS = 1 – MPC
Multiplier =
Multiplier =
1
1 – MPC
1
MPS
12-13
Calculating the Multiplier
Find the multiplier when MPC is 0.5
Multiplier =
1
1 - MPC
=
1
1 – .5
=
1
.5
12-14
How Does the Multiplier Work?
 Suppose the government pays you $1,000 to write a report as an
economic consultant. The MPC in this economy is 0.5 (or 50%).






You will spend $500 and save $500. Suppose you spend the $500 on a
laptop.
The seller of the laptop now has $500 in new income. The laptop seller
spends $250 and saves $250. Suppose she spends the $250 on used text
books.
The used bookseller now has $250 in new income, so he spends $125 on
concert tickets and saves $125.
The concert promoter now has $125 in new income, so she spends $62.50
on a watch and saves $62.50.
The watch seller now has $62.50 in new income, so he spends $31.25
buying gas and saves $31.25.
And so on…
12-15
Multiplier and MPC
 If you add up all the rounds of spending ($1,000 +
$500 + $250, etc.), you would get $2,000.
 Using the formula is quicker.
 Question: As the MPC increases, what happens to
the multiplier?
 Answer: It gets bigger!



Denominator is 1 – MPC.
If MPC increases, (1 – MPC) gets smaller.
Smaller denominator increases the number. (Hint: Compare
½ with 1/3.)
12-16
Applications of the Multiplier
 The multiplier is used to calculate the impact of a
change in C, I, or G on GDP.
 Formula:
GDPNew = GDPInitial + (Change in spending X Multiplier)
Example: GDP = 2,500; C rises by 10; Multiplier = 3
What is the new level of GDP?
GDPNew = 2500 + (10 x 3)
GDPNew = 2500 + (30)
GDPNew = 2530
Amount of increase in GDP
12-17
Applications of the Multiplier
 Formula:
Change in GDP = (Change in spending X Multiplier)
Example: Multiplier = 7; G falls by $5 billion
How much will GDP decrease?
Change in GDP =  5 x 7
Change in GDP =  $35 billion
12-18
Removing the Recessionary Gap
To remove the Recessionary
gap, raise AD from
C+I+G+Xn
to
C1+I1+G1+Xn1
This pushes equilibrium GDP
to $7 trillion (fullemployment GDP.)
12-19
Removing the Inflationary Gap
To remove the
inflationary gap, lower
AD from
C+I+G+Xn
to
C1+I1+G1+Xn1
This pushes equilibrium
GDP down to 1,000 and
removes the inflationary
gap.
12-20
Automatic Stabilizers:
(passively moderate business cycles)
 Personal Income and Payroll Taxes


During recessions, tax receipts decline.
During inflations, tax receipts rise.
 Personal Savings


During recessions, unemployed tend to use up their savings, so we
assume that savings declines. But sometimes savings increases because
consumer confidence decreases, so those with jobs try to save more.
During prosperity, we would expect that savings rises. But again,
reality does not always follow the theory.
 Credit Availability


Credit availability often helps get us through recessions, enabling
consumers to keep spending.
The Great Recession is different because one of its causes was a credit
crunch.
12-21
Automatic Stabilizers
 Unemployment Compensation

During recessions more people collect unemployment benefits, putting a floor under
purchasing power.

But only 40% of those out of work can quality for benefits in the U.S., compared with 90%
in Germany and 98% in France.

The usual cap on US benefits is 26 weeks, much longer than in Europe. During
recessions, Congress may extend the cap.
 The Corporate Profits Tax

During economic boom, profits rise quickly but corporate income taxes reduce the
inflationary impact.
 Other Transfer Payments

Welfare (or public assistance) payments, Medicaid payments, and food stamps rise during
recessions.
12-22
Automatic Stabilizers reduce, but do not
eliminate economic fluctuations.
12-23
Discretionary Fiscal Policy:
(under direction of Congress and President)
 Making Automatic Stabilizers More Effective
 Example: Extending unemployment benefits beyond 6
months.
 Due to the Great Recession and the “jobless” recovery,
unemployment benefits were extended for as long as 79 weeks.
 Corporate income taxes can be raised during periods of
inflation and lowered when recessions occur.
 Public Works
 New Deal programs built bridges, post offices, park trails, etc.
12-24
Discretionary Fiscal Policy
 Changes in Tax Rates
 To fight inflation, the government can raise taxes.
•

This may generate a budget surplus, or at least reduce the deficit.
To fight recession, the government can cut taxes.
•
This may increase the budget deficit.
 Changes in Government Spending
 To fight recession, increase government spending.
•

This may increase the budget deficit.
To fight inflation, decrease government spending.
•
This may generate a budget surplus.
12-25
U.S. Economic Growth Rate, 1871-2012
The U.S. economy has been more stable for most of the postwar period.
12-26
Questions for Thought and Discussion
 Are public works projects a bad idea?
 Cons:
 Public works projects are often labeled “pork barrel spending.”
 Members of Congress negotiate to bring spending projects to
their local communities, even if it is wasteful. Some projects
make headlines, like “Bridge to Nowhere in Alaska.”
 Pros:
 Our roads, bridges, and other public infrastructure are
crumbling. We need new public investment.
 “Green-collar jobs” is the idea that government should create
jobs that improve the environment.
12-27
Questions for Thought or Discussion
 Is extending unemployment benefits a good idea?
 Cons:

Unemployment benefits may be a disincentive to looking for a job.
 Pros:



Extending benefits strengthens automatic stabilizers to maintain
Aggregate Demand.
People who are unemployed during a recession and jobless recovery
may not be able to find jobs through no fault of their own.
Monetary incentives are only one reason to work. Many unemployed
would rather have a job than benefits anyway, because jobs provide
intrinsic rewards (like dignity, self-respect, identity, and purpose).
12-28
Who Makes Fiscal Policy?
 President submits budget to Congress.
 Congress amends budget and passes individual
appropriation bills.

Both House and Senate have to reconcile differences between
their versions.
 President can accept or veto.
 If vetoed, Congress can try to override.
12-29
Fiscal Policy Lags
 Fiscal Policy takes time due to three types of lags (or
delays):

Recognition lag: Policy makers must identify that there is a problem.
(Recessions only declared after 6 months, at minimum.)

Decision lag: President and Congress must agree on policy approach
and pass legislation.

Impact lag: It takes time for their actions to have effect.
 Changing Aggregate Demand through fiscal policy is
more like navigating a super-tanker than driving a car.
12-30
Policy Lags and The Great Recession
 President Bush used fiscal policy to stimulate the
economy in response to The Great Recession:

Recognition lag: Although there were strong signs of an economic
slowdown during Fall 2007, the Bush administration and many
members of Congress did not use the word “recession” until the
unemployment rate rose to 5.0% in January 2008.

Decision lag: The Bush administration and Congress took just a few
weeks to agree to a $168 billion economic stimulus package that
focused on taxpayer rebates (tax cuts).

Impact lag: The IRS did not mail out the rebates until May 2008.
And many people used the rebates to pay down debt rather than
increasing spending. But it was too small to have much of an impact.
12-31
The Economic Stimulus Package of 2009
 President Obama passed a $787 billion stimulus package.
 It included $287 billion in tax cuts and $500 in government spending.
• $233 billion in tax cuts for individuals and families
• $106 billion for education and job training, including aid to states to
prevent cutbacks and layoffs
• $87 billion to states for increased Medicaid costs
• $78 billion for programs for jobless workers
• $48 billion for highway and bridge construction and mass transit
• $44 billion for energy programs, modernization of electric grid
• $41 billion for other infrastructure and environment projects
• $29 billion for health, science, and research
• $21 billion for energy investments
• $20 billion to expand food stamp benefits
 By end of 2009, only 1/3 of funds had entered the economy.
12-32
Questions for Thought or Discussion
 Was the 2009 Stimulus Package effective?

Great Recession ended during the summer.
•


But the unemployment rate was still high.
It may have averted layoffs, especially by state and local
governments.
Additional funds spent in 2010 and 2011 support more job creation.
 Was the deficit too big?


FY 2008 budget deficit was $459 billion.
FY 2009 budget deficit was $1.4 trillion.
•
•
But it was only 9.8 percent of GDP.
In 1944, the budget deficit was 24.5 percent of GDP.
 How was the Chinese stimulus plan different?
12-33
The Deficit Dilemma
Discussion Question: How did the government get rid of deficits in the 1990s?
What led to the return of deficits after 2000? In 2009?
12-34
Why Are Large Deficits Bad?
 Government borrowing pushes up interest rates.
 Deficit is increasingly financed by foreign savers,
giving U.S. less control over financial markets.
 Money used to invest in government bonds is not
being used to finance private sector investment.
 Conclusion: We don’t need to balance the federal
budget every year, but deficit spending has limits.
12-35
Monetarists vs. Keynesians
• Monetarists emphasize
• Keynesians emphasize
• Any expansionary impact of
• Stimulus of increased
“crowding out”
budget deficits will be offset by
higher interest rates and
crowding out private sector
borrowing.
• Go back to “Laissez-Faire”
policy of Classical economics.
“crowding in”
government spending or tax
cuts will encourage
consumption and investment.
• Government “primes the
pump” to get the private sector
growing again.
12-36
The Public Debt
 Difference between Deficits and Debt
 Deficits occurs when federal government spending is greater
than tax revenue in a single fiscal year.
 Debt is the cumulative total of all the federal budget deficits
less any surpluses.
 Example:
 Suppose that our deficit declined one year from $200 billion to
$150 billion.
•
•
The national debt would still go up by $150 billion.
Every year that we have a deficit—even a declining one—the
national debt will go up.
12-37
Percentage of National Debt Publically Held and Held by
U.S. Government Agencies, 2013
12-38
The National Debt: 1980—2013
Debt on January 1 of each year.
Portion held by US
government agencies
Budget surpluses in
1990s led to decreases in
public portion of debt.
Portion held by public
Source: Economic Report of the President, 2013.
12-39
The U.S. National Debt as Percentage of GDP,
1980—2013
Since 1980, our debt has doubled as a percentage of GDP.
12-40
When do we have to pay off the Public Debt?
 We don’t. All we have to do is roll it over, or refinance it,
as it falls due.


Each year about $4 trillion dollars worth of federal securities fall
due.
By selling new ones, the Treasury keeps us going.
 But even if we never pay back one penny of the debt, our
children and our grandchildren will have to pay
hundreds of billions of dollars in interest.


At least to that degree, the public debt will be a burden to future
generations.
But it will also be income to Americans, since we owe much of it to
ourselves.
12-41
Questions for Thought and Discussion
 Baby Boomer retirements will increase outlays for
Social Security and Medicare. (Both programs now
run surpluses each year.)
 What are the options to avoid massive budget
deficits when Boomers retire?




Raise payroll taxes or eliminate the earnings cap on social
security taxes to increase revenue (T).
Raise retirement age or cut benefits to reduce spending (G).
Combine both approaches.
Which would you recommend?
12-42