Transcript ch29

Economics: Theory Through Applications
29-1
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Chapter 29
Balancing the Budget
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Learning Objectives
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What is the difference between the deficit and the debt?
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What are the links between the deficit and the debt?
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What are the budget constraints faced by the government?
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How does fiscal policy affect the budget deficit?
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How does the state of the economy affect the budget deficit?
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How do we determine if a budget deficit is because of fiscal policy or the
state of the economy?
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Learning Objectives
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When do countries run government budget deficits?
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Why might a country incur a government budget deficit?
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What is the crowding out effect?
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When is crowding out effect of government deficits large?
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What is the Ricardian theory about the effects of deficits on interest rates
and real GDP?
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What is the evidence on the Ricardian theory?
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Budget Deficit: Definition
government deficit  outlays  revenues  government purchases
 transfers   tax revenues  government purchases 
 tax revenues
 transfers 
 government purchases  net taxes
government surplus   government deficit
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Table 29.1 - Calculating the Deficit
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Figure 29.1 - The Government Sector in the
Circular Flow
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Table 29.2 - Recent Experience of Deficits
and Surpluses (Billions of Dollars)
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Table 29.3 - On-Budget, Off-Budget, and
Total Surplus, 2010 (Billions of Dollars)
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Table 29.4 - Federal Outlays, 2010 (Billions of Dollars)
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The Intertemporal Government Budget
Constraint
current debt outstanding  discounted present value of future primary surpluses
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Linking the Debt and the Deficit
change in government debt  in given year   deficit  in given year 
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Table 29.5 - Deficit and Debt
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Figure 29.2 - US Surplus and Debt, 1962–
2010
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Figure 29.3 - US Surplus and Debt as a
Fraction of GDP, 1962–2010
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Table 29.6 - Foreign Holdings of U.S.
Treasury Securities as of August 2008
(Billions of Dollars)
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Who Holds the Debt?
borrowing from other countries  imports  exports  trade deficit
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Figure 29.4 - Government Spending
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Taxation
net taxes  tax rate  income
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Figure 29.5 - The Tax Function
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Table 29.7 - Tax Receipts and Income
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Table 29.8 - Deficit and Income
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Figure 29.6 - Government Spending and Tax
Receipts
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Figure 29.7 - Deficit/Surplus and GDP
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Figure 29.8 - Expansionary Fiscal Policy
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Figure 29.9 - The Cyclically Adjusted Budget
Deficit
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Figure 29.10 - Cyclical Deficit
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Figure 29.11 - Structural Deficit
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Figure 29.12 - Balanced-Budget Requirement
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Figure 29.13 – Recession with a Balanced-Budget
Amendment
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Figure 29.14 - Ratio of US Debt to GDP,
1791–2004
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Table 29.9 - Budget Deficits Around the
World, 2005*
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Figure 29.15 - The Financial Sector in the
Circular Flow
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The Credit Market
investment  national savings  borrowing from abroad
or
investment  national savings  lending to abroad
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Figure 29.16 - The Credit Market
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Figure 29.17 - Crowding Out
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Crowding Out
investment  national savings  borrowing from abroad
investment  national saving  trade deficit
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Table 29.10 - Investment, Savings, and Net
Exports (Billions of Dollars)
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The Household’s Lifetime Budget Constraint
discounted present value present value of lifetime consumption
 discounted present value of lifetime disposable income
total lifetime disposable income  total lifetime consumption
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Figure 29.18 - Ricardian Equivalence
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Figure 29.19 - U.S. Surplus/GDP Ratio and
Real Interest Rate, 1965–2009
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Figure 29.20 - U.S. Government and Private
Savings Rates
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Figure 29.21 - Government and Private
Savings Rates in Spain and Greece
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Figure 29.22 - Government and Private
Savings Rates in France and Ireland
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Key Terms
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Government deficit: The difference between government outlays and
revenues
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Government outlays: Government outlays equal government purchases of
goods and services plus transfers
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Government revenues: Money that flows into the government sector from
households and firms, largely through taxation, is called government
revenues
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Government purchases: Government purchases equals spending by the
government on goods and services
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Key Terms
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Transfers: Transfers are cash payments from the government to
individuals and firms
– Examples are unemployment insurance and Medicaid payments
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Government surplus: The government surplus is equal to total tax
revenues collected by the governments less its purchases of goods and
services and transfers to households
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Government budget constraint: The government budget constraint says
that the deficit must be financed by issuing government debt
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Government debt: The stock of government debt is the total outstanding
obligations of a government at a point in time
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Key Terms
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Intertemporal budget constraint: According to the government’s
intertemporal budget constraint, the discounted present value of outlays,
excluding interest on the debt, minus the discounted present value of
taxes must equal the current stock of debt outstanding
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Primary deficit: The primary deficit is the difference between
government outlays excluding interest payments and government
revenues
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Primary surplus: The primary surplus is the negative of the primary
deficit
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Key Terms
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Fiscal policy: Fiscal policy refers to changes in taxation and the level of
government purchases, typically under the control of a country’s
lawmakers
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Exogenous variable: An exogenous variable is determined outside the
model and is not explained in the analysis
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Expansionary fiscal policy: Increases in government purchases or
reductions in tax rates are called expansionary fiscal policy
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Contractionary fiscal policy: Decreases in government purchases or
increases in tax rates are called contractionary fiscal policy
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Key Terms
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Cyclically adjusted budget deficit: The cyclically adjusted budget deficit
is the difference between outlays and revenues calculated under the
assumption that the economy is operating at potential GDP
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Potential output: Potential output is the amount of real GDP the economy
produces when the labor market is in equilibrium and capital goods are
not lying idle
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Key Terms
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Cyclical deficit: A cyclical deficit occurs when a government budget is in
deficit because of the low level of real GDP
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Standardized deficit: A standardized deficit occurs when a government
budget is in deficit because of expansionary fiscal policy
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Tax smoothing: To reduce the distortionary effects of taxes, a government
will finance some current spending by issuing debt to spread the tax
burden over time
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Credit market: The credit market brings together suppliers of credit, such
as households who are saving, and demanders of credit, such as businesses
and households who need to borrow
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Key Terms
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Real interest rate: The rate of return specified in terms of goods not
money
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National savings: The sum of private and government saving
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Crowding out: Crowding out occurs when an increase in the government
deficit leads to an increase in the real interest rate and to a decrease in
spending through reductions in investment and exports
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Appreciation: An appreciation is an increase in the price of a currency
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Ricardian equivalence: Ricardian equivalence occurs when a decrease in
taxes leads to an equal increase in private saving and thus no change in
either the real interest rate or investment
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Key Takeaways
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The deficit is the difference between government outlays and government
revenues
– It is a flow
– The debt is a measure of the stock of outstanding obligations of the
government at a point in time
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The change in the debt between two dates is equal to the deficit incured
during the time between those two dates
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Key Takeaways
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The government faces a single-year constraint that its deficit must be
financed by issuing new debt
– The government also faces an intertemport budget constraint that it debt at a
point in time must equal the discounted present value of future primary
surpluses
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At a given level of GDP, an expansionary fiscal policy will increase the
budget deficit and a contractionary fiscal policy will decrease the budget
deficit
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As the level of economic activity increases, tax revenues will increase,
transfers will fall and the budget deficit will fall
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Key Takeaways
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By looking at the cyclically adjusted budget deficit, it is possible to
evaluate how much of the budget deficit is due to the state of the
economy and how much is due to the stance of fiscal policy
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Countries run government budget deficits when faced with large
expenditures, such as a war
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By running a deficit, a government is able to spread distortionary taxes
over time
– Also, a deficit allows a government to allocate tax obligations across
generations of citizens who all benefit from some form of government spending
– Finally, stabilization policy often requires the government to run a deficit
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Key Takeaways
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Crowding out occurs when government deficits lead to higher real interest
rates and lower investment
– The high interest rates can also cause the domestic currency to appreciate and
exports to fall
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The crowding out effect is large when spending by households on durables
and investment spending is sensitive to variations in the real interest rate
and when exports are sensitive to changes in the exchange rate
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Key Takeaways
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According to Ricardian theory, a government deficit will be offset by an
increase in household saving leaving real interest rates and the level of
economic activity unchanged
– The key to the theory is the anticipation of households of future taxes when
the government runs a deficit
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There is some evidence that interest rates are high when deficits are high,
contrary to the prediction of the Ricardian view
– But, during some periods of large deficits, the household saving rate is high as
well
– The evidence on Ricardian equivalence is not conclusive
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