Chapter 12: Fiscal Policy and the National Debt

Chapter Objectives The deflationary gap The inflationary gap The multiplier and its applications Automatic stabilizers Discretionary fiscal policy Budget deficits and surpluses The public debt

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Chapter 12Fiscal Policy and the National Debt12-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesThe deflationary gapThe inflationary gapThe multiplier and its applicationsAutomatic stabilizersDiscretionary fiscal policyBudget deficits and surplusesThe public debt12-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Fiscal PolicyFiscal policy is the manipulation of the federal budget to attain price stability, relatively full employment, and a satisfactory rate of economic growthTo attain these goals, the government must manipulate its spending and taxes12-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.There was no such thing as fiscal policy until John Maynard Keynes invented it in the 1930sHe maintained thatThe only way out of the Depression was to boost aggregate demand by increasing government spendingIf we ran a big enough budget deficit, we could jump-start the economy and, in effect, spend our way out of the depressionPutting Fiscal Policy into Perspective12-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.It’s important that the aggregate supply of goods and services equals the aggregate demand for goods and services at just the level of spending that will bring about full employment at stable pricesPutting Fiscal Policy into Perspective 12-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Equilibrium GDP tells us the level of spending in the economyFull-employment GDP tells us the level of spending necessary to get the unemployment rate down to 5% (which we have been calling full-employment)Fiscal policy is used to push equilibrium GDP toward full-employment GDP Putting Fiscal Policy into Perspective 12-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Deflationary Gap and the Inflationary GapEquilibrium GDP is the level of output at which aggregate demand equals aggregate supplyAggregate demand is the sum of all expenditures for goods and services (that is, C + I + G + Xn) Aggregate supply is the nation’s total output of final goods and servicesSo at equilibrium GDP, everything produced is sold12-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Full-employment GDP is the level of spending necessary to provide full employment of our resourcesIf our plant and equipment is operating at between 85 and 90% of capacity, that’s full employmentIf only 5% of our labor force is unemployed, that’s full employment The Deflationary Gap and the Inflationary Gap 12-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Deflationary Gap & the Inflationary Gap 12-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Equilibrium GDPThe Deflationary GapWhen the full-employment GDP is greater than the equilibrium GDP, there is a deflationary gap. How much is it?$1 trillionThe Deflationary Gap & the Inflationary Gap12-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Inflationary GapEquilibrium GDPWhen equilibrium GDP is greater than full-employment GDP, there is an inflationary gap. How large is it?$200 trillionSummaryEquilibrium GDP is above the full-employment GDPSpending is too highResults in an inflationary gapToo eliminate the inflationary gap, we cut G and/or raise taxes 12-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Summary Equilibrium GDP is less than full-employment GDPSpending is too lowResults in a deflationary gapToo eliminate the deflationary gap, we raise G and/or cut taxes 12-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Multiplier and Its Applications12-13Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP GDP = C + I + G + XnHow much the multiplied change is depends on the MPC and MPSCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Calculating the MultiplierRememberMPC + MPS = 1, therefore, MPS = 1 - MPCMultiplier = -----------------------11 - MPCMultiplier = ----------------------1MPS12-14Because the multiplier (like C) deals with spending, 1/(1-MPC) is a more appropriate formula)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Calculating the Multiplier The MPC is .5. Find the multiplier12-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Calculating the Multiplier (Continued)The MPC is .5. Find the multiplierMultiplier = ---------------- = -------- = ----- = 211 - MPC12-1611 – .51 .5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Calculating the Multiplier 12-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Step-by-Step Working of the Multiplier When MPC is .5$1,000.00 $ 500.00 $ 250.00 $ 125.00 $ 62.50 $ 31.25 $ 15.625 $ 7.813 $ 3.906 $ etc. $ etc. $2,000.00It is surely much easier to use the multiplier of 2 (2 X $1,000 = $2000) than to go through this process and add up all the figures 12-18Calculating the Multiplier (Continued)The MPC is .75. Find the multiplierCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.12-19Calculating the Multiplier (Continued)The MPC is .75. Find the multiplierMultiplier = ---------------- = -------- = ----- = 41111 - MPC1 – .75 .25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Applications of the MultiplierThe Multiplier is used to calculate the effect of changes in C, I, or G on GDPGDP = 2,500; Multiplier = 3; C rises by 10What is the new level of GDP?12-20GDPNew = GDPInitial + (Change in spending X Multiplier)GDPNew = 2500 + ( 10 x 3)GDPNew = 2500 + ( 30)GDPNew = 2530Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDPGDP = X; Multiplier = 3; C rises by 10What happens to GDP?12-21GDPNew = GDPInitial + (Change in spending X Multiplier)GDPNew = X + ( 10 x 3)GDPNew = X + ( 30)GDP increases by 30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDPGDP = X; Multiplier = 7; G falls by 5What happens to GDP?12-22GDPNew = GDPInitial + (Change in spending X Multiplier)GDPNew = X + ( -5 x 7)GDPNew = X + ( -35)GDP decreases by 35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Applications of the Multiplier How big is the multiplier (M)?12-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.M = distance between the equilibrium GDP and the full-employment GDP / by the gapM = 2 / 2 = 1Applications of the Multiplier How big is the multiplier (M)?12-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.M = distance between the equilibrium GDP and the full-employment GDP / by the gapM = 500 / 200 = 2.5Removing the Deflationary Gap12-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.To remove the deflationary gap we raise aggregate demand from C+I+G+Xn to C1+I1+G1+Xn1This pushes equilibrium GDP to $7 trillion and removes the deflationary gapRemoving the Inflationary Gap12-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.To remove the inflationary gap we lower aggregate demand from C+I+G+Xn to C1+I1+G1+Xn1This pushes equilibrium GDP down to 1,000 and removes the inflationary gapThe Automatic StabilizersThe automatic stabilizers protect us from the extremes of the business cyclePersonal Income and Payroll TaxesDuring recessions, tax receipts declineDuring inflations, tax receipts risePersonal SavingsDuring recessions, saving declinesDuring prosperity, saving rises12-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Automatic Stabilizers The automatic stabilizers protect us from the extremes of the business cycleCredit AvailabilityCredit availability helps get us through recessionsUnemployment CompensationDuring recessions more people collect unemployment benefits12-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Automatic Stabilizers The automatic stabilizers protect us from the extremes of the business cycleThe Corporate Profits TaxDuring recessions, corporations pay much less corporate income taxesOther Transfer PaymentsWelfare (or public assistance) payments, Medicaid payments, and food stamps rise during recessions12-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Discretionary Fiscal PolicyMaking the Automatic Stabilizers More EffectivePublic Works The main fiscal policy to end the Depression was public worksTransfer PaymentsThe government could extend the benefit period for unemployment compensation and increase welfare payments, Social Security, and veteran’s pensions12-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Discretionary Fiscal Policy Making the Automatic Stabilizers More EffectiveChanges in Tax RatesTo fight inflation, the government can raise taxesTo fight recession, the government can cut taxesCorporate incomes taxes can be raised during periods of inflation and lowered when recessions occurUsing tax rate changes as a counter cyclical policy tool provides a quick fix, however, temporary tax cuts carried out during recessions should not become permanent 12-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Discretionary Fiscal Policy Making the Automatic Stabilizers More EffectiveChanges in Government SpendingThe government increases spending and cuts taxes to fight recessionsThe government decreases spending and raises taxes to fight inflationIn brief, we fight recessions with budget deficits and inflation with budget surpluses12-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Who Makes Fiscal Policy?The President and Congress make fiscal policyThis is complicated and can be time consuming, especially when one political party controls Congress while the president belongs to the other partyNo one seems to be in charge of making fiscal policy12-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Who Makes Fiscal Policy? The huge budget deficits we’ve been running since the early 1980s have sharply limited the government’s ability to use discretionary fiscal policy to create jobs and to stimulate the economyBetween legally mandated spending programs and legally mandated entitlement programs such as Social Security, Medicare, and Medicaid, there is little discretionary income to play withThe Treasury could borrow even more money but only if Congress and the president were willing to allow the budget deficit to grow12-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Deficit DilemmaDeficits, Surpluses, and the Balanced BudgetWhen government spending is greater than tax revenue, we have a federal budget deficitThe government borrows to make up the differenceDeficits are prescribed to fight recession12-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Deficit Dilemma Deficits, Surpluses, and the Balanced BudgetWhen the budget is in a surplus position, tax revenue is greater than government spendingBudget surpluses are prescribed to fight inflation12-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Deficit Dilemma Deficits, Surpluses, and the Balanced BudgetWe have a balanced budget when government expenditures are equal to tax revenueWe’ve never had an exactly balanced budgetWe’re dealing with a budget of nearly $4 trillion in taxes and spendingSo, if tax revenue and expenditures were within $10 billion of each other, perhaps that would be close enough to call the budget balanced12-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Deficit Dilemma 12-38Deficits and Surpluses: The RecordCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Federal Budget Deficit, Fiscal Years 1970-2001Why Are Large Deficits So Bad?Large deficits raise interest rates, which, in turn, discourages investmentOur real interest rate (the nominal interest rate less the rate of inflation) during the latter half of the 1980s and all of the 1990s was three times a high as the real interest rate in Japan’ and it was much higher than those in most Western European countries as well 12-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Why Are Large Deficits So Bad? The federal government has become increasingly dependent on foreign savers to finance the deficitIn the early – and mid – 1990s foreigners financed more than half the deficit12-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Why Are Large Deficits So Bad? Until the mid-1990s the deficit sopped up more than half the personal savings in this country, making that much less savings available to large corporate borrowers seeking funds for new plant and equipment12-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Why Are Large Deficits So Bad? On the positive side, budget deficits stimulate the economyThe only problem is that we should not have needed this stimulus during the “prosperous” mid-to late 1980s when we were running huge deficitsWe would do well to remember that John Maynard Keynes would have advocated running surpluses and paying off the debt during periods of prosperity 12-42Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Will We Be Able to Balance Future Budgets?The federal government finally managed to run a budget surplus in 1998This was the first time since 1969The congressional Budget Office forecasts a string of surpluses well into the new millenniumCongressional Republicans and Democrats have already proposed dueling plans to dispose of those surpluses with various combinations of tax cuts and spending increasesNo elected official proposed slowing down the projected increases in Social Security spending12-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Will We Be Able to Balance Future Budgets?A recession, a decline in stock prices, a tax cut, or an increase in government spending programs can easily eliminate any surpluses and replace them with deficitsAfter the year 2015, as the baby boom generation attains senior citizenship, the Social Security Trust Fund will be quickly depletedUnless the government has already raised Social Security taxes or cut benefits, the federal budget surplus will quickly become a large and growing deficit12-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Proposed Balanced Budget Amendment and the Line Item VetoMust we balance the budget each year?The government really tried to balance the budget each year into the early 1930sThe economic wisdom today tells us that we should have deficits in lean years and surpluses in fat yearsFrom 1961 through 1997 the government managed only one surplusThe national debt rose every year as we ran budget deficits in fat years12-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Proposed Balanced Budget Amendment and the Line Item Veto The first step in passing a Constitutional amendment to balance the budget is a two-thirds vote in both houses of CongressDespite some very close votes in 1994, 1995, 1996, and 1997, the balanced budget amendment failed in one or the other houses of CongressMost economists oppose such an amendment because it would put us in an economic straitjacket12-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Proposed Balanced Budget Amendment and the Line Item Veto In still another effort to lower the deficit, Congress passed a law in 1996 to permit the president to veto parts of tax and spending bills, he or she opposes, without vetoing the entire legislationThis line item veto can be eventually overridden by a two-thirds vote in each house of CongressIn February, 1998, a federal judge ruled the line item veto unconstitutional12-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Public DebtDifferentiating between the Deficit and the DebtThe deficit occurs when federal government spending is greater than tax revenueThe debt is the cumulative total of all the federal budget deficits less any surplusesSuppose that our deficit declined one year from $200 billion to $150 billionThe national debt would still go up by $150 billionSo every year that we have a deficit – even a declining one – the national debt will go up12-48Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Public Debt12-49Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.National Debt, 1975-2000Economic Report of the President, 2000The Public Debt Who holds the national debt?Private American citizens hold a little less than halfForeigners hold almost one-thirdThe rest is held by banks, other business firms, and U.S. government agenciesIs the national debt a burden that will have to borne by future generations?As long as we owe it to ourselves, the answer is noIf we did owe it mainly to foreigners, and if they wanted it paid off, it could be a great burden12-50Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Public Debt When do we have to pay off the debt?We don’t. All we have to do is roll it over, or refinance it, as it falls dueEach year several hundred billion dollars worth of federal securities fall dueBy selling new ones, the Treasury keeps us goingIn the future, 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 interestAt least to that degree, the public debt will be a burden to future generations12-51Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Public Debt Why not go ahead and just pay off the debt?Economists predict that following this course would have catastrophic consequencesIf we tried to pay off the debt too quickly, it might even send us into a deep depressionIf we keep running large surpluses and pay down the national debt, this will cause a problem for both the Social Security Trust Fund and the Federal ReserveAs the national debt goes down, eventually there would be no securities for them to buyStill, it is a whole lot better to have problems like these than those caused by running huge budget deficits every year 12-52Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.