Chapter 13: Fiscal Policy, Deficits, and Debt (2)

Chapter 13Fiscal Policy, Deficits, and DebtMcGraw-Hill/IrwinCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reservedFiscal PolicyDeliberate changes inGovernment spendingTaxesDesigned toAchieve full employmentControl inflationEncourage economic growth13-*Expansionary Fiscal PolicyUse during a recessionIncrease government spendingDecrease taxesCombination of bothCreate a deficit13-*Expansionary Fiscal PolicyReal GDP (billions)Price levelAD2AD1$5 billion increase inspending Full $20 billion increase inaggregate demandAS$490$510P1Recessionsdecrease AD13-*Contractionary Fiscal PolicyUse during demand-pull inflationDecrease government spendingIncrease taxesCombination of bothCreate a surplusLO113-*Contractionary Fiscal PolicyReal GDP (billions)Price levelAD3AD4$3 billion initialdecrease inspending Full $12 billion decrease inaggregate demandAS$502$522P2AD5$510dbaP1c13-*Built-in StabilityAutomatic stabilizersTaxes vary directly with GDPTransfers vary inversely with GDPReduces severity of business fluctuationsTax progressivityProgressive tax systemProportional tax systemRegressive tax system13-*Built-in StabilityGTDeficitSurplusGDP1GDP2GDP3Real domestic output, GDPGovernment expenditures, G,and tax revenues, T13-*Evaluating Fiscal PolicyIs the fiscal policy. . . Expansionary?Neutral?Contractionary?Use the cyclically adjusted budget to evaluate 13-*Recent U.S. Fiscal PolicyFederal Deficits (-) and Surpluses (+) as Percentages of GDP, 2000–2010(1)Year(2)Actual Deficit – or Surplus +(3)Cyclically Adjusted Deficit – or Surplus +*2000+2.5+1.02001+1.3+0.52002-1.5-1.32003-3.4-2.82004-3.5-3.32005-2.6-2.72006-1.9-2.22007-1.2-1.32008-3.2-2.92009-9.4-7.32010-8.4-6.1As a percentage of potential GDPSource: Congressional Budget Office, www.cbo.gov.13-*Fiscal Policy: The Great RecessionFinancial market problems began in 2007Credit market freezePessimism spreads to the overall economyRecession officially began December 2007 and lasted 18 months13-*Budget Deficits and ProjectionsSource: Congressional Budget Office, www.cbo.gov.LO4$4000-400-800-1200-160020142012201020082006200420022000199819961994Budget deficit (-) or surplus, billions13-*Problems, Criticisms, & ComplicationsProblems of timingRecognition lagAdministrative lagOperational lagPolitical considerationsFuture policy reversalsOffsetting state and local financeCrowding-out effect13-*Current Thinking on Fiscal PolicyLet the Federal Reserve handle short-term fluctuationsFiscal policy should be evaluated in terms of long-term effectsUse tax cuts to enhance work effort, investment, and innovationUse government spending on public capital projects13-*The U.S. Public Debt$13.6 trillion in 2010The accumulation of years of federal deficits and surplusesOwed to the holders of U.S. securitiesTreasury billsTreasury notesTreasury bondsU.S. savings bonds13-*The U.S. Public DebtDebt held outsidethe federal government and theFederal Reserve:61%Debt held bythe federal government and the Federal Reserve:39%Foreign Ownership32%11%13%5%6%U.S. Government Agencies33%U.S. Banks and Other Financial InstitutionsOther, including State and Local Gov’tsFederal ReserveU.S. Individuals13-*The U.S. Public Debt13-*Global SnapshotPublic Sector Debt as Percentage of GDP, 2010JapanGreeceItalyBelgiumUnited StatesHungaryFranceUnited KingdomGermanySpainNetherlandsCanada0 20 40 60 80 100 120 Source: Organization for Economic Cooperation and Development, OECD13-*The U.S. Public DebtInterest charges on debtLargest burden of the debt1.4 percent of GDP in 2010False ConcernsBankruptcyRefinancingTaxationBurdening future generations13-*Substantive IssuesIncome distributionIncentivesForeign-owned public debtCrowding-out effect revisitedFuture generationsPublic investment13-*Crowding-Out Effect5101520253035400246810121416Real interest rate (percent)Investment (billions of dollars)ID1ID2abcIncrease ininvestmentdemandCrowding-out effect13-*Social Security ShortfallsMore Americans will be receiving benefits as they ageSocial Security shortfallsIncome during retirementFunds will be depleted by 203613-*Social Security Shortfalls13-*Social Security ShortfallsPossible options “to fix” includeIncreasing the retirement ageIncreasing the portion of earnings subject to the Social Security taxDisqualifying wealthy individualsRedirecting low-skilled immigrants to higher-skilled, higher-paying workDefined contribution plans owned by individuals13-*