Chapter 13: Fiscal Policy, Deficits, and Debt

Fiscal Policy, Deficits, and Debt13McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Fiscal PolicyDeliberate changes in:Government spendingTaxesDesigned to:Achieve full-employmentControl inflationEncourage economic growthLO113-*Expansionary Fiscal PolicyUse during a recessionIncrease government spendingDecrease taxesCombination of bothCreate a deficitLO113-*Expansionary Fiscal PolicyReal GDP (billions)Price levelAD2AD1$5 billion increase inspending Full $20 billion increase inaggregate demandAS$490$510P1LO1RecessionsDecrease 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$510dbaP1cLO113-*Policy Options: G or T?To expand the size of governmentIf recession, then increase government spendingIf inflation, then increase taxesTo reduce the size of governmentIf recession, then decrease taxesIf inflation, then decrease government spendingLO113-*Built-In StabilityAutomatic stabilizersTaxes vary directly with GDPTransfers vary inversely with GDPReduces severity of business fluctuationsTax progressivityProgressive tax systemProportional tax systemRegressive tax systemLO213-*Built-In StabilityGTDeficitSurplusGDP1GDP2GDP3Real domestic output, GDPGovernment expenditures, G,and tax revenues, TLO213-*Fiscal Policy: The Great RecessionFinancial market problems began in 2007Credit market freezePessimism spreads to the overall economyRecession officially began December 2007 and lasted 18 monthsLO413-*Problems, Criticisms, & ComplicationsProblems of TimingRecognition lagAdministrative lagOperational lagPolitical business cyclesFuture policy reversalsOff-setting state and local financeCrowding-out effectLO413-*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 projectsLO413-*The U.S. Public Debt$11.9 trillion in 2009The accumulation of years of federal deficits and surplusesOwed to the holders of U.S. securitiesTreasury billsTreasury notesTreasury bondsU.S. savings bondsLO413-*The U.S. Public DebtLO4Debt held outsidethe Federal government and theFederal Reserve:57%Debt held bythe Federal government and the Federal Reserve:43%13-*Global PerspectivePublic Sector Debt as Percentage of GDP, 2009ItalyJapanGreeceBelgiumFranceUnited StatesFranceGermanyUnited KingdomSpainNetherlandsCanada0 20 40 60 80 100 Source: Organization for Economic Cooperation and Development, OECDLO413-*The U.S. Public DebtInterest charges on debtLargest burden of the debt1.3% of GDP in 2009False ConcernsBankruptcyRefinancingTaxationBurdening future generationsLO413-*Substantive IssuesIncome distributionIncentivesForeign-owned public debtCrowding-out effect revisitedFuture generationsPublic investmentLO413-*Crowding-Out Effect5101520253035400246810121416Real interest rate (percent)Investment (billions of dollars)ID1ID2abcIncrease ininvestmentdemandCrowding-out effectLO413-*