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Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1
ECON
Designed byAmy McGuire, B-books, Ltd.
McEachern 2010-2011
12
CHAPTERFederal Budgets and Public Policy
Macro
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2
LO1
The Federal Budget Process
Federal budget– Outlays• Government purchases• Transfer payments
– Revenues– Specific period
Federal government – shifted focus– From national defense– To redistribution
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 3
LO1
Defense’s Share of Federal Outlays Declined Since 1960 and Redistribution Increased
Exhibit 1
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 4
LO1
Presidential and Congressional Roles
The President– Budget proposal• Budget request from each agency• “The budget of U.S. government” to
Congress– Council of Economic Advisors• “Economic report of the President”
House and Senate– Budget committees: Budget resolution
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 5
LO1
Presidential and Congressional Roles
Budget deficit: Outlays > Revenues– Stimulates AD in short run– Reduces national saving– Long run: hinder economic growth
Budget surplus: Revenues > Outlays– Dampens AD in short run– Boosts domestic saving– Long run: promote economic growth
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 6
LO1
Problems with Federal Budget Process
Continuing resolutions– Instead of budget decisions
Lengthy budget process Uncontrollable budget items No separate capital budget Overly detailed budget
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 7
LO1
Possible Budget Reforms
Biennial budget (two-year budget) Simplify the budget document Federal spending– Capital budget– Operating budget
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 8
LO2
Fiscal Impact of the Federal Deficits
Rationale for deficits– Outlays that increase economy’s
productivity Budget philosophies and deficits– Annually balanced budget– Cyclically balanced budget– Functional finance
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 9
LO2
Fiscal Impact of the Federal Deficits
Federal deficits: since birth of the nation– 1789-1930
– Deficit: 33% of years (war)
– Since the Great Depression– Deficit: 85% of years
– 1980s relatively large deficits– Large tax cuts – High defense spending
– 1990s: improved economy– Decreasing deficits– By 1998: surplus
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 10
LO2
Fiscal Impact of the Federal Deficits
Federal deficits: since birth of the nation– 2001 recession
– Tax cuts– Higher federal spending– Deficits
– Weak recovery– War against terrorism
– 2003, deficit 3.5% of GDP– 2007 stronger economy
– Rising stock market– Deficit 1.2% of GDP
– 2009 deficit of $1.8 trillion projected
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 11
After Decades of Federal Budget Deficits, Surpluses Appeared from 1998 to 2001, But Deficits Are Back
LO2 Exhibit 2
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 12
LO2
Fiscal Impact of the Federal Deficits
Why have deficits persisted?– Tax cuts– Spending increase– Federal officials• Not required to balance the budget
– Elected officials• Big spending programs• Small taxes• Pork-barrel spending
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 13
LO2
Fiscal Impact of the Federal Deficits
Increase federal deficits– National saving – reduced– Interest rates – higher– Investment• Discouraged (crowding
out)• Stimulated (crowding in)
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14
Crowding-Out Effect
Crowding-out effect in an open economy: Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 15
Increase in budget deficit
Higher realinterest rates
Inflow of financial capital from abroad
Decline inprivate investment
Appreciation
of the dollar
Decline in net exports
Crowding-Out in an Open Economy
• An increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates.
• This retards private investment and Aggregate Demand.
• In an open economy, high interest rates attract foreign capital.
• As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates.
• The appreciation of the dollar causes net exports to fall.
• Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which limit the expansionary impact of a budget deficit.
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 16
Conclusion of Crowding-Out
2 factors: Private spending and attract inflow of capital
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 17
LO2
Fiscal Impact of the Federal Deficits
The twin deficits– Finance huge deficits• U.S. Treasury – sells IOUs• High interest rates• Greater demand for $• U.S. trade deficit increase• Foreigners buy U.S. assets
– Increase I– Decline S
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 18
LO2
Fiscal Impact of the Federal Deficits
The short-lived budget surplus– Tax increases
– 1990, spending cuts– Decrease deficits
– Slower growth in federal outlays– 1990-2000 reduced U.S. military abroad– Interest rates decreased
– A reversal of fortune in 2001– Recession + Terrorist attacks– Great federal spending– 2002 federal deficit
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 19
During the 1990s, Federal Outlays Declined Relative to GDP and Revenues
Increased, Turning Deficits into Surpluses, But Not for Long
LO2Exhibit 3
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 20
LO2C
ase
Stu
dy
Reforming Social Security and Medicare Social Security
From: current workers, employees
To: current retirees (pensions) $1,000 per month
Medicare From: payroll taxes To: short-term medical care
for the elderly $11,000 per beneficiary in
2007
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 21
LO2C
ase
Stu
dy
Reforming Social Security and Medicare 76 million baby boomers
1940: 42 workers per retiree 2007: 3.3 workers per retiree 2030: 2.1 workers per retiree
Reforms Increase taxes Reduce benefits Raise the eligibility age Smaller annual increases Reduce benefits to
wealthy retirees
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 22
Government Outlays as a Percentage of GDP Declined Between 1994 and 2008
in Most Major Economies
LO2Exhibit 4
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 23
The National Debt
LO3
National debt– Net accumulation of past deficits
Measuring the national debt– Gross debt• U.S. Treasury notes – by federal
agencies– Debt held by the public• U.S. Treasury securities
– Households; Firms– Banks (include the Fed)– Foreign entities
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 24
Federal Debt Held by the Public as a Percentage of GDP Since 1940
LO3 Exhibit 5
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 25
The National Debt
LO3
International perspective on public debt– Different economies• Different fiscal structures
– 40% of GDP– Australia• No debt
– Japan• Debt: 88% of GDP
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 26
Relative to GDP, U.S. Net Public Debt in 2008 Was Above Average for Major EconomiesLO3Exhibit 6
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 27
The National Debt
LO3
Interest on the national debt– Buyers of federal securities• Individuals, $25• Institutions, $1 million• Increasing interest rates• 1 percentage point
increase in nominal interest rate– Interest cost increase $58
billion per year
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 28
Interest Payments on Federal Debt Held by the Public as a Percentage of Federal Outlays Peaked in 1996
LO3 Exhibit 7
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 29
The National Debt
LO3
Who bears the burden of debt?– Billing future taxpayers• For current spending
– We owe it to ourselves• Future generations
– Service the debt– Receive the payments
– Foreign ownership of debt• Increase burden of debt
– Future generations of Americans
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 30
Foreign Holders of U.S. Treasury Securities
LO3Exhibit 8
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 31
The National Debt
LO3
Crowding out and capital formation– Deficit spending, long run– Borrowed funds – invested in
public capital• Increased productivity• Increased standard of living
– Borrowed funds – current expenditures• Less capital formation
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 32
The National Debt
LO3
Intergenerational view of deficits and debt– Welfare of generations• Tied together
– Parents now• Consume less• Save more• Reduce the burden on next
generation– Issues• People with no children• Informed of federal spending