INFLATIONARY & DEFLATIONARY GAP

Chapter 12

Fiscal Policy and the National Debt

12-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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


Fiscal Policy

• Fiscal policy is the manipulation of the federal budget to attain price stability, relatively full employment, and a satisfactory rate of economic growth– To attain these goals, the government must

manipulate its spending and taxes


• There was no such thing as fiscal policy until John Maynard Keynes invented it in the 1930s– He maintained that

• The only way out of the Depression was to boost aggregate demand by increasing government spending

• If we ran a big enough budget deficit, we could jump-start the economy and, in effect, spend our way out of the depression

Putting Fiscal Policy into Perspective


• 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 prices



• Equilibrium GDP tells us the level of spending in the economy

• Full-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



The Deflationary Gap and the Inflationary Gap

• Equilibrium GDP is the level of output at which aggregate demand equals aggregate supply– Aggregate 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 services

– So at equilibrium GDP, everything produced is sold


• Full-employment GDP is the level of spending necessary to provide full employment of our resources– If our plant and equipment is operating at

between 85 and 90% of capacity, that’s full employment

– If only 5% of our labor force is unemployed, that’s full employment

The Deflationary Gap and the Inflationary Gap


The Deflationary Gap & the Inflationary Gap


1 2 3 4 5 6 7 8 9

9

8

7

6

5

4

3

2

1

Deflationary gapC +I +G +Xn

2

GDP (in trillions of dollars)

Full-employment GDPEquilibrium GDP

The Deflationary Gap

When the full-employment GDP is greater than the equilibrium GDP, there is a deflationary gap. How much is it?

$1 trillion

The Deflationary Gap & the Inflationary Gap


2,000

1,500

1,000

500

0

Inflationary gap

500 1,000 1,500 2,000

C +I +G +Xn

500

Full-employment GDP


The Inflationary Gap

Equilibrium GDP

When equilibrium GDP is greater than full-employment GDP, there is an inflationary gap. How large is it?

$200 trillion

Summary

• Equilibrium GDP is above the full-employment GDP– Spending is too high– Results in an inflationary gap

• Too eliminate the inflationary gap, we cut G and/or raise taxes


Summary

• Equilibrium GDP is less than full-employment GDP– Spending is too low– Results in a deflationary gap

• Too eliminate the deflationary gap, we raise G and/or cut taxes


The Multiplier and Its Applications

12-13

• Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP

GDP = C + I + G + Xn

How much the multiplied change is depends on the MPC and MPS

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier

• RememberMPC + MPS = 1, therefore, MPS = 1 - MPC

Multiplier = -----------------------1

1 - MPC

Multiplier = ----------------------1

MPS

12-14

Because the multiplier (like C) deals with spending, 1/(1-MPC) is a more appropriate formula)



• The MPC is .5. Find the multiplier


Calculating the Multiplier(Continued)


Multiplier = ---------------- = -------- = ----- = 21

1 - MPC

12-16

1

1 – .5

1

.5




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. $2,000.00

It 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

12-18




12-19



Multiplier = ---------------- = -------- = ----- = 411 1

1 - MPC 1 – .75 .25


Applications of the Multiplier

• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP

GDP = 2,500; Multiplier = 3; C rises by 10

What is the new level of GDP?

12-20

GDPNew = GDPInitial + (Change in spending X Multiplier)

GDPNew = 2500 + ( 10 x 3)GDPNew = 2500 + ( 30)GDPNew = 2530




GDP = X; Multiplier = 3; C rises by 10

What happens to GDP?

12-21


GDPNew = X + ( 10 x 3)GDPNew = X + ( 30)GDP increases by 30




GDP = X; Multiplier = 7; G falls by 5

What happens to GDP?

12-22


GDPNew = X + ( -5 x 7)GDPNew = X + ( -35)GDP decreases by 35


Applications of the Multiplier• How big is the multiplier (M)?


1 2 3 4 5 6 7 8 9

9

8

7

6

5

4

3

2

1

Deflationary gapC +I +G +Xn

2


Full-employment GDP

M = distance between the equilibrium GDP and the full-employment GDP / by the gap

M = 2 / 2 = 1

Applications of the Multiplier• How big is the multiplier (M)?


2,000

1,500

1,000

500

0

Inflationary gap

500 1,000 1,500 2,000

C +I +G +Xn

500

Full-employment GDP


M = distance between the equilibrium GDP and the full-employment GDP / by the gap

M = 500 / 200 = 2.5

Removing the Deflationary Gap



1 2 3 4 5 6 7 8 9

9

8

7

6

5

4

3

2

1

C +I +G +Xn

C1 +I1 +G1 +Xn1

Full-employment GDP

To remove the deflationary gap we raise aggregate demand from C+I+G+Xn to C1+I1+G1+Xn1

This pushes equilibrium GDP to $7 trillion and removes the deflationary gap

Removing the Inflationary Gap


2,500

2,000

1,500

1,000

500

0

Inflationary gap

500 1,000 1,500 2,000

500

2,500

C1 +I1 +G1 +Xn1

C +I +G +Xn

Full-employment GDP

GDP (in billions of dollars)

To remove the inflationary gap we lower aggregate demand from C+I+G+Xn to C1+I1+G1+Xn1

This pushes equilibrium GDP down to 1,000 and removes the inflationary gap

The Automatic Stabilizers

• The automatic stabilizers protect us from the extremes of the business cycle– Personal Income and Payroll Taxes

• During recessions, tax receipts decline

• During inflations, tax receipts rise

– Personal Savings• During recessions, saving declines

• During prosperity, saving rises



• The automatic stabilizers protect us from the extremes of the business cycle– Credit Availability

• Credit availability helps get us through recessions

– Unemployment Compensation• During recessions more people collect

unemployment benefits



• The automatic stabilizers protect us from the extremes of the business cycle– The Corporate Profits Tax

• During recessions, corporations pay much less corporate income taxes

– Other Transfer Payments• Welfare (or public assistance) payments,

Medicaid payments, and food stamps rise during recessions


Discretionary Fiscal Policy

• Making the Automatic Stabilizers More Effective– Public Works

• The main fiscal policy to end the Depression was public works

– Transfer Payments• The government could extend the benefit period

for unemployment compensation and increase welfare payments, Social Security, and veteran’s pensions



• Making the Automatic Stabilizers More Effective– Changes in Tax Rates

• To fight inflation, the government can raise taxes• To fight recession, the government can cut taxes• Corporate incomes taxes can be raised during periods of

inflation and lowered when recessions occur

– Using 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



• Making the Automatic Stabilizers More Effective– Changes in Government Spending

• The government increases spending and cuts taxes to fight recessions

• The government decreases spending and raises taxes to fight inflation

• In brief, we fight recessions with budget deficits and inflation with budget surpluses


Who Makes Fiscal Policy?

• The President and Congress make fiscal policy– This is complicated and can be time

consuming, especially when one political party controls Congress while the president belongs to the other party

– No one seems to be in charge of making fiscal policy


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 economy– Between legally mandated spending programs and

legally mandated entitlement programs such as Social Security, Medicare, and Medicaid, there is little discretionary income to play with

– The Treasury could borrow even more money but only if Congress and the president were willing to allow the budget deficit to grow


The Deficit Dilemma

• Deficits, Surpluses, and the Balanced Budget– When government spending is greater than

tax revenue, we have a federal budget deficit• The government borrows to make up the

difference

• Deficits are prescribed to fight recession


The Deficit Dilemma

• Deficits, Surpluses, and the Balanced Budget– When the budget is in a surplus position, tax

revenue is greater than government spending

• Budget surpluses are prescribed to fight inflation


The Deficit Dilemma• Deficits, Surpluses, and the Balanced

Budget– We have a balanced budget when

government expenditures are equal to tax revenue

• We’ve never had an exactly balanced budget• We’re dealing with a budget of nearly $4 trillion

in taxes and spending– So, if tax revenue and expenditures were within $10

billion of each other, perhaps that would be close enough to call the budget balanced


The Deficit Dilemma

12-38

Deficits and Surpluses: The Record


The Federal Budget Deficit, Fiscal Years 1970-2001

Why Are Large Deficits So Bad?

• Large deficits raise interest rates, which, in turn, discourages investment– Our 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



• The federal government has become increasingly dependent on foreign savers to finance the deficit– In the early – and mid – 1990s foreigners

financed more than half the deficit



• 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 equipment



• On the positive side, budget deficits stimulate the economy– The only problem is that we should not have needed

this stimulus during the “prosperous” mid-to late 1980s when we were running huge deficits

– We would do well to remember that John Maynard Keynes would have advocated running surpluses and paying off the debt during periods of prosperity


Will We Be Able to Balance Future Budgets?

• The federal government finally managed to run a budget surplus in 1998– This was the first time since 1969

• The congressional Budget Office forecasts a string of surpluses well into the new millennium– Congressional Republicans and Democrats have

already proposed dueling plans to dispose of those surpluses with various combinations of tax cuts and spending increases

– No elected official proposed slowing down the projected increases in Social Security spending


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 deficits

• After the year 2015, as the baby boom generation attains senior citizenship, the Social Security Trust Fund will be quickly depleted– Unless the government has already raised Social

Security taxes or cut benefits, the federal budget surplus will quickly become a large and growing deficit


The Proposed Balanced Budget Amendment and the Line Item

Veto• Must we balance the budget each year?

– The government really tried to balance the budget each year into the early 1930s

– The economic wisdom today tells us that we should have deficits in lean years and surpluses in fat years

• From 1961 through 1997 the government managed only one surplus

• The national debt rose every year as we ran budget deficits in fat years


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 Congress– Despite some very close votes in 1994, 1995,

1996, and 1997, the balanced budget amendment failed in one or the other houses of Congress

– Most economists oppose such an amendment because it would put us in an economic straitjacket


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 legislation– This line item veto can be eventually

overridden by a two-thirds vote in each house of Congress

– In February, 1998, a federal judge ruled the line item veto unconstitutional


The Public Debt

• Differentiating between the Deficit and the Debt– The deficit occurs when federal government

spending is greater than tax revenue– The debt is the cumulative total of all the federal

budget deficits less any surpluses• Suppose that our deficit declined one year from $200

billion to $150 billion• The national debt would still go up by $150 billion• So every year that we have a deficit – even a declining one

– the national debt will go up


The Public Debt


1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

5

4

3

2

1

0

6

National Debt, 1975-2000

Economic Report of the President, 2000

The Public Debt

• Who holds the national debt?– Private American citizens hold a little less than half

– Foreigners hold almost one-third

– The rest is held by banks, other business firms, and U.S. government agencies

• Is the national debt a burden that will have to borne by future generations?– As long as we owe it to ourselves, the answer is no

– If we did owe it mainly to foreigners, and if they wanted it paid off, it could be a great burden


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 due

– Each year several hundred billion dollars worth of federal securities fall due

• By selling new ones, the Treasury keeps us going

– In 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 interest

• At least to that degree, the public debt will be a burden to future generations


The Public Debt

• Why not go ahead and just pay off the debt?– Economists predict that following this course would

have catastrophic consequences– If we tried to pay off the debt too quickly, it might

even send us into a deep depression– If 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 Reserve

• As the national debt goes down, eventually there would be no securities for them to buy

• Still, it is a whole lot better to have problems like these than those caused by running huge budget deficits every year


Documents

INFLATIONARY & DEFLATIONARY GAP