Section 6AP MacroeconomicsInflation, Unemployment & Stabilization PoliciesNancy K. Ware, InstructorGainesville High SchoolGainesville, Georgia

Module 30 Long-run

Implicationsof Fiscal

Policy: Deficitsand the Public

Debt

Module 30 Essential Questions

1. Why do governments calculate the cyclically adjusted budget balance?

2. Why might a large public debt be a cause for concern?

3. Why are implicit liabilities of the government also a cause for concern?

• Deficits• Surpluses• Good? Bad?• What is your opinion?

The Budget Balance

The Budget Balance as a Measure of Fiscal Policy ~ Review

• Sgov = Tax Revenue – G Spending - Transfers

• Expansionary policies reduce budget balance

• Contractionary policies increase budget balance

• G Spending has a greater impact than Taxes or Transfers – Why?

• Changes in budget balance are often the result, not cause, of economic fluctuations

The budget b__________is the difference between the government’s t____r________ & its s________, both on goods and services & on government transfers, in a given year.

SGovernment = T - G – TR

where T = t_____revenues, G = government s___________ on goods and services, & TR is the value of government t__________.

A budget surplus= p_______budget balance & a budget deficit= n________budget balance.

The Budget Balance as a Measure of Fiscal Policy Review

The budget balance is the difference between the government’s tax revenue and its spending, both on goods and services and on government transfers, in a given year.

That is, the budget balance—savings by government—is defined by:

SGovernment = T - G – TR

where T is the value of tax revenues, G is government spending on goods and services, and TR is the value of government transfers.

A budget surplus= positive budget balance & a budget deficit= negative budget balance.

The Budget Balance as a Measure of Fiscal Policy Review

Economic Case StudiesReview

Case 1: R_____________ Gap. What kind of fiscal policy is used? __________________. What are your options? 1.2.3.

These 3 policies should i____________AD and reverse the recession, but will cause the budget balance to ____________. This means either a smaller surplus or a bigger deficit.

Case 2: I_______________ Gap. What kind of fiscal policy is used? ______________. What are your options?1.2.3.

These 3 policies should d___________AD and reverse the inflation, but will cause

the budget balance to ___________. This means either a bigger surplus or a smaller deficit.

Economic Case StudiesReview

Case 1: Recessionary Gap. What kind of fiscal policy is used? Expansionary. What are your options? 1. Cut taxes.2. Increase transfers.3. Increase government spending.

These three policies should increase AD and reverse the recession, but will cause the budget balance to decrease. This means either a smaller surplus or a bigger deficit.

Case 2: Inflationary Gap. What kind of fiscal policy is used? Contractionary. What are your options?1. Increase taxes.2. Decrease transfers.3. Decrease government spending. These three policies should decrease AD and reverse the inflation, but will cause

the budget balance to increase. This means either a bigger surplus or a smaller deficit.

We Don’t Live in Perfect World

Changes in BB don’t always perfectly reflect changes in fiscal policy.

2 different changes in fiscal policy that have equal-size effects on the BB may have quite unequal effects on the economy.

EXAMPLE: If Government spending increases by $1000, it will have a larger impact on real GDP than a tax decrease of $1000. The budget balance would change by $1000 in each case, but the impacts would be different…why?

Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy (meaning they are caused from the business cycle)

The Business Cycle & the US Budget Deficit

• A strong relationship between budget balance and business cycle exists ~ WHY?

The Business Cycle & the US Budget Deficit

• A strong relationship between budget balance and business cycle exists ~ WHY?

The budget moves into deficit when the economy is in recession (think g spending), and deficits shrink when the economy moves into expansion (less g spending, increased tax revenues). During expansion, deficits get smaller or the budget balance moves into a surplus.

Automatic Stabilizers, Budget Balance in Recession & Inflation: A Review

Budget deficit rises when the UR rises & falls when the UR falls. Why? 1. A____________________ S________________ ~ programs built into our tax and transfer system that work to reduce the swings of the business cycle. 2. What happens to the budget balance (taxes & transfer payments) when the economy heads into a recession? Tax revenues d___________ because incomes and profits are d___________. T________________ P_____________, like welfare assistance, begin to rise as more

people find themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes & BB declines. 3. What happens to the budget balance (taxes & transfer payments) when the economy is heading into an inflationary period? Tax revenues r__________because incomes and profits are r________. Transfer payments, like welfare assistance, begin to d________as fewer people find

themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes & BB rises.

Budget deficit rises when the UR rises & falls when the UR falls. Why? 1. Automatic stabilizers ~ programs built into our tax and transfer system that work to reduce the swings of the business cycle. 2. What happens to the budget balance (taxes & transfer payments) when the economy heads into a recession? Tax revenues decrease because incomes and profits are decreasing. Transfer payments, like welfare assistance, begin to rise as more people find themselves

unemployed and struggling. These changes happen without any deliberate fiscal policy changes & BB declines. 3. What happens to the budget balance (taxes & transfer payments) when the economy is heading into an inflationary period? Tax revenues rise because incomes and profits are rising. Transfer payments, like welfare assistance, begin to decrease as fewer people find

themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes & BB rises.

Automatic Stabilizers, Budget Balance in Recession & Inflation: A Review

Cyclically Adjusted Business Cycle

1. In analyzing the budget balance it is necessary to separate out the changes that occur from deliberate f_________ p_________ & the movements of the b__________c_________.

2. WHY?

3. By removing their effects, the government can analyze and focus on their taxing and spending policies, and it can be ascertained if they are sustainable in the L___________ R_______.

4. An estimation is produced by the government of what the budget balance would be if there was neither a r_____________ nor an i_____________ gap.

5. This estimation is the c___________ a______________ b_________ b__________ is an estimate of what the budget balance would be if real GDP were exactly equal to potential output.

6. If the effects of the business cycle are adjusted for, and the government is still running a deficit, then WHAT does that MEAN?

Cyclically Adjusted Business Cycle

1. In analyzing the budget balance it is necessary to separate out the changes that occur from deliberate fiscal policy & the movements of the business cycle.

2. WHY? The effects of the business cycle are temporary. Recession and Inflation don’t last forever.

3. By removing their effects, the government can analyze and focus on their taxing and spending policies, and it can be ascertained if they are sustainable in the LONG RUN.

4. An estimation is produced by the government of what the budget balance would be if there was neither a recessionary nor an inflationary gap.

5. This estimation is the cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output.

6. If the effects of the business cycle are adjusted for, and the government is still running a deficit, then WHAT does that MEAN? Maybe that their fiscal policy decisions are not sustainable over the long run?

• Cyclically adjusted budget balance

The Business Cycle and the Cyclically Adjusted Budget Balance

Should the Budget Be Balanced?

• Political motivation for running deficits (pet projects) or balancing the budget (sounds good to voters)

• Economists argue against balanced budget rule in favor of cyclically balanced budget. Why?

• Should there be limits on deficits as a compromise?

What if you were President. What is your opinion: Is it a good idea to require a federal balanced budget annually? The fast answer is sure…

Case 1 : the economy is in a recessionary gap.Falling tax revenue and rising transfer payments push the budget toward deficit.1. How do you balance this deficit & what does this do to the economy?

Case 2: the economy is in an inflationary gap.Rising tax revenue and falling transfer payments push the budget toward surplus.2. How would we balance this surplus & what does this do to the economy?

3. What do most economists believe the government should do?

4. Why is this simple solution so difficult to achieve?

5. So are there serious downsides to an unbalanced budget?

Should the Budget Be Balanced?

What if you were President. What is your opinion: Is it a good idea to require a federal balanced budget annually?

Case 1 : the economy is in a recessionary gap.Falling tax revenue and rising transfer payments push the budget toward deficit.

1. How do you counter act this deficit to achieve balance & what does this do to the economy?

Increase taxes or decrease government spending, & how would that impact the recession? It would make it WORSE. Case 2: the economy is in an inflationary gap.Rising tax revenue and falling transfer payments push the budget toward surplus.

2. How would you counter act this surplus to achieve balance & what does this do to the economy?

Decrease taxes or increase government spending, & how would this impact the inflationary period? It would make it WORSE. 3. What do most Economists believe the government should do? Balance its budget on average; run deficits in bad years, offset by surpluses in good years. 4. Why is this simple solution so difficult to achieve? Political pressures (Americans LOVE tax cuts) make this difficult.

5. So are there serious downsides to an unbalanced budget?

Should the Budget Be Balanced?

Deficits, Surpluses, & Debt Oh My!When spending exceeds tax revenue, the government borrows…..

When a government spends more than the tax revenue it receives…..it runs a budget deficit….& it almost always borrows the extra funds…..and governments that run persistent budget deficits end up with substantial debts. http://www.usdebtclock.org/

Fiscal years….the national debt is the accumulation of all past fiscal year deficits, minus all past surpluses. http://www.youtube.com/watch?v=Jjv-MtGpj2U&feature=related&safety_mode=true&persist_safety_mode=1&safe=active

Public Debt….government debt held by individuals and institutions outside the government.

Problems Posed by Rising Government Debt p. 300

1. Government competes with private sector for investment funds

2. Financial pressure on future budgets

3. Possibility of Default

4. Monetizing the Debt

5. Cyclical budget

Problems Posed by Rising Government Debt p. 300

1. Government competes with private sector for investment funds (crowding out)

2. Financial pressure on future budgets (interest)

3. Possibility of Default (the act of not meeting financial loan obligations)

4. Monetizing the Debt (just print more money? – what about inflation?)

5. Cyclical budget (debt begats more debt – a vicious cycle)

1. What are 2 reasons to be concerned when a government runs persistent budget deficits?

2. So in the future, how can a government pay off the debt? Should they borrow the money?

Option 1 Fiscally Fix the debt:

What are these issues with this solution?

Option 2 Monetarily Fix the debt:

What are the issues with this solution?

Problems Posed by Rising Government Debt

1. What are 2 reasons to be concerned when a government runs persistent budget deficits? When the government borrows funds in the financial markets, it is competing with firms that plan to

borrow funds for investment spending. The RESULT: the government’s borrowing may “crowd out” private investment spending, increasing interest rates and reducing the economy’s long - run rate of growth.

Today’s deficits, by increasing the government’s debt, place financial pressure on future budgets & future generations of Americans. Those budgets will have to pay interest on that borrowed money in the future, and this can take dollars away from other future federal obligations like social security, education, defense, research grants, space exploration, etc.

2. So in the future, how can a government pay off the debt? Should they borrow the money?Borrowing to pay off your debt isn’t really an option. That’s like getting a new credit card to pay off the old credit card. Eventually, that is the road to personal bankruptcy. Nations have essentially declared bankruptcy in the past. It’s not pretty! (See Ireland, Greece, Cyprus)

Fiscally: Increase taxes or cut spending. Probably the best solution, but isn’t very politically popular or successful, especially when a nation as become accustomed to low taxes.

Monetarily: Printing money. Basically this means the Fed creates new money to pay the debts of the Treasury. This proves to be a fast track to serious inflation.

Problems Posed by Rising Government Debt

Deficits and Debt in Practice

Debt-GDP Ratio

The debt–GDP ratio, the government’s debt as a percentage of GDP assesses the ability of governments to pay their debt. This is a good indicator of the potential taxes the government can collect. If the government’s debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government’s potential tax revenue. **On your phone or Ipad, find data from 1990-2000 and from 2000-present . Is the debt-GDP ratio rising, falling, or staying roughly the same?

1. Implicit liabilities are s___________ p____________made by governments that are effectively a d______despite the fact that they are not included in the usual debt statistics. 2. In the US, promises to honor S_________ S__________, M__________ & M__________ amount to 40% of federal spending.

3. Is this a big deal? Why or Why Not?

Future Demands on the Federal Budget: Implicit Liabilities

1. Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. 2. In the US, promises to honor Social Security, Medicare and Medicaid amount to 40% of federal spending.

3. Is this a big deal? Why or Why Not?

Yes because the American population is aging and these commitments will only get larger.

Implicit Liabilities

Module Review Questions p. 305

Read Module 31 p. 307-312