Chapter 16: Budget Deficits in the Short and Long Run

Focus

Considers both long-run and short-run implications of fiscal and monetary policy decisions

- what difference does it make if we stimulate or restrain the economy with fiscal or monetary policy?

monetizing the deficit

The central bank is said to monetize the deficit when it purchases bonds issued by the government.

structural budget deficit or surplusThe structural budget

is the hypothetical deficit or surplus we would have under current fiscal policies if the economy were operating near full employment.

Rigid adherence to budget balancing would make the economy less stable, by reducing aggregate demand (via tax increases and reductions in government spending) when

when private spending is low and by raising aggregate demand when private spending is high.

Is the Fed Government Budget Deficit Too Large?

Budget Deficit Grows Because:

1) weak economy -> reduced taxes

2) extraordinary spending to fight the financial crisis and recession

- dissatisfaction with massive budget deficit became a major issue

- is it important to shrink the budget deficit quickly or should we be more patient?

*raising taxes and cutting spending while economy is struggling to lift itself could send them back to recession

Let us summarize what we have learned so far about the crowding-out controversy.

The basic argument of the crowding-out hypothesis is sound: Unless the economy produces enough additional saving, more government borrowing will force out some private borrowers, who are discouraged by the higher interest rates. This process will reduce investment spending and cancel out some of the expansionary effects of higher government spending.

Crowding out is rarely strong enough to cancel out the entire expansionary thrust of government spending. Some net stimulus to the economy remains.

If deficit spending induces substantial GDP growth, then the crowding-in effect will lead to more income and more saving—perhaps so much more that private industry can borrow more than it did previously, despite the increase in government borrowing.

The crowding-out effect is likely to dominate in the long run or when the economy is operating near full employment. The crowding-in effect is likely to dominate in the short run, especially when the economy has a great deal of slack.

Should the Budget Always Be Balanced in the Short Run?

- constitutional amendment to require a balanced budget has been proposed and debated many times

- instruct makers of fiscal policy to focus on balancing aggregate supply and aggregate demand

*budget deficits = when private demand (C+I+G+(X-IM) is weak

*budget surpluses = private demand (C+I+G+(X-IM) is strong

- budget should be balanced only when (C+I+G+(X-IM) = potential GDP

ex: budget initially balanced, but private spending sagged

-> multiplier pulls GDP down -> personal and corporate tax fall sharply (when GDP declines) so people will spend more -> government would cut spending or raise taxes (to restore budget balance)

YET

- attempts to balance the budget during recessions - as was done, during the Great Depression - will prolong and deepen slumps (if fiscal stimulus is removed too soon, it may fall right back into recession)

*vice versa: private spending increased -> multiplier pulls GDP up -> rising tax (when GDP increases) so people spend less -> induce a budget balancing government to spend more or to cut taxes, fiscal policy will "boom the boom" with unfortunate inflationary consequences

Importance of the Policy Mix

*the appropriate fiscal policy depends on the current stance of monetary policy. Although a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another

Change in Monetary Policy Will Alter the Appropriate Fiscal Policy

ex: monetary policy turns contractionary pulling aggregate demand inward (creating a recessionary gap: left of the potential GDP) -> fiscal authorities want to restore GDP to its original level by cutting taxes or raising spending

*tightening of monetary policy changes the appropriate fiscal policy from a balanced budget to a deficit

Change in Fiscal Policy Will Alter the Appropriate Monetary Policy

ex: increase budget deficit by raising government spending or cutting taxes -> Fed (controls monetary policy) wants real GDP to remain to the left of potential GDP, it must raise interest rates enough to restore the aggregate demand curve (lower GDP)

How Fiscal Policy Affects Monetary Policy

1) rising prices and output, push demand curve for bank reserves outward to the RIGHT (because more people want to keep their money in the bank) = raises interest rates (running out of reserves; therefore prices rise)

2) lowering prices and output shift the demand curve for reserves inward to the LEFT (because more people want from the bank to buy; therefore bank has less reserves) = lower interest rates (for people to buy more reserves)

*Monetary policy is not the only type of policy that affects interest rates. Fiscal policy does too. Increases in government spending or tax cuts normally push interest rates up, whereas restrictive fiscal policies normally pull interest rates down

Two Consequences of When Changes in Fiscal Policy Affect Interest Rates

1) The Multiplier Formula Revisited

- expansionary fiscal policy raises interest rates, which deters private investment spending -> when government raises G in (C+I+G+(X-IM), one side will probably be a reduction in the I component

- because a rise in G (or an autonomous rise in any component of total expenditure) pushes interest rates higher, and hence deters some investment spending, the increase in the sum (C+I+G+(X-IM) is smaller than the oversimplified multiplier formula predicts

*REASONS OVERSIMPLIFIED FORMULA OVERSTATES THE MULTIPLIER:

a) it ignores variable imports, which reduces the size of the multiplier

b) ignores price-level changes, which reduces the size of the multiplier

c) ignores the income tax, which reduces the size of the multiplier

d) ignores the rising interest rates that accompany any autonomous increase in spending, which reduces the size of the multiplier

2) The Government Budget and Investment

- lower deficits should lead to higher levels of private investment spending

ex: to reduce budget deficit, the government must engage in contractionary fiscal policies (by either reducing spending or raising taxes) -> lower interest rates -> spur investment spending

ex: higher budget deficit leads to less investment spending

Situations When Aggregate Demand Remains Unchanged

a) raising taxes, but cutting interest rates

- CONTRACTIONARY fiscal policy (tax raise or less government spending) and EXPANSIONARY monetary policy (low interest rate) should produce lower interest rates & more investment

-> shift composition of total expenditure (C+I+G+(X-IM) toward less G, less C (from tax raises), and more "I" (investment) -> more capital formation -> faster growth of potential GDP

b) cutting taxes, but raising interest rates

- EXPANSIONARY fiscal policy (tax cuts or higher government spending) and CONTRACTIONA

Deficits and Debt: Terminology and Facts

- Budget Deficit = is the amount which the government's expenditures exceed its receipts

ex: during fiscal year 2010, the federal government raised almost $2.2 trillion in revenue and spend almost $3.5 trillion resulting in a large deficit of $1.3 trillion

- National Debt = total value of the government's indebtedness at a moment in time

ex: U.S. national debt at the end of fiscal year 2010 was about $13.5 trillion

*Deficit and Debt are closely related because

a) government accumulates debt by running deficits (budget deficits raise national debt)

ex: run water into a bathtub "run a deficit", accumulated volume of water in the tub "the debt" rises

b) government reduces its debt by running surpluses (budget surpluses lower debt)

ex: letting water out of the tub ("run a surplus"), the level of the water ("the debt") falls

*getting rid of deficit (shutting off the flow of water) DOES NOT eliminate the accumulated debt, it just stops the debt from growing

Budget Deficit

is the amount by which the government's expenditures exceed its receipts during a specified period of time, usually a year.

Budget Surplus

is the amount by which the government's receipts exceed expenditures

National Debt (public debt)

is the federal government's total indebtedness at a moment in time. It is the result of previous budget deficits

Facts About National Debt

*public debt is enormous (fiscal year 2010:$43,000/person)

- one-third of the debt was held by agencies of the U.S. government (one branch of the government owed it to another) -> if we deduct this portion, the net national debt was $29,000 per person

*comparing debt with GDP (the volume of goods and services our economy produces in a year) does not seem so large after all

*until about 1983, almost all of the U.S. national debt stemmed from financing wars or from the loss of tax revenues that accompany recessions

*from about 1983 until 1993, the national debt grew faster than nominal GDP, (spurt happened without wars and with only one recession)

Interpreting the Budget Deficit or Surplus

government managed to turn the budget to surplus during the years 1998-2001, but then large deficits reemerged after the Bush tax cuts

The Structural Deficit or Surplus

- same fiscal program can lead to a deficit or a surplus, depending on the state of the economy

- as GDP falls, the government's major sources of tax revenue (income taxes, corporate taxes, and payroll taxes) all shrink because firms and people pay lower taxes when they earn less

- government spending (transfer payments such as unemployment benefits) rise when GDP falls because more people are out of work

*Deficit = G + Transfers - Taxes = G - (Taxes-Transfers) = G-T

Because a falling GDP leads to higher transfer payments and lower tax receipts:

*the deficit rises in a recession and falls in a boom, even with no change in fiscal policy

- as GDP rises, taxes rise and transfer payments fall = surplus

- as GDP falls, taxes lower and transfer payments rise = deficit

Structural Budget Deficit or Surplus

is the hypothetical deficit or surplus we would have under current fiscal policies if the economy were operating near full employment

- replaces both spending and taxes in the actual budget by ESTIMATES of how much the government would be spending and receiving (given current tax rates and expenditure rules, if the economy were operating at some fixed, high-employment level)

ex: if high-employment in figure 6 (pg. 323) was Y2 and actual GDP was only Y1, the structural deficit would be zero even though the actual deficit would be AB

*does not depend on the state of the economy

*better indicator of how much fiscal policy changed during the period

Interesting Facts (pg. 323)

1) even though official deficit fell between fiscal 1983 and fiscal 1995, the structural deficit grew slightly

2) the $381 billion swing in the budget deficit from 1993 to 1999 (from a deficit of $255 billion to a surplus of $126 billion) far exceeded the change in structural deficit, which fell by "only" $231 billion

3) movement from a moderate-size structural surplus in 2001 to a large structural deficit in 2003, due mainly to the Bush tax cuts, was both rapid and huge

4) Great Recession opened up a large gap between the actual and structural deficits ($312 billion), the structural deficit itself soared as the government spent hundreds of billions of dollars to fight the recession

On-Budget Vs. Off-Budget Surpluses

social security benefits are financed by the payroll tax, social security and a few minor items have traditionally been segregated in the federal fiscal accounts

Off-Budget Items:

- social security expenditures

- the payroll tax receipts that finance social security expenditures

Overall Budget Deficit = Off-Budget Deficit + On-Budget Deficit

ex: in fiscal year 2009, the overall budget showed a colossal $1,417 billion deficit. This was composed of a whopping $1,554 billion on-budget deficit less a $137 billion social security surplus

-> -$1,417 billion (total deficit/negative) = -$1,554 billion (on-budget deficit/negative) + $137 billion (off-budget surplus/positive)

Why is the National Debt Considered a Burden

- if the national debt is owned by domestic citizens, future interest payments just transfer funds from one group of Americans to another. However, the portion of the national debt owned by foreigners does constitute a burden on the nation as a whole

- there is a fundamental difference between nations that borrow in their own currency (such as the US) and nations that borrow in some other currency (which is often the US dollar). the former need never default (fail to pay) on their debts; the latter might have to

Budget Deficits and Inflation

- Suppose the government raises spending or cuts taxes enough to shift the aggregate demand schedule outward from D0D0 to D1D1. Equilibrium changes from point A to point B and the graph shows the price level rise from 100 to 106. Point B represents an inflationary gap

-> at point C, deficit spending will eventually raise the price level 12 percent (from 100 - 112)

*steep supply curve would lead to more inflation than a flat one (because the price of a steep curve will increase more than if it was flat)

The Monetization Issue

If the Federal Reserve takes no countervailing actions, an expansionary fiscal policy that increases the budget deficit will raise real GDP and prices, thereby raising the demand for bank reserves and driving up interest rates (figure 2). if the Fed does not want interest rates to rise, it can engage in expansionary open-market operations; that is, it can purchase more government debt. If the Fed does so, both bank reserves and the money supply will increase (figure 8). In this case, we say that prat of the deficit is monetized

Monetize the Deficit

the central bank is said to "monetize the deficit" when it purchases bonds issued by the government

Debt, Interest Rates, and Crowding Out

A larger national debt may lead a nation to leave less physical capital to future generations. If they inherit less plant and equipment, these generations will be burdened by a smaller productive capacity - a lower potential GDP. By that mechanism, large deficits may retard economic growth. By the same log, budget surpluses can stimulate capital formation and spur economic growth.

Crowding Out

occurs when deficit spending by the government forces private investment spending to contract

- is likely to dominate in the short run, especially when the economy has a great deal of slack

Crowding In

occurs when government spending, by raising real GDP, induces increases in private investment spending

- is likely to dominate in the long run or when the economy is operating near full employment

The Bottom Line

Crowding-Out Controversy (pg. 329)

The Main Burden of the National Debt: Slower Growth

- when government budget deficits take place in a high-employment economy, the crowding-out effect probably dominates. So deficits exact a toll by leaving a smaller capital stock, and hence lower potential GDP, to future generations

- deficits in an economy with high unemployment may well lead to more investment rather than less. In this case, in which the crowding-in effect dominates, deficit spending increases growth and the new debt is a blessing rather than a burden.

pg. 330 (for blue summary)