Fiscal Policy

The Relationships between Budget Deficits, Surplus and National Debt

Fiscal Policy Basics

• fiscal policy = how the govt uses spending and taxation to influence the economy (esp AD)

  • Expansionary fiscal policy = inc. spending or cut taxes to boost the economy

  • Contractionary fiscal policy = dec. spending or raise taxes to slow down the economy

Budget Deficit and Surplus

• Budget Deficit: when govt’s spending > govt revenue in the year (-)

  • expansionary fiscal policy usually causes deficits bc the gotv spends more and lowers taxes

• Budget Surplus) govt spending < govt revenue in the year (+)

  • contractionary fiscal policy often leads to surpluses because the govt cuts spending and raises taxes

• National Debt: the total of all past deficits of a govt

• deficit → increases national debt

• surplus → decrease national debt

• high national debt can lead to

  • more tax money just paying off old debt

  • government borrowing drives up interest rates

• sometimes deficits are necessary, like during recession recovery

• managing deficits and debt is about timing and trade-offs

Introduction to Bond Markets and Interest Rate Determination

• Bond: debt certificate; issued to finance deficits

• Bond Market: the place where governments issue bonds, which are bought by investors. the investors are the “creditors” and the governments are the “debtors”

• Relationship Between Bond Prices and Bond Yields (interest rates): inverse relationship

  • yield = the annual interest payment/the current market price of the bond

  • as bond prices rise, yields fall → lower borrowing cost for govt; conversely, when bond prices fall, yields rise → higher borrowing cost for govt

• large deficits require the supply of bonds to increase, which, ceteris paribus, will increase the interest rates of govt debt

• a large national debt will reduce demand for a govt’s bond, which, ceteris paribus, will increase the interest rates on govt debt

• if investors trust you’ll pay them back, they’ll accept lower interest rates

• if investors don’t trust you, you have to pay them higher interest rates to take the risk

The Crowding-out Effect

• Crowding out happens when govt deficit spending causes higher interest rates

• higher interest rates reduce private investment and private consumption

  • this hurts the private sector
    |t runs a deficit → borrows money by selling bonds

• more borrowing → higher demand for loanable funds

• higher demand → higher real interest rates

• higher interest rates → less private investment

why is this a problem?

• fiscal policy is supposed to stimulate AD, but if crowding out happens, private spending drops

• if private spending drops, boost from govt spending would get weakened

  • esp in recession because the reduction in private investment limits the overall economic activity needed for recovery

when crowding out is most likely

• if the economy is already near full employment, crowding out is a big risk

• in a recession, crowding out is less of a problem because businesses aren’t rushing to invest anyway

• severity of crowding out depends on

  • the state of economy (recession vs full employment)

  • how much private sector demand for money exist

special case: liquidity trap / deep recession

• In a deep recession, interest rates stay low even when the government borrows more

• So fiscal stimulus doesn’t crowd out much — it’s very effective because private investment wasn’t happening much anyway

Long-Run vs. Short-Run:

• Short-run: Expansionary fiscal policy can boost GDP

• Long-run: If deficits are sustained, higher interest rates can reduce private investment and slow down long-term economic growth