Tommy, Coral, Sean, Michael

4B

Module 30: Long-run Implications of Fiscal Policy: Deficits and the Public Debt

OBJECTIVES:

  • Determine why governments calculate the cyclically adjusted budget balance.
  • Determine why a large public debt may be a cause for concern.
  • Determine why implicit liabilities of the government are also a cause for concern.
  • Look at the long-term effects of fiscal policy, including budget balance, debt, and liabilities.

NOTES:

  • How does the government stabilize the economy?

The government can stabilize the economy through two different methods.

  1. Fiscal Policy – actions taken by Congress to stabilize the economy
  2. Monetary Policy – actions taken by the Federal Reserve Bank to stabilize the economy
  • What is the budget balance?

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. This is defined by an equation:

WhereS represents the total savings by the governmentin year, T represents the value of tax revenues, G is government purchases of goods and services, and TR is the value of government transfers.

Example

  1. In 2004, the total government savings was $6 billion dollars. If the government purchased $3 billion in goods and services and $2 billion on government transfers, how much money did the annual tax revenues consist of?

$11 billion

SGovernment = $6 billion, G = $3 billion, TR = $2 billion

$6 = T - $3 - $2

T = $11 billion in tax revenues in 2004

A budget surplus is a positive budget balance, and a budget deficit is a negative budget balance.

Expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. This can be done through cutting taxes, increasing transfers, and increasing government spending. The opposite processes are done for contractionary fiscal policies.

  • What is a deficit?

A deficit is the amount by which annual government spending exceeds tax revenues.

  • What is a surplus?

A surplus is the amount by which annual tax revenues exceed government expenditures.

  • The Budget Balance

A graph illustrating fluctuations in the budget deficit of a given country, which tends to be higher during recessions (indicated by the shaded areas below) and fall during expansions.

  • What is the cyclically adjusted budget balance?

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

  • What is a fiscal year?

The fiscal year is the budget totals for a country running from October 1st to September 30th and labeled according to the calendar year in which it ends.

  • What is the public debt?

The public debt is the total accumulation of all past yearly deficits and surpluses, held by individuals and institutions outside the government.

  • Why should we be concerned by a persistent deficit?

Crowding out investment

Rising debt may lead to government default, resulting in economic and financial turmoil. This can lead to interest on debt.

  • What is the purpose of the Debt-GDP Ratio?

Assesses the ability of a government to pay their debt.

If the government debt rises slower than GDP, the burden of paying is falling compared to the government’s potential tax revenue.

  • What are implicit liabilities?

Spending promises made by the government that are not included in debt.

Examples include social security, Medicare, and Medicaid, which is about 40% of federal spending

  • Problems with Fiscal Policy
  • Problems of timing

Recognition lag: Congress must react to economic indicators before it is too late

Administrative lag: Congress takes time to pass legislation

Operational lag: Spending/planning takes time to organize and execute (changing taxing is quicker)

  1. Politically motivated policies

Politicians may use economically inappropriate policies to get reelected. An example might be a president promising more public works programs when there is already an inflationary gap.

  1. Crowding-out effect

Government spending might cause unintended effects that weaken the impact of the policy

  • Example: We have a recessionary gap, the government creates a new public library (AD increases) but consumers spend less on books (AD decreases)
  1. Net export effect

International trade reduces the effectiveness of fiscal policies

  • Example: We have a recessionary gap so the government spends to increase AD, the increase in AD causes an increase in price level/interest rates, U.S. goods are now more expensive and the U.S. dollar appreciates, foreign countries buy less and net exports fall, decreasing AD.