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“I'm not worried about the deficit. It is big enough to take care of itself.” Ronald Reagan

“I'm not worried about the deficit. It is big enough to take care of itself.” Ronald Reagan. Fiscal Policy, Deficits, and Debt. Chapter Objectives. Some Definitions Purposes, Tools, and Limitations of Fiscal Policy Role of Built-In Stabilizers in Moderating Business Cycles

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“I'm not worried about the deficit. It is big enough to take care of itself.” Ronald Reagan

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  1. “I'm not worried about thedeficit. It is big enough to take care of itself.” Ronald Reagan Fiscal Policy, Deficits, and Debt

  2. Chapter Objectives • Some Definitions • Purposes, Tools, and Limitations of Fiscal Policy • Role of Built-In Stabilizers in Moderating Business Cycles • Possible Problems

  3. Some DefinitionsFiscal Policy Fiscal Policy • Changes in government purchases and tax collections designed to achieve full employment and non-inflationary domestic output. Discretionary Fiscal Policy • Deliberate changes in fiscal policy made by Congress to affect the level of economic activity Nondiscretionary Fiscal Policy • Automatic Stabilizers

  4. Some Definitions Debt and Deficit • Budgets are annual, beginning over again every year. • Government debt is a running total of the budget balances. • Budget surplusoccurs when tax revenues are greater than government expenditures. • Budget deficitoccurs when tax revenues are less than government expenditures

  5. Some Definitions Debt and Deficit Government Debt • Sum of all budget surpluses and deficits incurred by the US government since there WAS a U.S. government. • As of October 23, the US government debt was $11,895,889,017,77615

  6. Some Definitions Debt and Deficit • When the government has a budget surplus, the government debt decreases. • When the government has a budget deficit, the government debt increases. • The deficit (or surplus) = Govt spending – Tax revenues • The deficit is financed by selling government bonds (borrowing).

  7. Fiscal Policy and the AD-AS Model Expansionary Policy • Expansionary policy is used to fix recession, increase (expand) aggregate demand and real output. • Expansionary fiscal policies are: • Increase Government spending (‘G’ up) • Cut Taxes (‘C’ up) • Some combination of the two

  8. Fiscal Policy and the AD-AS ModelContractionary Policy • Contractionary policy is used to curb inflation, decrease (contract) aggregate demand and real output. • Contractionary fiscal policies are: • Decrease Government spending (‘G’ down) • Raise Taxes (‘C’ down) • Some combination of the two

  9. AD1 Recessionary Gap (Real Output < Potential) Fiscal Policy and the AD-AS ModelExpansionary Fiscal Policy LRAS Increase G or Cut Taxes SRAS Price Level P1 P0 AD0 $490 $510 = Potential GDP Real Domestic Output, GDP

  10. Fiscal Policy and the AD-AS ModelExpansionary Fiscal Policy LRAS Price Level SRAS P1 AD1 $510 = Potential GDP Real Domestic Output, GDP

  11. P1 AD1 Inflationary Gap (Real Output > Potential) Fiscal Policy and the AD-AS ModelContractionary Fiscal Policy LRAS Decrease G or Raise Taxes SRAS P0 Price Level AD0 Potential GDP = $510 $520 Real Domestic Output, GDP

  12. Fiscal Policy and the AD-AS ModelContractionary Fiscal Policy LRAS Price Level SRAS P1 AD1 Potential GDP = $510 Real Domestic Output, GDP

  13. Non-discretionary Fiscal Policy Automatic Stabilizers 1. Tax Structure: • Progressive Tax System • As income increases, percentage of income paid toward tax increases • Proportional Tax System • All incomes pay same percentage of income toward tax • Regressive Tax System • As income increases, percentage of income paid toward tax decreases

  14. Nondiscretionary Fiscal Policy Automatic Stabilizers Our U.S. income tax is progressive: • When economy contracts (recession), progressive tax system causes laid off employees to pay lower tax bill, partially offsetting loss of income, dampening recession. • When incomes increase in expansion, taxpayers jump into higher tax brackets, pay more taxes, lessening impact of overheated economy.

  15. Nondiscretionary Fiscal Policy Automatic Stabilizers 2. Means Tested Benefits (government benefits tied to income): • When economy contracts (recession), more people qualify for means-tested benefits (welfare, Medicaid, unemployment benefits), lessening impact of income loss. • When incomes increase in expansion, transfer payments for means-tested benefits decrease, lessening impact of overheated economy.

  16. Fiscal PolicyPossible Problems Timing • Recognition Lag • Takes time to recognize that intervention is necessary. • Administrative Lag • Takes LOTS of time for Congress to pass spending or tax legislation. • Operational Lag • Takes time for policy to take effect, change behavior, impact aggregate demand.

  17. Fiscal PolicyPossible Problems It is possible that discretionary fiscal policy can take so long to implement that the economy doesn’t need it anymore, or could require a boost in the opposite direction.

  18. Fiscal PolicyPossible Problems Crowding-Out Effect • Expansionary government spending (G) when there is already a budget deficit, means the government will have to borrow (issue bonds). • That borrowing, ceteris paribus, will put upward pressure on interest rates. • Higher interest rates will cause investment (I) to fall. • So government purchases can “crowd out” private investment, pushing aggregate demand in opposite direction. • SO, will aggregate demand increase or decrease??

  19. – 6 – 4 – 2 0 2 4 6 Full-Employment Budget Deficits or Surpluses as a Percentage of Potential GDP, 2005 Surpluses Deficits New Zealand Denmark Canada Ireland France Norway United Kingdom United States Japan +4.6 +3.1 +1.2 – 1.3 – 2.4 – 3.0 – 3.0 – 3.6 – 6.3 Source: Organization for Economic Cooperation and Development

  20. 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Federal Budget Deficits and Surpluses Actual and Projected, Fiscal 1992 – 2012 Actual Projected (as of March 2006) $300 200 100 0 -100 -200 -300 -400 -500 -1,381 -1,587 -921 -590 Budget Deficit (-) or Surplus, Billions Source: Congressional Budget Office

  21. US Federal Debt Held by the Public, 1940 - 2009

  22. US Federal Debt Held by the Public as aPercentage of GDP, 1940 - 2009

  23. US Federal Debt Held by the Public as aPercentage of GDP, 1970 - 2008 50% 40% 30% Debt Held by Public / GDP 20% 10% 0% 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Congressional Budget OfficeAs of March 2009

  24. Fiscal Policy, Deficits, and Debt Wrap-Up Fiscal Policy Government Deficit Government Debt Discretionary Expansionary Non-Discretionary Contractionary AutomaticStabilizers Evaluation

  25. Key Terms • Fiscal policy • Expansionary fiscal policy • Budget deficit • Contractionary fiscal policy • Budget surplus • Built-in stabilizer • Progressive tax system • Proportional tax system • Regressive tax system • Crowding-out effect • Public debt • US securities

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