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Chapter 6

Chapter 6. The Government Budget, the Government Debt, and the Limitations of Fiscal Policy. Key Questions. Can fiscal policy rescue monetary policy from ineffectiveness? What are the side effects of running a large budget deficit?

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Chapter 6

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  1. Chapter 6 The Government Budget, theGovernment Debt, and the Limitations of Fiscal Policy

  2. Key Questions Can fiscal policy rescue monetary policy from ineffectiveness? What are the side effects of running a large budget deficit? Why did the Great Depression last over a decade (from 1929 to 1941)? What are the lessons to be learned for applying fiscal policy to the Global Economic Crisis?

  3. The Recent US Government Budget Deficit 1998-2001: The U.S. ran a rare budget surplus, but subsequently reverted back to running deficits. Why? 2001-03: Political philosophy that favored tax cuts  T↓ Partially in response to 9/11 attacks  Military spending↑ 2008: The Global Economic Crisis  T↓ while Tr↑ 2008-10: Large fiscal stimulus package  T↓, Tr↑ and G↑

  4. Wars and the increasing size of the government • Five facts stand out in figure 6.1 • Government expenditures spike in war years, with WWII having much greater impact • Tax revenues exhibit a spike in wartime. • The size of the government increased in war years • Expenditures increase more than revenues during 1980s causing a persistent budget deficit • Revenues were 28-30% of GDP in 1980s and 1990s but declining back after.

  5. Figure 6-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2010 (1 of 2)

  6. The effect of recessions • During recessions government revenues decline and transfer payments increase. • Before 1980 deficits during recessions takes a sharp V shape, i.e., the deficits came to zero after recession. • Since 1980 deficits did not disappear after recessions and continued to be large. • The recession of 2008-09 cause by far the largest deficit due to fiscal stimulus and bail out programs.

  7. Figure 6-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2010 (2 of 2)

  8. Automatic stabilization and discretionary fiscal policy Net tax revenues T can be expressed as the net tax rate t times real income T = tY Hence government budget can be written as: Budget surplus = T - G = tY – G There are two main sources of changes in surplus or deficit - automatic stabilization (through changes in Y) - discretionary stabilization (through changes in t and G)

  9. Automatic stabilization • When Y increases taxes rise and transfer payments fall. • This higher surplus or less deficit helps to stabilize the economy. • In a recession taxes decrease and transfer payments increase help to dampen the recession. • The automatic stabilization effect of Y is illustrated in figure 6.2 • If G0 and t0 are constant, the slope of the budget line (BB) is t0 (tax rate)

  10. At YN there is a balanced budget. At Y0 there is a deficit as tax revenues decrease (t0∆Y) • The budget line shows the budget surplus or deficit at different Y levels. • The budget line slopes upward as higher Y raises tax revenues t0Y causing more surplus or less deficit. • Changes in Y causes a movement from along BB curve

  11. Figure 6-2 The Relation Between the Government Budget Surplus or Deficit and Real Income Budget balance

  12. Discretionary fiscal policy • Discretionary fiscal policy • alters tax rates or government expenditures deliberately to influence real output and the unemployment rate. • Figure 6.3 shows the effect of discretionary fiscal policy. • Suppose that government spending increases from G0 to G1, the budget line shifts down from BB0 to BB1 causing a lager deficit at Y0. • There are 3 ways to reduce the deficit 1. Movement from C to D (through expansionary monetary policy) causing Y to increase to YN. 2. Movement from C to B (decrease G) 3. increase the tax rate t0

  13. Figure 6-3 Effect on the Budget Line of an Increase in Government Expenditures Cyclical deficit

  14. As shown in 6.3 the budget can affect the economy and the economy can affect the budget. • An in crease in G or a reduction in T shifts the IS to the RHS causing Y to increase and sift BB upwards and vice versa.

  15. The natural employment surplus of deficit • The natural unemployment surplus (NES) (or deficit NED) is the government budget surplus or deficit if actual output Y equalsnatural output YN. • NES (NED) = tYN - G • NES is sometimes called Structural Deficit. • The CBO uses “Standardized Budget Deficit” for the natural or structural budget deficit • The Cyclical Deficit is the amount by which the actual government budget deficit exceeds the structural deficit. • The Structural Surplus (or equivalently, the Natural Employment Surplus (NES)) and the Cyclical Surplus are the same as the deficit concepts with the signs reversed.

  16. Figure 6-4 A Comparison of the Actual Budget and the Natural Employment Budget, 1970–2010

  17. Government debt: Basic concepts The public debt is the total amount of bonds and other government liabilities (or securities) that the government has issued. The gross debt is the same as the public debt. The net debt subtracts out debt held inside the government (intra-government debt), including government securities held by the Federal Reserve and the trust funds of Social Security and Medicare. The public debt is also the sum of all fiscal deficits (and/or surpluses) over time: Debt (end of 2011) = Debt (end of 2010) + Fiscal Deficit (during 2011)

  18. The Future Burden of the Government The future burden of the debt depends on the type of spending, i.e., consumption or investment. The burden of government borrowing for investment projects like building highways or schools is none,as long as the future return is greater than the social cost of the project. If some investment projects, like a rarely used highway, yield a very low return, then there will be future costs. What about the burden of government borrowing to pay for consumption items like bullets and food stamps? Since government consumption spending has only current benefits, there will costs to pay in the future. Future costs = interest plus debt principal repayment

  19. Will the Government Remain Solvent? How can we tell if the budget deficit is too high? Key variable: Debt to nominal GDP ratio(D / PY) Notation: The level of a variable is represented by a capital letter, while the growth rate of the variable is lowercase. The government will be able to afford its debt if the debt to nominal GDP ratio is stable over time. It can be shown that the growth of (D / PY) = d – (p + y) For stability of D/PY ratio we need: d = p + y Growth of debt/GDP ration must equal the growth of nominal GDP.

  20. Stability  growth of (D / PY) = 0  d = p + y (1) • Note: Additional debt each year = budget deficit = dD • Multiplying (1) by D on both sides  dD = (p + y)D (2) • The allowable deficit equals the rate of growth of nominal GDP times the debt • Result: D / PY remains constant if the budget deficit equals the outstanding debt times the growth rate of nominal GDP! • The deficit must equal (2) for D/PY to remain constant. • Example if p+y=5%, D=9000 billion • dD = (p+y)D= 0.05(9000) = 450 billion. • The maximum allowable deficit is $450 billion for the debt ratio to remain constant

  21. The Solvency Condition Note that: The basic limitation on the amount of government debt is that the government must pay interest on its debt. But as long as nominal GDP is growing and interest rates are low, the government can borrow more to pay the yearly interest expense and still maintain a constant D / PY.

  22. The Solvency Condition The solvency condition states that the government can meet its interest bill forever by issuing more bonds without increasing the debt-GDP ratio only if the economy’s growth rate (p + y) equals or exceeds its actual nominal interest rate (r). What about the U.S. debt level in 2010? D = $9,000B and suppose (p + y) = 5% Stability  d = 5%  Allowable deficit = 0.05*($9,000B) = $450B Actual deficit was much higher than $450B  (D / PY) ↑

  23. International Perspective The Debt-GDP Ratio: How Does the U.S. Compare?

  24. Figure 6-5 The Ratio of U.S. Government Debt to GDP, 1790-2010

  25. The Fiscal Policy Multiplier Effect Recall from Chapter 3 that the multiplier effect of an increase in G is greater than a cut in T because G has a direct effect on spending Other factors decreasing the multiplier effect include: Leakages from the spending stream that reduce induced consumption Income Taxes Imports Corporate Profits Higher interest rates that reduce interest-sensitive spending Capacity constraints when the economy is close to full employment  government purchases push aside private purchases Lesson: Fiscal stimulus is much more appropriate and effective when the economy is weak.

  26. Table 6-1 Multiplier Estimates for Selected Types of Fiscal Stimulus

  27. The Overall Effectiveness of the Bush-Obama Fiscal Stimulus The overall results from the stimulus are mixed Hundreds of billions in tax cuts had little impact on GDP Infrastructure spending was rolled out very slowly (only 40% spent by 2010) Most effective parts of the stimulus were aid to state and local governments and unemployment benefit extensions. Overall benefit according to one study = 7.8% of GDP Compare to overall cost of 7.6% of GDP Result: Overall multiplier = 7.8 / 7.6 = 1.03

  28. Table 6-2 Size of Fiscal Stimulus Measures in 2008-10

  29. Figure 6-6 The Role of Automatic Stabilizers in the Recession of 2008-09

  30. Bailouts as Unconventional Stimulus The severity of the 2008-09 crisis necessitated additional policies to prevent economic collapse. These novel policies have been called “financial policies” or “bailout policies.” These policies do not count as monetary or fiscal policies because they were carried out by both the Federal Reserve and the Treasury in cooperation with each other. The core bailout program was the Troubled Asset Relief Program (TARP). Initiated two weeks after the fall of Lehman Brothers Lent government money to financial institutions on the brink of insolvency due to insufficient equity capital Also prevented the sale of GM and Chrysler Motors Initial cost = $700B, but after loan repayment, estimated cost = $100B Measures of success of bailouts Risk premium fell from 5.5% (winter 2009) to 2.7% (mid 2010) One study: Without bailouts, Y would have been 5% lower and U = 12.5% Controversies persist because… Benefits not widely publicized Bailout of financial institutions seemed to reward those who caused the crisis!

  31. Recall the “Magic Equation” from Chapter 2: T – G = (I + NX) – S • The Magic Equation suggests 3 ways to finance a budget deficit (i.e. T – G < 0) • Private saving (S) can go up • Investment (I) can fall • Foreign investment (NX) can fall • Because an increase in the budget deficit increases the total public debt, persistent budget deficits can lead to higher taxes in the future.

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