Chapter 32

1. Chapter 32 Budget Deficits in the Short and Long Run Blessed are the young, for they shall inherit the national debt. HERBERT HOOVER

2. Budget – Always Balanced? Short Run • Balance • Aggregate supply and aggregate demand • Budget deficits, when • Private demand [C+I+G+(X-IM)] is weak • Budget surpluses, when • Private demand [C+I+G+(X-IM)] is strong

3. Budget – Always Balanced? Short Run • Budget – balanced • When C+I+G+(X-IM) • Approximately equals potential GDP • Balance budget – during recessions • Prolong & deepen slumps • Appropriate fiscal policy • Depends on current monetary policy

4. Figure 1 The interaction of monetary and fiscal policy Potential GDP S B Effect of Monetary policy A Effect of fiscal policy Price Level D0 D1 D1 D0 S Y1 Y0 Real GDP

5. Surpluses and Deficits: Long Run • Aggregate demand – unchanged • Real GDP – unchanged • Combinations: fiscal & monetary policy • E.g. • Government – raise taxes • Reduce aggregate demand • The Fed – cut interest rates • Increase aggregate demand

6. Surpluses and Deficits: Long Run • More expansionary fiscal policy • And tight monetary policy • Higher interest rates • Lower investment – less capital formation • Slower growth of potential GDP • Tighter budget (fiscal policy) • And looser monetary policy • Lower interest rates • Higher investment • Faster growth of potential GDP

7. Surpluses and Deficits: Long Run • Composition of aggregate demand • Major determinant • Rate of economic growth • Larger fraction of GDP – investment • Capital stock - grow faster • Aggregate supply schedule • Shift more quickly to right • Accelerated growth

8. Figure 2 Growth and investment in 24 countries

9. Deficits & Debt: Terminology & Facts • Budget deficit • Expenditures exceed receipts • Specified period of time • Budget surplus • Receipts exceed expenditures • National debt (public debt) • Total indebtedness • At a moment in time • Result of previous budget deficits

10. Deficits & Debt: Terminology & Facts • Government • Accumulates debt • Runs deficits • Reduces debt • Runs surpluses • Net national debt • 35% of GDP, 2007

11. Figure 3 The U.S. national debt relative to GDP, 1915–2007

12. Interpreting Budget Deficit or Surplus • Deficit = G + Transfers – Taxes = = G – (Taxes – Transfers) = = G – T • No change in fiscal policy • Deficit • Rises in a recession • Falls in a boom

13. Figure 4 Official fiscal-year budget deficits, 1981–2007

14. Figure 5 The effect of the economy on the budget T =Taxes - Transfers A B Surplus G Spending and Tax Receipts Deficit Y1 Y2 Y3 Gross Domestic Product

15. Interpreting Budget Deficit or Surplus • Structural budget deficit • Hypothetical deficit • Under current fiscal policies • If economy - near full employment • Doesn’t depend on state of economy • Changes • Only when policy changes • Not when GDP changes

16. Table 1 Alternative budget concepts, 1981–2007

17. Interpreting Budget Deficit or Surplus • Overall budget deficit = = On-budget deficit + Off-budget deficit • Off-budget • Social Security expenditures • Payroll tax receipts - finance them

18. Why: National Debt Considered a Burden? • National debt - owned by domestic citizens • Future interest payments • Transfer funds • From one group of Americans • To another • National debt - owned by foreigners • Burden on the nation as a whole

19. Why: National Debt Considered a Burden? • Fundamental difference • Nations - borrow in their own currency • Don’t default on their debt • Nations - borrow in some other currency • Might have to default on their debts

20. Budget Deficits and Inflation • Deficit spending • Increase aggregate demand • Higher real GDP • Higher price level • Budget deficits • Inflationary • Slope of aggregate supply curve • Degree of resource utilization • Policy mix

21. Figure 6 The inflationary effects of deficit spending D0 D1 Potential GDP S C B A Aggregate supply curve shifts inward as wages rise Deficit spending boosts aggregate demand Price Level 106 112 100 D1 D0 S $5,000 0 $6,000 $8,000 $7,000 Real GDP

22. Budget Deficits and Inflation • Monetize the deficit • Central bank • Purchases bonds issued by government • Deficit spending • Higher GDP & price level • Increase demand for bank reserves • Fed – no action • Interest rates – increase

23. Figure 7 Fiscal expansion and interest rates D1 D0 S Shift in demand for reserves caused by rising Y and P For given Fed policy B A Interest Rate D0 D1 S Quantity of Bank Reserves

24. Budget Deficits and Inflation • Deficit spending • Higher GDP & price level • Increase demand for bank reserves • Fed – expansionary monetary policy • Purchase government debt • Increase supply of bank reserves • No increase in interest rates • Increase money supply

25. Figure 8 Monetization and interest rates D1 D0 S0 S1 Expansionary Fed policy B A C Interest Rate D0 D1 S0 S1 Quantity of Bank Reserves

26. Debt, Interest Rates, and Crowding Out • Large budget deficit • And no Fed monetization • Higher interest rate • Lower investment • Future • Less capital • Smaller potential GDP • Burden future generations

27. Debt, Interest Rates, and Crowding Out • Crowding out • Deficit spending by government • Higher interest rates • Decreases private investment spending • Dominates – long run • Crowding in • Government spending • Faster real economic growth • Increase in private investment spending • More powerful – short run

28. Burden of National Debt: Slower Growth • Government budget deficits • For: high-employment economy • Crowding-out effect – dominates • Less investment • Smaller capital stock • Lower potential GDP • Future generations • Burden

29. Burden of National Debt: Slower Growth • Government budget deficits • For: high unemployment economy • More investment • Crowding-in effect dominates • Higher growth • Blessing

30. Burden of National Debt: Slower Growth • U.S. national debt • Not bankruptcy • Burden on future generations • If sold to foreigners • If contracted - fully employed, peacetime • Reduce the nation’s capital stock • Some circumstances • Budget deficits • Appropriate for stabilization-policy purposes

31. Burden of National Debt: Slower Growth • U.S. national debt • Until 1980s • Contracted: wars and recessions • Not a burden • Large deficits of 1980s and 2000s • Worrisome • Shift from budget surpluses to deficits • Slow down capital formation • Slow down future economic growth

32. Figure 9 Short-run effect of larger deficits or smaller surpluses D1 D0 S B A Price Level D0 D1 S Real GDP

33. Figure 10 Long-run effect of larger deficits or smaller surpluses D Potential GDP Potential GDP S0 S1 B A Price Level D S0 S1 Y0 Y1 Real GDP

34. Economics & Politics of US Budget Deficit • Deficits of 1980s, 1990s, and 2000s • Recessions: 1981-1982, 1990-1991, 2001 • Crowding out – not a serious concern • Actions - close the deficit • Threaten subsequent recoveries • Growing deficits - appropriate in each case • Crowding out - more serious issue • Economy recovered • 1990s, 2004-2007 • Budget deficit – declined • 1980s, 2002-2004 • Structural deficit – increased

35. Economics & Politics of US Budget Deficit • Get rid of deficit in 1990s • Raising taxes & reducing spending • 3 steps • Bipartisan budget agreement, 1990 • Deficit reduction package , 1993 • Smaller bipartisan budget deal, 1997 • Expansionary monetary policies • Rapid economic growth, late 1990s • More tax revenue • Off-budget surplus – increased • Budget surplus

36. Economics & Politics of US Budget Deficit • Surplus - gave way to large deficits rapidly • Recession • Tax cuts • Higher spending • National defense • Homeland security

37. Economics & Politics of US Budget Deficit • Future prospects for federal budget deficit • Not very good • 2011 - baby boomers • Medicare • Social Security benefits • Sharp increase in federal spending • If nothing changes • Budget deficit will start to grow again