Inflation, Unemployment, and Stabilization Policies: Long-run Implications of Fiscal PolicyAP EconomicsMr. Bordelon

Budget Balance as a Measure of Fiscal Policy

NOTE: Do not think of balanced budgets as either good or bad.

Balanced budget is the difference between government tax revenue and spending on g/s and transfers in a given year.

Sgovernment = T – G – TR

Sgovernment: government savings

T: tax revenues

G: gov’t purchases of g/s

TR: government transfers

Budget surplus. Positive budget balance.

Budget deficit. Negative budget balance.

Budget Balance as a Measure of Fiscal Policy

Recessionary Gap. Expansionary fiscal policy.

Cut taxes.

Increase transfers.

Increase government spending.

These policies would increase AD and reverse the recession, and cause the budget balance to decrease.

Result: Smaller surplus or bigger deficit.

Budget Balance as a Measure of Fiscal Policy

Inflationary Gap. Contractionary fiscal policy.

Increase taxes.

Decrease transfers.

Decrease government spending.

These policies would decrease AD and reverse inflation, and cause the budget balance to increase.

Result: Bigger surplus or smaller deficit.

Budget Balance as a Measure of Fiscal Policy

Changes in budget balance do not always reflect changes to fiscal policy.

Two different changes in fiscal policy that have equal-size effects on the budget balance may have unequal effects on the economy.

Gov’t spending increases by $1,000. It will have a larger impact on real GDP than a tax decrease of $1,000. The budget balance would change by $1,000 in each case, but the impacts would be different.

Changes in the budget balance itself are sometimes the result of fluctuations in the economy (cyclical).

Business Cycle and Cyclically Adjusted Budget Balance

Budget deficit almost always increases when unemployment rate increases and decreases when unemployment rate decreases.

This is not necessarily a result of expansionary fiscal policy—automatic stabilizers!

Business Cycle and Cyclically Adjusted Budget Balance

Recession and the budget balanceTax revenues decrease because incomes and profits decrease.

Transfer payments (unemployment, welfare, etc.) increase as more people struggle.

This happens without deliberate fiscal policy changes and budget balance decreases.

Inflation and the budget balanceTax revenues increase because incomes and profits increase.

Transfer payments decrease as less people struggle.

This happens without any deliberate fiscal policy changes and budget balance increases.

Business Cycle and Cyclically Adjusted Budget Balance

Awesome. So how do we figure out the effect of the business cycle on the budget balance?

Deliberate changes in fiscal policy.

Current state of the business cycle.

Governments estimate what the budget balance would be if there was neither a recessionary nor an inflationary gap.

Business Cycle and Cyclically Adjusted Budget Balance

Cyclically adjusted budget balance. Estimate of what the budget balance would be if real GDP equaled potential output (YP).

This takes into account the extra tax revenue the gov’t would collect and transfers would save if a recessionary gap were eliminated.

This also takes into account the tax revenue the gov’t would lose and transfers it would make if an inflationary gap were eliminated.

If we adjust for the effects of the business cycle, and the government is still running a deficit, then it’s a good bet the gov’t’s fiscal policy decisions are not sustainable over the long run.

Should the Budget Be Balanced?

No, Shane, it should not. Why?

Recessionary gapTax revenue decreases and transfer payments increase, pushing the budget towards a deficit.

To balance the deficit, taxes would need to increase and/or gov’t spending would have to decrease.

This would make the recession worse.

Inflationary gapTax revenue increases and transfer payments decrease, pushing the budget towards a surplus.

To balance the surplus, taxes would need to decrease and/or gov’t spending would have to increase.

This would make inflation worse.

I love you too, Shane.

Fiscal Policy in the Long-Run

Deficits, Surpluses, and Debt. When a government spends more than the tax revenue it receives (budget deficit) it almost always borrows the extra funds. Governments that run persistent budget deficits end up with substantial debts.

National debt. Accumulation of all past deficits minus all past surpluses.

Public debt. Gov’t debt held by individuals and institutions outside the gov’t.

In fiscal year 2010, the public debt was $6.4 trillion. Problem?

Fiscal Policy in the Long-Run

Problems Posed by Rising Government DebtCrowding out. When the government borrows funds in financial markets, it competes with firms that plan to borrow funds for investment spending. Government’s borrowing can crowd-out private investment spending, increasing interest rates and reducing the economy’s long-run rate of growth.

Pressure on future budgets. Today’s deficits, by increasing government’s debt, place financial pressure on future budgets. Interest must be paid in the future, and this can take dollars away from other future obligations.

Fiscal Policy in the Long-Run

Problems Posed by Rising Government Debt

How can gov’ts pay off debt?Borrowing to pay off your debt. Bad idea—more debt.

Print money. Fed creates new money to pay debts of the Treasury. Bad idea—lots of inflation.

Increase taxes or cut spending. Best solution, but politically dangerous.

Fiscal Policy in the Long-Run

Deficits and Debt in PracticeDebt-GDP ratio. Gov’t’s debt as a percentage of GDP.

This measure is used because GDP measures the size of the economy as a whole, and is a good indicator of the potential taxes the government can collect.

If gov’t’s debt grows more slowly than GDP, burden of paying that debt is actually falling compared with the gov’t’s potential tax revenue.

Fiscal Policy in the Long-Run

Implicit LiabilitiesImplicit liabilities. Spending promises made by gov’t’s that are effectively a debt despite the fact that they are not included in debt statistics.

For the U.S., promises to honor Society Security, Medicare, and Medicaid amount to 40% of federal spending. This is a problem because the American population is aging and these commitments will continue to grow.

Question 1

The government’s budget surplus in Macroland has risen consistently over the past five years. Two government policy makers disagree as to why this has happened. One argues that a rising budget surplus indicates a growing economy; the other argues that it shows that the government is using contractionary fiscal policy. Can you determine which policy maker is correct? If not, why not?

Question 2

You are an economic adviser to a candidate for national office. She asks you for a summary of the economic consequences of a balanced-budget rule for the federal government and for your recommendation on whether she should support such a rule. How do you respond?

Question 3In which of the following cases does the size of the government’s debt and the size of the budget deficit indicate potential problems for the economy?

The government’s debt is relatively low, but the government is running a large budget deficit as it builds a high-speed rail system to connect the major cities of the nation.

The government’s debt is relatively high due to a recently ended deficit-financed war, but the government is now running only a small budget deficit.

The government’s debt is relatively low, but the government is running a budget deficit to finance the interest payments on the debt.