Pump Primer:

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Pump Primer
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• List the three options for Expansionary Fiscal
  Policy that should increase AD and reverse the
  recession, but will cause the budget balance to
  decrease.
•  
• List the three options for Contractionary Fiscal
  Policy that should decrease AD and reverse the
  inflation, but will cause the budget balance to
  increase.

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Module Long-run Implications of Fiscal Policy
Deficits and the Public Debt
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• KRUGMAN'S
• MACROECONOMICS for AP

Margaret Ray and David Anderson
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Biblical Integration

• Christians are called to be good stewards of the
  "things" given unto us. A budget is a good way to
  ensure you are spending and saving your money
  wisely. How we spend and save our money is a
  testimony to others, so we need to make sure it
  is done wisely. (Eph.515 1 Tim 6 15- 17)

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What you will learnin this Module

• Why governments calculate the cyclically adjusted
  budget balance
• Why a large public debt may be a cause for
  concern
• Why implicit liabilities of the government are
  also a cause for concern

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The Budget Balance

• We hear a lot about the federal, or your state,
  governments attempts to balance a budget. If
  there is a surplus, this is usually considered to
  be a good outcome. If there is a deficit, this is
  cause for concern.
• Before we decide whether something normatively
  good or bad, lets analyze the particulars.
• ?

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The Budget Balance as a Measure of Fiscal Policy

• The budget balance is the difference between the
  governments tax revenue and its spending, both
  on goods and services and on government
  transfers, in a given year.
• That is, the budget balancesavings by
  governmentis defined by
• SGovernment T -G -TR
• Where T is the value of tax revenues, G is
  government purchases of goods and services, and
  TR is the value of government transfers.

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The Budget Balance as a Measure of Fiscal Policy

• A budget surplus is a positive budget balance and
  a budget deficit is a negative budget balance.
• How does this relate to fiscal policy discussed
  in previous modules?

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The Budget Balance as a Measure of Fiscal Policy

• Case 1 Recessionary Gap
• Expansionary fiscal policy is in order (3
  options)
• Cut taxes.
• Increase transfers.
• Increase government spending.
• These three policies should increase AD and
  reverse the recession, but will cause the budget
  balance to decrease. This means either a smaller
  surplus or a bigger deficit.

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The Budget Balance as a Measure of Fiscal Policy

• Case 2 Inflationary Gap.
• Contractionary fiscal policy is in order (3
  options)
• Increase taxes.
• Decrease transfers.
• Decrease government spending.
• These three policies should decrease AD and
  reverse the inflation, but will cause the budget
  balance to increase. This means either a bigger
  surplus or a smaller deficit.

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The Budget Balance as a Measure of Fiscal Policy
But, changes in the budget balance dont always
perfectly reflect changes to fiscal policy. Two
important reasons why it is more complicated.  
Two different changes in fiscal policy that have
equal-size effects on the budget balance may have
quite unequal effects on the economy.   .
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The Budget Balance as a Measure of Fiscal Policy
  Example If government spending increases by
1000, it will have a larger impact on real GDP
than a tax decrease of 1000. The budget balance
would change by 1000 in each case, but the
impacts would be different.   Often, changes in
the budget balance are themselves the result, not
the cause, of fluctuations in the economy.
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The Business Cycle and the Cyclically Adjusted
Budget Balance

• Strong relationship between budget balance and
  business cycle

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The Business Cycle and the Cyclically Adjusted
Budget Balance

• Cyclically adjusted budget balance

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The Business Cycle and the Cyclically Adjusted
Budget Balance
The budget deficit almost always rises when the
unemployment rate rises and falls when the
unemployment rate falls.   Why? Is it a
deliberate result of expansionary fiscal policy?
Not necessarily.   Recall the automatic
stabilizers discussed in earlier modules. These
are programs built into our tax and transfer
system that work to reduce the swings of the
business cycle.
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The Business Cycle and the Cyclically Adjusted
Budget Balance
Several things happen to the budget balance when
the economy heads into a recession.   Tax
revenues decline because incomes and profits are
declining. Transfer payments, like welfare
assistance, begin to rise as more people find
themselves unemployed and struggling.   These
changes happen without any deliberate fiscal
policy changes and the budget balance declines.
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The Business Cycle and the Cyclically Adjusted
Budget Balance
On the other hand,   Several things happen to the
budget balance when the economy is heading into
an inflationary period.   Tax revenues rise
because incomes and profits are rising.
Transfer payments, like welfare assistance, begin
to fall as fewer people find themselves
unemployed and struggling.   These changes happen
without any deliberate fiscal policy changes and
the budget balance rises.
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The Business Cycle and the Cyclically Adjusted
Budget Balance
What we need is a way to separate out two effects
on the budget balance The impact due to
deliberate changes in fiscal policy. The impact
due to the current state of the business
cycle.   To do this many governments produce an
estimate of what the budget balance would be
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The Business Cycle and the Cyclically Adjusted
Budget Balance
The cyclically adjusted budget balance is an
estimate of what the budget balance would be, if
there was neither a recessionary nor an
inflationary gap,  
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The Business Cycle and the Cyclically Adjusted
Budget Balance

• It takes into account the extra tax revenue the
  government would collect and the transfers it
  would save if a recessionary gap were
  eliminatedor the revenue the government would
  lose and the extra 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 we might come to the conclusion
  that their fiscal policy decisions are not
  sustainable over the long run.

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Should the Budget Be Balanced?
Would it be a good idea to require a balanced
budget annually? Most economists dont think
so.   What if the economy is in a recessionary
gap. Falling tax revenue and rising transfer
payments push the budget toward deficit.   How
would we balance this deficit? We would need to
increase taxes or decrease government
spending.   How would that impact the
recession? It would worsen it!
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Should the Budget Be Balanced?

• What if the economy is in an inflationary gap.
•  
• Rising tax revenue and falling transfer
  payments push the budget toward surplus.
•  
• How would we balance this surplus?
• We would need to decrease taxes or increase
  government spending.
•  
• How would this impact the inflationary period?
  It would worsen it.

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Should the Budget Be Balanced?
Most economists believe that the government
should only balance its budget on averagethat it
should be allowed to run deficits in bad years,
offset by surpluses in good years.   Political
pressures (who doesnt like tax cuts?) make this
difficult. So are there serious downsides to an
unbalanced budget.
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Deficits, Surpluses, and Debt
Many politicians, voters, and cable news
commentators seem to be worried about the growing
debt in the U.S. economy. Lets look at how
economists evaluate this situation. When a
government spends more than the tax revenue it
receiveswhen it runs a budget deficitit almost
always borrows the extra funds. Governments that
run persistent budget deficits end up with
substantial debts.
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Deficits, Surpluses, and Debt
The national debt is the accumulation of all past
deficits, minus all past surpluses.   Public
debt government debt held by individuals and
institutions outside the government. US federal
governments public debt was only 5.8
trillion, or 40 of GDP at the end of the 2008
fiscal year.   5,800,000,000,000 Thats a lot of
zeroes!   Is this a big deal?
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Problems Posed by Rising Government Debt
Two reasons to be concerned when a government
runs persistent budget deficits.   1. When the
government borrows funds in the financial
markets, it is competing with firms that plan to
borrow funds for investment spending. As a
result, the governments borrowing may
crowd-out private investment spending,
increasing interest rates and reducing the
economys long-run rate of growth.
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Problems Posed by Rising Government Debt
2. Todays deficits, by increasing the
governments debt, place financial pressure on
future budgets. Interest must be paid in the
future, and this can take dollars away from other
future obligations like education, the military,
space exploration, etc.
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Problems Posed by Rising Government Debt
So out into the future, how can a government pay
off the debt?   Borrowing to pay off your debt
isnt really an option. Thats like getting a new
credit card to pay off the old credit card.
Eventually, that is the road to personal
bankruptcy. Nations have essentially declared
bankruptcy in the past. Its not pretty.  
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Problems Posed by Rising Government Debt
  Increase taxes or cut spending. Probably the
best solution, but isnt very politically
successful, especially when a nation has become
accustomed to low taxes.   Printing money.
Basically this means the Fed creates new money to
pay the debts of the Treasury. This proves to be
a fast track to serious inflation.
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Deficits and Debt in Practice
To assess the ability of governments to pay their
debt, we often use the debtGDP ratio, the
governments debt as a percentage of GDP.   We
use this measure, rather than simply looking at
the size of the debt, because GDP, which measures
the size of the economy as a whole, is a good
indicator of the potential taxes the government
can collect.
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Deficits and Debt in Practice
If the governments debt grows more slowly than
GDP, the burden of paying that debt is actually
falling compared with the governments potential
tax revenue.  
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Deficits and Debt in Practice

• Debt-GDP Ratio

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Implicit Liabilities
Implicit liabilities are spending promises made
by governments that are effectively a debt
despite the fact that they are not included in
the usual debt statistics.   In the U.S.,
promises to honor Social Security, Medicare and
Medicaid amount to 40 of federal spending.   Big
deal? Maybe, because the American population is
aging and these commitments will only get larger.