15 budget deficits in the short and long run blessed are the young, for they shall inherit the...

1515

Budget Deficits in the Short and Long Run

Blessed are the young, for they shall

inherit the national debt.HERBERT HOOVER

Budget Deficits in the Short and Long Run

Blessed are the young, for they shall

inherit the national debt.HERBERT HOOVER

● Should the Budget Be Balanced? The Short Run

● Surpluses and Deficits: The Long Run

● Deficits and Debt: Terminology and Facts

● Interpreting the Budget Deficit or Surplus

● Why is the National Debt Considered a Burden?

● Should the Budget Be Balanced? The Short Run

● Surpluses and Deficits: The Long Run

● Deficits and Debt: Terminology and Facts

● Interpreting the Budget Deficit or Surplus

● Why is the National Debt Considered a Burden?

ContentsContents

Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

● Budget Deficits and Inflation

● Debt, Interest Rates, and Crowding Out

● The Main Burden of the National Debt: Slower Growth

● The Economics and Politics of the U.S. Budget Deficit

● Budget Deficits and Inflation

● Debt, Interest Rates, and Crowding Out

● The Main Burden of the National Debt: Slower Growth

● The Economics and Politics of the U.S. Budget Deficit

Contents (continued)Contents (continued)


Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

● Not always.♦ Attempts to achieve balance during a recession

or an inflationary episode would destabilize the economy.

● Not always.♦ Attempts to achieve balance during a recession

or an inflationary episode would destabilize the economy.

Should the Budget be Balanced? The Short RunShould the Budget be Balanced? The Short Run


Should the Budget be Balanced? The Short RunShould the Budget be Balanced? The Short Run

● The Importance of the Policy Mix♦ The appropriate fiscal policy depends, among

other things, on the current monetary policy stance.

♦ While a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another.

● The Importance of the Policy Mix♦ The appropriate fiscal policy depends, among

other things, on the current monetary policy stance.

♦ While a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another.

FIGURE 1: The Interaction of Monetary and Fiscal Policy

FIGURE 1: The Interaction of Monetary and Fiscal Policy


Effect of fiscal policy

Effect of monetary policy

S

S

Y1

D0

D0

Y0

Real GDP

Pri

ce

Le

ve

l

Potential GDP

D1

D1

A

B


● More expansionary fiscal policy and tighter money supply should produce higher real interest rates and therefore lower investment, slowing economic growth.

● More restrictive fiscal policy and looser monetary policy should reduce real interest rates and hence increase investment and spur economic growth.

● More expansionary fiscal policy and tighter money supply should produce higher real interest rates and therefore lower investment, slowing economic growth.

● More restrictive fiscal policy and looser monetary policy should reduce real interest rates and hence increase investment and spur economic growth.

Surpluses and Deficits: The Long RunSurpluses and Deficits: The Long Run

FIGURE 2: Growth and Investment in 24 Countries

FIGURE 2: Growth and Investment in 24 Countries


32 30 28 26 24 22

Japan

Norway Portugal

Finland

Austria

Luxembourg

Italy

Spain

Iceland

Ireland

Canada Greece

Germany France

Australia

Switzerland

New Zealand

Netherlands Sweden

Denmark U.S.

Turkey

Belgium

U.K.

20 18

Average Investment as Percent of GDP, 1970–1990

Ave

rag

e A

nn

ual

Gro

wth

Rat

e o

f p

er

Cap

ita

Rea

l G

DP

, 19

70–

1990

0

1

2

3

4%


Deficits and Debt: Terminology and FactsDeficits and Debt: Terminology and Facts

● Budget Deficit = excess of a government’s expenditures over its receipts in a period of time♦ A flow

● National Debt = total value of government indebtedness at a moment in time♦ A stock

● Budget Deficit = excess of a government’s expenditures over its receipts in a period of time♦ A flow

● National Debt = total value of government indebtedness at a moment in time♦ A stock


Deficits and Debt: Terminology and FactsDeficits and Debt: Terminology and Facts

● Some Facts about the National Debt♦ In absolute terms the debt is large, but as a

proportion of GDP it is less than one half.

♦ Some, but not all, is backed by government assets.

♦ Before the 1980s, most of the debt was accumulated in times of war and recession.

● Some Facts about the National Debt♦ In absolute terms the debt is large, but as a

proportion of GDP it is less than one half.

♦ Some, but not all, is backed by government assets.

♦ Before the 1980s, most of the debt was accumulated in times of war and recession.

FIGURE 3: The U.S. National Debt Relative to GDP, 1915-2004

FIGURE 3: The U.S. National Debt Relative to GDP, 1915-2004


Ratio of Public Debt toGross Domestic ProductRatio of Public Debt toGross Domestic Product

0.33

Ratio of Public Debt toGross Domestic Product

Year

0.50

0.67

1.00

1925 1935 1945 1955 1965 1975 1985 1995

WorldWar I

GreatDepression

WorldWar II

1974–1975Recession

1981–1984Tax cuts

1981–1982Recession

2005

1993 BudgetAgreement

2001–2003Tax cuts

1915

Rat

io o

f P

ub

lic D

ebt

toG

ross

Do

mes

tic

Pro

du

ct


● Deficit rises in a recession and falls in a boom even with no change in fiscal policy.

● Structural deficit (or surplus) = what the deficit (or surplus) would be at full employment ♦ Portion of the deficit unrelated to the business

cycle♦ Shows how the deficit is related to government

policy

● Deficit rises in a recession and falls in a boom even with no change in fiscal policy.

● Structural deficit (or surplus) = what the deficit (or surplus) would be at full employment ♦ Portion of the deficit unrelated to the business

cycle♦ Shows how the deficit is related to government

policy

Interpreting the Budget Deficit or SurplusInterpreting the Budget Deficit or Surplus

FIGURE 4: Official Fiscal-Year Budget Deficits, 1981-2004

FIGURE 4: Official Fiscal-Year Budget Deficits, 1981-2004


Fiscal Year

Federal Budget Deficit

0

–100

–150

–200

–300

–250

–400

–350

100

–50

50

150

200

250

300

350

$400

’00 ’01’02 ’03 ’04’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97

’98 ’99

Deficits

Surpluses

FIGURE 5: The Effect of the Economy on the Budget

FIGURE 5: The Effect of the Economy on the Budget


Gross Domestic Product

Sp

end

ing

an

d T

ax R

ecei

pts

Surplus

Deficit

G A

Y3 Y2 Y1

T = Taxes – Transfers

B


● On-budget Versus Off-budget Surpluses♦ Overall budget surplus = off-budget surplus +

on-budget surplus

♦ Off-budget surplus = revenues – expenditures of off-budget items (primarily Social Security taxes and payments)

♦ On-budget surplus = revenues – expenditures of on-budget items (most other items)

● On-budget Versus Off-budget Surpluses♦ Overall budget surplus = off-budget surplus +

on-budget surplus

♦ Off-budget surplus = revenues – expenditures of off-budget items (primarily Social Security taxes and payments)

♦ On-budget surplus = revenues – expenditures of on-budget items (most other items)

Interpreting the Budget Deficit or SurplusInterpreting the Budget Deficit or Surplus

TABLE 1: Alternative Budget Concepts, 1981-2003

TABLE 1: Alternative Budget Concepts, 1981-2003



Why the National Debt is Considered a BurdenWhy the National Debt is Considered a Burden

● “Our children will be burdened by high interest payments.”♦ Only a burden if the debt is held by foreigners.

♦ If held by domestic citizens, then future interest payments just transfer funds from one group of Americans to another.

● “Our children will be burdened by high interest payments.”♦ Only a burden if the debt is held by foreigners.

♦ If held by domestic citizens, then future interest payments just transfer funds from one group of Americans to another.


Why the National Debt is Considered a BurdenWhy the National Debt is Considered a Burden

● “A nation has a limited capacity to borrow.”♦ Debt is paid in U.S. dollars, so that the

government can always print more money to repay the debt and avoid default.

♦ If debt is denominated in some other currency, then it may be forced to default.

● “A nation has a limited capacity to borrow.”♦ Debt is paid in U.S. dollars, so that the

government can always print more money to repay the debt and avoid default.

♦ If debt is denominated in some other currency, then it may be forced to default.


● Deficits AD♦ Can cause inflation if economy is strong, since

AS curves slope upward

● Deficits AD♦ Can cause inflation if economy is strong, since

AS curves slope upward

Budget Deficits and InflationBudget Deficits and Inflation

FIGURE 6: The Inflationary Effects of Deficit Spending

FIGURE 6: The Inflationary Effects of Deficit Spending


Deficit spending boosts aggregate demand

Aggregate supply curve shifts inward as wages rise

Real GDP

S

S

D0

D0

$8,000 $7,000 $6,000 $5,000

112

106

Pri

ce

Le

ve

l

100

D1

D1 Potential GDP

C

B

A



● The Monetization Issue♦ If the Federal Reserve takes no countervailing

actions, an expansionary fiscal policy that increases the budget deficit will tend to■ real GDP and prices■Cause outward shift of the demand curve for

money interest rates

● The Monetization Issue♦ If the Federal Reserve takes no countervailing

actions, an expansionary fiscal policy that increases the budget deficit will tend to■ real GDP and prices■Cause outward shift of the demand curve for

money interest rates

FIGURE 7: Fiscal Expansion and Interest Rates

FIGURE 7: Fiscal Expansion and Interest Rates


S

S

D 0

D0

Inte

res

t R

ate

Shift in reserve demand caused by rising Y and P

For given Fed policy

Quantity of Bank Reserves

D 1

D1

A

B



● The Monetization Issue♦ If the Fed does not want interest rates to rise

■It can engage in expansionary open-market operations, that is, purchase more government debt.

■The money supply will then increase.■The portion of the deficit purchased by the Fed has

been monetized.

● The Monetization Issue♦ If the Fed does not want interest rates to rise

■It can engage in expansionary open-market operations, that is, purchase more government debt.

■The money supply will then increase.■The portion of the deficit purchased by the Fed has

been monetized.

FIGURE 8: Monetization and Interest Rates

FIGURE 8: Monetization and Interest Rates


S0

S 0

D 0

D0

Inte

rest

Rat

e

Expansionary Fed policy

Quantity of Bank Reserves

S1

S 1

D 1

D1

C

B

A

Monetized Deficit SpendingMonetized Deficit Spending


Real GDP

Expansionary monetary policy

Pri

ce

Lev

el

Expansionary fiscal policy

D 0

D0

D1

D 1

D2

D 2

S

S

AB

C


● Crowding out♦ Occurs when unemployment is low deficit interest rates investment + capital stock

♦ Investment spending is thus crowded out by government deficit.

● Crowding out♦ Occurs when unemployment is low deficit interest rates investment + capital stock

♦ Investment spending is thus crowded out by government deficit.

Debt, Interest Rates, and Crowding OutDebt, Interest Rates, and Crowding Out


Debt, Interest Rates, and Crowding OutDebt, Interest Rates, and Crowding Out

● Crowding in♦ Occurs when unemployment is high deficit output savings +

capacity utilization investment + capital stock

● Crowding-in is likely to dominate in the short run, crowding-out in the long run.

● Crowding in♦ Occurs when unemployment is high deficit output savings +

capacity utilization investment + capital stock

● Crowding-in is likely to dominate in the short run, crowding-out in the long run.


Main Burden of the National Debt: Slower GrowthMain Burden of the National Debt: Slower Growth

● Much of the debt prior to the 1980s was accrued during recessions, when crowding-in probably occurred.

● Since 1980, high deficits have often persisted along with high employment, leading one to think that crowding-out predominated.

● Much of the debt prior to the 1980s was accrued during recessions, when crowding-in probably occurred.

● Since 1980, high deficits have often persisted along with high employment, leading one to think that crowding-out predominated.



● The arguments that a large national debt may lead the nation into bankruptcy, or unduly burden future generations who have to make onerous payments of interest and principal, are mostly bogus.

● The arguments that a large national debt may lead the nation into bankruptcy, or unduly burden future generations who have to make onerous payments of interest and principal, are mostly bogus.



● The national debt will be a burden if ♦ It is sold to foreigners.

♦ It is contracted in a fully employed, peacetime economy.

♦ In the latter case, it will reduce the nation’s capital stock.

● The national debt will be a burden if ♦ It is sold to foreigners.

♦ It is contracted in a fully employed, peacetime economy.

♦ In the latter case, it will reduce the nation’s capital stock.



● Under some circumstances, budget deficits are appropriate for stabilization-policy reasons.

● Until the 1980s, the public debt was mostly contracted as a result of wars and recessions.♦ Precisely the circumstances under which the

valid burden-of-the-debt argument does not apply

● Under some circumstances, budget deficits are appropriate for stabilization-policy reasons.

● Until the 1980s, the public debt was mostly contracted as a result of wars and recessions.♦ Precisely the circumstances under which the

valid burden-of-the-debt argument does not apply



● However, the large deficits of the 1980s and 1990s were not mainly attributable to recessions, and were therefore worrisome.

● However, the large deficits of the 1980s and 1990s were not mainly attributable to recessions, and were therefore worrisome.


Issue Revisited: Was Fiscal Stimulus Warranted in 2001?Issue Revisited: Was Fiscal Stimulus Warranted in 2001?

● Emergency spending and first phase of tax cut after September 11th attacks stimulated economy.♦ Short-run effects: stimulate AD.

♦ Long-run effects: perhaps crowding out

● Emergency spending and first phase of tax cut after September 11th attacks stimulated economy.♦ Short-run effects: stimulate AD.

♦ Long-run effects: perhaps crowding out

??

FIGURE 9: S-R Effect of Larger Deficits or Smaller Surpluses

FIGURE 9: S-R Effect of Larger Deficits or Smaller Surpluses


S

S

Pri

ce L

evel

Real GDP

??

D1

D1

B

D0

D0

A

FIGURE 10: L-R Effect of Larger Deficits or Smaller Surpluses

FIGURE 10: L-R Effect of Larger Deficits or Smaller Surpluses


Potential GDP

Y1 Y0

Pri

ce

Le

ve

l

Real GDP

??

D

D

S1

S1

S0

S0

A

B


The Economics and Politics of the U.S. Budget DeficitThe Economics and Politics of the U.S. Budget Deficit

● The deficits of the early 1980s came during recessions and hence crowding out was not a serious problem.

● By 1987 the economy was approaching full employment and hence crowding out was becoming a problem.

● The deficits of the early 1980s came during recessions and hence crowding out was not a serious problem.

● By 1987 the economy was approaching full employment and hence crowding out was becoming a problem.



● In the 1990s, the deficit was eliminated by ♦ raising taxes and

♦ reducing spending;

♦ an expanding economy also produced more tax revenues.

● In the 1990s, the deficit was eliminated by ♦ raising taxes and

♦ reducing spending;

♦ an expanding economy also produced more tax revenues.



● Large deficits again ♦ 2001 recession reduced tax revenue;

♦ government spending on national defense;

♦ tax cuts in 2001 and 2003.

● Large deficits again ♦ 2001 recession reduced tax revenue;

♦ government spending on national defense;

♦ tax cuts in 2001 and 2003.

15 budget deficits in the short and long run blessed are the young, for they shall inherit the...

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