mcgraw-hill/irwin ©2008 the mcgraw-hill companies, all rights reserved deficits, surpluses, and...
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McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Deficits, Surpluses, and Debt
Deficits, Surpluses, and Debt
Chapter 12 Chapter 12
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Budget Effects of Fiscal Policy
Keynesian theory highlights the potential of fiscal policy to solve macro problems.
Fiscal Policy is the use of government taxes and spending to alter macroeconomic outcomes.
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Budget Surpluses and Deficits
Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues.
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Budget Surpluses and Deficits
Budget deficit is the amount by which government spending exceeds government revenue in a given time period.
Budget deficit = government spending – tax revenues > 0
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Budget Surpluses and Deficits
If the government spends less than its tax revenues, a budget surplus is created.
Budget surplus is an excess of government revenues over government expenditures in a given time period.
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Budget Deficits and Surpluses
Budget Totals (billions of dollars)
2000 2001 2002 2003
Revenues 2,025 1,991 1,853 1,782
Outlays -1,789 -1,864 -2,011 -2,157
Surplus (deficit) 236 127 (158) (375)
2004 2005 2006
Revenues 1,880 2,154 2,407
Outlays -2,293 -2,472 -2,654
Surplus (deficit) (413) (318) (247)
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A String of Deficits
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Keynesian View
Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy.
The goal of macro policy is not to balance the budget but to balance the economy at full-employment.
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Discretionary vs. Automatic Spending
At the beginning of each year, the President and Congress put together a budget blueprint for next fiscal year.
Fiscal year (FY) is the twelve-month period used for accounting purposes – begins on October 1 for the federal government.
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Discretionary vs. Automatic Spending
To a large extent, current revenues and expenditures are the result of decisions made in prior years.Roughly 80 percent of the budget is not discretionary so that only about 20 percent represents discretionary fiscal spending.
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Discretionary vs. Automatic Spending
• Discretionary fiscal spending are those elements of the federal budget not determined by past legislative or executive commitments.
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Discretionary vs. Automatic Spending
Since most of the budget is uncontrollable, fiscal restraint or fiscal stimulus is less effective.
Fiscal restraint – tax hikes or spending cuts intended to reduce (shift) aggregate demand.
Fiscal stimulus – tax cuts or spending hikes intended to increase (shift) aggregate demand.
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Automatic Transfers
Most of the uncontrollable line items in the federal budget change with economic conditions.
Outlays for unemployment compensation and welfare benefits increase when the economy goes into a recession.
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Automatic Transfers
These income transfers act as automatic stabilizers.
Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits.
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Automatic Transfers
Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.
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Automatic Transfers
Automatic stabilizers also exist on the revenue side of the budget.
Income taxes move up and down with the value of spending and output.
Being progressive, personal taxes siphon off increasing proportions of purchasing power as incomes rise.
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Cyclical Deficits
The size of the federal deficit or surplus is sensitive to expansion and contraction of the macro economy.
Actual budget deficits and surpluses may arise from economic conditions as well as policy.
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Cyclical Deficits
The cyclical deficit is that portion of the budget deficit attributable to unemployment or inflation.
The cyclical deficit widens when GDP growth slows or inflation decreases.
The cyclical deficit shrinks when GDP growth accelerates or inflation increases.
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Structural Deficits
To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components.
Structural deficit
Cyclical deficit
Total budget deficit
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Structural Deficits
The structural deficit is federal revenues at full-employment minus expenditures at full employment under prevailing fiscal policy.
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Structural Deficits
Part of the deficit arises from cyclical changes in the economy.
The rest is the result of discretionary fiscal policy.
Only changes in the structural deficit measure the thrust of fiscal policy.
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Structural Deficits
Fiscal policy is categorized as follows:
Fiscal stimulus is measured by the increase in the structural deficit (or shrinkage in the structural surplus).
Fiscal restraint is gauged by the decrease in the structural deficit (or increase in the structural surplus).
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Economic Effects of Deficits
There are a number of consequences of budget deficits.
Crowding out.
Opportunity cost.
Interest-rate movements.
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Crowding Out
Crowding-out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing.
Crowding out implies less private-sector output.
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Publ
ic-se
ctor
out
put (
quan
tity
per y
ear)
Private-sector output (quantity per year)
Crowding Out
Increase in government spending . . .
Crowds out private spending
b
ca
g2
g1
h2 h1
LO2
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Opportunity Cost
Crowding out reminds us that there is an opportunity cost to government spending.
Opportunity cost is the most desired goods or services that are forgone in order to obtain something else.
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Interest-Rate Movements
Rising interest rates are both a symptom and a cause of crowding out.
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Economic Effects of Surpluses
The economic effects of budget surpluses are the mirror image of those for deficits.
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Crowding In
There are four potential uses for a budget surplus:
Spend it on goods and services.
Cut taxes.
Increase income transfers.
Pay off old debt (“save it”).
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Crowding In
Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing.
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Cyclical Sensitivity
Crowding in depends on the state of the economy.
In a recession, a decline in interest rates is not likely to stimulate much spending if consumer and investor confidence is low.
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The Accumulation of Debt
The United States has accumulated a large national debt.
The national debt is the accumulated debt of the federal government.
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Debt Creation
When the Treasury borrows funds it issues treasury bonds.
Treasury bonds are promissory notes (IOUs) issued by the U.S. Treasury.
The national debt is a stock of IOUs created by annual deficit flows.
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Early History, 1776-1900
By 1783, the United States had borrowed over $8 million from France and $250,000 from Spain to finance the Revolutionary War.
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Early History, 1776-1900
During the period 1790-1812 the U.S. often incurred debt but typically repaid it quickly.
The War of 1812 caused a massive increase in national debt and, by 1816, the national debt was over $129 million.
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Early History, 1776-1900
1835-36: Debt Free! – The U.S. was completely out of debt by 1835.
The Mexican-American War (1846-48) caused a four-fold increase in the debt.
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Early History, 1776-1900
By the end of the Civil War (1861-65), the North owed over $2.6 billion, nearly half of its national income.
After the South lost, Confederate currency and bonds had no value.
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The Twentieth Century
The Spanish-American War (1898) also increased the national debt.
World War I raised the debt from 3% to 41% of the national income.
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The Twentieth Century
National debt declined during the 1920’s but rose again during the Great Depression.
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World War II
The greatest increase in national debt occurred during World War II.
Rather than raise taxes, the government rationed consumer goods.
U.S. War Bond purchases raised the debt from 45% of GDP to over 125% in 1946.
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The 1980s
During the 1980s, the national debt rose by nearly $2 trillion.
The increase was not war-related but as a result of recessions, a military buildup, and massive tax cuts.
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The 1990s
The early 1990s continued the same trend.
Discretionary federal spending increased sharply in the first two years of the Bush administration.
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The 1990s
The 1988-92 period saw the national debt increased by another trillion dollars.There was some success in reducing the structural deficit in 1993.
Budget deficits for 1993-96 have pushed the national debt to over $5 trillion.
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2000 -
By 2002, the accumulated debt was $5.6 trillion.
By 2007, the debt approximated $9 trillion, which works out to nearly $30,000 of debt for every U.S. citizen.
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Historical View of the Debt/GDP Ratio
Great Depression
Civil War World War I
World War II
1990-91 recession
1990-91recession
Bush tax cuts
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Who Owns the Debt?
Who can ever expect to pay off a debt measured in the trillions of dollars?
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Liabilities = Assets
National debt represents an asset as well as a liability in the form of bonds.
Liability – An obligation to make future payment; debt.
Asset – Anything having exchange value in the marketplace; wealth.
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Liabilities = Assets
The national debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury).
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Ownership of Debt
Federal agencies hold roughly 50 percent of the outstanding Treasury bonds.
State and local governments hold 7 percent of the national debt.
U.S. households hold nearly 20% of the national debt, either directly or indirectly.
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Ownership of Debt
Internal debt is the U.S. government debt (Treasury bonds) held by U.S. households and institutions.The external debt is U.S. government debt (Treasury bonds) held by foreign households and institutions.
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Ownership of Debt
Foreigners
Foreigners 25%
State and localgovernments 7%
Public SectorSocial Security21%
Federal agencies
24%Federal Reserve 9%
Private Sector
Internal debt14%
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Burden of the Debt
The burden of the debt is not so evident:
Refinancing.
Debt service.
Opportunity cost.
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Refinancing
The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due.
Refinancing is the issuance of new debt in payment of debt issued earlier.
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Debt Service
Debt service is the interest required to be paid each year on outstanding debt.
Interest payments restrict the government’s ability to balance the budget or fund other public sector activities.
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Debt Service
Most debt servicing is simply a redistribution of income from taxpayers to bondholders.
Interest payments themselves have virtually no direct opportunity cost.
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Opportunity Costs
Opportunity costs are incurred only when real resources (factors of production) are used.
The true burden of the debt is the opportunity costs of the activities financed by the debt.
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Government Purchases
The true burden of the debt is the opportunity cost of the activities financed by the debt.
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Transfer Payments
The only direct cost of transfer payments are the resources involved in the administrative process of making the transfer.
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The Real Trade-Offs
Deficit financing tends to change the mix of output in the direction of more public-sector goods.
The burden of the debt is the opportunity costs (crowding out) of deficit-financed government activity.
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The Real Trade-Offs
The primary burden of the debt is incurred when the debt-financed activity takes place.
The real burden of the debt cannot be passed on to future generations.
LO3
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Economic Growth
Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment.
The whole debate about the burden of debt is really an argument over the optimal mix of output.
LO3
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Repayment
Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future.
LO3
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External Debt
External debt presents some special opportunities and problems.
LO3
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No Crowding Out
External financing allows us to get more public-sector goods without cutting back on private-sector production.
As long as foreigners are willing to hold U.S. bonds, external financing imposes no real cost.
LO3
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External Financing
Extra output (imports)
financed with external debt
a
b d
h2 h1
g2
g1
Publ
ic-se
ctor
Out
put (
units
per
yea
r)
Private-sector Output (units per year)
LO3
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Repayment
Foreigners may not be willing to hold bonds forever.
External debt must be paid with exports of real goods and services.
LO3
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Deficit and Debt Limits
The key policy question is whether and how to limit or reduce the national debt.
LO3
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Deficit Ceilings
The only way to stop the growth of the national debt is to eliminate the budget deficit that created it.
Deficit ceilings are an explicit, legislated limitation on the size of the budget deficit.
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Deficit Ceilings
The Balanced Budget and Emergency Deficit Control Act of 1985 (Gramm-Rudman-Hollings Act) was the first explicit attempt to force the federal budget into balance.
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Gramm-Rudman-Hollings Act
It set a lower ceiling on each year’s deficit until budget balance was achieved.
It called for automatic cutbacks in spending if Congress failed to keep the budget below the ceiling.
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Debt Ceilings
A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt.
Like deficit ceilings, debt ceilings are just political mechanisms for forging political compromises on how to best use budget surpluses or deficits.
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Dipping into Social Security
The Social Security Trust Fund has been a major source of funding for the federal government for over 20 years.
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Aging Baby Boomers
Persistent surpluses in the Trust Fund largely result from Baby Boomers paying lots more payroll taxes than are paid out in benefits to the retired.
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Social Security Deficits
The Trust Fund balance shifts from surplus to deficit soon after 2014.
To pay back Social Security loans, Congress will have to significantly raise future taxes or substantially cut other programs.
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Changing Worker-Retiree Ratios
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McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Deficits, Surpluses, and Debt
Deficits, Surpluses, and Debt
End of Chapter 12 End of Chapter 12