CHAPTER 33
Fiscal Policy, Deficits, and Debt

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Fiscal Policy and the AD-AS Model
Built-in Stability
Evaluating How Expansionary or Contractionary Fiscal Policy Is
Determined
Recent and Projected U.S. Fiscal Policy
Problems, Criticisms, and Complications of Implementing Fiscal
Policy
The U.S. Public Debt
33-2
Chapter Contents

Federal Budget
• The federal budget is an annual statement of the
revenues, outlays, and surplus or deficit of the
government of the United States.
• The federal budget has two purposes:
• To finance the activities of the federal government
• To achieve macroeconomic objectives
• Fiscal policy is the use of the federal budget to achieve
the macroeconomic goals.
14-3

Macroeconomic Goals
• The government’s macroeconomic goals are
• To achieve full-employment
• To control inflation
• To encourage economic growth
14-4

Fiscal Policy
• Fiscal policy can be implemented by changes in
• Government expenditure: It directly affects the
aggregate expenditures.
• Taxes and transfer payments: It indirectly affects the
aggregate expenditures by affecting disposable incomes
of households who change their consumption
accordingly, and by affecting firms’ investment.
14-5

Effects of Fiscal Policy
• Fiscal policy may affect the macroeconomic
equilibrium directly or indirectly through affecting
• Aggregate demand: Government spending and taxes
affect the aggregate expenditure
• Aggregate supply: Government spending and taxes can
change quantities of resources, prices of resources, and
state of technology.
14-6

Two Types of Fiscal Policy
• Discretionary fiscal policy: Deliberate changes in
government spending and taxes to achieve its
macroeconomic goals.
• Non-Discretionary fiscal policy: Automatic changes in
government spending and taxes which affect the
macroeconomic conditions.
14-7

Discretionary Fiscal Policy
• Discretionary fiscal policy depends on the economic
condition
• Expansionary fiscal policy is used during a recession to
eliminate a recessionary (negative GDP) gap, reduce
unemployment, and increase real GDP.
• Contractionary fiscal policy is used during an
expansion to eliminate an inflationary (positive GDP)
gap, and lower the inflation.
14-8

Expansionary Fiscal Policy
• Expansionary fiscal policy involves
• Increase government spending (both expenditure and transfer
payments)
• Decrease taxes
• Expansionary fiscal policy may create a fiscal budget deficit.
• Expansionary fiscal policy will increase the aggregate
expenditure and the aggregate demand.
• Used to eliminate a recessionary (negative GDP) gap and to
reduce unemployment.
LO33.1
33-9

Expansionary Fiscal Policy with the Multiplier Effect
Real GDP (billions)
Pricelevel
AD2
AD1
$5 billion initial
increase in spending
Full $20 billion
increase in
aggregate demand
AS
$490 $510
P1
LO33.1
0
33-10
• Full-employment GDP is
$510 billion & there is
$20 billion of
recessionary (negative
GDP) gap, and
unemployment
problem.
• To eliminate the gap,
the government
implements an
expansionary fiscal
policy to shift AS curve
to right.

Contractionary Fiscal Policy
• Contractionary fiscal policy involves
• Decrease government spending (both expenditure and transfer
payments)
• Increase taxes
• Contractionary fiscal policy may create a fiscal budget surplus.
• Contractionary fiscal policy will decrease the aggregate
expenditure and the aggregate demand.
• Used to eliminate an inflationary (positive GDP) gap and to
reduce (demand-pull) inflation.
LO33.1
33-11

Contractionary Fiscal Policy
Real GDP (billions)
Pricelevel
AD3 AD4
$3 billion initial
decrease in
spending
Full $12 billion
decrease in
aggregate
demand
AS
$502 $522
P2
AD5
$510
d
b
aP1
c
LO33.1
0
33-12
• Full-employment GDP is
$510 billion & there is
$12 billion of
inflationary (positive
GDP) gap and inflation
problem (rising price
level to P2).
• To eliminate a gap, the
government implements
a contractionary fiscal
policy to shift AS curve
to left.

Policy Options: Expenditure vs Tax
• Effects of government spending changes and tax changes
could different in aggregate expenditure
• Government expenditure directly rises the aggregate
expenditure by the same amount.
• Taxes and transfer payments affect disposable incomes and
only a portion of them (MPC) affects consumption and the
aggregate expenditure by the less than the original change in
taxes.
14-13

Policy Options: Expenditure vs Tax
• The government can achieve the same goal by either
government spending or taxes
• Both government spending and taxes have the same effect on
budget.
• Those who prefer smaller government in size and role
advocate tax cuts as expansionary fiscal policy and government
spending cut as contractionary fiscal policy.
• Those who prefer larger government in size and role advocate
expanding government spending as expansionary fiscal policy
and tax raise as contractionary fiscal policy.
14-14

Policy Options: Spending vs Investing
• Government spending and taxes can affect current
consumption spending or investment for future
• Government expenditure on infrastructures and R&D raise
revenue of firms, while transfer payments raise disposable
income of households.
• Tax changes on corporate profits and R&D lower costs of firms,
while tax returns to households raise disposable income of
households
• Depending on how they are spent, they ultimately affect the
economic growth.
14-15

Policy Options: Spending vs Investing
• Some government spending and taxes affect capital and
technology over time, which will affect the aggregate supply
and the potential GDP.
• Tax credits or subsidies on households’ education spending
and government education spending increase human capital.
• Tax credits or subsidies on firms’ investment on factories and
machineries and government spending on infrastructure
increase capital stock of economy.
• Tax credits or subsidies on Firms’ R&D spending and
Government R&D spending advance technology.
14-16

Built-In (Automatic) Stability
• Non-discretionary (automatic) fiscal policy: a fiscal policy
action that is triggered by the state of the economy.
• Taxes vary directly with GDP: Tax revenue increases during
expansions and decreases during recessions
• Transfer payments vary inversely with GDP: Transfer payments
(e.g. welfare, unemployment compensation) decreases during
expansions and increases during recessions.
• Automatic stabilizers are features of fiscal policy that
stabilize real GDP without explicit action by the government.
LO33.2
33-17

Built-In (Automatic) Stability
• Automatic stabilizers Reduce severity of business
fluctuations by automatically counteracting to the business
cycle
• During an expansion, as national income increases, with
progressive tax system tax revenues increase more
proportionally and disposable income and consumption
increases less proportionally.
• During a recession, as more workers become unemployed,
more unemployment benefits are paid out, and maintain
consumption of unemployed households.
LO33.2
33-18

Built-In (Automatic) Stability
• Taxes and transfer payments automatically change according to
the phase of business cycle.
• Taxes vary directly with GDP: Taxes increase during expansion when
households’ income increase, and reduce disposable income.
• Transfers vary inversely with GDP: Welfare and unemployment
compensation payments increase during recession when
unemployment increases, and increase disposable income.
• Size and effects of automatic stabilizer depend on
• Tax progressivity: More progressively greater the changes in tax
amount.
• Safety net policy: Duration and amount of unemployment
compensation and welfare
LO33.2
33-19

Built-In Stability
LO33.2
G
T
Deficit
Surplus
GDP1 GDP2 GDP3
Governmentexpenditures,G,
andtaxrevenues,T
Real domestic output, GDP
0
33-20
• Automatic stabilizers also
affect government budget
automatically
• Deeper the recession,
greater the budget deficit.
• Greater the inflationary
gap, greater the budget
surplus.

Evaluating Fiscal Policy
• We cannot judge the government’s stance on fiscal policy
(expansionary, neutral, or contractionary) simply observing budget
deficit or surplus because actual budget deficit or surplus is total
effect of discretionary fiscal policy and automatic stabilizers.
• To reveal the government’s intention on discretionary fiscal policy
(expansionary or contractionary), the actual budget deficit or
surplus must be adjusted by effects of automatic stabilizers.
• During recession the government may run deficits simply because it
spends more on unemployment compensation and welfare without
implementation of any discretionary expansionary policy.
• How do we know which policy the government is taking discretionary?
LO33.3
33-21

Cyclically Adjusted Budget
• Cyclically adjusted budget: Estimated federal budget deficit or
surplus if the economy is at full-employment level of GDP
(eliminating effects of automatic stabilizers).
• During recession the government spends extra unemployment
compensation and welfare for cyclical unemployment. Deducting the
extra spending from the actual budget deficits indicates estimated
budget deficits due to the discretionary expansionary policy. If the
estimated budget deficits are zero, then the government is not taking
any discretionary expansionary policy (discretionary fiscal policy
involves increasing spending and cutting taxes, which result in budget
deficits).
LO33.3
33-22

Year Actual Deficit –or Surplus + Cyclically Adjusted Deficit–or Surplus +
2000 + 2.4 + 1.5
2001 + 1.2 + 1.1
2002 –1.4 –0.8
2003 –3.3 –2.4
2004 –3.4 –2.9
2005 –2.5 –2.3
2006 – 1.8 – 1.9
2007 –1.1 – 1.3
2008 –3.1 – 2.9
2009 –9.3 – 7.6
2010 –8.3 –6.4
2011 –8.1 – 6.5
2012 –6.6 – 5.3
2013 –4.0 – 2.8
2014 –2.7 – 1.8
2015 –2.4 – 1.9
2016 –3.1 – 2.7
2017 –3.4 – 3.1
2018 – 3.9 – 3.9
LO33.4
33-23
Federal Deficits (-) and Surpluses (+) as Percentages of GDP
• Full employment, 2000
• Tech stock bubble burst, 2000
• Terrorist attack, 2001
• Tax cuts, 2002 and 2003
Great Recession (2008)
• Financial market problems began
in 2007.
• Credit market freeze.
• Pessimism spreads to the overall
economy.
• Recession officially began
December 2007 and lasted 18
months.
• Economy slow to recover.

Problems, Criticisms, and Complications
• Fiscal Policy has its limitations and problems
• Problem of timing
• Political Business cycle
• Future policy reversals
• Offsetting state and local finance
• Crowding-out effect
LO33.5
33-24

Timing Problem of Fiscal Policy
• Fiscal policy may not be implemented and show effects in timely
manner
• Recognition lag: It takes time to recognize the state of economy and
problems – it takes time to collect data and forecast future course of
economy precisely
• Administrative lag: It takes Congress to pass the laws needed to
change taxes or spending
• Operational lag: It takes time to implement taxes and spending
changes and to have full effect on the economy
• Poorly-timed fiscal policy may destabilize the economy and worsen
recession and inflation. 14-25

Timing Problem of Fiscal Policy
• Effects of (Well-timed) Fiscal Policy
14-26
Real
GDP
2006 2007 2008 2009 2010
2011
Real
GDP
2006 2007 2008 2009 2010
2011
• Effects of (Poorly-timed) Fiscal Policy

Political Business Cycles
• Political business cycles: Fiscal policy is used for political
motivation of re-election of politicians
• In re-election year politicians want low unemployment
(happier voters toward incumbents), so they pursue an
expansionary fiscal policy without merit. After re-election, they
reverse to contractionary fiscal policy to offset.
• Politically-motivated fiscal policy without regard of economic
condition may initiate fluctuations of economy.
14-27

Complications of Fiscal Policy
• Future policy reversals: If households and firms expect future
reversals of fiscal policy, then they many not respond to fiscal
policy.
• Tax cut is implemented, but households believe that the
government must raise taxes near future to offset budget deficit,
then they may save tax return for future tax payment rather than
spending it.
• Off-setting state and local finance
• Expansionary fiscal policy by the federal government may be offset
by contractionary fiscal policy of state and local governments
14-28

Crowding-out Effect
• Crowding-out effect: A deficit-spending and tax-cut expansionary
fiscal policy will raise the market interest rate and discourage firms
and households from borrowing (crowd-out private borrowers from
financial market).
• With less borrowing, firms and households cut their spending and
offset the government spending, resulting in no change in
aggregate expenditure. Then, the expansionary fiscal policy has no
effect on aggregate demand.
• Decrease in firms’ investment also temper future economic growth.
14-29

Current View on Fiscal Policy
• Let the Federal Reserve handle short-term fluctuations
• Fiscal policy should be evaluated in terms of long-term
effects
• Fiscal policy focuses on long-run effect of economic
growth
• Use tax cuts to enhance work effort, investment, and
innovation
• Use government spending on public capital projects,
R&D, and human capital 14-30

The U.S. Public Debt
• National debt: The amount of debt outstanding that
arises from past budget deficits
• National debt clock: http://www.usdebtclock.org/
• $22.1 trillion in April, 2019
• As federal budget deficits continue and widen in future,
the national debt will increase even faster
• The federal government finances its deficit by issuing
U.S. Treasury securities (Treasury bills, notes, and
bonds).
LO33.6
33-31

Ownership of U.S. Public Debt, 2018
Sources: Economic Report of the President 2019 and Treasury Bulletin,
March 2019, U.S. Treasury.
LO33.6
33-32
• No problem: 38% of national
debt is held by the federal
government and Federal
Reserves.
• Problem: 29% of national
debt is held by foreigners.
Most of them are held by
Chinese financial institutions
and investors.

Federal Debt Held by the Public, Excluding the Federal
Reserve, as a Percentage of GDP, 1970–2018
Sources: Federal Reserve Bank of St. Louis and the U.S. Office of
Management and Budget
LO33.6
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
80
70
60
50
40
30
20
10
0
Year
PercentofGDP
Federal debt held by
the public as a
percentage of GDP
33-33
• Large debt may not be
problem if a borrower
earns enough income to
pay back.
• Low debt-to-GDP ratio
means the government
can pay back with its
taxing power.
• High debt-to-GDP ratio
is a warning sign of
possible default of
government debt since
an economy cannot
generate enough taxes
to pay back.

Global Perspective 33.1
Source: Central Intelligence Agency.
LO33.6
33-34
• Debt-to-GDP ratio varies greatly
among countries.
• A debt-to-GDP ratio of the U.S. is
relatively low as compared with
many other developed countries
who encountered financial crisis
in recent years such as Greece
and Italy.

The U.S. Public Debt Concerns
• Large national debt is a concern of
• Interest payments on debt amount 6% of federal government
spending.
• 29% of national debt are held by foreigners
• Burdening future generations
• Crowding-out of private investment
• Income distribution
• Large national debt will not lead to bankruptcy of the U.S.
government
• About 75% of GDP
• U.S. government can refinance or collect taxes to pay
LO33.6 33-35

Last Word: The Social Security and Medicare Time Bombs
• More Americans will be receiving benefits as they age.
• Social Security shortfalls: Funds will be depleted by 2033
• Medicare shortfalls: Funds will be depleted by 2024
• Possible options “to fix” include:
• Increasing the retirement age
• Increasing the portion of earnings subject to the social security
tax
• Disqualifying wealthy individuals
• High-skilled immigrants rather than low-skilled
• Defined contribution plans owned by individuals (privatization
of social security) 33-36