Brue Chap 014

Chapter 14:Fiscal Policy,

Deficits, and Debt

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Fiscal Policy Fiscal policy consists of deliberate

changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth.


Fiscal Policy andthe AD-AS Model

The Council of Economic Advisors (CEA) provides advice and assistance on economic matters to the president.

Discretionary fiscal policy is initiated on the advise of the CEA and changes to government spending and taxes are at the option of the Federal government.

Nondiscretionary fiscal policy are changes that occur automatically.


Expansionary Fiscal Policy When the economy is in recession,

expansionary fiscal policy may be in order. Expansionary fiscal policy is an increase

in government spending, a decrease in taxes, or some combination of the two for the purpose of increasing aggregate demand and real output. If the Federal budget is balanced at the outset,

expansionary fiscal policy will create a government budget deficit.


Expansionary Fiscal Policy


Contractionary Fiscal Policy When demand-pull inflation occurs,

contractionary fiscal policy may help to control it.

Contractionary fiscal policy is a decrease in government spending, an increase in taxes, or some combination of the two for the purpose of decreasing aggregate demand and halting inflation. Contractionary fiscal policy may create a

budget surplus.


Contractionary Fiscal Policy


Built-In Stability A built-in stabilizer is anything that

increases the government’s budget deficit (or reduce its budget surplus) during a recession and increase its budget surplus (or reduce its budget deficit) during an expansion without requiring explicit action by policymakers. Examples include personal income taxes,

payroll taxes, corporate income taxes, sales taxes and excise taxes.


Built-In Stability Taxes reduce spending and aggregate

demand; in addition, reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping.

Built in stability has reduced the severity of business fluctuations in the U.S..


Evaluating Fiscal Policy In evaluating the status of fiscal policy, we

must adjust deficits and surpluses to eliminate automatic changes in tax revenues and compare the sizes of the adjusted budget deficits (or budget surpluses) to the level of potential GDP.

The standardized budget (or full-employment budget) is used for this purpose.


Evaluating Fiscal Policy The standardized budget is a measure of

what the Federal budget deficit or surplus would be with existing tax rates and government spending programs if the economy had achieved its full-employment GDP in the year. The standardized budget deficit is zero at the

full-employment output level.


Evaluating Fiscal Policy If the economy slides into a recession, the

standardized budget deficit is still zero since government expenditure equals the tax revenue that would be forthcoming at the full-employment GDP.


Evaluating Fiscal Policy The deficit that arises in a recession is a

cyclical deficit and is not caused by government discretionary fiscal policy. A cyclical deficit is a Federal deficit that is

caused by a recession and the consequent decline in tax revenue.


Evaluating Fiscal Policy If a standardized deficit of zero in one year

is followed by a standardized budget deficit in the next year, then fiscal policy is expansionary.

Conversely, if a standardized deficit of zero in one year is followed by a standardized budget surplus in the next year, then fiscal policy is contractionary.


Problems, Criticisms,and Complications

A number of significant problems may arise in enacting and applying fiscal policy such as: problems of timing political considerations future policy reversals offsetting state and local finance crowding-out effect



Timing issues include recognition lag, administrative lag and operational lag.

Political considerations include political business cycles: the alleged tendency of presidential administration and Congress to create macroeconomic instability by reducing taxes and increasing government spending before elections and to raise taxes and reduce expenditures after elections.



Consumption smoothing arises when taxpayers believe policy is only temporary and is likely to be reversed in the future.

The fiscal policies of state and local governments are frequently pro-cyclical; they worsen rather than correct recession or inflation.



Another potential flaw in fiscal policy is the crowding-out effect: a decrease in private investment caused by higher interest rates that result from the Federal government’s increased borrowing to finance deficits (or debt).


Current Thinking onFiscal Policy

Despite the many complications of fiscal policy, the current popular view is that fiscal policy can help “push the economy” in an intended direction but cannot “fine-tune it” to a specific outcome.

Monetary policy is considered by many to be the best month-to-month stabilization tool for the U.S. economy.


The Public Debt The national or public debt is essentially

the total accumulation of the deficits (minus the surpluses) the Federal government has incurred through time. Deficits have emerged because of war

financing, recessions, fiscal policy, and lack of political will by Congress.


The Public Debt The total public debt represents the total

amount of money owed by the Federal government to the owners of government securities. U.S. securities are Treasury bills, Treasury

notes, Treasury bonds, U.S. savings bonds, and I-bonds issued by the Federal government to finance expenditures that exceed tax revenues.


The Public Debt The U.S. and other highly productive

nations can incur and carry a large public debt more easily than poor nations.

Many economists conclude that the annual interest charge accruing on the bonds sold to finance the debt is the primary burden of the U.S. debt.


False Concerns The large U.S. debt does not threaten to

bankrupt the Federal government, leaving it unable to meet its financial obligations. One reason is the public debt is easily

refinanced. Another reason is the Federal government has

the option to impose new taxes or increase existing tax rates to finance the debt.


Substantive Issues The distribution of ownership of

government securities is highly uneven, where ownership of the public debt is concentrated among wealthier groups.

A large public debt may impair economic growth if higher taxes for interest payments on government securities dampen incentives to bear risk, to innovate, to invest, and to work.


Substantive Issues External public debt, or the part of the

public debt owned by foreigners, is an economic burden to Americans.

Another potentially serious problem is that the financing of the large public debt transfers a real economic burden to future generations by passing a smaller stock of capital goods on to them.


The Long-Run FiscalImbalance: Social Security

The most significant fiscal issue in the U.S. is the long-term funding imbalance in the Social Security and Medicare programs. There is a severe long-run shortfall in Social

Security funding because of growing payments to retiring baby boomers.

The accumulation of monies in the Social Security trust fund will be greatly inadequate for paying the retirement benefits to future retirees.



The problem is one of demographics; the percentage of the American population age 62 and older will rise substantially over the next several decades.



To help make Social Security financially sound, some suggest investing all or part of the trust fund in corporate stocks and bonds, since these presumably have higher returns relative to U.S. securities.

Another option is to increase the payroll tax immediately and allocate the new revenues to individual accounts.



Yet, another idea is to place half the payroll tax into accounts that individuals would own, maintain, and bequeath.

New options for reform will likely develop over time; nevertheless, society will eventually need to confront the problem of trillions of dollars of unfunded Social Security liabilities.

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Brue Chap 014