The Budget BalanceThe Budget Balance

Chapter 12-3Chapter 12-3

Laugher Curve

• When Albert Einstein died, he met three New Zealanders in the queue outside the pearly gates.

• To pass the time, he asked what were their IQs.

Laugher Curve

• The first replied 190.

• "Wonderful," exclaimed Einstein, "We can discuss the contribution made by Earnest Rutherford to atomic physics and my theory of general relativity.”

Laugher Curve

• The second answered 150.

• "Good," said Einstein, "I look forward to discussing the role of New Zealand's nuclear-free legislation in the quest for world peace.”

Laugher Curve

• The third New Zealander mumbled 50.

• Einstein paused, and then asked, "So what is your forecast for the budget deficit next year?"

The Budget Balance

How do surpluses and deficits fit into the analysis of fiscal policy?

Are deficits ever a good thing and surpluses a bad thing?

The Budget Balance as a Measure of Fiscal Policy

The Budget Balance as measure of Fiscal Policy• Other things equal, discretionary

expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year

The Budget Balance as measure of Fiscal Policy*• expansionary

fiscal policies make a budget surplus smaller or a budget deficit bigger.

Contractionary fiscal policies increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

The Budget Balance as measure of Fiscal PolicyThis approach is sometimes misleading:

1. Different changes in Fiscal policy that have equal effects on budget balance may have unequal effect on Aggregate Demand. (Effect of Taxes v. Government spending

2. Often Budget Balance are the result result of fluctuation in the economy.

The Business Cycle and Cyclically Adjusted Budget Balance Some of the fluctuations in the budget

balance are due to the effects of the business cycle.

In order to separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.

Automatic Stabilizers

• During Expansions Tax Revenues Rise and Unemployment Benefits (Transfer Payment) Fall

SGovernment =T -G-TR

• What do you think happens in a Recession?

The Federal Budget Deficit & The Business Cycle

The budget deficit as a percentage of GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions.

The U.S. Federal Budget Deficit and the

Unemployment Rate

There is a close relationship between the budget balance and the business cycle: A recession moves the budget balance toward deficit, but an expansion moves it toward surplus.

The Actual Budget Deficit & Cyclically Adjusted Budget Deficit

Balancing the Budget Destabilize the Economy?• State constitutional provisions mandating

balanced budgets act as automatic destabilizers.

• These states cut spending and raise taxes during recessions and increase spending and cut taxes during expansions.

Should the Budget be Balanced? Most economists don’t believe the

government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.

Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.