Inflationary & Deflationary Gap

Chapter 12
Fiscal Policy and the National Debt
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-1
Chapter Objectives
The deflationary gap

The inflationary gap
The multiplier and its applications
Automatic stabilizers
Discretionary fiscal policy
Budget deficits and surpluses
The public debt
12-2
Fiscal Policy
Fiscal policy is the manipulation of the
federal budget to attain price stability,
relatively full employment, and a
satisfactory rate of economic growth
To attain these goals, the government must
manipulate its spending and taxes
12-3
Putting Fiscal Policy into

Perspective
There was no such thing as fiscal policy
until John Maynard Keynes invented it
in the 1930s
He maintained that
The only way out of the Depression was to boost
aggregate demand by increasing government
spending
If we ran a big enough budget deficit, we could
jump-start the economy and, in effect, spend our
way out of the depression
12-4

Perspective
Its important that the aggregate supply
of goods and services equals the
aggregate demand for goods and services
at just the level of spending that will
bring about full employment at stable
prices
12-5

Perspective
Equilibrium GDP tells us the level of
spending in the economy
Full-employment GDP tells us the level of
spending necessary to get the
unemployment rate down to 5% (which
we have been calling full-employment)
Fiscal policy is used to push equilibrium
GDP toward full-employment GDP
12-6
The Deflationary Gap and the

Inflationary Gap
Equilibrium GDP is the level of output at
which aggregate demand equals
aggregate supply
Aggregate demand is the sum of all
expenditures for goods and services (that is,
C + I + G + X n)
Aggregate supply is the nations total output
of final goods and services
So at equilibrium GDP, everything produced
is sold
12-7
The Deflationary Gap and the

Inflationary Gap
Full-employment GDP is the level of
spending necessary to provide full
employment of our resources
If our plant and equipment is operating at
between 85 and 90% of capacity, thats full
employment
If only 5% of our labor force is unemployed,
thats full employment
12-8
The Deflationary Gap & the Inflationary Gap

The Deflationary Gap
When the full-employment
GDP is greater than the
equilibrium GDP, there is a
deflationary gap. How
much is it?
9
8
Deflationary gap
C + I +G +X n
7
6
5
4
3
2
1
$1 trillion
2
1
Equilibrium GDP
Full-employment GDP
GDP (in trillions of dollars)
12-9
The Deflationary Gap & the Inflationary Gap

The Inflationary Gap
When equilibrium
GDP is greater
than fullemployment GDP,
there is an
inflationary gap.
How large is it?
2,000
C +I +G + Xn
Inflationary gap
1,500
1,000
500
$200 trillion
500
500
1,000
1,500
Full-employment GDP
2,000
Equilibrium GDP
12-10
Summary
Equilibrium GDP is above the fullemployment GDP
Spending is too high
Results in an inflationary gap
Too eliminate the inflationary gap, we cut G
and/or raise taxes
12-11
Summary
Equilibrium GDP is less than fullemployment GDP
Spending is too low
Results in a deflationary gap
Too eliminate the deflationary gap, we raise G
and/or cut taxes
12-12
The Multiplier and Its

Applications
Any change in spending (C, I, or G) will
set off a chain reaction, leading to a
multiplied change in GDP
GDP = C + I + G + Xn
How much the multiplied change is
depends on the MPC and MPS
12-13
Calculating the Multiplier

Remember
MPC + MPS = 1, therefore, MPS = 1 - MPC
1
Multiplier = ----------------------1 - MPC
1
Multiplier = ---------------------MPS
Because the multiplier

(like C) deals with
spending, 1/(1-MPC)
is a more appropriate
formula)
12-14

The MPC is .5.
Find the multiplier
12-15

(Continued)
The MPC is .5. Find the multiplier
1
1
1
Multiplier = ---------------- = -------- = ----- = 2
1 - MPC
1 .5
.5
12-16

Step-by-Step Working of the Multiplier When MPC is .5
$1,000.00
$ 500.00
$ 250.00
$ 125.00
$ 62.50
$ 31.25
$ 15.625
$ 7.813
$ 3.906
$ etc.
$ etc.
$2,000.00
It is surely much easier to use the multiplier of 2

(2 X $1,000 = $2000) than to go through this
process and add up all the figures
12-17

(Continued)
12-18

(Continued)
1
1
1
Multiplier = ---------------- = -------- = ----- = 4
1 - MPC
1 .75 .25
12-19
Applications of the Multiplier

The Multiplier is used to calculate the
effect of changes in C, I, or G on GDP
GDP = 2,500; Multiplier = 3; C rises by 10
What is the new level of GDP?
GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = 2500 + ( 10 x 3)
GDPNew = 2500 + ( 30)
GDPNew = 2530
12-20

GDP = X; Multiplier = 3; C rises by 10
What happens to GDP?
GDPNew = X + ( 10 x 3)
GDPNew = X + ( 30)
GDP increases by 30
12-21

GDP = X; Multiplier = 7; G falls by 5
What happens to GDP?
GDPNew = X + ( -5 x 7)
GDPNew = X + ( -35)
GDP decreases by 35
12-22

How big is the multiplier (M)?
9
M = distance between the

equilibrium GDP and the fullemployment GDP / by the gap
Deflationary gap
C + I +G +X n
7
6
5
4
3
2
M=2/2=1
2
1
Full-employment GDP
12-23

How big is the multiplier (M)?
M = distance between the
equilibrium GDP and the fullemployment GDP / by the gap
2,000
C +I +G + Xn
Inflationary gap
1,500
1,000
500
M = 500 / 200 = 2.5
500
500
1,000
1,500
2,000
Full-employment GDP
12-24
Removing the Deflationary Gap

9
8
C1 +I1 +G1 +Xn1
C +I +G +Xn
To remove the deflationary

gap we raise aggregate
demand from C+I+G+Xn
to C1+I1+G1+Xn1
5
4
3
2
1
1
Full-employment GDP
This pushes equilibrium

GDP to $7 trillion and
removes the deflationary
gap
12-25
Removing the Inflationary Gap

2,500
2,000
C + I +G +Xn
1,500
C1 + I1 +G1 + Xn1
Inflationary gap
1,000
This pushes equilibrium

GDP down to 1,000 and
removes the inflationary
gap
500
500
500
1,000
To remove the inflationary

gap we lower aggregate
demand from C+I+G+Xn
to C1+I1+G1+Xn1
1,500
2,000
2,500
Full-employment GDP
GDP (in billions of dollars)
12-26
The Automatic Stabilizers

The automatic stabilizers protect us from
the extremes of the business cycle
Personal Income and Payroll Taxes
During recessions, tax receipts decline
During inflations, tax receipts rise
Personal Savings
During recessions, saving declines
During prosperity, saving rises
12-27

Credit Availability
Credit availability helps get us through
recessions
Unemployment Compensation
During recessions more people collect
unemployment benefits
12-28

The Corporate Profits Tax
During recessions, corporations pay much less
corporate income taxes
Other Transfer Payments

Welfare (or public assistance) payments,
Medicaid payments, and food stamps rise during
recessions
12-29
Discretionary Fiscal Policy

Making the Automatic Stabilizers More
Effective
Public Works
The main fiscal policy to end the Depression was
public works
Transfer Payments
The government could extend the benefit period
for unemployment compensation and increase
welfare payments, Social Security, and veterans
pensions
12-30

Effective
Changes in Tax Rates
To fight inflation, the government can raise taxes
To fight recession, the government can cut taxes
Corporate incomes taxes can be raised during periods of
inflation and lowered when recessions occur
Using tax rate changes as a counter cyclical policy

tool provides a quick fix, however, temporary tax
cuts carried out during recessions should not become
permanent
12-31

Effective
Changes in Government Spending
The government increases spending and cuts
taxes to fight recessions
The government decreases spending and raises
taxes to fight inflation
In brief, we fight recessions with budget deficits
and inflation with budget surpluses
12-32
Who Makes Fiscal Policy?

The President and Congress make fiscal
policy
This is complicated and can be time
consuming, especially when one political
party controls Congress while the president
belongs to the other party
No one seems to be in charge of making fiscal
policy
12-33
Who Makes Fiscal Policy?

The huge budget deficits weve been running
since the early 1980s have sharply limited the
governments ability to use discretionary fiscal
policy to create jobs and to stimulate the
economy
Between legally mandated spending programs and
legally mandated entitlement programs such as
Social Security, Medicare, and Medicaid, there is
little discretionary income to play with
The Treasury could borrow even more money but
only if Congress and the president were willing to
allow the budget deficit to grow
12-34
The Deficit Dilemma

Deficits, Surpluses, and the Balanced
Budget
When government spending is greater than
tax revenue, we have a federal budget deficit
The government borrows to make up the
difference
Deficits are prescribed to fight recession
12-35
The Deficit Dilemma

Budget
When the budget is in a surplus position, tax
revenue is greater than government spending
Budget surpluses are prescribed to fight inflation
12-36
The Deficit Dilemma

Budget
We have a balanced budget when
government expenditures are equal to tax
revenue
Weve never had an exactly balanced budget
Were dealing with a budget of nearly $4 trillion
in taxes and spending
So, if tax revenue and expenditures were within $10
billion of each other, perhaps that would be close
enough to call the budget balanced
12-37
The Deficit Dilemma

Deficits and Surpluses: The Record
The Federal Budget Deficit, Fiscal Years 1970-2001
12-38
Why Are Large Deficits So

Bad?
Large deficits raise interest rates, which,
in turn, discourages investment
Our real interest rate (the nominal interest
rate less the rate of inflation) during the
latter half of the 1980s and all of the 1990s
was three times a high as the real interest
rate in Japan and it was much higher than
those in most Western European countries as
well
12-39

Bad?
The federal government has become
increasingly dependent on foreign savers
to finance the deficit
In the early and mid 1990s foreigners
financed more than half the deficit
12-40

Bad?
Until the mid-1990s the deficit sopped up
more than half the personal savings in
this country, making that much less
savings available to large corporate
borrowers seeking funds for new plant
and equipment
12-41

Bad?
On the positive side, budget deficits stimulate
the economy
The only problem is that we should not have needed
this stimulus during the prosperous mid-to late
1980s when we were running huge deficits
We would do well to remember that John Maynard
Keynes would have advocated running surpluses
and paying off the debt during periods of prosperity
12-42
Will We Be Able to Balance

Future Budgets?
The federal government finally managed to run
a budget surplus in 1998
This was the first time since 1969
The congressional Budget Office forecasts a

string of surpluses well into the new
millennium
Congressional Republicans and Democrats have
already proposed dueling plans to dispose of those
surpluses with various combinations of tax cuts and
spending increases
No elected official proposed slowing down the
projected increases in Social Security spending
12-43
Will We Be Able to Balance

Future Budgets?
A recession, a decline in stock prices, a tax cut,
or an increase in government spending
programs can easily eliminate any surpluses
and replace them with deficits
After the year 2015, as the baby boom
generation attains senior citizenship, the Social
Security Trust Fund will be quickly depleted
Unless the government has already raised Social
Security taxes or cut benefits, the federal budget
surplus will quickly become a large and growing
deficit
12-44
The Proposed Balanced Budget

Amendment and the Line Item
Veto
Must we balance the budget each year?
The government really tried to balance the
budget each year into the early 1930s
The economic wisdom today tells us that we
should have deficits in lean years and
surpluses in fat years
From 1961 through 1997 the government
managed only one surplus
The national debt rose every year as we ran
budget deficits in fat years
12-45

Amendment and the Line Item Veto
The first step in passing a Constitutional
amendment to balance the budget is a
two-thirds vote in both houses of
Congress
Despite some very close votes in 1994, 1995,
1996, and 1997, the balanced budget
amendment failed in one or the other houses
of Congress
Most economists oppose such an amendment
because it would put us in an economic
straitjacket
12-46

Amendment and the Line Item Veto
In still another effort to lower the deficit,
Congress passed a law in 1996 to permit
the president to veto parts of tax and
spending bills, he or she opposes, without
vetoing the entire legislation
This line item veto can be eventually
overridden by a two-thirds vote in each
house of Congress
In February, 1998, a federal judge ruled the
line item veto unconstitutional
12-47
The Public Debt

Differentiating between the Deficit and
the Debt
The deficit occurs when federal government
spending is greater than tax revenue
The debt is the cumulative total of all the federal
budget deficits less any surpluses
Suppose that our deficit declined one year from $200
billion to $150 billion
The national debt would still go up by $150 billion
So every year that we have a deficit even a declining one
the national debt will go up
12-48
The Public Debt

National Debt, 1975-2000
6
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Economic Report of the President, 2000

12-49
The Public Debt

Who holds the national debt?
Private American citizens hold a little less than half
Foreigners hold almost one-third
The rest is held by banks, other business firms, and
U.S. government agencies
Is the national debt a burden that will have to

borne by future generations?
As long as we owe it to ourselves, the answer is no
If we did owe it mainly to foreigners, and if they
wanted it paid off, it could be a great burden
12-50
The Public Debt

When do we have to pay off the debt?
We dont. All we have to do is roll it over, or
refinance it, as it falls due
Each year several hundred billion dollars worth of
federal securities fall due
By selling new ones, the Treasury keeps us going
In the future, even if we never pay back one penny

of the debt, our children and our grandchildren will
have to pay hundreds of billions of dollars in interest
At least to that degree, the public debt will be a burden to
future generations
12-51
The Public Debt

Why not go ahead and just pay off the debt?
Economists predict that following this course would
have catastrophic consequences
If we tried to pay off the debt too quickly, it might
even send us into a deep depression
If we keep running large surpluses and pay down
the national debt, this will cause a problem for both
the Social Security Trust Fund and the Federal
Reserve
As the national debt goes down, eventually there would be
no securities for them to buy
Still, it is a whole lot better to have problems like these than
those caused by running huge budget deficits every year
12-52

Inflationary & Deflationary Gap

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Chapter 12

Fiscal Policy and the National Debt

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The deflationary gap

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Putting Fiscal Policy into

Putting Fiscal Policy into

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Putting Fiscal Policy into

The Deflationary Gap and the

The Deflationary Gap and the

The Deflationary Gap & the Inflationary Gap

GDP (in trillions of dollars)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deflationary Gap & the Inflationary Gap

GDP (in trillions of dollars)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier and Its

Calculating the Multiplier

Because the multiplier

Calculating the Multiplier

Find the multiplier

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier

It is surely much easier to use the multiplier of 2

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Applications of the Multiplier

Applications of the Multiplier

Applications of the Multiplier

Applications of the Multiplier

M = distance between the

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Applications of the Multiplier

M = 500 / 200 = 2.5

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Removing the Deflationary Gap

C1 +I1 +G1 +Xn1

To remove the deflationary

This pushes equilibrium

GDP (in trillions of dollars)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Removing the Inflationary Gap

This pushes equilibrium

To remove the inflationary

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Automatic Stabilizers

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Automatic Stabilizers

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Automatic Stabilizers

Other Transfer Payments

Discretionary Fiscal Policy

Discretionary Fiscal Policy

Using tax rate changes as a counter cyclical policy