Chapter 12

Fiscal Policy and the National Debt

McGraw-Hill/Irwin
2009 The McGraw-Hill Companies, All Rights Reserved

Learning Objectives
In this chapter you will learn about:
1.
2.
3.
4.
5.
6.
7.
8.
9.

The recessionary gap.

The inflationary gap.
The multiplier and its applications.
Automatic stabilizers.
Discretionary fiscal policy.
Budget deficits and surpluses.
Fiscal policy lags.
The public debt.
Crowding-in and crowding-out.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-2

Fiscal Policy
Definition: the manipulation of the federal budget to
attain price stability, relatively full employment, and a
satisfactory rate of economic growth.

Two sides to federal budget: Government spending

(outlays) and federal tax revenue.
Focus on level of Government spending (G), not how the
funds are allocated.
Focus on level of tax revenue (T), not using tax policy to
reward certain behavior (e.g., home ownership).
Both are responsibility of Congress and President.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-3

Three Options for Fiscal Policy

Balanced Budget: G = T

Government expenditures equal tax revenue for the fiscal

year.

Budget Deficit: G > T

Government spending is greater than tax revenue for the

fiscal year.
Government borrows difference by issuing Treasury bonds.

Budget Surplus: G < T

Government spending is less than tax revenue for the fiscal

year.

Before Keynes, economists argued government

should always balance its budget. No active fiscal
policy.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-4

Putting Fiscal Policy into Perspective

John Maynard Keynes invented fiscal policy.
Problem in Depression was inadequate Aggregate
Demand for output (real GDP).
Equilibrium stuck below full-employment level:
C stays low because consumers are unemployed or cutting
back.
I stays low because businesses have low profit expectations
and no incentive to expand.
The only component of AD that the government can control is
G. Increase G to increase AD.
Or, by cutting taxes (T), government can hope consumers and
businesses will spend additional income.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-5

Modeling Fiscal Policy Using Aggregate

Expenditures
Equilibrium GDP tells us the level of spending in the
economy.
Level of output at which everything produced is sold
(Aggregate Demand equals Aggregate Supply).

Full-employment GDP tells us the level of spending

necessary to reach full employment.
If plant and equipment is operating at between 85 and 90%
of capacity, thats considered full employment.
If approximately 5% of labor force is unemployed, thats
considered full employment.

Fiscal policy is used to push equilibrium GDP toward

full-employment GDP.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-6

Recessionary Gaps and Inflationary Gaps

Recessionary Gap occurs when equilibrium GDP is
less than full-employment GDP.
Inadequate Aggregate Demand (C + I + G + Xn)
Fiscal Policy solution is to run a budget deficit (raise G or
lower T).

Inflationary Gap occurs when equilibrium GDP is

greater than full-employment GDP.
Excess Aggregate Demand sparking inflation
Too many dollars chasing too few goods.
Fiscal Policy solution is to create a budget surplus (decrease
G or raise T).

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-7

Questions for Thought and Discussion

Which do you think is easier politically for members of
Congress and a President to doraise taxes or lower
taxes?
Which do you think is easier politically for members of
Congress and a President to doincrease
government spending or cut government programs?
Given your answers, which is easier politically to do
use fiscal policy to fight recessions or inflation?

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-8

Graphing a Recessionary Gap

When the fullemployment GDP is
greater than the
equilibrium GDP, there
is a recessionary gap.
How much is it?

$7 trillion $6 trillion = $1 trillion

Note that the recessionary

gap is less than the gap in
output on the horizontal axis.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-9

Graphing an Inflationary Gap

When the fullemployment GDP is
less than the
equilibrium GDP, there
is an inflationary gap.
How much is it?

$200 trillion

Note that the inflationary

gap is less than the excess
output on the horizontal axis.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-10

Summary of Graphs
Recessionary Gap:
Difference between full-employment GDP and equilibrium
GDP is $2 trillion.
Recessionary gap (inadequate spending) is $1 trillion.

Inflationary Gap:
Difference between full-employment GDP and equilibrium
GDP is $500 trillion.
Inflationary gap (excess spending) is $200 trillion.

Why is gap in spending less than gap in output?

Multiplier effects

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-11

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.

C + I + G + Xn

GDP

Size of multiplied change depends on MPC and MPS.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-12

Calculating the Multiplier

Remember: MPC + MPS = 1, therefore, MPS = 1 MPC

Multiplier =

Multiplier =

1
1 MPC
1
MPS

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-13

Calculating the Multiplier

Find the multiplier.
The MPC is .5.

Multiplier =

1
1 - MPC

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1
1 .5

1
.5

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How Does the Multiplier Work?

Suppose the government pays you $1,000 to write a
report as an economic consultant. The MPC in this
economy is .5.
You will spend $500 and save $500. Suppose you spend the
$500 on a laptop.
The seller of the laptop now has $500 in new income. The
laptop seller spends $250 and saves $250. Suppose she
spends the $250 on used text books.
The used bookseller now has $250 in new income, so he
spends $125 on concert tickets and saves $125.
The concert promoter now has $125 in new income, so she
spends $62.50 on a watch and saves $62.50.
The watch seller now has $62.50 in new income, so he
spends $31.25 buying gas and saves $31.25.
And so on
2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-15

Multiplier and MPC

If you add up all the rounds of spending ($1,000 +
$500 + $250, etc.), you would get $2,000.
Using the formula is quicker.
Question: As the MPC increases, what happens to the
multiplier?
Answer: It gets bigger!
Denominator is 1 MPC.
If MPC increases, (1 MPC) gets smaller.
Smaller denominator increases the number. (Hint: Compare
with 1/3.)

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-16

Applications of the Multiplier

The multiplier is used to calculate the impact of a
change in C, I, or G on GDP.
Formula:
GDPNew = GDPInitial + (Change in spending X Multiplier)

Example: GDP = 2,500; C rises by 10; Multiplier = 3

What is the new level of GDP?
GDPNew = 2500 + (10 x 3)
GDPNew = 2500 + (30)
GDPNew = 2530

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Amount of increase in GDP

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Applications of the Multiplier

Formula:
Change in GDP = (Change in spending X Multiplier)

Example: Multiplier = 7; G falls by $5 billion

How much will GDP decrease?
Change in GDP = - 5 x 7
Change in GDP = - $35 billion

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-18

Removing the Recessionary Gap

To remove the deflationary

gap, raise AD from
C+I+G+Xn
to
C1+I1+G1+Xn1

This pushes equilibrium GDP

to $7 trillion (full-employment
GDP.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-19

Removing the Inflationary Gap

To remove the
inflationary gap, lower
AD from
C+I+G+Xn
to
C1+I1+G1+Xn1

This pushes
equilibrium GDP down
to 1,000 and removes
the inflationary gap.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-20

Automatic Stabilizers:
(passively moderate business cycles)
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.

Credit Availability

Credit availability helps get us through recessions.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-21

Automatic Stabilizers:
(passively moderate business cycles continued)
Unemployment Compensation

During recessions more people collect unemployment

benefits.

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.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-22

Discretionary Fiscal Policy:

(under direction of Congress and President)
Making Automatic Stabilizers More Effective
Example: Extending unemployment benefits beyond 6
months.

Public Works and Public-Sector Job Creation

New Deal programs built bridges, post offices, park trails, etc.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Discretionary Fiscal Policy:

(under direction of Congress and President
continued)
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.

Changes in Government Spending

To fight recession, increase government spending; run deficit.
To fight inflation, decrease government spending; run surplus.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-24

Questions for Thought and Discussion

Are public works projects a bad idea?
Cons:
Public works projects are often labeled pork barrel spending.
Members of Congress negotiate to bring spending projects to
their local communities, even if it is wasteful. Some projects
make headlines, like Bridge to Nowhere in Alaska.

Pros:
Our roads, bridges, and other public infrastructure are
crumbling. We need new public investment.
Green-collar jobs is the idea that government should create
jobs that improve the environment.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-25

Who Makes Fiscal Policy?

President submits budget to Congress.
Congress amends budget and passes appropriation
bills.
Both House and Senate have to reconcile differences
between their versions.

President can accept or veto.

If vetoed, Congress can try to override.

Fiscal Year begins October 1st.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-26

Fiscal Policy Lags

Fiscal Policy takes time due to three types of lags (or
delays):
Recognition lag: Policy makers must identify that there is a
problem. (Recessions only declared after 6 months.)
Decision lag: President and Congress must agree on policy
approach and pass legislation.
Impact lag: It takes time for their actions to have effect.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-27

The Deficit Dilemma

Discussion Question: How did the government get rid of deficits in the 1990s?
What led to the return of deficits after 2000?
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12-28

Why Are Large Deficits Bad?

Large deficits are problematic:
1. Government borrowing pushes up interest rates.
2. Deficit is increasingly financed by foreign savers, giving U.S.
less control over financial markets.
3. Money used to invest in government bonds is not being
used to finance private sector investment.

Conclusion: We dont need to balance the federal

budget every year, but deficit spending has limits.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-29

Monetarists vs. Keynesians

Monetarists emphasize
crowding out

Keynesians emphasize
crowding in

Any expansionary impact of

budget deficits will be offset
by higher interest rates and
crowding out private sector
borrowing.

Stimulus of increased
government spending or tax
cuts will encourage
consumption and investment.

Go back to Laissez-Faire
policy of Classical
economics!

Government primes the

pump to get the private
sector growing again.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-30

The Public Debt

Difference between Deficits and Debt
Deficits occurs when federal government spending is greater
than tax revenue in a single fiscal year.
Debt is the cumulative total of all the federal budget deficits
less any surpluses.

Example:
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 deficiteven a declining onethe
national debt will go up.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-31

The National Debt: 19802008*

*Debt on January 1 of each year.

Portion held by US
government agencies

Portion held by public

Budget surpluses in 1990s led to decreases in public portion of debt.

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12-32

Percentage of Outstanding National Debt Held

by Foreigners, 19532007

Two periods of increase: the 1970s and 1990s.

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12-33

When do we have to pay off the Public Debt?

We dont. All we have to do is roll it over, or refinance
it, as it falls due.
Each year more than three trillion dollars worth of federal
securities fall due.
By selling new ones, the Treasury keeps us going.

But 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.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-34

Questions for Thought and Discussion

Baby Boomer retirements will increase outlays for
Social Security and Medicare. (Both programs now run
surpluses each year.)
What are the options to avoid massive budget deficits
when Boomers retire?
Raise payroll taxes or eliminate the earnings cap on social
security taxes to increase revenue (T).
Raise retirement age or cut benefits to reduce spending (G).
Combine both approaches.
Which would you recommend?

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

12-35