Understanding Budget Deficits: Short-Run and Long-Run Impacts on the Economy

1. Chapter 32 Budget Deficits in the Short and Long Run Blessed are the young, for they shall inherit the national debt. HERBERT HOOVER

2. Budget – Always Balanced? Short Run • Balance • Aggregate supply and aggregate demand • Budget deficits, when • Private demand [C+I+G+(X-IM)] is weak • Budget surpluses, when • Private demand [C+I+G+(X-IM)] is strong

3. Budget – Always Balanced? Short Run • Budget – balanced • When C+I+G+(X-IM) • Approximately equals potential GDP • Balance budget – during recessions • Prolong & deepen slumps • Appropriate fiscal policy • Depends on current monetary policy

4. Figure 1 The interaction of monetary and fiscal policy Potential GDP S B Effect of Monetary policy A Effect of fiscal policy Price Level D0 D1 D1 D0 S Y1 Y0 Real GDP

5. Surpluses and Deficits: Long Run • Aggregate demand – unchanged • Real GDP – unchanged • Combinations: fiscal & monetary policy • E.g. • Government – raise taxes • Reduce aggregate demand • The Fed – cut interest rates • Increase aggregate demand

6. Surpluses and Deficits: Long Run • More expansionary fiscal policy • And tight monetary policy • Higher interest rates • Lower investment – less capital formation • Slower growth of potential GDP • Tighter budget (fiscal policy) • And looser monetary policy • Lower interest rates • Higher investment • Faster growth of potential GDP

7. Surpluses and Deficits: Long Run • Composition of aggregate demand • Major determinant • Rate of economic growth • Larger fraction of GDP – investment • Capital stock - grow faster • Aggregate supply schedule • Shift more quickly to right • Accelerated growth

8. Figure 2 Growth and investment in 24 countries

9. Deficits & Debt: Terminology & Facts • Budget deficit • Expenditures exceed receipts • Specified period of time • Budget surplus • Receipts exceed expenditures • National debt (public debt) • Total indebtedness • At a moment in time • Result of previous budget deficits

10. Deficits & Debt: Terminology & Facts • Government • Accumulates debt • Runs deficits • Reduces debt • Runs surpluses • Net national debt • 35% of GDP, 2007

11. Figure 3 The U.S. national debt relative to GDP, 1915–2007

12. Interpreting Budget Deficit or Surplus • Deficit = G + Transfers – Taxes = = G – (Taxes – Transfers) = = G – T • No change in fiscal policy • Deficit • Rises in a recession • Falls in a boom

13. Figure 4 Official fiscal-year budget deficits, 1981–2007

14. Figure 5 The effect of the economy on the budget T =Taxes - Transfers A B Surplus G Spending and Tax Receipts Deficit Y1 Y2 Y3 Gross Domestic Product

15. Interpreting Budget Deficit or Surplus • Structural budget deficit • Hypothetical deficit • Under current fiscal policies • If economy - near full employment • Doesn’t depend on state of economy • Changes • Only when policy changes • Not when GDP changes

16. Table 1 Alternative budget concepts, 1981–2007

17. Interpreting Budget Deficit or Surplus • Overall budget deficit = = On-budget deficit + Off-budget deficit • Off-budget • Social Security expenditures • Payroll tax receipts - finance them

18. Why: National Debt Considered a Burden? • National debt - owned by domestic citizens • Future interest payments • Transfer funds • From one group of Americans • To another • National debt - owned by foreigners • Burden on the nation as a whole

19. Why: National Debt Considered a Burden? • Fundamental difference • Nations - borrow in their own currency • Don’t default on their debt • Nations - borrow in some other currency • Might have to default on their debts

20. Budget Deficits and Inflation • Deficit spending • Increase aggregate demand • Higher real GDP • Higher price level • Budget deficits • Inflationary • Slope of aggregate supply curve • Degree of resource utilization • Policy mix

21. Figure 6 The inflationary effects of deficit spending D0 D1 Potential GDP S C B A Aggregate supply curve shifts inward as wages rise Deficit spending boosts aggregate demand Price Level 106 112 100 D1 D0 S $5,000 0 $6,000 $8,000 $7,000 Real GDP

22. Budget Deficits and Inflation • Monetize the deficit • Central bank • Purchases bonds issued by government • Deficit spending • Higher GDP & price level • Increase demand for bank reserves • Fed – no action • Interest rates – increase

23. Figure 7 Fiscal expansion and interest rates D1 D0 S Shift in demand for reserves caused by rising Y and P For given Fed policy B A Interest Rate D0 D1 S Quantity of Bank Reserves

24. Budget Deficits and Inflation • Deficit spending • Higher GDP & price level • Increase demand for bank reserves • Fed – expansionary monetary policy • Purchase government debt • Increase supply of bank reserves • No increase in interest rates • Increase money supply

25. Figure 8 Monetization and interest rates D1 D0 S0 S1 Expansionary Fed policy B A C Interest Rate D0 D1 S0 S1 Quantity of Bank Reserves

26. Debt, Interest Rates, and Crowding Out • Large budget deficit • And no Fed monetization • Higher interest rate • Lower investment • Future • Less capital • Smaller potential GDP • Burden future generations

27. Debt, Interest Rates, and Crowding Out • Crowding out • Deficit spending by government • Higher interest rates • Decreases private investment spending • Dominates – long run • Crowding in • Government spending • Faster real economic growth • Increase in private investment spending • More powerful – short run

28. Burden of National Debt: Slower Growth • Government budget deficits • For: high-employment economy • Crowding-out effect – dominates • Less investment • Smaller capital stock • Lower potential GDP • Future generations • Burden

29. Burden of National Debt: Slower Growth • Government budget deficits • For: high unemployment economy • More investment • Crowding-in effect dominates • Higher growth • Blessing

30. Burden of National Debt: Slower Growth • U.S. national debt • Not bankruptcy • Burden on future generations • If sold to foreigners • If contracted - fully employed, peacetime • Reduce the nation’s capital stock • Some circumstances • Budget deficits • Appropriate for stabilization-policy purposes

31. Burden of National Debt: Slower Growth • U.S. national debt • Until 1980s • Contracted: wars and recessions • Not a burden • Large deficits of 1980s and 2000s • Worrisome • Shift from budget surpluses to deficits • Slow down capital formation • Slow down future economic growth

32. Figure 9 Short-run effect of larger deficits or smaller surpluses D1 D0 S B A Price Level D0 D1 S Real GDP

33. Figure 10 Long-run effect of larger deficits or smaller surpluses D Potential GDP Potential GDP S0 S1 B A Price Level D S0 S1 Y0 Y1 Real GDP

34. Economics & Politics of US Budget Deficit • Deficits of 1980s, 1990s, and 2000s • Recessions: 1981-1982, 1990-1991, 2001 • Crowding out – not a serious concern • Actions - close the deficit • Threaten subsequent recoveries • Growing deficits - appropriate in each case • Crowding out - more serious issue • Economy recovered • 1990s, 2004-2007 • Budget deficit – declined • 1980s, 2002-2004 • Structural deficit – increased

35. Economics & Politics of US Budget Deficit • Get rid of deficit in 1990s • Raising taxes & reducing spending • 3 steps • Bipartisan budget agreement, 1990 • Deficit reduction package , 1993 • Smaller bipartisan budget deal, 1997 • Expansionary monetary policies • Rapid economic growth, late 1990s • More tax revenue • Off-budget surplus – increased • Budget surplus

36. Economics & Politics of US Budget Deficit • Surplus - gave way to large deficits rapidly • Recession • Tax cuts • Higher spending • National defense • Homeland security

37. Economics & Politics of US Budget Deficit • Future prospects for federal budget deficit • Not very good • 2011 - baby boomers • Medicare • Social Security benefits • Sharp increase in federal spending • If nothing changes • Budget deficit will start to grow again