CH 31+32: Deficit and DebtLECTURE

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2020

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2019

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2018

2017

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2016

2015

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Fiscal Policy

Fiscal Policy

• Fiscal policy refers to the government's policy on taxes and government spending and how they affect the flow of income in the economy

Expansionary Fiscal Policy

• Expansionary fiscal policy: a fiscal policy that increases aggregate demand (AD)

• Can be in the form of: an increase in government spending or a decrease in taxes (or an increase in transfer payments)

Contractionary Fiscal Policy

• Contractionary fiscal policy: a fiscal policy that decreases aggregate demand (AD)

• Can be in the form of: a decrease in government spending or an increase in taxes (or a decrease in transfer payments)

Discretionary Fiscal Policy

• Discretionary fiscal policy involves actions taken by the government to correct economic instability/problems

• This is spending that has to be authorized by Congress each year

• Estimated at $1.485 trillion for 2021 fiscal year

• The largest discretionary spending category is national defense which is more than 50% of the discretionary budget

Nondiscretionary Spending

• Nondiscretionary spending is money the government is required to spend (also known as mandatory spending) and is often fixed by law

• It can include interest on the national debt as well as entitlement programs, such as Social Security and Medicare

• Estimated at $2.966 trillion for 2021 fiscal year

• Social Security is the biggest expense ($1.151 trillion estimated for 2021 fiscal year)

Deficit and Debt

The Federal Deficit and Debt

• Budget surplus: when annual government spending and transfer payments are less than tax revenue

• The last surplus was between 1998-2001

• Budget deficit: when annual government spending and transfer payments are greater than tax revenue

• If the government increases spending without increasing taxes they will increases the annual deficit and the national debt

The Federal Deficit and Debt

• Deficit spending: when a government spends more than it collects in revenue for a given year

• Annual deficits contribute to the national debt, the total amount of money that our nation owes

• A government must pay interest on its accumulated debt, thus increasing the national debt

•As a result, they forgo using these funds for other uses

Financing the Deficit• When the government borrows money to fund the deficit it is

affecting private investment

• As the government borrows large amounts of money, its can increase interest rates, resulting in crowding out

• Higher interest rates discourage individuals and businesses from borrowing money, which reduces their spending and investmentactivities• Private investment is crowded out by expansionary fiscal policy• Leads to a decrease in interest-sensitive private sector

spending• In the long run this can lead to a decrease in economic growth

Financing the Deficit• Think back to the loanable funds market: If the government borrows money

to cover its deficit, it increases demand for loanable funds and crowds out private investment as the real interest rate increases

Real Interest Rate

Q of Loanable FundsQ1

S1 or SLF1

r2

D1 or DLF1

r1

Q2

D2 or DLF2

Raising Money for Deficit Spending

• The government finances its deficit by selling bonds to private individuals and the Fed

• The U.S. Treasury must sell new bonds to pay for a deficit and refinance previously issued bonds as they come due

• Treasury bills (T bills) are short-term bonds that mature in less than one year

• Treasury notes are bonds that mature between two and ten years

• Some Treasury bonds are issued for 30 years

Raising Money for Deficit Spending

• To get people to buy/hold bonds, they need to be attractive

• This means higher interest rates

•This pushes up interest rates making it more expensive for businesses to borrow and in turn, reduces their investment

Ownership of the Debt

• The U.S. debt is more than $23 trillion

• See http://www.usdebtclock.org/

• About 75% of the debt is held by the public

• The government owes this to buyers of U.S. Treasury bills, notes, and bonds

• The other 25% is owed to various government departments such as Social Security

Automatic Stabilizers

• An automatic stabilizer is a built-in fiscal policy that work counter cyclically to stabilize the economy

• It supports the economy during recessions and help prevent the economy from becoming overheated during expansionary periods

• For example, tax revenues increase as GDP rises, which slows consumption and prevents the economy from overheating

• When GDP decreases, government spending increases and taxes fall

• Examples: welfare, unemployment insurance, and income taxes