CHAPTER 30: FISCAL POLICY, DEFICITS, AND DEBT

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1 CHAPTER 30: FISCAL POLICY, DEFICITS, AND DEBT Introduction Changes in aggregate supply and demand affect output, employment, and price level in the economy. But as a result of Keynesian theory, government now has tools it can use to reduce inflationary gaps or close recessionary gaps, all with the goal of returning the economy to full-employment output. Use of these policy tools, though, can also result in budget surpluses or deficits, which can affect the national debt. Material from Chapter 30 is included in several multiple-choice questions and commonly appears as part of a freeresponse question on the AP macroeconomics exam. Expansionary Fiscal Policy ss billion Iniri.1 Fu ll $20 billion increase in o L.,,-..,,-,,_-::,,-:: ' --1 EXpllnsionary fis~al policy R.u l GOP ~billion l l Fiscal policy is the use of discretionary government spending or taxes in order to stabilize the economy. Ifaggregate demand falls, output falls and cyclical unemployment rises. If prices are sticky, the full effect of the decrease in aggregate demand accrues in lower output. Government can use expansionary fiscal policy to shift aggregate demand to the right by increasing government spending, reducing taxes, or both. Precisely how much of a change in taxes or spending is required depends on the marg inal propensity to consume and the related multipliel If the MPC is 0,75, the MPS is 025, and the multiplier is 4 (I 1025), If the negative GDP gap is $20 billion, government spending would only have to increase by $5 billion, because the multiplier would continue to fill the rest of the gap. However, we know that a reduction in taxes is not as effective as an increase in government spending, because consumers will save some of the tax cut. In this case, consumers would only spend 75% of a tax cut, so taxes would have to be reduced by $6.67 billion to achieve the same $20 billion increase in aggregate demand that was achieved by a $5 billion increase in government spending. Chapter 30: Fiscal Policy, Deficits, and Debt 211

2 b Expansionary fiscal policy also has ramifications for the federal budget. Assume the United States begins with a balanced budget. If the government lowers taxes or increases spending as a part of expansionary fiscal policy, it will create a budget deficit- spending more than its revenues in a year. Government must borrow money through the sale of government securities (bonds, bills, and notes) in order to finance that deficit. A deficit also adds to the national debt, the total amount the government has borrowed over the years. Contractionary Fiscal Policy " --_--~.,,,.. Sl bilh,," lnl~.l d... In.penOI"1 FullSllbllU"n do<,..,. in ",, -. AD, AD, AD. L -=~~~=_ SSOI nlo Sill ~e. 1 GOP,b,I"",,,) Conrractionaryjisca/ policy under the ratchet effect Contractionary fiscal policy is the use of a tax increase or a reduction in government spending in order to reduce a demand-pull inflationary gap. If aggregate demand rises, part of the inflationary gap increases prices, while the other part increases output. To correct an inflationary gap, the government uses contractionary fiscal policy: increasing taxes, reducing government spending, or both. A reduction in spending directly affects aggregate demand. But in determining how far to lower spending, it is important to keep the ratchet effect in mind. A ratchet is a tool that turns a screw or bolt in one direction but not the other. With the ratchet effect, once the price level ratchets up, it tends not to come back down- the sticky wages and prices we discussed earlier. So when the government decides how much to reduce spending, it must take this ratchet effect into account. In this figure, if the increase in real output is $12 billion with a multiplier of 4, the government should reduce spending by $3 billion to bring aggregate demand back down to full employment GOP at point C. Notice, however, that the price remains at the higher level. The contractionary fiscal policy is able to stop the escalation of the inflation rate but generally is not effective in reducing prices to their former levels. The government also has the option of closing an inflationary gap by increasing taxes. As we have noted, changes in taxes are not as effective as spending changes, because part of the increase in the tax rate will be paid from savings, rather than reducing consumption by the full amount of the tax. If the MPC is 0.75, consumers will use savings to pay a quarter of their tax increases. So in order to fill the gap, government must increase taxes by $4 billion in order to reduce consumption by $3 billion. The multiplier of 4 will then continue to reduce consumption by the entire $12 billion negative GDP gap. 2t2 Chapter 30: Fiscal Policy, Deficits, and Debt

3 Contractionary fiscal policy also has ramifications for the national budget. If government begins with a balanced budget, the increase in taxes or reduction in government spending to address the inflationary gap will result in a budget surplus-tax revenues greater than government spending for a year. This surplus can reduce the amount of the national debt. Politics and Fiscal Policy While we know that changes in taxes and government spending can both be effective in closing recessionary and inflationary gaps, which policy is best to use? It depends on your view of government. Conservatives tend to prefer a smaller role for government and are more likely to call for tax cuts during recessions and spending cuts during inflation. Liberals tend to prefer a larger role for government and more often call for spending increases during recessions and tax increases during inflation. Each policy is effective in achieving the desired economic result, but the political philosophy of those in power tends to guide the policy choices. Automatic Stabilizers Automatic stabilizers are government programs that automatically change spending and taxes during economic instability, without requiring government policymakers to pass a new policy. The two primary automatic stabilizers are transfer payments from safety net programs and progressive income taxes. During a recession, as workers lose jobs and incomes fall, households become eligible for government programs such as unemployment benefits, food stamps, and rent subsidies. Government spending automatically rises and works to mitigate the amount by which aggregate demand declines, helping to stabilize the economy. Nations with stronger safety net programs have more effective automatic stabilizers. Progressive income taxes base the tax rate on household income level. Those with lower incomes pay a lower percentage of their income in taxes, while those with higher incomes pay a larger percentage of their income in taxes. During periods of inflation, as incomes increase, taxpayers can ascend into higher tax brackets. As a result, they pay a higher percentage of their income in taxes, leaving less income available for consumption spending. Therefore, the higher tax rate helps to reduce the effects of inflation by reining in consumer spending. Economies with more strongly progressive tax structures have a more effective tax stabilizer. In general, when GOP increases, tax revenues increase from all sources-individual income taxes, business taxes, excise taxes, and payroll taxes- because as more jobs are created, incomes rise and consumers are able to buy more products. During periods of recession, tax revenues from all of these sources decline. Transfer payments work in reverse, with government spending for these programs increasing during periods of recession and declining as the economy grows. As a result, the federal budget is affected by economic instability even before fiscal policy is considered. During recessions, a balanced budget tends to go into deficit because tax revenues fall as government spending increases. During economic growth or even inflation, a balanced budget tends to go into surplus because tax. revenues rise as goverrunent spending declines. But Chapler 30: Fiscal Policy, Deficits, and Debt 213

4 automatic stabilizers alone are usually not powerful enough to deal with significant swings in aggregate demand. so government action is required. Problems of Fiscal Policy The recognition lag refers to the time between the initial development of a recessionary or inflationary gap and when it is recognized. It can take months to detennine whether a recession or inflation is underway. In December 2008, the National Bureau of Economic Research announced that the U.S. economy had already been in recession for a full year before it was recognized. An administrative lag follows, as Congress takes time, often months, to pass legislation to change taxes or spending to address the identified gap. Finally, an operational lag requires time for the policy to actually take effect, as changes rumble through the system and the multiplier takes effect. This can take yet another six months to a year for fiscal policy to take full cffect. These combined lags illustrate how long a recession or inflation can be underway before a fiscal policy solution can take effect. It also points out the imponance of automatic stabilizers in helping to reduce the impacts of economic instability. Another problem with fiscal policy is the political considerations involved in making policy. Voters don't want to hear about tax increases or cuts in their favorite programs, so public officials may hesitate to use contractionary policy when it is warranted. And in order to ga in votes at election time, public officials have an incentive to reduce taxes and increase spending for popular programs, even if such actions are contrary to the fiscal policy appropriate for the economic situation. In addition. the government may need to significantly increase spending to deal with a crisis- a natural disaster or a war-even during a time of inflation, exacerbating an inflationary gap. Further, the balanced budget requirements of many state and local governments force them to reduce spending during a recession- which on ly reduces aggregate demand further, contradicting the federal fi scal policy. I n 10 t r, t R a t Loon.hle Funds Market _ e , D. t---~---+--~~--+---~ o 2,. 10 Quantity or Money (in millions) s 214 Chapter 30: Fiscal Policy, Deficits. and Debt

5 Another problem with fi scal policy is the problem of crowding out. When the government uses expansionary fiscal policy to increase spending and reduce taxes, a budget deficit develops. Government must borrow money to fmance the deficit. As government demand for money in the loanable funds market increases, interest rates rise. We already know that investment spending is the most volatile of the four sectors-and if interest rates increase, finns can significantly reduce investment spending, crowding other finns out of the loanable funds market. So while government is borrowing money to increase aggregate demand, crowding out reduces the effectiveness of the fiscal policy by offsetting part of that increase in aggregate demand. The higher interest rate can also reduce interest-sensitive consumption spending, such as consumer purchases of homes, cars, and durable goods, further reducing aggregate demand. The crowding out effect, if it occurs at all, tends to occur less during a time of recession, because consumer and investment demand for loans has likely decreased already due to the recession. But if the government increases deficit spending when the economy is at or near full ~e mployment output, crowding out is likely to have a more substantial effect on aggregate demand. National Debt Concerns Each year the federal government incurs a budget deficit, it adds to the national debt. In 2008, the U.S. national debt surpassed $ \0 trillion. As of2007, interest payments on the debt were the fourth-largest item in the federal budget. Policymakers undertook unprecedented debt in 2008 and 2009 with the stimulus and bailout packages as the economy dramatically deteriorated, so interest payments on the debt will only increase. And those payments do not payoff the debt; they only service the interest on the debt. This significant increase in interest payments leaves policymakers with the difficult decision of raising taxes or cutting spending to make these interest payments-qr borrowing even more to pay the interest. Another concern is the redistribution of income from those with lower incomes to those with higher incomes. Government securities and the interest they earn are disproportionately held by those with higher incomes because of their ability to save. Because the federal income tax system is only slightly progressive, those with lower and middle incomes largely pay the taxes that will pay the interest to the bondholders with higher incomes. Many people are also concerned about the level of foreign-owned public debt. More than a quarter of the national debt is owned by foreign countries and foreign citizens, and so interest payments on that debt flow out of the U.S. economy. Finally, concerns about the level of crowding out due to extensive borrowing in a full-employment economy may have serious implications for future economic growth. But if the deficit spending is for infrastructure or other capital improvements, overall investment may actually increase. Chapter 30: Fiscal Policy, Deficits, and Debt 2 15

6 Multiple-Choice Questions I. An increase in government spending increases the real GDP by more than the amount of the initial spending because of the (A) automatic stabilizers. (B) spending multiplier. (C) trade deficit. (D) aggregate supply. (E) national debt. 2. If the economy is operating in the upward-sloping section of the aggregate supply curve, a reduction in personal taxes will cause (A) unemployment to increase. (8) the price level to decrease. (C) aggregate demand to decrease. (D) real GDP to increase. (E) the budget deficit to decrease. 3. If the country is experiencing significant cyclical unemployment, how would an increase in government spending affect real output, prices, and unemployment? RealOutput Price Level Unemployment (A) Increase Increase Increase (8) Decrease Decrease Increase (C) Increase Increase Decrease (0) Decrease Decrease Decrease (E) Increase Decrease Decrease 4. If the government uses a contractionary fiscal policy. it must increase taxes by how much in ordt!r to have the same effect as a change in spending? (A) by the same amount that it raises spending (B) by the full amount of the inflationary GDP gap (C) by more than it would reduce spending (D) by less than it would increase spending (E) by the percentage increase in the inflation rate 5. When the government implements an expansionary fiscal policy to resolve a rccessionary gap, it results in a (A) budget defi cit. (D) reduction in interest rates. (C) reduction in the national debt. (D) budget surplu s. (E) reduction in real GOP. 6. A situation in which the federal government's taxes are greater than its revenues In one year IS (A) a budget deficit. 2t6 Chapter 30: Fiscal Policy, Deficits. and Debt

7 (B) (C) (D) (E) a budget surplus. the national debt. a trade deficit. a trade surplus. 7. How does the federal government finance deficits? (A) with higher taxes (B) with imports (C) by lowering spending (D) by the sale of bonds (E) by the sale of stock 8. According to the Keynesian ratchet effect, once the price level increases due to an increase in aggregate demand, (A) price levels are most effectively reduced by changing taxes. (B) aggregate supply must be decreased to reduce the price level. (C) price levels are most effectively reduced by changing spending. (D) the price level tends not to go back down due to sticky wages. (E) a decrease in aggregate demand will reduce prices to their original levels. 9. Automatic stabilizers have an advantage over discretionary fiscal policy because automatic stabi lizers (A) are directed by the president, while fi scal policy is set by Congress. (B) are stronger than fiscal policy tools. (C) do not add to the national debt. (D) affect the money supply more than they affect discretionary fiscal policy. (E) take effect without requiring action by policymakers. 10. Crowding out occurs when (A) a product price is set too low, creating a shortage. (B) too many producers are in a market, forcing some firms out of an industry. (C) too many firms request government subsidies in the same budget cycle. (D) government spending is reduced, so programs are eliminated. (B) government borrowing increases interest rates, so firms reduce investment. II. Concerns about the size of the national debt include all of the following EXCEPT (A) interest on the debt consuming a larger ponion of the national budget. (B) the redistribution of income from those with lower incomes to those with higher incomes. (C) lower interest rates as a result of increased government borrowing. (D) the increase in the level of foreign-owned debt. (E) the impact of crowding out on future economic growth. Chapter 30: Fiscal Policy, Deficits, and Debt 217

8 Free~Response Question Assume the economy is operating at less than full-employment output on the upwardsloping portion of the aggregate supply curve and the federal budget is balanced. (a) Using a correctly labeled aggregate supply and aggregate demand graph, show the following. (i) real output (ii) price level (b) Identify one fiscal policy government could use to return the economy to fullemployment output. Explain the following. (i) how that policy works to achieve full-employment output (ii) the effect of the policy on the federal budget (iii) the effect of the policy on the national debt (c) On the graph you drew for (a), illustrate the effect of the fiscal policy you identified. Explain the effects of the policy on the following. (i) real output (ii) price level (iii) employment (d) Using a correctly labeled money market graph, illustrate the effect of the policy you identified in (b) on the market. Explain the effect on the following. (i) the interest rate (ii) investment Multiple-Choice Explanations I. (8) The multiplier increases the value of the initial spending as the income is spent and re-spent throughout the circular flow. 2. (D) A reduction in taxes leads to an increase in aggregate demand; the other four options result from an increase in taxes. 3. (C) An increase in government spending increases aggregate demand, raising real GDP and price level while reducing unemployment. 4. (C) Taxes are less effective than spending because consumers will pay part of the tax increase with savings, so consumption will not fall as far as it would if the government decreased spending by the same amount. 5. (A) An expansionary fiscal policy creates a budget deficit as taxes are reduced and government spending increases. The additional government borrowing increases interest rates in the loanable funds market and increases the national debt. 6. (A) A budget deficit counts overspending in one year; the national debt is the total amount of money the government owes. 7. (D) Government sells securities on the open market to borrow money for deficit spending. 8. (D) Because workers tend to be hired on contract, firms cannot reduce wages in the short run, leaving wages and prices sticky; therefore, once prices increase, they tend not to decrease again. 218 Chapter 30: Fiscal Policy, Deficits, and Debt

9 9. (E) Automatic stabilization programs, such as unemployment benefits or food stamps, go into effect quickly upon the eligibility of households for the programs, avoiding the lag time involved with discretionary fiscal policy. 10. (E) Government's increased demand for funds in the loanable funds market raises interest rates, so finns reduce their borrowing, lowering their investment in capital goods. It. (C) Increased government borrowing raises interest rates. Free Response Explanation 15 points ( ) (a) 3 points: 1 point is earned for a correctly labeled aggregate supply and aggregate demand graph. I point is earned for correctly identifying real output (GDP). I point is earned for correctly identifying the price level. (b) 4 points: I point is earned for identifying either an increase in government spending or a decrease in taxes. I point is earned for explaining that lower taxes allow consumers and firms more disposable income to increase aggregate demand or that higher government spending directly increases aggregate demand, raising incomes. 1 point is earned for stating that the policy would cause a budget deficit. I point is earned for stating that the deficit would increase the national debt. (c) 4 points: I point is earned for showing an increase in aggregate demand. I point is earned for stating that real output will increase. I point is earned for stating that the price level will increase. I point is earned for stating that employment will increase in order to make the additional output. (d) 4 points: I point is earned for a correctly labeled loanable funds market graph. I point is earned for showing an increase in demand for loanable funds. I point is earned for stating that the interest rate increases due to increased demand. I point is earned for stating that investment fall s because of the higher interest rate finns must pay to borrow. Chapter 30: Fiscal Policy, DeficilS, and Debt 219

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