Econ chapter 13
Austerity:
contractionary fiscal methods or measure such as gov spending cut or tax increase to reduce budget deficit
The budget deficit almost always rises when the unemployment rate
rises and falls when the unemployment rate falls.
There are two reasons to be concerned when a government runs persistent budget deficits that result in government debt that rises over time.
1. Crowding Out When the economy is at full employment and the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government's borrowing may crowd out private investment spending, increasing interest rates and reducing the economy's long-run rate of growth. 2. Financial Pressure and Default Today's deficits, by increasing the government's debt, place financial pressure on future budgets. The impact of current deficits on future budgets is straightforward. Like individuals, governments must pay their bills, including interest payments on their accumulated debt. When a government is deeply in debt, those interest payments can be substantial. In fiscal 2016, the U.S. federal government paid 1.3% of GDP, or $241 billion, in interest on its debt. The more heavily indebted government of Italy paid interest of 4% of its GDP in 2016, according to estimates.
Fiscal policy that reduces aggregate demand, called contractionary fiscal policy, is the opposite of expansionary fiscal policy. It is implemented in three possible ways:
A reduction in government purchases of goods and services An increase in taxes A reduction in government transfers
Problems from debt -
Crowd out investment spending which reduces long run economic growth default
There are three main arguments against the use of expansionary fiscal policy.
Government spending always crowds out private spending Government borrowing always crowds out private investment spending Government budget deficits lead to reduced private spending
Long run implications of fiscal policy
Persistent budget deficits
Keynesian advice -
Run a deficit during a recession to stimulate AD Pay down the debt during good times
What happened?
Speaking increases Y but raising taxes reduces Y Balanced budget multiplier: Spending multiplier + tax multiplier It is hard to fight a recession and balance the budget at the same time
Automatic stabilizers
Spending that occurs automatically when there is a recession Unemployment insurance Progressive taxation Income redistribution Does Not require as much time
The budget balance
The budget deficit as a percentage of GDP tends to rise during recessions and fall during expansions
To understand the nature of these lags, consider the three things that have to happen before the government increases spending to fight a recessionary gap.
The government has to realize that the recessionary gap exists: economic data take time to collect and analyze, and recessions are often recognized only months after they have begun. As we've seen, the Great Recession is generally considered to have begun in December 2007, but as late as September 2008 some economists were still questioning whether the recession was real. The government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation. It takes time to spend money. For example, a road construction project begins with activities such as surveying that don't involve spending large sums. It may be quite some time before the big spending begins. The Recovery Act was passed in the first quarter of 2009, but much of its effect on federal spending, especially purchases of goods and services, didn't come until 2011.
The term social insurance is used to describe government programs that are intended to protect families against economic hardship.
These include Social Security, Medicare, Medicaid, and the ACA, as well as smaller programs such as unemployment insurance and food stamps.
In fact, economists often do just that: they use changes in the budget balance as a "quick-and-dirty" way to assess whether current fiscal policy is expansionary or contractionary. But they always keep in mind two reasons this quick-and-dirty approach is sometimes misleading:
Two different changes in fiscal policy that have equal-sized effects on the budget balance may have quite unequal effects on the economy. As we have already seen, changes in government purchases of goods and services have a larger effect on real GDP than equal-sized changes in taxes and government transfers. Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.
The automatic decrease in government tax revenue generated by a fall in real GDP—caused by a decrease in the amount of taxes households pay—acts like an
automatic expansionary fiscal policy implemented in the face of a recession. Similarly, when the economy expands, the government finds itself automatically pursuing a contractionary fiscal policy—a tax increase. Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands, without requiring any deliberate action by policy makers, are called automatic stabilizers.
The former are affected by automatic stabilizers and the latter by deliberate changes in government purchases, government transfers, or taxes. It's important to realize that business-cycle effects on the budget balance are temporary:
both recessionary gaps (in which real GDP is below potential output) and inflationary gaps (in which real GDP is above potential output) tend to be eliminated in the long run. Removing their effects on the budget balance sheds light on whether the government's taxing and spending policies are sustainable in the long run.
Discretionary fiscal policy arises from
deliberate actions from policy makers rather than from the business cycle
Deficit -
difference between amount of money a gov spends and the amount it receives in taxes
Contractionary fiscal policy - cut spending
makes the recession worse because spending is cut
Discretionary budget
military, medicare, science, education, etc
So either an increase in taxes or a reduction in government transfers
reduces disposable income
Rules governing taxes and some transfers act as automatic stabilizers
reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle.
Mandatory budget
social security, etc
The category "Other goods and services" consists mainly of
state and local spending on a variety of services, from police and firefighters to highway construction and maintenance
Debt
sum of money a gov owes at a particular point in time
The other form of government spending is government transfers
which are payments by the government to households for which no good or service is provided in return Social Security, which provides guaranteed income to older Americans, disabled Americans, and the surviving spouses and dependent children of deceased or retired beneficiaries Medicare, which covers much of the cost of health care for Americans over age 65 Medicaid, which covers much of the cost of health care for Americans with low incomes The Affordable Care Act (ACA), which seeks to make health insurance available and affordable to all Americans
Deficit and Debt in Practice -
A widely used measure of fiscal health is the debt-GDP ratio Our gdp is what we have to pay off the debt, so that's what we should compare it to This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.
Fiscal policy that increases aggregate demand, called expansionary fiscal policy, normally takes one of three forms:
An increase in government purchases of goods and services A cut in taxes An increase in government transfers
And a fall in disposable income, other things equal, leads to
a fall in consumer spending. Conversely, either a decrease in taxes or an increase in government transfers increases disposable income. And a rise in disposable income, other things equal, leads to a rise in consumer spending.
Other things equal, expansionary fiscal policy leads to
a larger budget deficit and greater government debt. And higher debt will eventually require the government to raise taxes to pay it off. So, according to the third argument against expansionary fiscal policy, consumers, anticipating that they must pay higher taxes in the future to pay off today's government debt, will cut their spending today in order to save money. This argument, first made by nineteenth-century economist David Ricardo, is known as Ricardian equivalence. It is an argument often taken to imply that expansionary fiscal policy will have no effect on the economy because far-sighted consumers will undo any attempts at expansion by the government.
Other things equal, expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—
reduce the budget balance for that year. That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. Conversely, contractionary fiscal policies—reduced government purchases of goods and services, lower government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.
The effect of these automatic increases in tax revenue is to
reduce the size of the multiplier. Remember, the multiplier is the result of a chain reaction in which higher real GDP leads to higher disposable income, which leads to higher consumer spending, which leads to further increases in real GDP. The fact that the government siphons off some of any increase in real GDP means that at each stage of this process, the increase in consumer spending is smaller than it would be if taxes weren't part of the picture. The result is to reduce the multiplier.
The reason is the problem of implicit liabilities. Implicit liabilities are
spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. The implicit liabilities of the U.S. government arise mainly from transfer programs that are aimed at providing security in retirement and protection from large health care bills: Social Security is the main source of retirement income for most older Americans. Medicare pays most of older Americans' medical costs. Medicaid provides health care to lower-income families. The Affordable Care Act subsidizes health insurance premiums for many low- to moderate-income families who are ineligible for Medicaid. In each of these cases, the government has promised to provide transfer payments to future as well as current beneficiaries. So these programs represent a future debt that must be honored, even though the debt does not currently show up in the usual statistics. Together, these programs currently account for approximately half of federal spending.
To assess the ability of governments to pay their debt, we use
the debt-GDP ratio, the government's debt as a percentage of GDP. We use this measure, rather than simply looking at the size of the debt, because GDP, which measures the size of the economy as a whole, is a good indicator of the potential taxes the government can collect. If the government's debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government's potential tax revenue. Under these conditions the underlying economy is strong enough to generate future surpluses, allowing the government to pay off its debt, at a time of its own choosing, and avoid the potential dangers of financial pressure and default.
Discretionary fiscal policy is
the direct result of deliberate actions by policy makers rather than automatic adjustment. For example, during a recession, the government may pass legislation that cuts taxes and increases government spending in order to stimulate the economy. In general, economists tend to support the use of discretionary fiscal policy only in the case of a severe recession or sustained economic weakness.
The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. It takes into account
the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated—or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated.