PRINCIPLES OF MACROECONOMICS 2e

for AP Courses

Chapter 16 Government Budgets and Fiscal Policy

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COLLEGE PHYSICS

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Chapter # Chapter Title

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CH.16 OUTLINE

Shut Downs and Parks

• Yellowstone National Park is one of the many national parks forced to close down during the government shutdown in October 2013.

(Credit: modification of work by “daveynin”/flickr Creative Commons)

16.1 Government Spending

Federal Spending, 1960–2014

• Since 1960, total federal spending has ranged from about 18% to 22% of GDP, although it climbed above that level in 2009, but quickly dropped back down to that level by 2013.
• The share that the government has spent on national defense has generally declined, while the share it has spent on Social Security and on healthcare expenses (mainly Medicare and Medicaid) has increased. (Source: Economic Report of the President, Tables B-2 and B-22, http://www.gpo.gov/fdsys/pkg/ERP-2014/content-detail.html)

Deficit vs Debt

Slices of Federal Spending, 2014

• About 73% of government spending goes to four major areas: national defense, Social Security, healthcare, and interest payments on past borrowing.
• This leaves about 29% of federal spending for all other functions of the U.S. government.

(Source: https://www.whitehouse.gov/omb/budget/Historicals/)

State and Local Spending, 1960–2013

• Spending by state and local government increased from about 10% of GDP in the early 1960s to 14–16% by the mid-1970s.
• It has remained at roughly that level since.
• The single biggest spending item is education, including both K–12 spending and support for public colleges and universities, which has been about 4–5% of GDP in recent decades.

(Source: Bureau of Economic Analysis.)

16.2 Taxation

• Federal tax revenues have been about 17–20% of GDP during most periods in recent decades.
• The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare.
• Corporate income taxes and social insurance taxes provide smaller shares of revenue. (Source: Economic Report of the President, 2015. Table B-21, https://www.whitehouse.gov/administration/eop/cea/ economic-report-of-the-President/2015)

Taxes Collected by the Federal

Government

Taxes Collected by the Federal

Government, Continued

Taxes Collected by the Federal

Government, Continued

State and Local Taxes

State and Local Tax Revenue as a

Share of GDP, 1960–2014

• State and local tax revenues have increased to match the rise in state and local spending.

(Source: Economic Report of the President, 2015. Table B-21, https://www.whitehouse.gov/administration/eop/cea/economic-report-of-the-President/2015)

16.3 Federal Deficits and the National Debt

Pattern of Federal Budget Deficits and Surpluses, 1929–2014

• The federal government has run budget deficits for decades.
• The budget was briefly in surplus in the late 1990s, before heading into deficit again in the first decade of the 2000s - and especially deep deficits in the 2008-2009 recession.

(Source: Federal Reserve Bank of St. Louis (FRED). http://research.stlouisfed.org/fred2/series/FYFSGDA188S)

Federal Debt as a Percentage of GDP, �1942–2014

• Federal debt is the sum of annual budget deficits and surpluses.
• Annual deficits do not always mean that the debt/GDP ratio is rising.
• During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time.
• In the 2008–2009 recession, the debt/GDP ratio rose sharply. (Source: Economic Report of the President, Table B-20, http://www.gpo.gov/fdsys/pkg/ERP-2015/content-detail.html)

Total Government Spending and Taxes

as a Share of GDP, 1990–2014

• When government spending exceeds taxes, the gap is the budget deficit.
• When taxes exceed spending, the gap is a budget surplus.
• The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create a large deficit in 2009. (Source: Economic Report of the President, Tables B-21 and B-1,"http://www.gpo.gov/fdsys/pkg/ERP-2015/ content-detail.html)

16.4 Using Fiscal Policy to Fight

Recession, Unemployment, and Inflation

A Healthy, Growing Economy

• In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E₀ to E₁ to E₂.
• Each year, the economy produces at potential GDP with only a small inflationary increase in the price level.
• However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

Expansionary Fiscal Policy, Illustrated

• The original equilibrium (E₀) represents a recession, occurring at a quantity of output (Y₀) below potential GDP.
• However, a shift of aggregate demand from AD₀ to AD₁, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E₁ at the level of potential GDP which the LRAS curve shows.
• Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P₀ to P₁ that results should be relatively small.

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Contractionary Fiscal Policy, Illustrated

• The economy starts at the equilibrium quantity of output Y₀, which is above potential GDP.
• The extremely high level of aggregate demand will generate inflationary increases in the price level.
• A contractionary fiscal policy can shift aggregate demand down from AD₀ to AD₁, leading to a new equilibrium output E₁, which occurs at potential GDP, where AD₁ intersects the LRAS curve.

16.5 Automatic Stabilizers

The Standardized Employment Deficit or Surplus

Comparison of Actual Budget Deficits with the Standardized Employment Deficit

• When the economy is in recession, the standardized employment budget deficit is less than the actual budget deficit because the economy is below potential GDP, and the automatic stabilizers are reducing taxes and increasing spending.

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Comparison of Actual Budget Deficits with the Standardized Employment Deficit, Cont.

• When the economy is performing extremely well, the standardized employment deficit (or surplus) is higher than the actual budget deficit (or surplus) because the economy is producing about potential GDP, so the automatic stabilizers are increasing taxes and reducing the need for government spending. (Sources: Actual and Cyclically Adjusted Budget Surpluses/Deficits, http://www.cbo.gov/publication/43977; and Economic Report of the President, Table B-1, http://www.gpo.gov/fdsys/pkg/ERP-2013/content-detail.html)

16.6 Practical Problems with

Discretionary Fiscal Policy

Fiscal Policy and Interest Rates Example

• When a government borrows money in the financial capital market, it causes a shift in the demand for financial capital from D₀ to D₁.
• As the equilibrium moves from E₀ to E₁, the equilibrium interest rate rises from 6% to 7%.
• In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.

Long and Variable Time Lags

16.7 The Question of a Balanced Budget

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