Fiscal Policy, Government Budget and Debt
Fiscal Policy Multiplier:
Which Is More Effective: changes in T or G?
All Income must either be consumed (C), saved (S), or paid in taxes (T)
Concept: an initial increase in GDP produces higher incomes which, in turn, generate even higher levels of spending in future cycles.
After tax income is divided into C and S
An increase in G directly increases AD (GDP) by the same amount – it is all spending
An descrease in T will increase household after tax income by the same amount, but households will only increase C spending by part of that amount. The other portion is saved and doesn’t increase spending.
Therefore, an increase in G has more impact on raising GDP than a same-sized reduction in T since part of the tax cut will be saved and not spent.
Practical Problems with Fiscal policy and AD management
Automatic vs. Discretionary?
Automatic stabilizers are very, very effective, but often cannot deliver the full stimulus needed
Recognition Political agreement implementation multiplier time
Measurement of needed changes in policy:
Estimating ‘full employment’
Credibility of temporary vs. permanent policy changes
Weak and ineffective against supply shocks – may actually worsen problem
Tax-based policy vs. Spending-based policy
Spending on what? Whose taxes get cut?
Political business cycle
Financing government budgets
Government debt is often perceived as ‘bad’ or a problem
Coordination between federal budget fiscal policy actions and state/local government fiscal policy
Coordination with Monetary Policy
Government Budget Balance (a Flow)
Deficits and Surpluses Change Debt
Deficits add to Total Debt if new bonds are issued as borrowing
Surpluses reduce Total Debt
Similar to income statement or profit-and-loss statement for a person or firm.
Particular ‘fiscal year’.
Government fiscal years run from Oct 1 to Sept 30
For macro economic purposes (Aggregate Demand and GDP), what matters is total government spending from all levels of government.
Often what appears as a large increase in the federal government budget deficit is actually offet in effect by simultaneous reductions in state and local government spending.
Why Is Government Spending so difficult to cut?
Where Does the Money Go?
Approx. 2/3 of all government spending each year is already committed by decisions of previous Congresses in the form of:
Interest on Debt
Less than 1/3 of federal government spending each year is ‘discretionary’, meaning that Congress that year choose to spend that much money
Effect of automatic stabilizers may make it unnecessary to ‘cut’ government spending to balance the budget.
When the economy goes into recession or slows, the automatic stabilizers automatically increase spending and reduce tax dollars collected, increasing the deficit.
When the economy grows briskly these same automatic stabilizers automatically reduce spending and increase dollars of taxes collected. The deficit automatically is reduced.
Debt vs. Deficits
Deficits can be financed by either borrowing (sell bonds) or by creating new bank reserves
US voluntarily has adopted a policy of not creating bank reserves to finance deficits, leaving bank reserve creation to The Fed, the central bank. This is a political decision, not an economiic necessity.
Surpluses will reduce debt outstanding. They cannot be ‘saved’.
Debt is the accumulation of all past deficit borrowing and surpluses.
Can the government go bankrupt or default on debt?
NO, if the government is a sovereign (monopoly) issuer of fiat currency that is not convertible into any commodity or other currency at a fixed rate.
Examples: US, Japan, UK, Canada, Australia, China, Brazil, many others
The government can always create new currency to pay off it’s existing debts.
The only known case of a sovereign default on debt under these conditions was Japan in 1942 who strategically chose to default on debt owed to UK and US banks during World War II.
Yes, if the government does not issue or determine the currency or it has pegged a fixed exchange rate to gold, some commodity or other currency.
Examples: any country currently in the Euro zone using the Euro as currency, Argentina before 2001 (fixed conversion to USD), any nation on gold standard,
Are deficits and debt really undesirable?
Government is not like a household or firm.
government issues and creates currency; households can’t
households can die or go bankrupt or lose income stream; governments can always tax
Remember the national saving-investment identity:
Simplifing and rearranging: (S-I) = (G-T) + (X-M)
rephrased: net private savings (accumulation of financial assets) = government budget balance + foreign trade balance
in other words, the private sector cannot as a whole get financially wealthier unless government runs a budget deficit and/or a trade deficit.
Government deficits enable households and firms to accumulate financial assets
government surpluses require the private sector to go deeper into debt
the limit on deficits is inflation and the availab
ility of real resources. If Aggregate Demand is greater than LRAS, then inflation results.