Recaping the effects of both Fiscal policy and Monetary policy in the long run

Transcription

1 Recaping the effects of both Fiscal policy and Monetary policy in the long run When the government ran a record surplus in 2000, many regarded it as a cause for celebration. Conversely, people usually think of deficits as bad: when the Congressional Budget Office projected a record deficit for 2009, many people regarded it as a cause for concern. How do surpluses and deficits fit into the analysis of fiscal policy? Are deficits ever a good thing and surpluses a bad thing? To answer those questions, we need to look at the causes and consequences of surpluses and deficits. 1

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3 When a family spends more than it earns over the course of a year, it has to raise the extra funds either by selling assets or by borrowing. And if a family borrows year after year, it will eventually end up with a lot of debt. The same is true for governments. With a few exceptions, governments don t raise large sums by selling assets such as national parkland. For a country the mortgage never gets paid off and the citizenry doesn t get too old to drive. To do what we are doing there will always be an acceptable amount of debt, just as there is in your family. 3

4 If only it were that easy first lets give a little more background about balancing budgets before we answer this question. 4

5 Recall that the Budget Balance is the difference between the government s tax revenue and its spending. T= value of tax revenues G = government purchases of goods and services TR = value of government transfers The three aspects of fiscal policy! A budget surplus is a positive budget balance, and a budget deficit is a negative budget balance. 5

6 The economy tends to move into deficit when the it is experiencing a recession, but deficits tend to get smaller or even turn into surpluses when the economy is expanding. Remember that automatic stabilizers are when government tax revenue tends to rise and some government transfers, like unemployment benefit payments, tend to fall when the economy expands. Conversely, government tax revenue tends to fall and some government transfers tend to rise when the economy contracts. So the budget tends to move towards surplus duringexpansions and toward deficit duringrecessions recessions even without any deliberate action on the part of policy makers. We need to separate movements in the budget balance due to the business cycle (which is affected by automatic stabilizers) and discretionary fiscal policy changes. Removing the business cycle s effect on the budget balance tells us whether our government s tax policies will create enough revenue to sustain our spending in the long run. The government will estimate what the budget balance would be if there were in neither a recessionary nor inflationary gap! Meaning that they would estimate what the budget balance would be at potential output! 6

7 Most economists don t think it should be adjusted yearly, but on average Why? Let s graph it out on our Aggregate Model. The tendency of tax revenue to fall and transfers to rise when the economy contracts helps to limit the size of recessions. But falling tax revenue and rising transfer payments push the budget toward deficit. If constrained by a balance budget rule, the government would have to respond to this deficit with contractionary fiscal policies that would tend to deepen a recession. Nonetheless, policy makers who are concerned about excessive deficits feel that rigid rules, or at least an upper limit on deficits is necessary. 7

8 While it can be debated forever whether or not you can but a specific dollar amount on when we would reach a fiscal cliff and falter on our debts, the fact is that being in debt does hinder long run growth and prevent the government from executing other important goals. 8

9 KGQ #7: Crowding Out A government paying large sums in interest must raise more revenue from taxes or spend less than it would otherwise be able to afford or it must borrow even more to cover the gap. And a government that borrows to pay interest on its outstanding debt pushes itself even deeper into debt. 9

10 Our grandchildren will be no more broke than us so long as the debt GDP ratio stays consistant. There is always an acceptable amount of debt. Their ratio of deficit spending to GDP is not necessarily going to be any different than ours. 10

11 In reality, the US has run a brief surplus after WWII, but it has normally run a deficit ever since. This seems inconsistent with the previous conclusion we made. However, our continued deficit has not (at least yet) led to default. We use this measure, rather than just looking at the size of the debt because GDP 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. Key: debt GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt. Growth and inflation sometimes allow a government that run persistent budget deficits to nevertheless have a declining debt GDP ratio and thus the easing ability to pay off past debts. Still, a government that runs persistent large deficits will have a rising debt GDP ration when debt grows faster than GDP and that is no bueno! The issue that causes most alarm is the problem of implicit liabilities. These present a future debt that must be honored, even though the cost of these programs will become less sustainable over time. 11

12 Look at the AD/AS graph. What would happen if we significantly decreased transfer payments to U.S. citizens? We would immediately create a recession which we could not recover from in less than 40 years or so, unless we were to give the people money. Oh wait! That is what we wanted to stop! Unfortunately, while the future of social security and the issue of implicit liabilities is certainly a worth debate to be had, just getting rid of it all together, or at least not extremely gradually, will have devastating effects on the economy and retirees lives. 12

13 Ya, this is a really bad idea because if we print more money what is that going to cause INFLATION! We don t want to end up like Zimbabwe and have an inflation rate of 11 million % per year yikes! 13

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