Todays Agenda

1. The Government Budget, Deficits, and Debt

2. Fiscal Policy and Budget Balances

Fiscal Policy,
Part 1

23-1 23-2

The Government Budget, Deficits, and Debt

The government budget consists of:
1. Government outlays or spending, and
The Government Budget, 2. Receipts or tax revenues.
Deficits, and Debt

23-3 23-4

1
The Government Budget, Deficits, and Debt
Major components of government spending:
1. Government purchases, G, which consists of:
Government consumption, GC, and
Government investment, GI.
2. Transfer payments, TRANSFERS.
3. Grants-in-aid to state and local governments.
4. Net Interest Payments, INTEREST.
23-5
The Government Budget, Deficits, and Debt
23-7
The Government Budget, Deficits, and Debt
Major components of receipts (TAXES):
1. Personal taxes,
2. Contributions for social insurance,
3. Taxes on production and imports,
4. Corporate taxes, and
5. Grants-in-aid to state and local governments.
23-6
The Government Budget, Deficits, and Debt
23-8
2
The Government Budget, Deficits, and Debt
All government outlays must be financed by:
1. Tax revenues, and/or
2. Borrowing.
23-9
The Government Budget, Deficits, and Debt
Government debt is the value of all outstanding
government bonds, B, on a given date.
Government debt = deficit
Government debt is a stock variable.
23-11
The Government Budget, Deficits, and Debt
The government budget deficit is the difference
between government purchases and (net) tax
revenues during a particular time period.
The government budget deficit = G T
The government budget deficit is the change total
debt outstanding, B, during the year.
The government budget deficit is a flow variable.
23-10
The Government Budget, Deficits, and Debt
Most governments run budget deficits most of
the time so global government debt outstanding
has grown over time.
Whether or not government debt has been growing
more or less rapidly than economic activity can be
measured by a countrys debt-to-GDP ratio.
23-12
3
The Government Budget, Deficits, and Debt The Government Budget, Deficits, and Debt
The U.S. government finances its budget
deficits primarily by borrowing from the public.
So the correlation between budget deficits and the
debt-to-GDP ratio is high.

Because of recent large budget deficits the debt-

to-GDP ratio has been high and is rising.

23-13 23-14

The Government Budget, Deficits, and Debt The Government Budget, Deficits, and Debt

23-15 23-16

4
The Government Budget, Deficits, and Debt The Government Budget, Deficits, and Debt
The change in the debt-to-GDP ratio equals: The change in the debt-to-GDP ratio equals:

1. The deficit-to-GDP ratio (B/GDP) = B/GDP (B/GDP) * gP*Y

MINUS
Two things cause the debt-to-GDP ratio to rise:
2. The debt-to-GDP ratio * growth of nominal GDP.
1. A high deficit-to-GDP ratio, and

(B/GDP) = B/GDP (B/GDP) * gP*Y 2. Slow growth of the nominal economy.

23-17 23-18

Fiscal Policy and Budget Balances

Basic budget arithmetic:

1. The government purchases equation: G = G

Fiscal Policy
2. The (net) tax revenue equation: T = T + t*Y
and Budget Balances

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5
 Fiscal Policy and Budget Balances
The budget balance, BB, is given by:

1. BB = T G = T + t*Y G

2. BB = (T G) + t*Y

where:

(T G) is the autonomous budget, and

t*Y is the induced (or endogenous) budget.

23-21 23-22

Fiscal Policy and Budget Balances Fiscal Policy and Budget Balances
Economic output, Y, is determined in the TG
AD/AS model. Surplus
BB = T G
(+)
The budget balance, BB, is determined along
the BB line.
0 Y

(T G)
Deficit
(-)
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6
Fiscal Policy and Budget Balances
Fiscal policy includes both:
1. Automatic stabilizers, and
2. Discretionary fiscal policy changes.
23-25
Fiscal Policy and Budget Balances
Because of automatic stabilizers, the
government budget balance will:
1. Automatically decline during recessions, and
2. Automatically increase during expansions.
23-27
Fiscal Policy and Budget Balances
1. Automatic stabilizers cause fiscal policy to be
counter-cyclical by changing government
outlays and/or tax revenues endogenously.
a. During recessions, unemployment insurance
payments automatically increase because the
number of unemployed people increases.
b. During recessions, tax revenues decline
automatically because (taxable) income declines.
23-26
Fiscal Policy and Budget Balances
These automatic changes in the budget balance
result from changes in induced (net) taxes.
1. BB = (T G) + t*Y
2. T = t*Y
3. BB = (T G) + t* Y
The effects of automatic stabilizers are
represented by movements on a given BB line.
23-28
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Fiscal Policy and Budget Balances Fiscal Policy and Budget Balances
TG 2. Discretionary fiscal policy changes are the
Surplus deliberate changes in:
BB = T G
(+)
1. Autonomous government purchases, G, and/or

0 Y 2. Autonomous tax revenues, T, and/or

3. The tax rate, t.

(T G)
Deficit
(-)
23-29 23-30

Increasing G or Decreasing T Increasing G or Decreasing T

TG
Surplus
BB = T G
(+)

SRAS0
0 0 Y

AD0 (T G)
Deficit
Y0 Y
(-)
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Decreasing the Tax Rate, t Decreasing the Tax Rate, t

TG
Surplus
BB = T G
(+)

SRAS0
0 0 Y

AD0 (T G)
Deficit
Y0 Y
(-)
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Fiscal Policy and Budget Balances
1. Changes in autonomous government purchases
or in autonomous tax revenues cause a parallel
shift of the BB line.
2. Changes in the tax rate cause a rotation of the
BB line.
Fiscal Policy and Budget Balances
How do we compare:
1. Changes in autonomous government purchases,
G, (which are measured in dollars)
With
2. Changes in tax rates, t, (which are measured in
percent).

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Fiscal Policy and Budget Balances
Comparing G changes with t changes:
The structural budget balance, SBB, is the budget
balanced measured at the economys potential
output.
It is what the actual budget balance would be if the
economy were in general equilibrium.
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Fiscal Policy and Budget Balances
The structural budget balance DOES NOT
CHANGE with the business cycle; only with
changes in discretionary fiscal policy.
Therefore, changes in the structural budget balance
represent changes in discretionary fiscal policy.
23-39
Fiscal Policy and Budget Balances
The structural budget balance is given by:
SBB = (T G) + t*YP
The structural budget balance is a measure of what
the actual government budget balance would be IF
the economy were at its potential level.
23-38
Fiscal Policy and Budget Balances
Comparing G changes with t changes:
The structural budget balance, SBB, is also called:
1. The standardized budget balance,
2. The cyclically adjusted budget balance,
3. The natural employment budget balance, or
4. The full employment budget balance.
23-40
10
Increasing G or Decreasing T Decreasing the Tax Rate, t
TG YP TG YP
Surplus Surplus
BB = T G BB = T G
(+) (+)

0 Y 0 Y

(T G) (T G)
Deficit Deficit
(-) (-)
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Fiscal Policy and Budget Balances Fiscal Policy and Budget Balances
There are three budget measures: The cyclical budget balance is given by:

1. The actual budget balance, ABB, is measured at

actual economic output, Y. CBB = ABB SBB

2. The structural budget balance, SBB, is measured

at potential economic output, YP. 1. If ABB < SBB, then CBB < 0.

3. The cyclical budget balance, CBB, occurs when 2. If ABB > SBB, then CBB > 0.
the economy is not at potential output.

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11
Fiscal Policy and Budget Balances
TG YP

BB = T G
SBB0

Y0 CBB0 Y
The End
0

ABB0

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