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Fiscal Chapter13: Policy, Deficits, and Debt
AFTER READING THIS CHAPTER, YOU SHOULD BE ABLE TO:
Identify and explain the purposes, tools, and limitations of fiscal
Explain the role of built-in stabilizers in moderating business
Describe how the cyclically adjusted budget reveals the status of
U.S. fiscal policy.
Discuss the size, composition, and consequences of the U.S.
ORIGIN OF THE IDEA
In the previous chapter we saw that an excessive increase in aggregate
demand can cause demand-pull inflation and that a significant decline in
aggregate demand can cause recession and cyclical unemployment. For
these reasons, the Federal government sometimes uses budgetary actions to
try to stimulate the economy or rein in inflation. Such countercyclical fiscal
policyChanges in government spending and tax collections designed to
achieve a full-employment and noninflationary domestic output; also called
discretionary fiscal policy. consists of deliberate changes in government
spending and tax collections designed to achieve full employment, control
inflation, and encourage economic growth. (The adjective fiscal simply
We begin this chapter by examining the logic behind fiscal policy, its current
status, and its limitations. Then we examine a closely related topic: the U.S.
Our discussion of fiscal policy and public debt is very timely. In 2009,
Congress and the Obama administration began a $787 billion stimulus
program designed to help lift the U.S. economy out of deep recession. This
fiscal policy contributed to a $1.4 trillion Federal budget deficit in 2009, which
increased the size of the U.S. public debt to $11.9 trillion.
Fiscal Policy and the AD-AS Model
The fiscal policy just defined is discretionary (or active). It is often initiated on
the advice of the president's Council of Economic Advisers (CEA) A group of
three persons that advises and assists the president of the United States on
economic matters (including the preparation of the annual Economic Report
of the President)., a group of three economists appointed by the president to
provide expertise and assistance on economic matters. Discretionary changes
in government spending and taxes are at the option of the Federal
government. They do not occur automatically. Changes that occur without
congressional action are nondiscretionary (or passive or automatic), and
we will examine them later in this chapter.
Expansionary Fiscal Policy
When recession occurs, an expansionary fiscal policyAn increase in
government purchases of goods and services, a decrease in net taxes, or
some combination of the two for the purpose of increasing aggregate demand
and expanding real output. may be in order. This policy consists of
government spending increases, tax reductions, or both, designed to increase
aggregate demand and therefore raise real GDP. Consider Figure 13.1, where
we suppose that a sharp decline in investment spending has shifted the
economy's aggregate demand curve to the left from AD 1 to AD2. (Disregard
the arrows and dashed downsloping line for now.) The cause of the recession
may be that profit expectations on investment projects have dimmed,
curtailing investment spending and reducing aggregate demand.
Expansionary fiscal policy.
Expansionary fiscal policy uses increases in government spending or tax cuts to push the
economy out of recession. In an economy with an MPC of .75, a $5 billion increase in
government spending or a $6.67 billion decrease in personal taxes (producing a $5 billion
initial increase in consumption) expands aggregate demand from AD 2 to the downsloping
dashed curve. The multiplier then magnifies this initial increase in spending to AD 1. So real
GDP rises along the broken horizontal line by $20 billion.
Suppose the economy's potential or full-employment output is $510 billion in
Figure 13.1. If the price level is inflexible downward at P1, the broken
horizontal line becomes relevant to the analysis. The aggregate demand
curve moves leftward and reduces real GDP from $510 billion to $490 billion.
A negative GDP gap of $20 billion (= $490 billion $510 billion) arises. An
increase in unemployment accompanies this negative GDP gap because
fewer workers are needed to produce the reduced output. In short, the
economy depicted is suffering both recession and cyclical unemployment.
What fiscal policy should the Federal government adopt to try to stimulate the
economy? It has three main options: (1) increase government spending, (2)
reduce taxes, or (3) use some combination of the two. If the Federal budget is
balanced at the outset, expansionary fiscal policy will create a government
budget deficitThe amount by which the expenditures of the Federal
government exceed its revenues in any year.government spending in
excess of tax revenues.
Increased Government Spending Other things equal, a sufficient increase
in government spending will shift an economy's aggregate demand curve to
the right, from AD2 to AD1 in Figure 13.1. To see why, suppose that the
recession prompts the government to initiate $5 billion of new spending on
highways, education, and health care. We represent this new $5 billion of
government spending as the horizontal distance between AD 2 and the dashed
downsloping line immediately to its right. At each price level, the amount of
real output that is demanded is now $5 billion greater than that demanded
before the expansion of government spending.
But the initial increase in aggregate demand is not the end of the story.
Through the multiplier effect, the aggregate demand curve shifts to AD 1, a
distance that exceeds that represented by the originating $5 billion increase in
government purchases. This greater shift occurs because the multiplier
process magnifies the initial change in spending into successive rounds of
new consumption spending. If the economy's MPC is .75, then the simple
multiplier is 4. So the aggregate demand curve shifts rightward by four times
the distance between AD2 and the broken downsloping line. Because this
particular increase in aggregate demand occurs along the horizontal brokenline segment, real output rises by the full extent of the multiplier. Observe that
real output rises to $510 billion, up $20 billion from its recessionary level of
$490 billion. Concurrently, unemployment falls as firms increase their
employment to the full-employment level that existed before the recession.
Tax Reductions Alternatively, the government could reduce taxes to shift the
aggregate demand curve rightward, as from AD 2 to AD1. Suppose the
government cuts personal income taxes by $6.67 billion, which increases
disposable income by the same amount. Consumption will rise by $5 billion (=
MPC of .75 $6.67 billion) and saving will go up by $1.67 billion (= MPS of .
25 $6.67 billion). In this case the horizontal distance between AD 2 and the
dashed downsloping line in Figure 13.1 represents only the $5 billion initial
increase in consumption spending. Again, we call it initial consumption
spending because the multiplier process yields successive rounds of
increased consumption spending. The aggregate demand curve eventually
shifts rightward by four times the $5 billion initial increase in consumption
produced by the tax cut. Real GDP rises by $20 billion, from $490 billion to
$510 billion, implying a multiplier of 4. Employment increases accordingly.
You may have noted that a tax cut must be somewhat larger than the
proposed increase in government spending if it is to achieve the same amount
of rightward shift in the aggregate demand curve. This is because part of a tax
reduction increases saving, rather than consumption. To increase initial
consumption by a specific amount, the government must reduce taxes by
more than that amount. With an MPC of .75, taxes must fall by $6.67 billion
for $5 billion of new consumption to be forthcoming because $1.67 billion is
saved (not consumed). If the MPC had instead been, say, .6, an $8.33 billion
reduction in tax collections would have been necessary to increase initial
consumption by $5 billion. The smaller the MPC, the greater the tax cut
needed to accomplish a specific initial increase in consumption and a specific
shift in the aggregate demand curve.
Combined Government Spending Increases and Tax Reductions The
government may combine spending increases and tax cuts to produce the
desired initial increase in spending and the eventual increase in aggregate
demand and real GDP. In the economy depicted in Figure 13.1, the
government might increase its spending by $1.25 billion while reducing taxes
by $5 billion. As an exercise, you should explain why this combination will
produce the targeted $5 billion initial increase in new spending.
If you were assigned Chapter 11, think through these three fiscal policy
options in terms of the recessionary-expenditure-gap analysis associated with
the aggregate expenditures model (Figure 11.7). And recall from the appendix
to Chapter 12 that rightward shifts of the aggregate demand curve relate
directly to upward shifts of the aggregate expenditures schedule.
Contractionary Fiscal Policy
When demand-pull inflation occurs, a restrictive or contractionary fiscal
policyA decrease in government purchases of goods and services, an
increase in net taxes, or some combination of the two, for the purpose of
decreasing aggregate demand and thus controlling inflation. may help control
it. This policy consists of government spending reductions, tax increases, or
both, designed to decrease aggregate demand and therefore lower or
eliminate inflation. Look at Figure 13.2, where the full-employment level of real
GDP is $510 billion. The economy starts at equilibrium at point a, where the
initial aggregate demand curve AD3 intersects aggregate supply curve AS.
Suppose that after going through the multiplier process, a $5 billion initial
increase in investment and net export spending shifts the aggregate demand
curve to the right by $20 billion, from AD3 to AD4. (Ignore the downsloping
dashed line for now.) Given the upsloping AS curve, however, the equilibrium
GDP does not rise by the full $20 billion. It only rises by $12 billion, to $522
billion, thereby creating an inflationary GDP gap of $12 billion ($522 billion
$510 billion). The upslope of the AS curve means that some of the rightward
movement of the AD curve ends up causing demand-pull inflation rather than
increased output. As a result, the price level rises from P1 to P2 and the
equilibrium moves to point b.
Contractionary fiscal policy.
Contractionary fiscal policy uses decreases in government spending, increases in taxes, or
both, to reduce demand-pull inflation. Here, an increase in aggregate demand from AD 3 to
AD4 has driven the economy to point b and ratcheted the price level up to P2, where it
becomes inflexible downward. If the economy's MPC is .75 and the multiplier therefore is 4,
the government can either reduce its spending by $3 billion or increase its taxes by $4
billion (which will decrease consumption by $3 billion) to eliminate the inflationary GDP gap
of $12 billion (= $522 billion $510 billion). Aggregate demand will shift leftward, first from
AD4 to the dashed downsloping curve to its left, and then to AD 5. With the price level
remaining at P2, the economy will move from point b to point c and the inflationary GDP gap
Without a government response, the inflationary GDP gap will cause further
inflation (as input prices rise in the long run to meet the increase in output
prices). If the government looks to fiscal policy to eliminate the inflationary
GDP gap, its options are the opposite of those used to combat recession. It
can (1) decrease government spending, (2) raise taxes, or (3) use some
combination of those two policies. When the economy faces demand-pull
inflation, fiscal policy should move toward a government budget surplus The
amount by which the revenues of the Federal government exceed its
expenditures in any year.tax revenues in excess of government spending.
But before discussing how the government can either decrease government
spending or increase taxes to move toward a government budget surplus and
control inflation, we have to keep in mind that the price level is like a ratchet.
While increases in aggregate demand that expand real output beyond the fullemployment level tend to ratchet the price level upward, declines in aggregate
demand do not seem to push the price level downward. This means that
stopping inflation is a matter of halting the rise of the price level, not trying to
lower it to the previous level. It also means that the government must take the
ratchet effect into account when deciding how big a cut in spending or an
increase in taxes it should undertake.
Decreased Government Spending To control demand-pull inflation, the
government can decrease aggregate demand by reducing government
spending. To see why the ratchet effect matters so much, look at Figure 13.2
and consider what would happen if the government ignored the ratchet effect
and attempted to design a spending-reduction policy to eliminate the
inflationary GDP gap. Since the $12 billion gap was caused by the $20 billion
rightward movement of the aggregate demand curve from AD 3 to AD4, the
government might naively think that it could solve the problem by causing a
$20 billion leftward shift of the aggregate demand curve to move it back to
where it originally was. It could attempt to do so by reducing government
spending by $5 billion and then allowing the multiplier effect to expand that
initial decrease into a $20 billion decline in aggregate demand. That would
shift the aggregate demand curve leftward by $20 billion, putting it back at
This policy would work fine if there were no ratchet effect and if prices were
flexible. The economy's equilibrium would move back from point b to point a,
with equilibrium GDP returning to the full-employment level of $510 billion and
the price level falling from P2 back to P1.
But because there is a ratchet effect, this scenario is not what will actually
happen. Instead, the ratchet effect implies that the price level is stuck at P2, so
that the broken horizontal line at price level P2 becomes important to the
analysis. The fixed price level means that when the government reduces
spending by $5 billion to shift the aggregate demand curve back to AD 3, it will
actually cause a recession! The new equilibrium will not be at point a. It will be
at point d, where aggregate demand curve AD3 crosses the broken horizontal
line. At point d, real GDP is only $502 billion, $8 billion below the fullemployment level of $510 billion.
The problem is that, with the price level downwardly inflexible at P2, the $20
billion leftward shift of the aggregate demand curve causes a full $20 billion
decline in real GDP. None of the change in aggregate demand can be
dissipated as a decline in the price level. As a result, equilibrium GDP declines
by the full $20 billion, falling from $522 billion to $502 billion and putting it $8
billion below potential output. By not taking the ratchet effect into account, the
government has overdone the decrease in government spending, replacing a
$12 billion inflationary GDP gap with an $8 billion recessionary GDP gap. This
is clearly not what it had in mind.
Here's how it can avoid this scenario. First, the government takes account of
the size of the inflationary GDP gap. It is $12 billion. Second, it knows that
with the price level fixed, the multiplier will be in full effect. Thus, it knows that
any decline in government spending will be multiplied by a factor of 4. It then
reasons that government spending will have to decline by only $3 billion
rather than $5 billion. Why? Because the $3 billion initial decline in
government spending will be multiplied by 4, creating a $12 billion decline in
aggregate demand. Under the circumstances, a $3 billion decline in
government spending is the correct amount to exactly offset the $12 billion
GDP gap. This inflationary GDP gap is the problem that government wants to
eliminate. To succeed, it need not undo the full increase in aggregate demand
that caused the inflation in the first place.
Graphically, the horizontal distance between AD 4 and the dashed downsloping
line to its left represents the $3 billion decrease in government spending.
Once the multiplier process is complete, this spending cut will shift the
aggregate demand curve leftward from AD 4 to AD5. With the price level fixed
at P2, the economy will come to equilibrium at point c. The economy will
operate at its potential output of $510 billion, and the inflationary GDP gap will
be eliminated. Furthermore, because the government took the ratchet effect
correctly into account, the government will not accidentally push the economy
into a recession by making an overly large initial decrease in government
Increased Taxes Just as government can use tax cuts to increase
consumption spending, it can use tax increases to reduce consumption
spending. If the economy in Figure 13.2 has an MPC of .75, the government
must raise taxes by $4 billion to achieve its fiscal policy objective. The $4
billion tax increase reduces saving by $1 billion (= the MPS of .25 $4 billion).
This $1 billion reduction in saving, by definition, is not a reduction in spending.
But the $4 billion tax increase also reduces consumption spending by $3
billion (= the MPC of .75 $4 billion), as shown by the distance between AD 4
and the dashed downsloping line to its left in Figure 13.2. After the multiplier
process is complete, this initial $3 billion decline in consumption will cause
aggregate demand to shift leftward by $12 billion at each price level (multiplier
of 4 $3 billion). With the economy moving to point c, the inflationary GDP
gap will be closed and the inflation will be halted.
Combined Government Spending Decreases and Tax Increases The
government may choose to combine spending decreases and tax increases in
order to reduce aggregate demand and check inflation. To check your
understanding, determine why a $1.5 billion decline in government spending
combined with a $2 billion increase in taxes would shift the aggregate demand
curve from AD4 to AD5. Also, if you were assigned Chapter 11, explain the
three fiscal policy options for fighting inflation by referring to the inflationaryexpenditure-gap concept developed with the aggregate expenditures model
(Figure 11.7). And recall from the appendix to Chapter 12 that leftward shifts
of the aggregate demand curve are associated with downshifts of the
aggregate expenditures schedule.
Policy Options: G or T?
Which is preferable as a means of eliminating recession and inflation? The
use of government spending or the use of taxes? The answer depends largely
on one's view as to whether the government is too large or too small.
Economists who believe there are many unmet social and infrastructure
needs usually recommend that government spending be increased during
recessions. In times of demand-pull inflation, they usually recommend tax
increases. Both actions either expand or preserve the size of government.
Economists who think that the government is too large and inefficient usually
advocate tax cuts during recessions and cuts in government spending during
times of demand-pull inflation. Both actions either restrain the growth of
government or reduce its size.
The point is that discretionary fiscal policy designed to stabilize the economy
can be associated with either an expanding government or a contracting
QUICK REVIEW 13.1
Discretionary fiscal policy is the purposeful change of
government expenditures and tax collections by
government to promote full employment, price stability,
and economic growth.
Expansionary fiscal policy consists of increases in
government spending, reductions in taxes, or both,
and is designed to expand real GDP by increasing
Contractionary fiscal policy entails decreases in
government spending, increases in taxes, or both, and
is designed to reduce aggregate demand and slow or
halt demand-pull inflation.
To be implemented correctly, contractionary fiscal
policy must properly account for the ratchet effect and
the fact that the price level will not fall as the
government shifts the aggregate demand curve
To some degree, government tax revenues change automatically over the
course of the business cycle and in ways that stabilize the economy. This
automatic response, or built-in stability, constitutes nondiscretionary (or
passive or automatic) budgetary policy and results from the makeup of
most tax systems. We did not include this built-in stability in our discussion of
fiscal policy over the last few pages because we implicitly assumed that the
same amount of tax revenue was being collected at each level of GDP. But
the actual U.S. tax system is such that net tax revenues vary directly with
GDP. (Net taxes are tax revenues less transfers and subsidies. From here on,
we will use the simpler taxes to mean net taxes.)
Virtually any tax will yield more tax revenue as GDP rises. In particular,
personal income taxes have progressive rates and thus generate more-thanproportionate increases in tax revenues as GDP expands. Furthermore, as
GDP rises and more goods and services are purchased, revenues from
corporate income taxes and from sales taxes and excise taxes also increase.
And, similarly, revenues from payroll taxes rise as economic expansion
creates more jobs. Conversely, when GDP declines, tax receipts from all
these sources also decline.
Transfer payments (or negative taxes) behave in the opposite way from tax
revenues. Unemployment compensation payments and welfare payments
decrease during economic expansion and increase during economic
Automatic or Built-In Stabilizers
A built-in stabilizerA mechanism that increases government's budget deficit
(or reduces its surplus) during a recession and increases government's
budget surplus (or reduces its deficit) during an expansion without any action
by policymakers. The tax system is one such mechanism. is anything that
increases the government's budget deficit (or reduces its budget surplus)
during a recession and increases its budget surplus (or reduces its budget
deficit) during an expansion without requiring explicit action by policymakers.
As Figure 13.3 reveals, this is precisely what the U.S. tax system does.
Government expenditures G are fixed and assumed to be independent of the
level of GDP. Congress decides on a particular level of spending, but it does
not determine the magnitude of tax revenues. Instead, it establishes tax rates,
and the tax revenues then vary directly with the level of GDP that the
economy achieves. Line T represents that direct relationship between tax
revenues and GDP.
Tax revenues, T, vary directly with GDP, and government spending, G, is assumed to be
independent of GDP. As GDP falls in a recession, deficits occur automatically and help
alleviate the recession. As GDP rises during expansion, surpluses occur automatically and
help offset possible inflation.
Economic Importance The economic importance of the direct relationship
between tax receipts and GDP becomes apparent when we consider that:
Taxes reduce spending and aggregate demand.
Reductions in spending are desirable when the economy is moving
toward inflation, whereas increases in spending are desirable when the
economy is slumping.
As shown in Figure 13.3, tax revenues automatically increase as GDP rises
during prosperity, and since taxes reduce household and business spending,
they restrain the economic expansion. That is, as the economy moves toward
a higher GDP, tax revenues automatically rise and move the budget from
deficit toward surplus. In Figure 13.3, observe that the high and perhaps
inflationary income level GDP3 automatically generates a contractionary
Conversely, as GDP falls during recession, tax revenues automatically
decline, increasing spending by households and businesses and thus
cushioning the economic contraction. With a falling GDP, tax receipts decline
and move the government's budget from surplus toward deficit. In Figure 13.3,
the low level of income GDP1 will automatically yield an expansionary budget
Tax Progressivity Figure 13.3 reveals that the size of the automatic budget
deficits or surplusesand therefore built-in stabilitydepends on the
responsiveness of tax revenues to changes in GDP. If tax revenues change
sharply as GDP changes, the slope of line T in the figure will be steep and the
vertical distances between T and G (the deficits or surpluses) will be large. If
tax revenues change very little when GDP changes, the slope will be gentle
and built-in stability will be low.
The steepness of T in Figure 13.3 depends on the tax system itself. In a
progressive tax systemA tax whose average tax rate increases as the
taxpayer's income increases and decreases as the taxpayer's income
decreases., the average tax rate (= tax revenue/GDP) rises with GDP. In a
proportional tax systemA tax whose average tax rate remains constant as the
taxpayer's income increases or decreases., the average tax rate remains
constant as GDP rises. In a regressive tax systemA tax whose average tax
rate decreases as the taxpayer's income increases and increases as the
taxpayer's income decreases., the average tax rate falls as GDP rises. The
progressive tax system has the steepest tax line T of the three. However, tax
revenues will rise with GDP under both the progressive and the proportional
tax systems, and they may rise, fall, or stay the same under a regressive tax
system. The main point is this: The more progressive the tax system, the
greater the economy's built-in stability.
The built-in stability provided by the U.S. tax system has reduced the severity
of business fluctuations, perhaps by as much as 8 to 10 percent of the change
in GDP that otherwise would have occurred.1 In recession-year 2009, for
example, revenues from the individual income tax fell by a staggering 22
percent. This decline helped keep household spending and real GDP from
falling even more than they did. But built-in stabilizers can only dampen, not
counteract, swings in real GDP. Discretionary fiscal policy (changes in tax
rates and expenditures) or monetary policy (central bankcaused changes in
interest rates) therefore may be needed to try to counter a recession or
inflation of any appreciable magnitude.
Alan J. Auerbach and Daniel Feenberg, The Significance of Federal Taxes as Automatic
Stabilizers, Journal of Economic Perspectives, Summer 2000, p. 54.
Evaluating Fiscal Policy
How can we determine whether a government's discretionary fiscal policy is
expansionary, neutral, or contractionary? We cannot simply examine the
actual budget deficits or surpluses that take place under the current policy
because they will necessarily include the automatic changes in tax revenues
that accompany every change in GDP. In addition, the expansionary or
contractionary strength of any change in discretionary fiscal policy depends
not on its absolute size but on how large it is relative to the size of the
economy. So, in evaluating the status of fiscal policy, we must adjust deficits
and surpluses to eliminate automatic changes in tax revenues and also
compare the sizes of the adjusted budget deficits and surpluses to the level of
Cyclically Adjusted Budget
Economists use the cyclically adjusted budgetA comparison of the
government expenditures and tax collections that would occur if the economy
operated at full employment throughout the year; the full-employment budget.
(also called the full-employment budget) to adjust actual Federal budget
deficits and surpluses to account for the changes in tax revenues that happen
automatically whenever GDP changes. The cyclically adjusted budget
measures what the Federal budget deficit or surplus would have been under
existing tax rates and government spending levels if the economy had
achieved its full-employment level of GDP (its potential output). The idea
essentially is to compare actual government expenditures with the tax
revenues that would have occurred if the economy had achieved fullemployment GDP. That procedure removes budget deficits or surpluses that
arise simply because of cyclical changes in GDP and thus tell us nothing
about whether the government's current discretionary fiscal policy is
fundamentally expansionary, contractionary, or neutral.
Consider Figure 13.4a, where line G represents government expenditures and
line T represents tax revenues. In full-employment year 1, government
expenditures of $500 billion equal tax revenues of $500 billion, as indicated by
the intersection of lines G and T at point a. The cyclically adjusted budget
deficit in year 1 is zerogovernment expenditures equal the tax revenues
forthcoming at the full-employment output GDP1. Obviously, the cyclically
adjusted deficit as a percentage of potential GDP is also zero. The
government's fiscal policy is neutral.
Cyclically adjusted deficits.
(a) In the left-hand graph, the cyclically adjusted deficit is zero at the full-employment output
GDP1. But it is also zero at the recessionary output GDP2 because the $500 billion of
government expenditures at GDP2 equals the $500 billion of tax revenues that would be
forthcoming at the full-employment GDP1. There has been no change in fiscal policy. (b) In
the right-hand graph, discretionary fiscal policy, as reflected in the downward shift of the tax
line from T1 to T2, has increased the cyclically adjusted budget deficit from zero in year 3
(before the tax cut) to $25 billion in year 4 (after the tax cut). This is found by comparing the
$500 billion of government spending in year 4 with the $475 billion of taxes that would
accrue at the full-employment GDP3. Such a rise in the cyclically adjusted deficit (as a
percentage of potential GDP) identifies an expansionary fiscal policy.
Now suppose that a recession occurs and GDP falls from GDP 1 to GDP2, as
shown in Figure 13.4a. Let's also assume that the government takes no
discretionary action, so lines G and T remain as shown in the figure. Tax
revenues automatically fall to $450 billion (point c) at GDP2, while government
spending remains unaltered at $500 billion (point b). A $50 billion budget
deficit (represented by distance bc) arises. But this cyclical deficitA Federal
budget deficit that is caused by a recession and the consequent decline in tax
revenues. is simply a by-product of the economy's slide into recession, not the
result of discretionary fiscal actions by the government. We would be wrong to
conclude from this deficit that the government is engaging in an expansionary
fiscal policy. The government's fiscal policy has not changed. It is still neutral.
That fact is highlighted when we remove the cyclical part of the deficit and
thus consider the cyclically adjusted budget deficit for year 2 in Figure 13.4a.
The $500 billion of government expenditures in year 2 is shown by b on line
G. And, as shown by a on line T, $500 billion of tax revenues would have
occurred if the economy had achieved its full-employment GDP. Because both
b and a represent $500 billion, the cyclically adjusted budget deficit in year 2
is zero, as is this deficit as a percentage of potential GDP. Since the cyclically
adjusted deficits are zero in both years, we know that government did not
change its discretionary fiscal policy, even though a recession occurred and
an actual deficit of $50 billion resulted.
Next, consider Figure 13.4b. Suppose that real output declined from fullemployment GDP3 in year 3 to GDP4 in year 4. Also suppose that government
responded to the recession by reducing tax rates in year 4, as represented by
the downward shift of the tax line from T1 to T2. What has happened to the
size of the cyclically adjusted deficit? Government expenditures in year 4 are
$500 billion, as shown by e. Compare that amount with the $475 billion of tax
revenues that would occur if the economy achieved its full-employment GDP.
That is, compare position e on line G with position h on line T2. The $25 billion
of tax revenues by which e exceeds h is the cyclically adjusted budget deficit
for year 4. As a percentage of potential GDP, the cyclically adjusted budget
deficit has increased from zero in year 3 (before the tax-rate cut) to some
positive percent [= ($25 billion/GDP3) 100] in year 4. This increase in the
relative size of the full-employment deficit between the two years reveals that
the new fiscal policy is expansionary.
In contrast, if we observed a cyclically adjusted deficit (as a percentage of
potential GDP) of zero in one year, followed by a cyclically adjusted budget
surplus in the next, we could conclude that fiscal policy has changed from
being neutral to being contractionary. Because the cyclically adjusted budget
adjusts for automatic changes in tax revenues, the increase in the cyclically
adjusted budget surplus reveals that government either decreased its
spending (G) or increased tax rates such that tax revenues (T) increased.
These changes in G and T are precisely the discretionary actions that we
have identified as elements of a contractionary fiscal policy.
Recent U.S. Fiscal Policy
Table 13.1 lists the actual Federal budget deficits and surpluses (column 2)
and the cyclically adjusted deficits and surpluses (column 3), as percentages
of actual GDP and potential GDP, respectively, between 2000 and 2009.
Observe that the cyclically adjusted deficits are generally smaller than the
actual deficits. This is because the actual deficits include cyclical deficits,
whereas the cyclically adjusted deficits eliminate them. Only cyclically
adjusted surpluses and deficits as percentages of potential GDP (column 3)
provide the information needed to assess discretionary fiscal policy and
determine whether it is expansionary, contractionary, or neutral.
Federal Deficits () and Surpluses
(+) as Percentages of GDP, 2000
As a percentage of potential GDP.
Source: Congressional Budget Office, www.cbo.gov.
Fiscal Policy from 2000 to 2007 Take a look at the data for 2000, for
example, which shows that fiscal policy was contractionary that year. Note
that the actual budget surplus was 2.4 percent of GDP in 2000 and the
cyclically adjusted budget surplus was 1.1 percent of potential GDP. Because
the economy was fully employed and corporate profits were strong, tax
revenues poured into the Federal government and exceeded government
But not all was well in 2000. Specifically, the so-called dot-com stock market
bubble burst that year, and the U.S. economy noticeably slowed over the
latter half of the year. In March 2001 the economy slid into a recession.
Congress and the Bush administration responded by cutting taxes by $44
billion in 2001 and scheduling an additional $52 billion of cuts for 2002. These
stimulus policies helped boost the economy and offset the recession as well
as cushion the economic blow delivered by the September 11, 2001, terrorist
attacks. In March 2002 Congress passed further tax cuts totaling $122 billion
over two years and extended unemployment benefits.
As Table 13.1 reveals, the cyclically adjusted budget moved from a surplus of
1.1 percent of potential GDP in 2000 to a deficit of 1.3 percent two years
later in 2002. Fiscal policy had definitely turned expansionary. Nevertheless,
the economy remained sluggish through 2002 and into 2003. In June 2003
Congress again cut taxes, this time by a much larger $350 billion over several
years. Specifically, the tax legislation accelerated the reduction of marginal tax
rates already scheduled for future years and slashed tax rates on income from
dividends and capital gains. It also increased tax breaks for families and small
businesses. Note from the table that this tax package increased the cyclically
adjusted budget deficit as a percentage of potential GDP to 2.7 percent in
2003. The economy strengthened and both real output and employment grew
between 2003 and 2007. By 2007 full employment had been restored,
although a 1.2 percent cyclically adjusted budget deficit still remained.
Fiscal Policy during the Great Recession As pointed out in previous
chapters, major economic trouble began in 2007. In the summer of 2007, a
crisis in the market for mortgage loans flared up. Later in 2007 that crisis
spread rapidly to other financial markets, threatened the survival of several
major U.S. financial institutions, and severely disrupted the entire financial
system. As credit markets began to freeze, general pessimism spread beyond
the financial markets to the overall economy. Businesses and households
retrenched on their borrowing and spending, and in December 2007 the
economy entered a recession. Over the following two years, it became known
as the Great Recessionone of the steepest and longest economic
downturns since the 1930s.
In 2008 Congress acted rapidly to pass an economic stimulus package. This
law provided a total of $152 billion in stimulus, with some of it coming as tax
breaks for businesses, but most of it delivered as checks of up to $600 each
to taxpayers, veterans, and Social Security recipients.
As a percentage of GDP, the actual Federal budget deficit jumped from 1.2
percent in 2007 to 3.2 percent in 2008. This increase resulted from an
automatic drop-off of tax revenues during the recession, along with the tax
rebates (fiscal stimulus checks) paid out in 2008. As shown in Table 13.1, the
cyclically adjusted budget deficit rose from 1.2 percent of potential GDP in
2007 to 2.8 percent in 2008. This increase in the cyclically adjusted budget
reveals that fiscal policy in 2008 was expansionary.
The government hoped that those receiving checks would spend the money
and thus boost consumption and aggregate demand. But households instead
saved substantial parts of the money from the checks or used some of the
money to pay down credit card loans. Although this stimulus plan boosted
output somewhat in mid-2008, it was neither as expansionary nor long-lasting
as policymakers had hoped. The continuing forces of the Great Recession
simply overwhelmed the policy.
With the economy continuing its precipitous slide, the Obama administration
and Congress enacted the American Recovery and Reinvestment Act of 2009.
This gigantic $787 billion programcoming on top of a $700 billion rescue
package for financial institutionsconsisted of low- and middle-income tax
rebates, plus large increases in expenditures on infrastructure, education, and
health care. The idea was to flood the economy with additional spending to try
to boost aggregate demand and get people back to work.
The tax cuts in the package were aimed at lower- and middle-income
individuals and households, who were thought to be more likely than highincome people to spend (rather than save) the extra income from the tax
rebates. Rather than sending out lump-sum stimulus checks as in 2008, the
new tax rebates showed up as small increases in workers' monthly payroll
checks. With smaller amounts per month rather than a single large check, the
government hoped that people would spend the bulk of their enhanced
incomerather than save it as they had done with the one-time-only, lumpsum checks received in 2008. The second part of the fiscal policy (60 percent
of the funding) consisted of increases in government expenditures on a wide
assortment of programs, including transportation, education, and aid to state
governments. The highly stimulative fiscal policy for 2009 is fully reflected in
column 3 of Table 13.1. The cyclically adjusted budget deficit rose
dramatically from 2.8 percent of potential GDP in 2008 to a very high 7.3
percent of potential GDP in 2009.
Other nations also experienced recessions and also responded with
expansionary fiscal policies. Global Perspective 13.1 shows the magnitudes
of the cyclically adjusted surpluses and deficits of a number of countries in
Budget Deficits and Projections
Figure 13.5 shows the absolute magnitudes of actual (not cyclically adjusted)
U.S. budget surpluses and deficits, here from 1994 through 2009. It also
shows the projected future deficits through 2014, as estimated by the
Congressional Budget Office (CBO). In recession year 2009, the Federal
budget deficit reached $1413 billion, mainly but not totally due to reduced tax
revenues from lower income and record amounts of stimulus spending. The
CBO projects high deficits for several years to come. But projected deficits
and surpluses are subject to large and frequent changes, as government
alters its fiscal policy and GDP growth accelerates or slows. So we suggest
that you update this figure by going to the Congressional Budget Office Web
site, www.cbo.gov, and selecting Budget and Economic Outlook and then
Executive Summary. The relevant numbers are in Table 1 in the row labeled
surpluses, actual and projected,
fiscal years 19942014 (in billions
of nominal dollars).
The annual budget deficits of 1992 through 1997 gave way to budget surpluses from 1998
through 2001. Deficits reappeared in 2002 and declined through 2007. They greatly
ballooned in recessionary years 2008 and 2009 and are projected to remain high for many
years to come.
Source: Congressional Budget Office, www.cbo.gov.
GLOBAL PERSPECTIVE 13.1
Cyclically Adjusted Budget Deficits or Surpluses as a Percentage of
Potential GDP, Selected Nations
Because of the global recession, in 2009 all but a few of the world's major
nations had cyclically adjusted budget deficits. These deficits varied as
percentages of potential GDP, but they each reflected some degree of
expansionary fiscal policy.
Source: Organization for Economic Cooperation and Development, OECD Economic
Problems, Criticisms, and
Economists recognize that governments may encounter a number of
significant problems in enacting and applying fiscal policy.
Problems of Timing
Several problems of timing may arise in connection with fiscal policy:
Recognition lag The recognition lag is the time between the beginning
of recession or inflation and the certain awareness that it is actually
happening. This lag arises because the economy does not move
smoothly through the business cycle. Even during good times, the
economy has slow months interspersed with months of rapid growth
and expansion. This makes recognizing a recession difficult since
several slow months will have to happen in succession before people
can conclude with any confidence that the good times are over and a
recession has begun.
The same is true with inflation. Even periods of moderate inflation have
months of high inflation so that several high-inflation months must
come in sequence before people can confidently conclude that inflation
has moved to a higher level.
Attempts to reduce the length of the recognition lag by trying to predict
the future course of the economy also have proven to be highly difficult,
at best. As a result, the economy is often 4 to 6 months into a
recession or inflation before the situation is clearly discernible in the
relevant statistics. Due to this recognition lag, the economic downslide
or the inflation may become more serious than it would have if the
situation had been identified and acted on sooner.
Administrative lag The wheels of democratic government turn slowly.
There will typically be a significant lag between the time the need for
fiscal action is recognized and the time action is taken. Following the
terrorist attacks of September 11, 2001, the U.S. Congress was
stalemated for 5 months before passing a compromise economic
stimulus law in March 2002. (In contrast, the Federal Reserve began
lowering interest rates the week after the attacks.)
Operational lag A lag also occurs between the time fiscal action is
taken and the time that action affects output, employment, or the price
level. Although changes in tax rates can be put into effect relatively
quickly once new laws are passed, government spending on public
worksnew dams, interstate highways, and so onrequires long
planning periods and even longer periods of construction. Such
spending is of questionable use in offsetting short (for example, 6- to
12-month) periods of recession. Consequently, discretionary fiscal
policy has increasingly relied on tax changes rather than on changes in
spending as its main tool.
Fiscal policy is conducted in a political arena. That reality not only may slow
the enactment of fiscal policy but also may create the potential for political
considerations swamping economic considerations in its formulation. It is a
human trait to rationalize actions and policies that are in one's self-interest.
Politicians are very humanthey want to get reelected. A strong economy at
election time will certainly help them. So they may favor large tax cuts under
the guise of expansionary fiscal policy even though that policy is economically
inappropriate. Similarly, they may rationalize increased government spending
on popular items such as farm subsidies, health care, highways, education,
and homeland security.
At the extreme, elected officials and political parties might collectively hijack
fiscal policy for political purposes, cause inappropriate changes in aggregate
demand, and thereby cause (rather than avert) economic fluctuations. For
instance, before an election, they may try to stimulate the economy to improve
their reelection hopes. And then after the election, they may try to use
contractionary fiscal policy to dampen the excessive aggregate demand that
they caused with their preelection stimulus. In short, elected officials may
cause so-called political business cyclesFluctuations in the economy caused
by the alleged tendency of Congress to destabilize the economy by reducing
taxes and increasing government expenditures before elections and to raise
taxes and lower expenditures after elections.swings in overall economic
activity and real GDP resulting from election-motivated fiscal policy, rather
than from inherent instability in the private sector. Political business cycles are
difficult to document and prove, but there is little doubt that political
considerations weigh heavily in the formulation of fiscal policy. The question is
how often those political considerations run counter to sound economics.
Future Policy Reversals
Fiscal policy may fail to achieve its intended objectives if households expect
future reversals of policy. Consider a tax cut, for example. If taxpayers believe
the tax reduction is temporary, they may save a large portion of their tax cut,
reasoning that rates will return to their previous level in the future. They save
more now so that they will be able draw on this extra savings to maintain their
future consumption levels if taxes do indeed rise again in the future. So a tax
reduction thought to be temporary may not increase present consumption
spending and aggregate demand by as much as our simple model ( Figure
The opposite may be true for a tax increase. If taxpayers think it is temporary,
they may reduce their saving to pay the tax while maintaining their present
consumption. They may reason they can restore their saving when the tax
rate again falls. So the tax increase may not reduce current consumption and
aggregate demand by as much as policymakers intended.
To the extent that this so-called consumption smoothing occurs over time,
fiscal policy will lose some of its strength. The lesson is that tax-rate changes
that households view as permanent are more likely to alter consumption and
aggregate demand than tax changes they view as temporary.
Offsetting State and Local Finance
The fiscal policies of state and local governments are frequently pro-cyclical,
meaning that they worsen rather than correct recession or inflation. Unlike the
Federal government, most state and local governments face constitutional or
other legal requirements to balance their budgets. Like households and
private businesses, state and local governments increase their expenditures
during prosperity and cut them during recession.
During the Great Depression of the 1930s, most of the increase in Federal
spending was offset by decreases in state and local spending. During and
immediately following the recession of 2001, many state and local
governments had to offset lower tax revenues resulting from the reduced
personal income and spending of their citizens. They offset the decline by in
revenues raising tax rates, imposing new taxes, and reducing spending.
In view of these past experiences, the $787 billion fiscal package of 2009
made a special effort to reduce this problem by giving substantial aid dollars
to state governments. Because of the sizable Federal aid, the states did not
have to increase taxes and reduce expenditure by as much as otherwise. So
their collective fiscal actions did not fight as much against the increase in
aggregate demand that the Federal government wanted to achieve with its tax
cuts and expenditure increases.
Another potential flaw of fiscal policy is the so-called crowding-out effect A rise
in interest rates and a resulting decrease in planned investment caused by
the Federal government's increased borrowing to finance budget deficits and
refinance debt.: An expansionary fiscal policy (deficit spending) may increase
the interest rate and reduce investment spending, thereby weakening or
canceling the stimulus of the expansionary policy. The rising interest rate
might also potentially crowd out interest-sensitive consumption spending
(such as purchasing automobiles on credit). But since investment is the most
volatile component of GDP, the crowding-out effect focuses its attention on
investment and whether the stimulus provided by deficit spending may be
partly or even fully neutralized by an offsetting reduction in investment
ORIGIN OF THE IDEA
To see the potential problem, realize that whenever the government borrows
money (as it must if it is deficit spending), it increases the overall demand for
money. If the monetary authorities are holding the money supply constant, this
increase in demand will raise the price paid for borrowing money: the interest
rate. Because investment spending varies inversely with the interest rate,
some investment will be choked off or crowded out.
Economists vary in their opinions about the strength of the crowding-out
effect. An important thing to keep in mind is that crowding out is likely to be
less of a problem when the economy is in recession, because investment
demand tends to be weak. Why? Because output purchases slow during
recessions and therefore most businesses end up with substantial excess
capacity. As a result, they do not have much incentive to add new machinery
or build new factories. After all, why should they add capacity when some of
the capacity they already have is lying idle?
With investment demand weak during a recession, the crowding-out effect is
likely to be very small. Simply put, there is not much investment for the
government to crowd out. Even if deficit spending does increase the interest
rate, the effect on investment may be fully offset by the improved investment
prospects that businesses expect from the fiscal stimulus.
By contrast, when the economy is operating at or near full capacity,
investment demand is likely to be quite strong so that crowding out will
probably be a much more serious problem. When the economy is booming,
factories will be running at or near full capacity and firms will have high
investment demand for two reasons. First, equipment running at full capacity
wears out fast, so firms will be investing substantial amounts just to replace
machinery and equipment that wears out and depreciates. Second, the
economy is likely to be growing overall so that firms will be heavily investing to
add to their production capacity to take advantage of the greater anticipated
demand for their outputs.
Current Thinking on Fiscal Policy
Where do these complications leave us as to the advisability and
effectiveness of discretionary fiscal policy? In view of the complications and
uncertain outcomes of fiscal policy, some economists argue that it is better not
to engage in it at all. Those holding that view point to the superiority of
monetary policy (changes in interest rates engineered by the Federal
Reserve) as a stabilizing device or believe that most economic fluctuations
tend to be mild and self-correcting.
But most economists believe that fiscal policy remains an important, useful
policy lever in the government's macroeconomic toolkit. The current popular
view is that fiscal policy can help push the economy in a particular direction
but cannot fine-tune it to a precise macroeconomic outcome. Mainstream
economists generally agree that monetary policy is the best month-to-month
stabilization tool for the U.S. economy. If monetary policy is doing its job, the
government should maintain a relatively neutral fiscal policy, with a cyclically
adjusted budget deficit or surplus of no more than 2 percent of potential GDP.
It should hold major discretionary fiscal policy in reserve to help counter
situations where recession threatens to be deep and long lasting, as in 2008
and 2009, or where a substantial reduction in aggregate demand might help
the Federal Reserve to quell a major bout of inflation.
Finally, economists agree that proposed fiscal policy should be evaluated for
its potential positive and negative impacts on long-run productivity growth.
The short-run policy tools used for conducting active fiscal policy often have
long-run impacts. Countercyclical fiscal policy should be shaped to
strengthen, or at least not impede, the growth of long-run aggregate supply
(shown as a rightward shift of the long-run aggregate supply curve in Figure
12.5). For example, a tax cut might be structured to enhance work effort,
strengthen investment, and encourage innovation. Alternatively, an increase in
government spending might center on preplanned projects for public capital
(highways, mass transit, ports, airports), which are complementary to private
investment and thus support long-term economic growth.
QUICK REVIEW 13.2
Automatic changes in net taxes (taxes minus
transfers) add a degree of built-in stability to the
Cyclical deficits arise from declines in net tax revenues
that automatically occur as the economy recedes and
incomes and profits fall.
The cyclically adjusted budget eliminates cyclical
effects on net tax revenues; it compares actual levels
of government spending to the projected levels of net
taxes that would occur if the economy were achieving
its full-employment output.
Time lags, political problems, expectations, and state
and local finances complicate fiscal policy.
The crowding-out effect indicates that an expansionary
fiscal policy may increase the interest rate and reduce
The U.S. Public Debt
The U.S. national debt, or public debtThe total amount owed by the Federal
government to the owners of government securities; equal to the sum of past
government budget deficits less government budget surpluses. , is essentially
the accumulation of all past Federal deficits and surpluses. The deficits have
greatly exceeded the surpluses and have emerged mainly from war financing,
recessions, and fiscal policy. In 2009 the total public debt was $11.9 trillion
$6.8 trillion held by the public, excluding the Federal Reserve; and $5.1 trillion
held by Federal agencies and the Federal Reserve. Between 2007 and 2009,
the public debt expanded by a huge $2.9 trillion. During the Great Recession,
Federal tax revenues plummeted because incomes and profit fell, and Federal
expenditures jumped because of huge spending to rescue failing financial
institutions and to stimulate the shrinking economy.
You can find the current size of the public debt at the Web site of the
Department of Treasury, Bureau of the Public Debt, at
www.treasurydirect.gov/NP/BPDLogin?application=np . At this site, you
will see that the U.S. Treasury defines the public to include the Federal
Reserve. But because the Federal Reserve is the nation's central bank,
economists view it as essentially part of the Federal government and not part
of the public. Economists typically focus on the part of the debt that is not
owned by the Federal government and the Federal Reserve.
The total public debt of $11.9 trillion represents the total amount of money
owed by the Federal government to the holders of U.S. securities U.S.
Treasury bills, notes, and bonds used to finance budget deficits; the
components of the public debt.: financial instruments issued by the Federal
government to borrow money to finance expenditures that exceed tax
revenues. These U.S. securities (loan instruments) are of four types: Treasury
bills (short-term securities), Treasury notes (medium-term securities),
Treasury bonds (long-term securities), and U.S. savings bonds (long-term,
Figure 13.6 shows that the public, sans the Federal Reserve, held 57 percent
of the Federal debt in 2009 and that Federal government agencies and the
Federal Reserve held the remaining 43 percent. The Federal agencies hold
U.S. securities as risk-free assets that they can cash in as needed to make
latter payments. The Federal Reserve holds these securities to facilitate the
open-market operations that it uses to control the nation's money supply
(Chapter 16). Observe that the public in the pie chart consists of individuals
here and abroad, state and local governments, and U.S. financial institutions.
Foreigners held about 29 percent of the total U.S. public debt in 2009,
meaning that most of the U.S. public debt is held internally and not externally.
Americans owed 71 percent of the public debt to Americans. Of the $3.7
trillion of debt held by foreigners, China held 24 percent, Japan held 21
percent, and oil-exporting nations held 6 percent.
Ownership of the total public debt,
The $11.9 trillion public debt can be divided into the proportion held by the public, excluding
the Federal Reserve (57 percent), and the proportion held by Federal agencies and the
Federal Reserve System (43 percent). Of the total debt, 29 percent is foreign-owned.
Source: Economic Report of the President, 2010, www.gpoaccess.gov/eop; authors'
derivation from Table B-89, September 2009 data. Federal Reserve percentage is from the
U.S. Treasury, www.fms.treas.gov/bulletin.
Debt and GDP
A simple statement of the absolute size of the debt ignores the fact that the
wealth and productive ability of the U.S. economy is also vast. A wealthy,
highly productive nation can incur and carry a large public debt much more
easily than a poor nation can. A more meaningful measure of the public debt
relates it to an economy's GDP. Figure 13.7 shows the yearly relative sizes of
the U.S. public debt held outside the Federal Reserve and Federal agencies.
In 2009 the percentage was 47 percent. Most noticeably, the percentage rose
dramatically in 2008 and 2009 because of huge budget deficits together with
declining real GDP.
Federal debt held by the public,
excluding the Federal Reserve, as
a percentage of GDP, 19702009.
As a percentage of GDP, the Federal debt held by the public (held outside the Federal
Reserve and Federal government agencies) increased sharply over the 19801995 period
and declined significantly between 1995 and 2001. Since 2001, the percentage has gone
up again, and jumped abruptly and sharply in 2008 and 2009.
Source: Derived by the authors by subtracting Fed-held debt ( www.fms.treas.gov/bulletin)
from debt held by the public (www.gpoaccess.gov/eop).
It is not uncommon for countries to have sizable public debts. As shown in
Global Perspective 13.2, the public debt as a percentage of real GDP in the
United States is neither particularly high nor low relative to such debt
percentages in other advanced industrial nations.
Many economists conclude that the primary burden of the debt is the annual
interest charge accruing on the bonds sold to finance the debt. In 2009
interest on the total public debt was $187 billion. Although this amount is
sizable in absolute terms, it was only 1.3 percent of GDP for 2009. So, the
Federal government had to collect taxes equal to 1.3 percent of GDP to
service the total public debt. This percentage was down from 3.2 percent in
1990 and 2.3 percent in 2000, mainly because interest rates in 2009 were
GLOBAL PERSPECTIVE 13.2
Publicly Held Debt: International Comparisons
Although the United States has the world's largest public debt, a number of
other nations have larger debts as percentages of their GDPs.
Source: Organization for Economic Cooperation and Development, OECD Economic
Outlook, www.oecd.org. These debt calculations encompass Federal, state, and local
debt, including the debt of government-owned enterprises (not just Federal debt as in
You may wonder if the large public debt might bankrupt the United States or at
least place a tremendous burden on your children and grandchildren.
Fortunately, these are largely false concerns. People were wondering the
same things 50 years ago!
The large U.S. public debt does not threaten to bankrupt the Federal
government, leaving it unable to meet its financial obligations. There are two
main reasons: refinancing and taxation.
Refinancing As long as the U.S. public debt is viewed by lenders as
manageable and sustainable, the public debt is easily refinanced. As portions
of the debt come due on maturing Treasury bills, notes, and bonds each
month, the government does not cut expenditures or raise taxes to provide
the funds required. Rather, it refinances the debt by selling new bonds and
using the proceeds to pay holders of the maturing bonds. The new bonds are
in strong demand because lenders can obtain a market-determined interest
return with no risk of default by the Federal government.
Of course, refinancing could become an issue with a high enough debt-toGDP ratio. Some countries such as Greece have run into this problem. High
and rising ratios in the United States might raise fears that the U.S.
government might be unable to pay back loans as they come due. But, with
the present U.S. debt-to-GDP ratio and the prospects of long-term economic
growth, this is a false concern for the United States.
Taxation The Federal government has the constitutional authority to levy and
collect taxes. A tax increase is a government option for gaining sufficient
revenue to pay interest and principal on the public debt. Financially distressed
private households and corporations cannot extract themselves from their
financial difficulties by taxing the public. If their incomes or sales revenues fall
short of their expenses, they can indeed go bankrupt. But the Federal
government does have the option to impose new taxes or increase existing
tax rates if necessary to finance its debt. Such tax hikes may be politically
unpopular and may weaken incentives to work and invest, but they are a
means of raising funds to finance the debt.
Burdening Future Generations
In 2009 public debt per capita was $37,437. Was each child born in 2009
handed a $37,437 bill from the Federal government? Not really. The public
debt does not impose as much of a burden on future generations as
The United States owes a substantial portion of the public debt to itself. U.S.
citizens and institutions (banks, businesses, insurance companies,
governmental agencies, and trust funds) own about 71 percent of the U.S.
government securities. Although that part of the public debt is a liability to
Americans (as taxpayers), it is simultaneously an asset to Americans (as
holders of Treasury bills, Treasury notes, Treasury bonds, and U.S. savings
To eliminate the American-owned part of the public debt would require a
gigantic transfer payment from Americans to Americans. Taxpayers would pay
higher taxes, and holders of the debt would receive an equal amount for their
U.S. securities. Purchasing power in the United States would not change.
Only the repayment of the 29 percent of the public debt owned by foreigners
would negatively impact U.S. purchasing power.
The public debt increased sharply during the Second World War. But the
decision to finance military purchases through the sale of government bonds
did not shift the economic burden of the war to future generations. The
economic cost of the Second World War consisted of the civilian goods
society had to forgo in shifting scarce resources to war goods production
(recall production possibilities analysis). Regardless of whether society
financed this reallocation through higher taxes or through borrowing, the real
economic burden of the war would have been the same. That burden was
borne almost entirely by those who lived during the war. They were the ones
who did without a multitude of consumer goods to enable the United States to
arm itself and its allies.
The next generation inherited the debt from the war but also an equal amount
of government bonds that would pay them cash in future years. It also
inherited the enormous benefits from the victorynamely, preserved political
and economic systems at home and the export of those systems to
Germany, Italy, and Japan. Those outcomes enhanced postwar U.S.
economic growth and helped raise the standard of living of future generations
Although the preceding issues relating to the public debt are false concerns, a
number of substantive issues are not. Economists, however, attach varying
degrees of importance to them.
The distribution of ownership of government securities is highly uneven. Some
people own much more than the $37,437-per-person portion of government
securities; other people own less or none at all. In general, the ownership of
the public debt is concentrated among wealthier groups, who own a large
percentage of all stocks and bonds. Because the overall Federal tax system is
only slightly progressive, payment of interest on the public debt mildly
increases income inequality. Income is transferred from people who, on
average, have lower incomes to the higher-income bondholders. If greater
income equality is one of society's goals, then this redistribution is
The current public debt necessitates annual interest payments of $187 billion.
With no increase in the size of the debt, that interest charge must be paid out
of tax revenues. Higher taxes may dampen incentives to bear risk, to
innovate, to invest, and to work. So, in this indirect way, a large public debt
may impair economic growth and therefore impose a burden of reduced
output (and income) on future generations.
Foreign-Owned Public Debt
The 29 percent of the U.S. debt held by citizens and institutions of foreign
countries is an economic burden to Americans. Because we do not owe that
portion of the debt to ourselves, the payment of interest and principal on this
external public debtThe portion of the public debt owed to foreign citizens,
firms, and institutions. enables foreigners to buy some of our output. In return
for the benefits derived from the borrowed funds, the United States transfers
goods and services to foreign lenders. Of course, Americans also own debt
issued by foreign governments, so payment of principal and interest by those
governments transfers some of their goods and services to Americans.
Crowding-Out Effect Revisited
A potentially more serious problem is the financing (and continual refinancing)
of the large public debt, which can transfer a real economic burden to future
generations by passing on to them a smaller stock of capital goods. This
possibility involves the previously discussed crowding-out effect : the idea that
public borrowing drives up real interest rates, which reduces private
investment spending. If public borrowing only happened during recessions,
crowding out would not likely be much of a problem. Because private
investment demand tends to be weak during recessions, any increase in
interest rates caused by public borrowing will at most cause a small reduction
in investment spending.
In contrast, the need to continuously finance a large public debt may be more
troublesome. At times, that financing requires borrowing large amounts of
money when the economy is near or at its full-employment output. Because
this usually is when private demand is strong, any increase in interest rates
caused by the borrowing necessary to refinance the debt may result in a
substantial decline in investment spending. If the amount of current
investment crowded out is extensive, future generations will inherit an
economy with a smaller production capacity and, other things equal, a lower
standard of living.
A Graphical Look at Crowding Out We know from Chapter 10 that the
amount of investment spending is inversely related to the real interest rate.
When graphed, that relationship is shown as a downsloping investment
demand curve, such as either ID1 or ID2 in Figure 13.8. Let's first consider
curve ID1. (Ignore curve ID2 for now.) Suppose that government borrowing
increases the real interest rate from 6 percent to 10 percent. Investment
spending will then fall from $25 billion to $15 billion, as shown by the
economy's move from a to b. That is, the financing of the debt will compete
with the financing of private investment projects and crowd out $10 billion of
private investment. So the stock of private capital handed down to future
generations will be $10 billion less than it would have been without the need
to finance the public debt.
The investment demand curve and
the crowding-out effect.
If the investment demand curve (ID1) is fixed, the increase in the interest rate from 6 percent
to 10 percent caused by financing a large public debt will move the economy from a to b,
crowding out $10 billion of private investment and decreasing the size of the capital stock
inherited by future generations. However, if the public goods enabled by the debt improve
the investment prospects of businesses, the private investment demand curve will shift
rightward, as from ID1 to ID2. That shift may offset the crowding-out effect wholly or in part.
In this case, it moves the economy from a to c.
Public Investments and Public-Private Complementarities But even with
crowding out, two factors could partly or fully offset the net economic burden
shifted to future generations. First, just as private expenditures may involve
either consumption or investment, so it is with public goods. Part of the
government spending enabled by the public debt is for public investment
outlays (for example, highways, mass transit systems, and electric power
facilities) and human capital (for example, investments in education, job
training, and health). Like private expenditures on machinery and equipment,
those public investmentsGovernment expenditures on public capital (such as
roads, highways, bridges, mass-transit systems, and electric power facilities)
and on human capital (such as education, training, and health). increase the
economy's future production capacity. Because of the financing through debt,
the stock of public capital passed on to future generations may be higher than
otherwise. That greater stock of public capital may offset the diminished stock
of private capital resulting from the crowding-out effect, leaving overall
production capacity unimpaired.
So-called public-private complementarities are a second factor that could
reduce the crowding out effect. Some public and private investments are
complementary. Thus, the public investment financed through debt could spur
some private-sector investment by increasing its expected rate of return. For
example, a Federal building in a city may encourage private investment in the
form of nearby office buildings, shops, and restaurants. Through its
complementary effect, the spending on public capital may shift the private
investment demand curve to the right, as from ID1 to ID2 in Figure 13.8. Even
though the government borrowing boosts the interest rate from 6 percent to
10 percent, total private investment need not fall. In the case shown as the
move from a to c in Figure 13.8, it remains at $25 billion. Of course, the
increase in investment demand might be smaller than that shown. If it were
smaller, the crowding-out effect would not be fully offset. But the point is that
an increase in investment demand may counter the decline in investment that
would otherwise result from the higher interest rate.
QUICK REVIEW 13.3
The U.S. public debt$11.9 trillion in
2009is essentially the total
accumulation of all past Federal
budget deficits and surpluses; about
29 percent of the U.S. public debt is
held by foreigners.
The U.S. public debt held by the public
(excluding the Federal Reserve) was
47 percent of GDP in 2009, up from 30
percent in 2000.
The Federal government is in no
danger of going bankrupt because it
needs only to refinance (not retire) the
public debt and it can raise revenues, if
needed, through higher taxes.
The borrowing and interest payments
associated with the public debt may (a)
increase income inequality; (b) require
higher taxes, which may dampen
incentives; and (c) impede the growth
of the nation's stock of capital through
crowding out of private investment.
Word The Social Security and Medicare Shortfalls
Social Security and Medicare Face Gigantic Future Funding Shortfalls. Metaphorically
Speaking, Some Economists See These Programs as Financial and Political Time Bombs
The American population, on average, is getting decidedly older. The percentage of the populati
age 62 or older will rise substantially over the next several decades, with the greatest increases
people age 75 and above. In the future, more people will be receiving Social Security benefits (in
during retirement) and Medicare (medical care during retirement) for longer periods. Each perso
benefits will be paid for by fewer workers. The number of workers per Social Security and Medic
beneficiary was roughly 5:1 in 1960. Today it is 3:1, and by 2040 it will be only 2:1.
The combined cost of the Social Security and Medicare programs was 7.6 percent of GDP in 20
and that percentage is projected to grow to 12 percent of GDP in 2030 and 17.2 percent of GDP
Social Security and Medicare Board of Trustees, Status of the Social Security and Medicare Programs: A Summar
2009 Annual Reports, www.ssa.gov. This publication is also the source of most of the statistical information that fo
The Social Security Shortfall Social Security is the major public retirement program in the U
States. The program costs $615 billion annually and is financed by a 12.4 percent tax on earning
to a set level of earnings ($106,800 in 2009). Half the tax (6.2 percent) is paid by the worker; the
half by the employer. Social Security is largely an annual pay-as-you-go plan, meaning that mo
the current revenues from the Social Security tax are paid to current Social Security retirees. Th
the start of 2009, Social Security revenues exceeded Social Security payouts in anticipation of th
large benefits promised to the baby boomers when they retire. That excess inflow was used to b
U.S. Treasury securities that were credited to a government account called the Social Security T
Fund. But the combined accumulation of money in the trust fund through 2009 plus the projected
future revenues from the payroll tax in later years was expected to be greatly inadequate for pay
the promised retirement benefits to all future retirees.
This underfunding of future retirement promises was brought into sharper focus in the latter half
2009 when for the first time, Social Security revenues fell below Social Security retirement payo
and the system started shifting money from the trust fund to make up the difference. The trust fu
expected to be exhausted in 2037. For each year thereafter, annual tax revenues will cover only
percent of the promised benefits.
The Medicare Shortfall The Medicare program is the U.S. health care program for people ag
and older in the United States. The program costs $462 billion per year and has been growing a
about 9 percent annually. Like Social Security, it also is a pay-as-you-go plan, meaning that curr
medical benefits for people age 65 or older are being funded by current tax revenues from the 2
percent Medicare tax on earnings. Like the Social Security tax, half the Medicare tax is paid by t
employer (1.45 percent) and half the by the employee. But the 2.9 percent Medicare tax is applie
The financial status of Medicare is much worse than that of Social Security. To begin with, the
Medicare Trust Fund will be depleted in 2017, 20 years before the Social Security Trust Fund is
expected to be depleted. Then, in subsequent years, the percentage of scheduled Medicare ben
covered by the Medicare tax will decline from 81 percent in 2017 to 50 percent in 2035 and 29 p
The Unpleasant Options To restore long-run balance to Social Security and Medicare, the Fe
government must either reduce benefits or increase revenues. It's as simpleand as complicate
that! The Social Security Administration concludes that bringing projected Social Security revenu
and payments into balance over the next 75 years would require a 16 percent permanent reduct
Social Security benefits, a 13 percent permanent increase in tax revenues, or some combination
the two. To bring projected Medicare revenues and expenses into long-run balance would requir
increase in the Medicare payroll tax by 122 percent, a 51 percent reduction of Medicare paymen
from their projected levels, or some combination of each.
All the general options for closing all or part of the Social Security and Medicare gaps involve dif
economic trade-offs and dangerous political risks, because one group or another will strongly op
them. Here are just a few examples:
Increasing the retirement age for collecting Social Security or Medicare benefits will upse
preretirement workers who have been paying into the system and will receive their benefi
later than they expected.
Subjecting a larger portion of total earnings to the Social Security tax would constitute a
gigantic tax increase on the earnings of the country's highest trained and educated individ
This might reduce the incentive of younger people to obtain education and advance in the
Disqualifying wealthy individuals from receiving Social Security and Medicare benefits wo
the programs toward welfare and redistribution, rather than insurance programs. This wou
undermine the broad existing political support for the programs.
Redirecting legal immigration toward high-skilled, high-earning entrants and away from lo
skilled, low-earning immigrants to raise Social Security and Medicare revenues would als
raise the ire of some native-born high-skilled workers and the proponents of immigration b
on family reunification.
Placing the payroll tax revenues into accounts that individuals, not the government, would
maintain, and bequeath would transform the Social Security and Medicare programs from
guaranteed defined benefit plans into much riskier defined contribution plans. The extr
short-run volatility of the stock market might leave some unlucky people destitute in old a
The problem is huge and will not go away. One recent attempt to add up the underfunding of all
promised Social Security and Medicare benefits finds that the total underfunding greatly exceed
combined current wealth (net worth) of everyone in the United States today. Even if this estima
somewhat extreme, the fact remains: The Federal government and American people eventually
have to face up to the overpromising-underfunding problem and find ways to resolve it.
Bruce Bartlett, The 81% Tax Increase, Forbes.com, August 8, 2009, www.forbes.com.
1. Fiscal policy consists of deliberate changes in government spending, taxes, or some
combination of both to promote full employment, price-level stability, and economic growt
Fiscal policy requires increases in government spending, decreases in taxes, or botha
budget deficitto increase aggregate demand and push an economy from a recession.
Decreases in government spending, increases in taxes, or botha budget surplusare
appropriate fiscal policy for decreasing aggregate demand to try to slow or halt demand-p
2. Built-in stability arises from net tax revenues, which vary directly with the level of GDP. Du
recession, the Federal budget automatically moves toward a stabilizing deficit; during
expansion, the budget automatically moves toward an anti-inflationary surplus. Built-in sta
lessens, but does not fully correct, undesired changes in real GDP.
3. Actual Federal budget deficits can go up or down because of changes in GDP, changes in
fiscal policy, or both. Deficits caused by changes in GDP are called cyclical deficits. The
cyclically adjusted budget removes cyclical deficits from the budget and therefore measur
budget deficit or surplus that would occur if the economy operated at its full-employment
throughout the year. Changes in the cyclical-budget deficit or surplus provide meaningful
information as to whether the government's fiscal policy is expansionary, neutral, or
contractionary. Changes in the actual budget deficit or surplus do not, since such deficits
surpluses can include cyclical deficits or surpluses.
4. In 2001 the Bush administration and Congress chose to reduce marginal tax rates and ph
out the Federal estate tax. A recession occurred in 2001, and Federal spending for the wa
terrorism rocketed. The Federal budget swung from a surplus of $128 billion in 2001 to a
of $158 billion in 2002. In 2003 the Bush administration and Congress accelerated the tax
reductions scheduled under the 2001 tax law and cut tax rates on capital gains and divide
The purposes were to stimulate a sluggish economy. By 2007 the economy had reached
employment level of output.
5. The Federal government responded to the deep recession of 20072009 by implementin
highly expansionary fiscal policy. In 2008 the Federal government passed a tax rebate pr
that sent $600 dollar checks to qualified individuals. Later that year, it created a $700 billi
emergency fund to keep key financial institutions from failing. These and other programs
increased the cyclically adjusted budget deficit from 1.2 percent of potential GDP in 200
2.8 percent in 2008. When the economy continued to plunge, the Obama administration
Congress enacted a massive $787 billion stimulus program to be implemented over 2 y
The cyclically adjusted budget deficit shot up from 2.8 percent of potential GDP in 2008
7.3 percent in 2009.
6. Certain problems complicate the enactment and implementation of fiscal policy. They incl
(a) timing problems associated with recognition, administrative, and operational lags; (b)
potential for misuse of fiscal policy for political rather than economic purposes; (c) the fac
state and local finances tend to be pro-cyclical; (d) potential ineffectiveness if households
expect future policy reversals; and (e) the possibility of fiscal policy crowding out private
7. Most economists believe that fiscal policy can help move the economy in a desired direct
but cannot reliably be used to fine-tune the economy to a position of price stability and ful
employment. Nevertheless, fiscal policy is a valuable backup tool for aiding monetary pol
fighting significant recession or inflation.
8. The public debt is the total accumulation of all past Federal government deficits and surp
and consists of Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds.
2009 the U.S. public debt was $11.9 trillion, or $37,437 per person. The public (which her
includes banks and state and local governments) holds 57 percent of that Federal debt; th
Federal Reserve and Federal agencies hold the other 43 percent. Foreigners hold 29 per
of the Federal debt. Interest payments as a percentage of GDP were about 1.3 percent in
This is down from 3.2 percent in 1990.
9. The concern that a large public debt may bankrupt the U.S. government is generally a fal
worry because (a) the debt needs only to be refinanced rather than refunded and (b) the
Federal government has the power to increase taxes to make interest payments on the d
10. In general, the public debt is not a vehicle for shifting economic burdens to future generat
Americans inherit not only most of the public debt (a liability) but also most of the U.S.
securities (an asset) that finance the debt.
11. More substantive problems associated with public debt include the following: (a) Paymen
interest on the debt may increase income inequality. (b) Interest payments on the debt re
higher taxes, which may impair incentives. (c) Paying interest or principal on the portion o
debt held by foreigners means a transfer of real output abroad. (d) Government borrowing
refinance or pay interest on the debt may increase interest rates and crowd out private
investment spending, leaving future generations with a smaller stock of capital than they
have had otherwise.
12. The increase in investment in public capital that may result from debt financing may partly
wholly offset the crowding-out effect of the public debt on private investment. Also, the ad
public investment may stimulate private investment, where the two are complements.
Terms and Concepts
fiscal policyChanges in government spending and tax collections designed to achieve a fullemployment and noninflationary domestic output; also called discretionary fiscal policy.
Council of Economic Advisers (CEA)A group of three persons that advises and assists the presi
of the United States on economic matters (including the preparation of the annual Economic Re
expansionary fiscal policyAn increase in government purchases of goods and services, a decrea
net taxes, or some combination of the two for the purpose of increasing aggregate demand and
expanding real output.
budget deficitThe amount by which the expenditures of the Federal government exceed its reve
in any year.
contractionary fiscal policyA decrease in government purchases of goods and services, an incre
net taxes, or some combination of the two, for the purpose of decreasing aggregate demand an
budget surplusThe amount by which the revenues of the Federal government exceed its expend
in any year.
built-in stabilizerA mechanism that increases government's budget deficit (or reduces its surplus
during a recession and increases government's budget surplus (or reduces its deficit) during an
expansion without any action by policymakers. The tax system is one such mechanism.
progressive tax systemA tax whose average tax rate increases as the taxpayer's income increas
and decreases as the taxpayer's income decreases.
proportional tax systemA tax whose average tax rate remains constant as the taxpayer's income
increases or decreases.
regressive tax systemA tax whose average tax rate decreases as the taxpayer's income increas
and increases as the taxpayer's income decreases.
cyclically adjusted budgetA comparison of the government expenditures and tax collections that
occur if the economy operated at full employment throughout the year; the full-employment budg
cyclical deficitA Federal budget deficit that is caused by a recession and the consequent decline
political business cycleFluctuations in the economy caused by the alleged tendency of Congress
destabilize the economy by reducing taxes and increasing government expenditures before elec
and to raise taxes and lower expenditures after elections.
crowding-out effectA rise in interest rates and a resulting decrease in planned investment cause
the Federal government's increased borrowing to finance budget deficits and refinance debt.
public debtThe total amount owed by the Federal government to the owners of government secu
equal to the sum of past government budget deficits less government budget surpluses.
U.S. securitiesU.S. Treasury bills, notes, and bonds used to finance budget deficits; the compon
of the public debt.
external public debtThe portion of the public debt owed to foreign citizens, firms, and institutions
public investmentsGovernment expenditures on public capital (such as roads, highways, bridges
mass-transit systems, and electric power facilities) and on human capital (such as education, tra
1. What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? U
Internet search to find the names and university affiliations of the present members of the
2. What are government's fiscal policy options for ending severe demand-pull inflation? Whi
these fiscal options do you think might be favored by a person who wants to preserve the
of government? A person who thinks the public sector is too large? How does the ratche
effect affect anti-inflationary fiscal policy? LO1
3. (For students who were assigned Chapter 11) Use the aggregate expenditures model to
how government fiscal policy could eliminate either a recessionary expenditure gap or an
inflationary expenditure gap (Figure 11.7). Explain how equal-size increases in G and T c
eliminate a recessionary gap and how equal-size decreases in G and T could eliminate a
inflationary gap. LO1
4. Some politicians have suggested that the United States enact a constitutional amendmen
requiring that the Federal government balance its budget annually. Explain why such an
amendment, if strictly enforced, would force the government to enact a contractionary fisc
policy whenever the economy experienced a severe recession. LO1
5. Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy.
Explain the idea of a political business cycle. How might expectations of a near-term polic
reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out ef
and why might it be relevant to fiscal policy? In view of your answers, explain the followin
statement: Although fiscal policy clearly is useful in combating the extremes of severe
recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the
economy to the full-employment, noninflationary level of real GDP and keep the economy
6. Explain how built-in (or automatic) stabilizers work. What are the differences between
proportional, progressive, and regressive tax systems as they relate to an economy's buil
7. Define the cyclically adjusted budget, explain its significance, and state why it may differ f
the actual budget. Suppose the full-employment, noninflationary level of real output is GD
(not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2,
instead of GDP3, what is the status of its cyclically adjusted budget? The status of its curr
fiscal policy? What change in fiscal policy would you recommend? How would you accom
that in terms of the G and T lines in the figure? LO3
8. How do economists distinguish between the absolute and relative sizes of the public debt
Why is the distinction important? Distinguish between refinancing the debt and retiring the
How does an internally held public debt differ from an externally held public debt? Contra
effects of retiring an internally held debt and retiring an externally held debt. LO4
9. True or false? If false, explain why. LO4
a. The total public debt is more relevant to an economy than the public debt as a
percentage of GDP.
b. An internally held public debt is like a debt of the left hand owed to the right hand.
c. The Federal Reserve and Federal government agencies hold more than three-four
the public debt.
d. The portion of the U.S. debt held by the public (and not by government entities) wa
larger as a percentage of GDP in 2009 than it was in 2000.
e. As a percentage of GDP, the total U.S. public debt is the highest such debt among
world's advanced industrial nations.
10. Why might economists be quite concerned if the annual interest payments on the U.S. pu
debt sharply increased as a percentage of GDP? LO4
11. Trace the cause-and-effect chain through which financing and refinancing of the public de
might affect real interest rates, private investment, the stock of capital, and economic gro
How might investment in public capital and complementarities between public capital and
private capital alter the outcome of the cause-effect chain? LO4
12. LAST WORD What do economists mean when they say Social Security and Medicare ar
pay-as-you-go plans? What are the Social Security and Medicare trust funds, and how l
will they have money left in them? What is the key long-run problem of both Social Secur
Medicare? Do you favor increasing taxes or do you prefer reducing benefits to fix the prob
1. Assume that a hypothetical economy with an MPC of .8 is
experiencing severe recession. By how much would government
spending have to rise to shift the aggregate demand curve rightward
by $25 billion? How large a tax cut would be needed to achieve the
same increase in aggregate demand? Determine one possible
combination of government spending increases and tax decreases
that would accomplish the same goal. LO1
2. Refer back to the table in Figure 12.7 in the previous chapter.
Suppose that aggregate demand increases such that the amount of
real output demanded rises by $7 billion at each price level. By what
percentage will the price level increase? Will this inflation be demandpull inflation or will it be cost-push inflation? If potential real GDP (that
is, full-employment GDP) is $510 billion, what will be the size of the
positive GDP gap after the change in aggregate demand? If
government wants to use fiscal policy to counter the resulting inflation
without changing tax rates, would it increase government spending or
decrease it? LO1
3. (For students who were assigned Chapter 11) Assume that, without
taxes, the consumption schedule for an economy is as shown below:
a. Graph this consumption schedule. What is the size of the
b. Assume that a lump-sum (regressive) tax of $10 billion is
imposed at all levels of GDP. Calculate the tax rate at each
level of GDP. Graph the resulting consumption schedule and
compare the MPC and the multiplier with those of the pretax
c. Now suppose a proportional tax with a 10 percent tax rate is
imposed instead of the regressive tax. Calculate and graph the
new consumption schedule and note the MPC and the
d. Finally, impose a progressive tax such that the tax rate is 0
percent when GDP is $100, 5 percent at $200, 10 percent at
$300, 15 percent at $400, and so forth. Determine and graph
the new consumption schedule, noting the effect of this tax
system on the MPC and the multiplier.
e. Use a graph similar to Figure 13.3 to show why proportional
and progressive taxes contribute to greater economic stability,
while a regressive tax does not.
4. Refer to the accompanying table for Waxwania: LO2, LO3
a. What is the marginal tax rate in Waxwania? The average tax
rate? Which of the following describes the tax system:
proportional, progressive, regressive?
b. Suppose Waxwania is producing $600 of real GDP, whereas
the potential real GDP (or full-employment real GDP) is $700.
How large is its budget deficit? Its cyclically adjusted budget
deficit? Its cyclically adjusted budget deficit as a percentage of
potential real GDP? Is Waxwania's fiscal policy expansionary
or is it contractionary?
5. Suppose that a country has no public debt in year 1 but experiences
a budget deficit of $40 billion in year 2, a budget deficit of $20 billion
in year 3, a budget surplus of $10 billion in year 3, and a budget
deficit of $2 billion in year 4. What is the absolute size of its public
debt in year 4? If its real GDP in year 4 is $104 billion, what is this
country's public debt as a percentage of real GDP in year 4? LO4
6. Suppose that the investment demand curve in a certain economy is
such that investment declines by $100 billion for every 1 percentage
point increase in the real interest rate. Also, suppose that the
investment demand curve shifts rightward by $150 billion at each real
interest rate for every 1 percentage point increase in the expected
rate of return from investment. If stimulus spending (an expansionary
fiscal policy) by government increases the real interest rate by 2
percentage points, but also raises the expected rate of return on
investment by 1 percentage point, how much investment, if any, will
be crowded out? LO4
FURTHER TEST YOUR KNOWLEDGE AT
At the text's Online Learning Center (OLC), www.mcconnell19e.com, you
will find one or more Web-based questions that require information from the
Internet to answer. We urge you to check them out; they will familiarize you
with Web sites that may be helpful in other courses and perhaps even in your
career. The OLC also features multiple-choice questions that give instant
feedback and provides other helpful ways to further test your knowledge of