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Economics: Theory Through Applications

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Chapter 29Balancing the Budget

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Learning Objectives

• What is the difference between the deficit and the debt?

• What are the links between the deficit and the debt?

• What are the budget constraints faced by the government?

• How does fiscal policy affect the budget deficit?

• How does the state of the economy affect the budget deficit?

• How do we determine if a budget deficit is because of fiscal policy or the state of the economy?

Learning Objectives

• When do countries run government budget deficits?

• Why might a country incur a government budget deficit?

• What is the crowding out effect?

• When is crowding out effect of government deficits large?

• What is the Ricardian theory about the effects of deficits on interest rates and real GDP?

• What is the evidence on the Ricardian theory?

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Budget Deficit: Definition

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government deficit outlays revenues government purchases

transfers tax revenues government purchases tax revenues transfers

government purchases net taxes

government surplus government deficit

Table 29.1 - Calculating the Deficit

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Figure 29.1 - The Government Sector in the Circular Flow

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Table 29.2 - Recent Experience of Deficits and Surpluses (Billions of Dollars)

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Table 29.3 - On-Budget, Off-Budget, and Total Surplus, 2010 (Billions of Dollars)

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Table 29.4 - Federal Outlays, 2010 (Billions of Dollars)

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The Intertemporal Government Budget Constraint

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current debt outstanding discounted present value of future primary surpluses

Linking the Debt and the Deficit

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change in government debt in given year deficit in given year

Table 29.5 - Deficit and Debt

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Figure 29.2 - US Surplus and Debt, 1962–2010

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Figure 29.3 - US Surplus and Debt as a Fraction of GDP, 1962–2010

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Table 29.6 - Foreign Holdings of U.S. Treasury Securities as of August 2008 (Billions of Dollars)

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Who Holds the Debt?

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borrowing from other countries imports exports trade deficit

Figure 29.4 - Government Spending

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Taxation

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net taxes tax rate income

Figure 29.5 - The Tax Function

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Table 29.7 - Tax Receipts and Income

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Table 29.8 - Deficit and Income

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Figure 29.6 - Government Spending and Tax Receipts

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Figure 29.7 - Deficit/Surplus and GDP

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Figure 29.8 - Expansionary Fiscal Policy

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Figure 29.9 - The Cyclically Adjusted Budget Deficit

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Figure 29.10 - Cyclical Deficit

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Figure 29.11 - Structural Deficit

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Figure 29.12 - Balanced-Budget Requirement

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Figure 29.13 – Recession with a Balanced-Budget Amendment

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Figure 29.14 - Ratio of US Debt to GDP, 1791–2004

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Table 29.9 - Budget Deficits Around the World, 2005*

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Figure 29.15 - The Financial Sector in the Circular Flow

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The Credit Market

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investment national savings borrowing from abroad

or

investment national savings lending to abroad

Figure 29.16 - The Credit Market

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Figure 29.17 - Crowding Out

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Crowding Out

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investment national savings borrowing from abroad

investment national saving trade deficit

Table 29.10 - Investment, Savings, and Net Exports (Billions of Dollars)

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The Household’s Lifetime Budget Constraint

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discounted present value present value of lifetime consumption

discounted present value of lifetime disposable income

total lifetime disposable income total lifetime consumption

Figure 29.18 - Ricardian Equivalence

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Figure 29.19 - U.S. Surplus/GDP Ratio and Real Interest Rate, 1965–2009

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Figure 29.20 - U.S. Government and Private Savings Rates

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Figure 29.21 - Government and Private Savings Rates in Spain and Greece

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Figure 29.22 - Government and Private Savings Rates in France and Ireland

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Key Terms

• Government deficit: The difference between government outlays and revenues

• Government outlays: Government outlays equal government purchases of goods and services plus transfers

• Government revenues: Money that flows into the government sector from households and firms, largely through taxation, is called government revenues

• Government purchases: Government purchases equals spending by the government on goods and services

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Key Terms

• Transfers: Transfers are cash payments from the government to individuals and firms

– Examples are unemployment insurance and Medicaid payments

• Government surplus: The government surplus is equal to total tax revenues collected by the governments less its purchases of goods and services and transfers to households

• Government budget constraint: The government budget constraint says that the deficit must be financed by issuing government debt

• Government debt: The stock of government debt is the total outstanding obligations of a government at a point in time 29-47

Key Terms

• Intertemporal budget constraint: According to the government’s intertemporal budget constraint, the discounted present value of outlays, excluding interest on the debt, minus the discounted present value of taxes must equal the current stock of debt outstanding

• Primary deficit: The primary deficit is the difference between government outlays excluding interest payments and government revenues

• Primary surplus: The primary surplus is the negative of the primary deficit

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Key Terms

• Fiscal policy: Fiscal policy refers to changes in taxation and the level of government purchases, typically under the control of a country’s lawmakers

• Exogenous variable: An exogenous variable is determined outside the model and is not explained in the analysis

• Expansionary fiscal policy: Increases in government purchases or reductions in tax rates are called expansionary fiscal policy

• Contractionary fiscal policy: Decreases in government purchases or increases in tax rates are called contractionary fiscal policy

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Key Terms

• Cyclically adjusted budget deficit: The cyclically adjusted budget deficit is the difference between outlays and revenues calculated under the assumption that the economy is operating at potential GDP

• Potential output: Potential output is the amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle

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Key Terms

• Cyclical deficit: A cyclical deficit occurs when a government budget is in deficit because of the low level of real GDP

• Standardized deficit: A standardized deficit occurs when a government budget is in deficit because of expansionary fiscal policy

• Tax smoothing: To reduce the distortionary effects of taxes, a government will finance some current spending by issuing debt to spread the tax burden over time

• Credit market: The credit market brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow 29-51

Key Terms

• Real interest rate: The rate of return specified in terms of goods not money

• National savings: The sum of private and government saving

• Crowding out: Crowding out occurs when an increase in the government deficit leads to an increase in the real interest rate and to a decrease in spending through reductions in investment and exports

• Appreciation: An appreciation is an increase in the price of a currency

• Ricardian equivalence: Ricardian equivalence occurs when a decrease in taxes leads to an equal increase in private saving and thus no change in either the real interest rate or investment

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Key Takeaways

• The deficit is the difference between government outlays and government revenues

– It is a flow

– The debt is a measure of the stock of outstanding obligations of the government at a point in time

• The change in the debt between two dates is equal to the deficit incured during the time between those two dates

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Key Takeaways

• The government faces a single-year constraint that its deficit must be financed by issuing new debt

– The government also faces an intertemport budget constraint that it debt at a point in time must equal the discounted present value of future primary surpluses

• At a given level of GDP, an expansionary fiscal policy will increase the budget deficit and a contractionary fiscal policy will decrease the budget deficit

• As the level of economic activity increases, tax revenues will increase, transfers will fall and the budget deficit will fall

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Key Takeaways

• By looking at the cyclically adjusted budget deficit, it is possible to evaluate how much of the budget deficit is due to the state of the economy and how much is due to the stance of fiscal policy

• Countries run government budget deficits when faced with large expenditures, such as a war

• By running a deficit, a government is able to spread distortionary taxes over time

– Also, a deficit allows a government to allocate tax obligations across generations of citizens who all benefit from some form of government spending

– Finally, stabilization policy often requires the government to run a deficit

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Key Takeaways

• Crowding out occurs when government deficits lead to higher real interest rates and lower investment

– The high interest rates can also cause the domestic currency to appreciate and exports to fall

• The crowding out effect is large when spending by households on durables and investment spending is sensitive to variations in the real interest rate and when exports are sensitive to changes in the exchange rate

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Key Takeaways

• According to Ricardian theory, a government deficit will be offset by an increase in household saving leaving real interest rates and the level of economic activity unchanged

– The key to the theory is the anticipation of households of future taxes when the government runs a deficit

• There is some evidence that interest rates are high when deficits are high, contrary to the prediction of the Ricardian view

– But, during some periods of large deficits, the household saving rate is high as well

– The evidence on Ricardian equivalence is not conclusive

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