The Government BudgetWhat are the sources of government revenue?How does the government allocate its revenue?What is the difference between deficit and debt?

Why does running a deficit matter?

Remember:

• The objective of macroeconomics is three-fold:– Price stability (control inflation)– Low unemployment– Economic growth

• In 2.4 and 2.5 we will investigate alternative government policies to affect AD/AS– Fiscal and monetary policy– The difference between demand- and supply-side

policies

Demand-side policy

• Demand-side or demand management policies are meant to change aggregate demand to achieve macroecon. goals– Based on idea that short-term business cycle flux is

due to consumers and producers causing inflation/deflationary gaps

• This is also known as discretionary policy, as it’s at the discretion (choice) of the gov’t – Two types: fiscal and monetary

• D-S policies try to counteract inflation/deflationary gaps, bring AD to full employment level of real GDP (potential GDP)

Government Budget

• To influence AD, gov’t must have a plan of revenues and expenditures

• The gov’t budget is exactly that: an outline or proposal of all gov’t spending, transfer payments, and tax revenues for the coming fiscal year—a chosen time period for this economic activity to occur (in the US, Oct. 1-Sept. 30)

• The composition and amount of spending is politically motivated, rather than what may be needed

• The budget is often considered part of a political agenda, as it reflects the goals of the dominant party in power

Sources of Revenue Expenditures

TAXES!-direct and indirect

Profits from state-owned businesses (Amtrak, electricity/utilities…)

Social welfare program contributions

Sales of state-owned businesses (privatization)

Defense

Social Security (not usually budgeted in US)

Infrastructure

Education

Public Works

Healthcare

Government expenditure (G)

• Current expenditures—day-to-day items (consumables) such as wages, supplies and equipment, social services

• Capital expenditures—investment in roads, bridges, infrastructure

• Transfer payments—payments to vulnerable groups for income distribution purposes (welfare, pension, social security)

Debt and deficit

• Balanced budget—when (tax) revenues are equal to expenditures in a fiscal year

• Deficit—when expenditures are larger than (tax) revenues in a fiscal year

• Surplus—when expenditures are smaller than (tax) revenues in a fiscal year

• Debt—accumulation of deficits (minus surpluses) over time

debt clock

Points to remember

In a balanced economy . . .

• Withdrawls = injections or S+T+M = I+G+X

Types of deficits:

• Trade deficit M > X

• Spending deficit G > T

Where do T and G come from?

T=taxes

G=government spending

Growth of National Debt as Percentage of GDP

Where does money come from when G>T?

Types of gov’t issued debt:

• T-Bills

• Treasury Notes

• Bonds

• US Savings Bonds

To whom is the money owed?To whom is the money owed?

Who Owns the National Debt? June 2009

Federal Reserve andIntragovernmental Holdings

Depository institutions

U.S. savings bonds

Private: Pension Funds

Private: State and localgovernments

Insurance companies

Mutual funds

State and local governments

Foreign and international

Other investors

Foreign Holders of the National Foreign Holders of the National DebtDebt

Historic National Debt adjusted Historic National Debt adjusted for inflationfor inflation

National Debt as a percentage of National Debt as a percentage of GDP, 2009GDP, 2009

Impact of the DebtShort-run impact, 5 years• With excess capacity (full

employment), less noticeable impact

Intermediate run, 5 - 15 years• G>T and growing

• Baby boomers retirement means increased demand on medicare and social security

• Less tax revenue, as boomers no longer working

• Falling savings rate• Boomers are drawing down on

their savings in 401k and other investment plans

• Falling Investment rate• Deficits = increased borrowing =

increased interest rates. This is called Crowding Out (next slide)

• In the short run, deficits can have two potentially damaging effects on the economy:

• If the economy is at full employment, a government deficit is inflationary, because the excess of government spending over government revenues adds to aggregate demand pressures in the economy.

• To the extent that federal deficits raise interest rates, they can retard growth in investment and housing activities, which are interest-sensitive.

“Crowding out” effect• Crowding out: increased public sector

spending (gov’t) replaces, or drives down, private sector spending

• Government must finance its spending with taxes and/or with deficit spending, leaving businesses with less money and effectively "crowding them out"

• One explanation: because the government borrows such large amounts of capital, its activities can increase interest rates.

• Higher interest rates discourages individuals/firms from borrowing money reduces spending and investment activities

Examples:

1. higher taxes required for government to fund social welfare programs leaves less discretionary income for individuals and businesses to make charitable donations.

2. When government funds certain activities there is little incentive for businesses and individuals to spend on those same things.

3. Increased government spending on Medicaid, which has been linked to decreased availability of private health insurance.

Impact of the Debt

Long run, More than 15 years• As debt grows, more interest

is owed relative to debt principle

• National savings rate will fall as more money goes to pay off interest, and less towards principle

• In the long run, deficits can be harmful if they add to the debt burden:

• Persistent deficits mean a rising national debt. If the national debt rises fast than GDP/GNP, then this can have serious negative ramifications for the future growth potential of the U.S.

• Moreover, if a large portion of the debt is held by other countries, then this means that foreigners have a large claim on U.S. resources.

Big Ideas

1. Deficits can rise not only because policy makers raise spending or lower taxes, but also when the economy is in a recession.

2. During recessions, unemployment benefits and welfare payments rise automatically while tax receipts drop. a. One way to separate the cyclical and

structural components of the deficit is to estimate what the deficit would be if the economy were operating at full employment.

Big Ideas

3. Government budgets should not necessarily be balanced at all times. Specifically, in a recession, balancing the budget means cutting spending and/or raising taxes—both of which have a contractionary effect on GDP/GNP.a. Nevertheless, in the long run the structural deficit (as measured

by the full-employment deficit, for example) should be close to zero

4. It is important to distinguish between balancing the budget and reducing the size of the government. A large government can have a balanced budget while a small government can run a large deficit.

Sources:

http://www.learner.org/series/econusa/unit24

https://sites.google.com/a/bvsd.org/paa-rogers/ib-economics

http://mysite.cherokee.k12.ga.us/personal/sean_sharrock/site/ECON%20WORKSHEETS/1/Fixing%20an%20Economy%20Fiscal%20and%20Monetary%20Worksheet.pdf