Chapter 32 notes

Budget Surplus, Deficit

Budget balance= Tax revenues- outlays

balanced budget- revenues=outlay
budget surplus- revenues>outlay, balance is positive
budget deficit- revenues<outlay, balance is negative

The President and Congress make the budget and develop fiscal policy on a fixed annual time line.

Fiscal Year is a year that begins on October 1 and ends on September 30 of the next year.

Federal budget deficit is the amount of debt in a given year when government spending exceeds government revenue from taxes

Budget deficit for Fiscal year 2014 is $627b.

The amount of debt outstanding that arises from past budget deficits is called national debt.

Federal Government Revenue
Pay check(81%)
Personal income tax(41%)
Social Security tax(40%)

Federal Government Expenditures
Transfer(65%, 2,357b)
Social Security(20% 725b)
Medicare(24% $870b)
Transfer to persons(21% $761b)

Debt and Defense(26%)
National Defense and Homeland Security(20% $725b)
INterest on other national debt (6% $217b)

Other (9% $326b)

Budget Deficit
1. Debt deferred to the younger generation
2. $21,000 per household
3. HIgher taxes in the future
4. Cut in government investment and government services in the future
5. Crowding out effect of private consumption and investments
6. Wage wedge(lower) due to higher taxes in the future
7. Mortgaging our future to foreign countries
8. Weaker dollar: If a large budget deficit persists, debt increases, confidence in the value of money is eroded, and inflation erupts.
9. Lower standard of living

Social Security and Medicare Time Bomb
There are 77 million baby boomers in the US and the first of them started to collect SOcial Security pensions in 2008 and became eligible for Medicare in 2011.

By 2030, all baby boomers will be supported by SOcial Security and Medicare and benefit payments will have doubled.

The government's Social Security obligations are a debt. How big is this debt?
$91 trillion in 2012 and it grows by $3 trillion a year

The government has four alternatives:
Raise income taxes
Raise Social Security taxes
Cut Social Security benefits
Cut other federal government spending

To defuse the time bomb, income taxes would need to be raised by 69 percent or Social Security raised by 95 percent or Social Security benefits cut by 56 percent

Deficits crowd out private consumption and investment by $400 billion by increasing interest rates from 5% to 7%

Wages $35/hr
Wage $20/hr

A $10 tax wedge is created between the wage rate that firms pay ($30) and workers receive ($20) after the tax increase.

A $15 tax wedge is created between the wage rate the workers need to earn ($35) to keep the same standard of living after tax increase and how much workers receive ($20) after tax increase.

Fiscal Policy:
Changes in government spending
Changes in transfer payments
Changes in Taxes
To influence the real GDP (AD=C+I+G+XN) in the economy

Fiscal Policy can be 4 types:
Discretionary Fiscal Policy(changes in taxes and government spending)
-A fiscal policy action that is initiated by an act of Congress

Disadvantages of discretionary fiscal Policy
The use of discretionary fiscal policy is seriously hampered by four factors:
Law-making time lag
Shrinking area of law-maker discretion
Estimating potential GDP
Economic Forecasting

Automatic Fiscal policy and automatic stabilizers(increase in welfare, unemployment, disability benefits, transfer payments, reduced taxes)
-a fiscal policy action that is triggered by the state of the economy such as an increase in payments to the unemployed and a decrease in tax receipts triggered by recession. No congressional action is required.


Demand Side Effect

Supply Side Effect

Automatic Fiscal Policy
A fiscal policy action that is triggered by the state of the economy such as an increase in payments to the unemployed and a decrease in tax receipts triggered by recession. Does not require congressional approval.

Because government tax revenues fall and outlays increase in a recession, the budget provides automatic stimulus that helps to shrink the recessionary gap. Similarly, because tax revenues rise and outlays decrease in a boom, the budget provides an automatic restraint to shrink an inflationary gap.
1. Welfare
2. Unemployment insurance
3. Transfer payment (social security and disability
4. Ged G spending increases(recession) and decreases(inflation) based on business cycle

Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits- that vary with need and with the state of the economy.

Fiscal Stimulus
The government expenditure multiplier is the effect of a change in government expenditure on goods and services on aggregate demand.
The tax multiplier is the effect of a change in taxes on aggregate demand.
The magnitude of the tax multiplier is smaller than the government expenditure multiplier.

A successful Demand Side Fiscal Stimulus
If real GDP is below potential GDP, the government might pursue a fiscal stimulus by:
Increasing government expenditure on goods and services,
Increasing transfer payments
Cutting taxes, or
A combination of all three.

Fiscal Policy to combat recession using demand side solution
Aggregate Demand Curve shifts rightward from
1. Fiscal Policy
2. Recession
3. Increase G (government spending)
4. Decrease T (taxes)
5. both increase G and decrease T

Benefits
1. Real GDP from at Potential GDP
Fully Employed (13T)
Higher Multiplier effect
1-3 year recovery(Quick)

Cost:
Budget Deficit
Higher Prices(Inflation)

Fiscal Policy to combat inflation using demand side solution
1. Fiscal policy
2. Inflation
3. decrease G (government spending)
4. Increase T (taxes)
5. both decrease G and increase T

Side Fiscal policy and Supply side fiscal policy

Discretionary Fiscal Policy: Supply-Side Effects (Trickle-down Economics)
1. Tax policies that increase output
2. tax policies that decrease resource prices
3. Tax policies that favor businesses
4. Tax policies that favor investments rather than consumption
-Training Workers(tax cuts on training/education)
-Technological advances(tax cuts of R&D)
-Reduce government regulations on business(environment and labor)
-Tax cuts(incentive to work, save, and invest
-capital gains cut(reward risk)

Fiscal Policy to combat rescession using supply side solution
1. Tax policies that increase output
2. Tax policies that decrease resource prices
3. Tax policies that favor businesses

Benefit
1. Real GDP at potential GDP
Fully employed(13T)
2. Lower Prices
Cost:
1. Budget Deficit
2. Slower recovery in 3 to 6 years
3. multiplier effect slow

Supply-side effects and Demand side effects of fiscal policy on potential GDP.

Time: Supply-side effects operate more slowly(4-7 years) than the demand-side effects(1-3 years).
Inflation: You get full-employment with higher prices with demand-side expansionary fiscal policy.(Increase in budget deficit)
You get full employment with lower prices with supply-side expansionary fiscal policy.(Lower budget deficit)
Budget Deficit: You get full-employment with higher deficit using demand-side expansionary fiscal policy.
You get full-employment with lower deficit using supply-side expansionary fiscal policy.
Business cycle: Supply-side effects are often ignored in times of recession when the focus is on fiscal stimulus and restoring full employment(business pessimism). Demand side is used during server recession(trough), supply side is used during recovery and boom times(peak)

But in the long run, the supply-side effects of fiscal policy dominate and determine potential GDP.