Economics 302 Intermediate Macroeconomic Theory and Policyy Fall 2010 Prof Menzie Chinn Lecture 11 Wednesday October 13 2010 slide 0 Outline Government budgets Fluctuations in the deficit purchases transfers and taxes The effects of the government deficit The government and the IS curve slide 1 13 1 GOVERNMENT BUDGETS Because the United States has a federal system of government we need to distinguish between the different types of government federal state and local In 2003 2003 federal government purchases were 38 percent of total government purchases and state and local p purchases were 62 p percent slide 2 The Federal Government Budget and Deficit The federal government budget summarizes all three of the types of effects on aggregate demand purchases purchases transfers transfers and taxes taxes Purchases of goods and services and transfers are lumped together as government outlays slide 3 slide 4 State and Local Government Budgets A major development in the 1980s and 1990s was a shift in responsibility away from the federal government to the local level level especially state governments If this decentralization process continues continues state and local governments will play an increasingly important p role in the economyy in the future slide 5 13 2 FLUCTUATIONS IN THE DEFICIT PURCHASES TRANSFERS AND TAXES From the point of view of macroeconomic fluctuations what matters most about the government budget deficit is not its average level but the way the budget responds to conditions in the economy economy How large is this response How do the fluctuations in the government deficit compare with the fluctuations in the economy as a whole slide 6 Updated Figure 13 1 11 10 1 4 14 Unemployment rate left scale 1 6 9 1 8 8 2 0 7 2 2 6 2 4 2 4 5 2 6 Log Federal gov tt cons gov cons n n to GDP ratio left scale 4 3 70 75 80 85 90 95 2 8 3 0 00 Source BEA 2010Q2 2nd release and BLS September 2010 release 05 10 slide 7 1 000 1 000 800 Federal nondefense 600 400 Federal Defense cons n inv 200 0 70 75 80 85 GOV FEDDEF05 90 95 00 05 10 GOV FEDNDEF05 slide 8 Updated Figure 13 2 11 10 20 Unemployment rate left scale 18 Federal gov gov tt transfers to GDP right scale 9 8 16 14 7 12 6 10 5 08 08 4 06 3 04 70 75 80 85 90 95 00 05 10 slide 9 Updated Figure 13 3 11 10 22 Federal tax receipts social contrib to GDP right g scale Unemployment rate left scale 21 9 20 8 19 7 18 6 17 5 16 4 15 3 14 70 75 80 85 90 95 00 05 10slide 10 slide 11 13 2 FLUCTUATIONS IN THE DEFICIT PURCHASES TRANSFERS AND TAXES In Chapter 77 we wrote tax receipts T as a constant proportion of income Y T TA0 tY Where t is the constant tax rate It is incorrect to treat the tax rate t as a constant constant tax rate t actually falls when income Y falls and rises when income rises Note that the effect of such countercyclical movements in taxes and transfers is to reduce the multiplier of the IS LM model IS LM d l slide 12 13 3 THE EFFECTS OF THE GOVERNMENT DEFICIT Why is the government deficit so controversial and mysterious The deficit is just a summary statistic that reflects the behavior of many other variables The budget deficit is simply the difference between government expenditure purchases and transfers and receipts Deficits must be financed by issuing bonds or money to the pubic slide 13 Updated Figure 13 4 11 10 04 Federal budget surplus to GDP right scale Unemployment rate left scale 9 02 00 8 02 7 04 6 06 5 08 4 10 3 12 70 75 80 85 90 95 00 05 10 slide 14 Cyclical versus Structural Deficits The government budget deficit always goes deep in the red during recessions Expenditures rise and receipts fall during a recession Automatic stabilizers exacerbate the swing of the deficit during a recession slide 15 Cyclical versus Structural Deficits Economists have developed the concept of the full employment deficit to adjust for cyclical effects The full employment deficit is the deficit that would occur if the economy were at full employment The full full employment employment deficit takes out the cyclical effects on the deficit by estimating reaction functions for expenditures and receipts and calculating what expenditures and receipts would occur at potential GDP and full employment slide 16 Cyclical versus Structural Deficits The structural deficit is the same thing as the full employment deficit and the cyclical deficit is the difference between the actual deficit and the structural deficit slide 17 Have Deficits Been Related to Interest Rates in Recent U S History The relation between the deficit and interest p issues with rates is one of the most important respect to the government s role in aggregate demand slide 18 Have Deficits Been Related to Interest Rates in Recent U S History Over short run periods and for much of the last 40 years it appears that the real interest rate falls when the government budget goes into the red Deficits f do not appear to cause h high h reall interest rates Before jumping to conclusions conclusions recall the previous discussion which pointed to the cyclical behavior of the deficit slide 19 Updated Figure 13 5 08 Real interest rate 04 00 04 Federal budget surplus to GDP 08 08 12 12 70 75 80 85 90 95 00 05 Real interest rate 3 mo T bill minus lagged one year CPI inflation Sources BLS 10 slide 20 Have Deficits Been Related to Interest Rates in Recent U S History Evidence indicates a positive relation between the budget deficit and interest rates during the 1982 90 1982 90 period period Real interest rates were higher than normal rates and the budget g deficit reached a high water g mark as well Perhaps the very large deficits and prospects for future deficits raised interest rates rates But real interest rates fell in 1991 and 1992 even though deficits continued slide 21 Updated Figure 13 5 08 Reall interest R i t t rate 04 00 04 04 Cyclically adjusted b d t balance budget b l 08 08 Budget balance 12 12 70 75 80 85 90 95 00 05 Real interest rate 3 mo T bill minus lagged one year CPI inflation Sources Fed CBO 10 slide 22 When the government runs a deficit it must p borrow from the public Most of the debt consists of interest bearing bonds but part is non interest bearing bonds non interest bearing money slide 23 Updated Figure 13 6 9 000 9 000 Federal debt held by the public in billions left scale 8 000 7 000 7 000 6 000 60 55 55 50 Federal debt to GDP ratio right scale 5 000 5 000 65 65 45 45 4 000 40 3 000 3 000 35 35 2 000 30 1 000 1 000 …