Economics 302Intermediate Macroeconomic Theory and Policyy(Fall 2010)Prof. Menzie ChinnLecture 11Wednesday, October 13, 2010slide 0slide 0OutlineOutline•Government budgets•Government budgets• Fluctuations in the deficit: purchases, transfers and tax esand tax es• The effects of the government deficit• The government and the IS curveslide 113.1 GOVERNMENT BUDGETS•Because the United States has a federalBecause the United States has a federal system of government, we need to distinguish between the different types of government:between the different types of government: federal, state, and local –In 2003 federal government purchases were 38–In 2003, federal government purchases were 38 percent of total government purchases, and state and local purchases were 62 percent.p pslide 2The Feder al Government Budget and DeficitDeficit•The federal government budget summarizesThe federal government budget summarizes all three of the types of eff ects on aggregate demand: purchases transfers and tax esdemand: purchases, transfers, and tax es.– Purchases of goods and services and transfers are lumped together as governmentoutlays.lumped together as government outlays.slide 3slide 4State and Local Government Budgets •A major development in the 1980s and 1990sA major development in the 1980s and 1990s was a shift in responsibility away from the federal government to the local levelfederal government to the local level, especially state governments. –If this decentralization process continues state–If this decentralization process continues, state and local governments will play an increasingly important role in the economy in the future. p yslide 513.2 FLUCTUATIONS IN THE DEFICIT: PURCHASES, TRANSFERS, AND TAXES •From the point of view of macroeconomicFrom the point of view of macroeconomic fluctuations, what matters most about the government budget deficit is not its averagegovernment budget deficit is not its average level, but the way the budget responds to conditions in the economyconditions in the economy. – How large is this response? How do the fluctuations in the government deficit–How do the fluctuations in the government deficit compar e with the fluctuations in the economy as a whole? slide 61114Updated Figure 13-11011-1.6-1.4Unemploymentrate [left scale]89-2.0-1.867-2 4-2.256-2.6-2.4Log Federalgov'tcons'n34-3.0-2.8707580859095000510govtconsnto GDP ratio[left scale]slide 7707580859095000510Source: BEA 2010Q2 2ndrelease, and BLS, September 2010 release10008001,000600Federalnondefense400Federalnondefense200FederalDefense(cons'n&inv.)070 75 80 85 90 95 00 05 10)slide 8GOV_FEDDEF05 GOV_FEDNDEF0511 .20Updated Figure 13-210 .18Federalgov'tUnemploymentrate [left scale]89.14.16Federalgovttransfers to GDP[right scale]78.12.145608.1045.06.08slide 93 .0470 75 80 85 90 95 00 05 1011 .22Updated Figure 13-310 .21Federal taxreceipts& social contrib. to GDP[right scale]Unemploymentrate [left scale]89.19.20[g]7 .1856.16.1745.15.16slide 103 .1470 75 80 85 90 95 00 05 10slide 1113.2 FLUCTUATIONS IN THE DEFICIT: PURCHASES, TRANSFERS, AND TAXES•In Chapter 7 we wrote tax receiptsTas a•In Chapter 7, we wrote tax receipts T as a constant proportion of income Y:T TA+tY–T = TA0+ tY– Where t is the constant tax rate. It is incorrect to treat the tax ratetas a constanttreat the tax rate t as a 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 ISLM dlslide 12IS‐LM model.13.3 THE EFFECTS OF THE GOVERNMENTDEFICITGOVERNMENT DEFICIT •Why is the government deficit so controversialWhy is the government deficit so controversial and mysterious?–The deficit is just a summary statistic that reflects–The deficit is just a summary statistic that reflects the behavior of many other variables.–The budget deficit is simply the differenceThe 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 1311 .04Updated Figure 13-410 .02Federal budgetsurplus to GDP[rightscale]Unemploymentrate [left scale]89-.02.00[rightscale]7 -.0456-.08-.064 -.10slide 143 -.1270 75 80 85 90 95 00 05 10Cyclical ver sus Structural Deficits •The government budget deficit always goesThe government budget deficit always goes deep in the red during recessions. –Expenditures rise and receipts fall during a–Expenditures rise and receipts fall during a recession. –Automatic stabilizers exacerbate the swing of theAutomatic stabilizers exacerbate the swing of the deficit during a recession.slide 15Cyclical ver sus Structural Deficits • Economists have developed the concept of the full‐employment deficit to adjust for cyclical eff ects.– The full‐employment deficit is the deficit that would occur if the economy were at full employment. The fullemployment deficit takes out the cyclical–The full‐employment deficit tak es out the cyclical eff ects on the deficit by estimating reaction functions for expenditures and receipts and ca lculating what expenditures and receipts would occur at potential GDP and full employment.slide 16Cyclical ver sus Structural Deficits •Thestructural deficitis the same thing as theThe structural deficit is the same thing as the full‐employment deficit, and the cyclical deficitis the difference between the