The Budget Balance

Receipts and outlays (percentage of GDP)

  • Government savings is defined by the following equation:

    • s Government T — G — TR

    • T: Tax Revenues

    • G: Government purchases of goods & services

    • TR: Government transfers

  • As a rule of thumb, expansionary fiscal policies server to reduce the budget balance (ie. decrease budget surplus or increases budget deficit)

    • increase government spending

    • decrease taxes

    • increase transfer payments

  • Generally, contractionary fiscal policies will increase the budget balance (ie. increase budget surplus or decrease budget deficit)

    • decrease government spending

    • increase taxes

    • decrease transfer payments

    25 • 15 • 1980 (a) Receipts 30 • 25 • 20 • 15 • 1980 Year (b)
Outlays Personal income taxes Corporate income taxes Social Security
taxes Indirect taxes 1985 Transfer payments Debt interest Expenditure
on goods and services 985 1990 2000 2005 2010 2010 2015 2015

Cyclically Adjusted Budget Balance

  • An estimate of what the budget balance would be if real GDP were exactly equal to potential output

  • Government tax revenue tends to rise and government transfers fall during economic expansions. Budget tend towards a surplus

  • Conversely, tax receipts decrease and government transfers increase during contractions. Budget tend towards a deficit

    Actual budget deficit, cyclically adjusted budget deficit (percent
of GDP) 8 6 4 2 -2 -4 Actual budget deficit Cyclically adjusted budget
deficit Year

Should the Budget Be Balanced

  • This is a normative question!

  • A balanced budget amendment nearly passed through Congress to be sent to the states for ratification in 1994, falling 4 votes short of the 2/3rd Senators necessary (63-67)

  • A good number of economists would argue against an amendment as that would restrict a country's ability to run a budget deficit during recessions. Recessions would be worsened!

  • However, when large deficits persist year after year, the national debt grows and grows and grows and grows…

  • The National Debt in February 2014 ~$17.3 trillion

Problems of a Rising Government Debt

  • "Crowding out" effect

  • When the government borrows funds in the financial markets, it competes with private firms and "crowds out" private spending by raising interests rates and reducing long-run economic growth

  • Today's deficits increase the public debt and so puts financial strains on future budgets

  • Like a consumer maxed out on credit cards, a government with rising amount of debt may eventually default on payment

  • In 2001, Argentia defaulted on its payments and caused havoc in the country's economy and a serve recession

  • So why not print money to pay off the debt??

  • Inflation!!!

    raises interest rote and crowds out investment 10 12 SIF 15 16
Increase in deficits 18 Loanable funds (trillions of 2005 dollars)
Figure I The global loanable funds market 7 out 0 1.5 PDIF 2.0 2.5
Borrowing from Of world shrinks Increase •n government deficit 3.0 3.5
Figure 2 The U.S. Loanable f•onds (trillions of 2005 dollars) loanable
funds market

Trends in Debt-GDP Ratio


  • During times of war, the US has trended towards runing a budget deficit

  • During World War II, the government ran up a huge deficit, and so the US Debt-GDP ratio was over 100% at its peak

  • In 2012, during "relative" peace, the US Total Debt-GDP ratio exceeded 100%

  • With projected budget deficits to continue, the debt will continue to get larger and larger

  • Some troubled countries in 2013

    • Greece 173% Debt-GDP ratio

    • Japan 140% Debt-GDP ratio

Implicit Liabilities

  • Spending promises made by the government but not included in the actual debt totals

  • Three largest implicit liabilities of the American Government

    • Social Security

    • Medicare

    • Medicaid

  • If included in the national debt, the $17.3 trillion figure (Feb 2014) would actually much higher

  • If the government prepared its financial reports the way private companies do, the net present value of all debt would be closer to $100 trillion!

    Spending (percent of GDP) 30% 20 10 1962 Medicare and Medicaid
Social Security Actual data 1980 2000 2008 2020 CBO projection 2040
2060 2083 Year

Practice Questions

  • Drawn an AD-AS graph an economy in a recession. What will happen if the government increase taxes and decreases spending to reduce the deficit and lower the national debt?


  • If government spending exceeds tax revenues which of the following is necessarily true?

    a. Positive budget balance

    b. Budget deficit

    c. Recession

    Answer: b

  • Which of the following fiscal policies is contractionary

    a. Increasing taxes by $100 billion and increasing spending by $100 billion

    b. Decreasing taxes by $100 billion and Decreasing spending by $100 billion

    c. Increasing taxes by $100 billion and decreasing spending by $100 billion

    d. Decreasing taxes by $100 billion and increasing spending by $100 billion

    e. None of the above

    Answer: c

  • Which of the following is reason to be concerned about perpetural beget deficits?

    a. Crowding out

    b. Government default

    c. The opportunity cost of future interest payments

    d. Higher interest rates leading to decrease long-run growth

    e. All the above

    Answer: e

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