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Classical and Keynesian Analysis
DETERMINANTS AT A GLANCE
What causes the aggregate demand curve or
the aggregate supply curve to change (increase or decrease)?
Factors that Shift Aggregate
depends on consumer confidence and on the short-term
interest rate determined by the Fed via raising or lowering short-run
interest rates in the money market. The Fed controls the nation's AGGREGATE money
supply and increases or decreases the supply as needed to slow inflation
or promote economic growth.
levels depend on long-run interest rates
from the long-term capital market for loanable funds (loans >5
yrs). Businesses and individuals depend on such loans for the long-term
capital projects needed for economic growth.
-- deficit spending, tax cuts
for consumers, economic stimulus packages and etc -- can increase or
decrease the level of aggregate demand.
(NX) tend to be a negative value for the US due to our practice
of importing more products from, and exporting fewer products to, other
A change in any of these factors will cause
the aggregate demand schedule to change and aggregate demand to increase
Factors that Shift Aggregate Supply
Producer and Saver
Tax Policies --
Laffer’s Curve suggests that high taxes on producers and savers will kill the goose
that lays the golden egg and implies that tax cuts for this group will
result in a rightward shift of aggregate supply, raising all boats
and trickling down to benefit the rest of the economy through lower
inflation and higher GDP.
-- prices for any land, labor or capital resource --
count as costs to the economy. Higher costs will shift aggregate supply
to the left and, if sudden in nature, will cause stagflation. Lower
input costs (cheaper energy, cheaper labor, etc) will shift aggregate
supply to the right.
through adopting new technologies or education reform
will shift aggregate supply outward.
if rapidly increasing, can cause stagflation. Harnessing new and
cheaper energy sources shifts aggregate supply outward.
Number of Suppliers
-- More suppliers result in a robustly competitive
economy and shifts aggregate supply to the right. Few suppliers lead
to a highly concentrated economy consisting of relatively few very large
and powerful conglomerates, shifting aggregate supply leftward and causing
stagflation. You might remember that Adam Smith's invisible hand
is possible only in a competitive environment.
A change in any of these factors will cause
the aggregate supply schedule to change and aggregate supply to increase
Lower production costs lead to increased
supply at every price (supply increases, curve shifts to right).
Conversely, higher production costs
lead to decreased supply at every price (supply decreases, curve
shifts to left).
Acts of nature usually lead to decreased
supply (curve shifts to left).
Government policies can lead to either
increased or decreased supply … taxes will decrease supply, subsidies
will increase supply.
Technological changes usually lead to
increased supply (curve shifts to right).
I. The Classical Model: This model, which traces
its origins to the 1770s, was the first systematic attempt to explain the determinants
of the price level and the national levels of output, income, employment, consumption,
saving and investment.
Say’s Law: Supply creates its own demand, or desired
aggregate expenditures will equal actual aggregate expenditures. People only
produce more goods than they want because they want to trade them for other
goods. It follows that full employment of labor and other resources would be
the normal state of affairs in such economies.
Assumptions of the Classical Model: Supply creates
its own demand, or desired expenditures will equal actual expenditures.
Pure Competition Exists: No single buyer or
seller of a commodity or an input can affect its price.
Wages and Prices are Flexible: Prices, wages,
and interest rates are free to move to the level dictated by supply and
demand in the long-run.
People are Motivated by Self-Interest: There
is an underlying assumption that businesses want to maximize their profits
and households want to maximize their economic well-being.
People Cannot be Fooled by the Money Illusion:
Buyers and sellers react to changes in relative prices.
Equilibrium in the Credit Market: When income is
saved, it is not reflected in product demand. Consumption expenditures can fall
short of total output when saving occurs. The classical economists argued that
each dollar saved would be invested by businesses. In the credit market the
interest rate equates the quantity of credit demanded with the quantity of credit
supplied and thus planned investment equals planned saving. Saving represents
the supply of credit and investment represents the demand for credit.
Equilibrium in the Labor Market: In the Classical
Model if an excess quantity of labor is supplied at a particular wage level,
the wage level is too high and some workers are unemployed. By accepting lower
wages, unemployed workers will be put back to work. Only structural and frictional
unemployment will exist in this model, that is there is a natural rate of unemployment.
The Relationship Between Employment and Real
GDP: The level of employment in an economy determines, other things held
constant, that economy's real GDP.
Classical Theory, Vertical Aggregate Supply and
the Price Level: In the Classical Model long-term involuntary unemployment is
impossible. Say’s law, coupled with flexible interest rates, prices, and wages,
tends to keep workers fully employed so the aggregate supply curve (LRAS) is
vertical at full employment. Full employment is the amount of employment that
would be produced year in and year out in an economy with full information and
full adjustment of wages and prices.
The Effect of an Increase in Aggregate Demand
in the Classical Model: There will be an increase in the price level as
wages rise in response to an increase in the demand for labor which is at
full employment. Other input prices will also rise.
The Effect of a Decrease in Aggregate Demand
in the Classical Model: There will be a decrease in the price level as wages
fall in due to a decrease in the demand for labor which causes workers to
bid down wages in response to an increase in unemployment. Other input prices
II. Keynesian Economics and the Keynesian Short-Run
Aggregate Supply Curve: A horizontal short-run aggregate supply curve is called
the Keynesian short-run aggregate supply curve. According to Keynes, the existence
of unions and long-term contracts between workers and employers in and outside unionized
environments can explain downward inflexibility of nominal wage rates. Such “stickiness”
of wages makes involuntary unemployment of labor a possibility. Even in situations
of excess capacity and large amounts of unemployment, the price level may not fall.
There may be continuing unemployment and a reduction in the equilibrium level of
real GDP per year.
III. Output Determination Using Aggregate Demand-Aggregate
Supply: Fixed Versus Changing Price Levels in the Short-Run: An increase in
aggregate demand using the Keynesian SRAS curve results in real GDP increasing by
the amount of the increase in aggregate demand. When the price level can vary, i.e.
the SRAS curve is upward sloping, then real GDP increases by less than the increase
in aggregate demand because part of the increase in nominal GDP is a result of an
increase in the price level.
Reasons for Upward-Sloping Short-Run Aggregate
Flexibility of Hours and Work. Employers can
require workers to work more hours and work harder.
Existing Capital Can be Used More Intensively.
Profits Rise If Prices Go up but Wage Rates
do not. Firms will produce more as profit rise.
IV. Shifts in the Aggregate Supply Curve: There
is a core class of events that causes a shift in both the short-run and long run
aggregate supply curves.
Shifts in Both Short and Long Run Aggregate Supply:
Any change in the endowments of the factors of production, and any change in
the level of technology or knowledge shifts the aggregate supply curve.
Shifts in SRAS Only: The most obvious occurrence
that causes a shift in SRAS is a temporary change in input prices.
V. Consequences of Changes in Short-Run Aggregate
Demand: Aggregate demand shocks are any unanticipated shocks that cause the
aggregate demand curve to shift inward or outward. Aggregate supply shock are any
unanticipated shocks that cause the aggregate supply curve to shift inward or outward.
Effects When Aggregate Demand Falls While Aggregate
Supply is Stable: A decrease in AD will decrease the price level and real GDP.
If real GDP is less than full employment on LRAS, the difference between full
employment and actual real GDP is defined as a recessionary gap.
The Short-Run Effects When Aggregate Demand Increases:
The price level and real GDP increase. If real GDP is now greater than full
employment on LRAS, the difference between full employment and actual real GDP
is defined as an expansionary gap.
VI. Explaining Variations in Inflation—Demand-Pull
Demand-Pull Inflation: Inflation caused by increases
in AD that are not matched by increases in aggregate supply.
Cost-Push Inflation: Inflation caused by decreases
in short run aggregate supply.
VII. Aggregate Demand and Supply in an Open Economy:
The effect of exchange rates and trade with the rest of the world has an impact
on both the aggregate supply and the aggregate demand curves.
How a Weaker Dollar Affects Aggregate Supply: A
weaker dollar increases the dollar price of imported inputs and shifts the SRAS
to the left.
How a Weaker Dollar Affects Aggregate Demand: A
weaker dollar increases the dollar price of imports and decreases the price
of exports in terms of foreign currency. Thus US exports increase and imports
decrease, that is, net exports increase, and the aggregate demand curve shifts
to the left.
The Net Effect: An increase in aggregate demand
and a decrease in aggregate supply will have an indeterminate effect on real
GDP. If AD increases by more than SRAS decreases then real GDP will increase.
If AD increases by less than SRAS decreases then real GDP will decrease. What
is clear is that the price level will increase.
VIII. Some Simplifying Assumptions in a Keynesian
Model: (1) Businesses pay no indirect taxes, such as sales taxes. (2) Businesses
distribute all of their profits to shareholders. (3) There is no depreciation, or
capital consumption allowances, so gross private domestic investment equals net
investment. (4) The economy is closed. Given all these simplifying assumptions,
real disposable income will be equal to real national income minus taxes.
IX. Determinants of Planned Consumption and Planned
Saving: The consumption function shows the relationship between planned consumption
and various levels of disposable income. Real saving and consumption decisions depend
primarily on an individual’s current real disposable income.
Dissaving and Autonomous Consumption: The
amount of planned consumption that does not depend at all on disposable
income is called autonomous consumption. Dissaving is negative saving:
it is a situation where spending exceeds income. Dissaving can occur
when a household is able to borrow or use up existing owned assets.
Average Propensity to Consume and to Save:
Average Propensity to Consume (APC):
Consumption divided by disposable income; the proportion of total
disposable income that is consumed.
Average Propensity to Save (APS): Saving
divided by disposable income; the proportion of total disposable
income that is saved.
Marginal Propensity to Consume and to Save:
Marginal Propensity to Consume (MPC): The change
in consumption divided by the change in disposable income.
Marginal Propensity to Save (MPS): The change
in saving divided by the change in disposable income.
The Causes of Shifts in the Consumption Function:
Whenever there is a change in non-income determinants of consumption, the consumption
curve shifts upward or downward. A change in population up or down, a change
in expectations, or a change in real household wealth will cause the consumption
function to shift.
Saving Rate: Delayed Consumption from
Federal Reserve Bank of San Francisco
X. Determinants of Investment: Investment is
defined as expenditures on new plant, capital equipment, and changes in business
inventories. Real gross private domestic investment in the United States has been
volatile compared to real consumption, because investment decisions of business
people are based on highly variable, subjective expectations of the economic future.
The Planned Investment Function: At all times businesses
perceive an array of investment opportunities. Since each project is profitable
only if its rate of return exceeds the rate of interest; it follows that as
the interest rate falls, planned investment spending increases, and vice versa.
The investment function is represented as an inverse relationship between the
rate of interest and the quantity of planned investment.
What Causes the Investment Function to Shift: If
non-interest rate determinants of investment change, the investment schedule
will shift. Expectations of business people, changes in productive technology,
and changes in business taxes cause a shift in the investment function.
XI. Savings and Investment: Planned Versus Actual:
Equilibrium occurs at the intersection of the planned saving and planned investment
schedules. There is no tendency for businesses to alter the rate of production or
the level of employment because they are neither increasing nor decreasing their
inventories in an unplanned way. When the saving rate planned by households differs
from the investment rate planned by businesses, there will be an increase or decrease
in real GDP in the form of unplanned inventory changes. Real GDP and employment
will change until unplanned inventory changes are again zero.
XII. Keynesian Equilibrium with Government and the
Foreign Sector Added
Government: Resource-using federal, state, and
local government purchases are politically determined and can thus be considered
The Foreign Sector: The level of exports depends
on international economic conditions in the countries that buy US products.
Imports depend on economic conditions in the United States. The difference between
imports and exports is net exports.
XIII. The Multiplier: The multiplier is the
number by which a permanent change in autonomous spending such as autonomous investment
or autonomous consumption is multiplied to get the change in the equilibrium level
of real GDP. Any permanent increase in autonomous spending will cause a more than
proportional increase in real national income.
Putting Things in Context
Lessons from the Great Recession: Best and Worst
Monetary Policy of 2012
of Economic Thought
What Steps Can Be Taken to Increase Savings in the US?
Percent of Total Personal Consumption Spending
Where Does the Money Go?
100 Years of Consumer Spending
How Average Americans Spend Their Money
The Millennial Consumer
How the Great Recession Has Changed Life in America
XIV. Output Growth and the Long-Run Aggregate Supply
Curve: The total of all planned production for the entire economy is referred
to as the aggregate supply of real output.
Long-Run Aggregate Supply Curve: The long-run aggregate supply curve (LRAS)
is some amount of output of real goods and services in a world in which technology
is constant, the price level has not changed, labor productivity has not changed,
all resources are fully employed, and people have fully adjusted to all the
information they have. The curve is a vertical line relating full employment
real GDP to the price level.
Economic Growth and Long-Run Aggregate Supply:
Economic growth is shown by the LRAS curve shifting to the right over time.
A long-run growth path can be derived showing real GDP at full employment over
XV. Spending and Total Expenditures: The spending
decisions of individuals, firms, governments, and foreigners determine the total
value of nominal GDP. There are two issues that need to be addressed. The first
issue is, what determines the total amount that individuals, governments, businesses,
and foreigners want to spend? Second, what determines the equilibrium price level
and the rate of inflation? The total of all planned expenditures in the entire economy
is called aggregate demand.
XVI. Aggregate Demand: The aggregate
demand curve, AD, shows planned purchase rates for all goods and services in the
economy at various price levels, ceteris paribus.
Aggregate Demand Curve: The aggregate
demand curve shows planned purchase rates for all final goods and
services in the economy at various price levels, other things constant.
What Happens When the Price Level Rises?
The Real-Balance Effect: The change
in expenditures resulting from the real value of money balances
when the price level changes. A rise in the price level decreases
the real value of a given amount of money balances and planned
spending will decrease.
Interest Rate Effect: Higher prices
result in a rising interest rate. Households spend less on consumer
durables businesses spend less on capital investments, and the
aggregate quantity of goods and services demanded decreases.
The Open Economy Effect: Substitution
of Foreign Produced Goods: An increase in the price level in
the United States makes US goods relatively more expensive compared
with foreign produced goods. Planned purchases of domestically
produced goods will fall and planned purchases of foreign produced
goods (imports) will rise. Foreigners will no longer want to
purchase as much US production as before and US exports will
fall. The aggregate quantity of US produced goods and services
What Happens When the Price Level Falls:
There are the same three effects when the price level falls as when
it rises, they just have the reverse effect on the aggregate quantity
of goods and services demanded.
Demand for All Goods and Services Versus
Demand for a Single Good or Service: When the aggregate demand curve
is derived, the entire economic system is viewed. The aggregate
demand curve differs from an individual demand curve because it
shows the circular flow of income and product constructed as AD.
XVII. Shifts in the Aggregate Demand
Curve: When non-price level determinants of aggregate demand change,
a shift in the aggregate demand curve occurs. Any non-price-level change
that increases aggregate spending on domestic goods shifts AD to the
right. Any non-price-level change that decreases aggregate spending
on domestic goods shifts AD to the left.
XVIII. Long-Run Equilibrium and the Price Level:
Long-run equilibrium occurs at the intersection of the aggregate demand and the
long-run aggregate supply curve. At this point planned real expenditures for the
entire economy equal actual GDP produced by firms.
XIX. The Effects of Economic Growth on the Price
Level: If LRAS increased over time and aggregate demand stayed constant, the
price level would fall and there would be secular deflation. If aggregate demand
increased at the same rate as LRAS, the price level would remain constant.
XX. Causes of Inflation: Inflation rates in
the last 45 years have been positive but variable. Secular inflation rather than
secular deflation has been the problem.
Supply-Side Inflation?: Inflation could be caused
by a decrease in aggregate supply with a given aggregate demand curve. This
cannot be the explanation of inflation for the persistent or secular inflation,
because of the long-run increase in population, productivity, and real GDP,
i.e. the aggregate supply curve has shifted to the right.
Demand-Side Inflation: If the aggregate demand
curve shifts rightward over time at a pace faster than the rightward progression
of aggregate supply, then persistent or secular inflation will occur.
Test Yourself: Classical and Keynesian Analysis
Discretionary Fiscal Policy: The discretionary changing of government expenditures
and/or taxes in order to achieve national economic goals, such as high employment
with price stability. It is a deliberate attempt to cause the economy to move to
full employment and price stability more quickly than it otherwise might.
Changes in Government Spending:
When There is a Recessionary Gap: An expansionary
fiscal policy, which would cause the AD curve to shift to the right, is
required. By increasing government expenditures policy makers can shift
the aggregate demand curve to the right, and the price level and real GDP
will go up.
When There is an Inflationary Gap: A contractionary
fiscal policy, which would cause the AD curve to shift to the left, is required.
By decreasing government expenditures policy makers can shift the aggregate
demand curve to the left, the price level and real GDP will go down.
Changes in Taxes: Holding all other things constant,
a rise in taxes creates a reduction in AD for 1 of 3 reasons: it reduces (1)
consumption, (2) investment or (3) net exports.
When the Current Short-Run Equilibrium is Greater
than LRAS: An increase in taxes will cause AD to shift inward, real GDP
and the price level index falls.
When the Current Short-Run Equilibrium is Less
than LRAS: A decrease in taxes will cause AD to shift outward, real GDP
and the price level will rise.
Fiscal Policy and
Inflationary Fiscal Policy
FISCAL POLICY SOLUTION
MONETARY POLICY COMPLEMENT
a deep recessionary gap and high unemployment
and increase spending to rapidly increase AD
and real GDP.
higher interest rates, crowding out private investment, lower
net exports, even weaker AD
money supply to keep interest rates from rising.
Increase AD to
assist fiscal policy.
a mild recessionary gap and moderate unemployment
increase spending to gradually increase AD
and real GDP.
rising prices, mild crowding out, lower net exports, weakening
money supply to keep inflation from rising. Decrease AD, offsetting
rising interest rates
an inflationary gap
and/or decrease spending to rapidly
decrease AD and real GDP.
lower interest rates, crowding in private investment, higher
net exports, even stronger AD
money supply to keep interest rates from falling.
to assist fiscal policy.
II. Offsets to Fiscal Policy: Fiscal
policy does not operate in a vacuum so offsets can occur.
Indirect Crowding Out: An increase
in government spending without raising taxes creates additional
government borrowing from the private sector or from foreigners.
Induced Interest Rate Changes:
Deficit spending tends to crowd out private spending reducing
the positive effect of increased government spending on AD.
Planned investment and consumption in the private sector decrease
because of the rise in interest rates.
The Firm’s Investment Decision:
The rise in interest rates causes monthly loan payments to go
up and discourages some firms from making investments.
Planning for the Future: The Ricardian
Equivalence Theorem: The proposition that an increase in the government
budget deficit has no effect on aggregate demand. The idea is that
people’s horizons extend beyond this year, and they take into account
the effects of today’s government policies on the future. The Ricardian
equivalence theorem is the proposition that an increase in the budget
deficit has no effect on aggregate demand. If government spending
increases without increasing taxes (increased budget deficit), taxes
will have to be higher in the future and individual saving has to
take place now to be able to pay this future tax liability. In the
extreme case there is long-run no effect on AD.
Direct Expenditure Offsets: Actions
on the part of the private sector in spending income that offset
fiscal policy actions. Any increase in government spending that
competes with the private sector will have some offset effect.
The Extreme Case: In this case
the offset is dollar for dollar, so we merely end up with a
relabeling of spending from private to public. Aggregate demand
and GDP are unchanged.
The Less Extreme Case: To the extent
that there are some offsets to fiscal policy, predicted changes
in aggregate demand will be lessened and real output and the
price level will be less affected.
The Supply-Side Effects of Changes
in Taxes: Supply-side economics is the notion that creating incentives
for individuals and firms to increase productivity will cause the
aggregate supply curve to shift outward. Thus the government will
not necessarily lose tax revenues by lowering marginal tax rates.
The lower marginal rates will be applied to a growing tax base because
of economic growth.
III. Discretionary Fiscal Policy in
Practice: Coping with Time Lags: The political process of fiscal
policy and the various time lags involved in conducting fiscal policy
create problems of achieving the policy makers’ goals. A recognition
time lag is the time required to gather information about the current
state of the economy.
A decision-making time lag (associated with activist
policy) is the time needed to decide what to do once a
macroeconomic problem has been identified. An
action time lag is the time required between
recognizing an economic problem and putting policy into effect. The
action time lag is short for monetary policy but quite long for fiscal
policy, which requires congressional approval. The effect time lag
the time that elapses between the onset of policy and the results of
that policy. By the time a proposed change in fiscal policy works its
way through the system, it may no longer be applicable and may even
IV. Automatic Stabilizers: Types
of automatic (or nondiscretionary) fiscal policies which do not require
new legislation on the part of Congress which are provisions of the
tax laws and certain entitlement programs that cause changes in desired
The Tax System as an Automatic Stabilizer:
As taxable income rises, marginal tax rates rise. The progressive
nature of the personal and corporate income tax systems means that
when the economy expands, tax collections increase faster than income,
while during contractions, tax collections fall faster than income.
Unemployment Compensation and Welfare
Payments: As the economy contracts, unemployment compensation and
welfare payments rise. As the economy expands, unemployment compensation
and welfare payments fall. Disposable income does not fluctuate
by as much as does total income.
The Stabilizing Impact: The automatic
stabilizers mitigate undesirable changes in disposable income, consumption,
and the equilibrium level of national income. If disposable income
is not allowed to fall as far as it would during a recession, the
downturn will be moderated. If disposable income is not allowed
to rise as rapidly as it would during an expansion, the boom will
not get out of hand.
V. What Do We Really Know About Fiscal Policy?
Fiscal Policy During Normal Times: Discretionary
fiscal policy probably is not very effective at these times. Automatic stabilizers
are probably the most useful.
Fiscal Policy During Abnormal Times: Fiscal policy
can be important during these times. Consider some classic examples: the Great
Depression and periods of war.
The Great Depression: When there is a substantial
drop in GDP, such as in the Great Depression, fiscal policy can probably
stimulate aggregate demand. However, there was in fact very little stimulation
by government in the form of aggressive expansionary fiscal policy during
Wartime: War expenditures have little or no
direct expenditure offsets. So, war spending as part of expansionary fiscal
policy usually has significant effects.
The “Soothing” Effect of Keynesian Fiscal Policy:
The knowledge by consumers and investors that the federal government can use
fiscal policy to prevent another great depression may induce more buoyant and
stable expectations, thereby smoothing investment decisions.
Nation of Government Dependents
How Do the US, Switzerland and Sweden Spend Money?
Using the Cost-Benefit Principle
What is Fiscal Policy?
Government Spending: Measuring Federal Expenditures from the
Federal Reserve Bank of San Francisco
Economics Animation: Contractionary Fiscal Policy (1:22) (EA's other You
Tube titles are also good.)
Test Yourself: Fiscal Policy
I. Public Deficits and Debts: Flows Versus Stocks:
The deficit is the excess of
government spending over government revenues during a given period of
time. The deficit is financed by the US Treasury borrowing by selling
bonds to US and foreign households, businesses and governments.
A. Distinguishing Between
Deficits and Debts: The deficit is a flow
and is the negative difference between tax receipts and total federal
spending during a given time period. The federal government has
a balanced budget when revenues equal spending during a given period
Public Debt: The total accumulated public debt is a stock
measured at a given point in time. It increases when there is a
II. Government Finance: Spending More Than Tax Collections:
A. Historical Record of Federal Budget Deficits: Surpluses have
occurred in only 13 years since 1940. In the other years the federal
government has run deficits. The size of the real annual budget
deficit as a percent of GDP peaked during the Reagan Administration,
began rising during the first George W. Bush administration and
fell in fiscal 2005.
B. The Resurgence of Federal Budget Deficits: Between 2002 and 2004
federal spending increased faster than at any time since World War
II. In 2001 tax rates were reduced near the end of a recession that
reduced federal revenue for a time. When the economy began to grow
rapidly in 2003 revenues began to grow rapidly as well.
C. How did the US get $14.3 trillion in debt? And who are the creditors?
Click on the thumbnail to the right.
III. Evaluating the Rising Public Debt:
All federal government debt is the gross
public debt. The net public debt is the gross public debt minus the
debt held by government agencies.
IV. Accumulation of the Net Public Debt:
The US net public debt, as a percentage
of GDP, fell steadily from the end of World War II until the early 1970s
when it leveled off until the 1980s. It has risen since, except for
declining slightly in the period of budget surpluses from 1998–2001.
V. Annual Interest Payments on the National Debt:
Around 1975 interest payments on the
public debt as a percentage of GDP started rising dramatically and have
declined since. Today they are about 16 percent higher than they were
about a half a century ago. Foreigners currently own around 40 percent
of the US public debt.
Burdens of the Public Debt
1. How Today’s Budget Deficits Might
Burden Future Generations:
Future generations will have to be taxed to retire the higher
public debt resulting from the present generation’s increased
consumption of public goods.
2. The Crowding-Out Effect: In a full employment economy the
increased level of consumption by the present generation
crowds out investment and reduces the growth of capital
goods leaving them with a smaller capital stock and thereby
reducing their wealth. In this case future taxpayers will
have higher taxes.
3. Paying Off the Public Debt in the Future: If the debt had to be paid
off by raising taxes, what would mostly happen is that taxpayers would incur
higher tax liabilities while bondholders, who are also mostly US taxpayers
would get the money. As a generation US citizens would both pay higher taxes
and receive (most of) the money back.
4. Our Debt to Foreign Residents: The percentage of the US public debt owned
by foreigners is about 40 percent. If foreigners buy US government bonds,
we do not owe that debt to ourselves, and a potential burden on future generations
may result. If government expenditures financed by foreigners are made on
wasteful projects rather than on goods and services that increase productivity
and output, then a burden may be placed on future generations.
5. The Effect of Unemployment: If the economy is operating at a level substantially
below full-employment real GDP, crowding out need not take place. In such
a situation an expansionary fiscal policy via deficit spending can increase
current consumption (of governmentally provided goods) without crowding
B. Not All Borrowing is Bad: Increased public debt is not necessarily bad if
it creates a net investment for the future. Much of the analysis so far has
assumed that deficit spending increases the demand for credit, while the supply
of credit remains constant so interest rates rise and investment is crowded
VI. Federal Budget Deficits in an Open Economy:
There is a link between
US trade deficits and government budget deficits. By virtue of trade deficits, foreigners
have accumulated US dollars and purchased US assets.
A. Trade Deficits and Government Budget Deficits:
Larger trade deficits tend to accompany larger fiscal deficits.
B. Why the Two Deficits are Related: Part of
the money to finance the federal government deficit must come from abroad. When
the US runs large deficits, foreign dollar holders spend more on US government
securities, bonds, and less on US produced goods and services, our exports.
The effect is to
increase the trade deficit.
VII. Growing US Government Deficits: Implications
for US Economic Performance
A. Which Government deficit is
the “True Deficit?:
There is disagreement about how the deficit is measured. The problem has to
do with the use of measurements that minimize the reported deficit. The other
is that the government does not track its expenditures and receipts in a business-like
B. Capital Budgeting Theory:
Businesses, state and local governments have operating budgets that include
expenditures for current operations and capital budgets that include
expenditures on investment items. The federal government has only one
budget. The federal budget is a plan for federal government outlays and
revenues for a specified period, usually a year.
It has been recommended that Congress set up a capital budget, removing
investment outlays from its operating budget. Opponents say this would allow
the government to grow even faster since the operating budget, and its
deficit would be reduced and the pressure would be reduced on Congress to
curtail federal spending.
C. Pick a Deficit, Any Deficit: The government
figures can be used to report several different deficits. The problem is that
no one number gives a complete picture of how much the government is spending
over and above what it is receiving.
VIII. The Macroeconomic Consequences of Budget
Deficits: The effects
of deficits should be compared to the effects higher taxes to finance government
spending. In addition the effects of a deficit when the economy is at full employment
and when there is substantial unemployment.
A. Short-Run Macroeconomic Effects of Higher
Budget Deficits: If there is a recessionary gap, then deficits due to higher
government spending or lower taxes can increase aggregate demand and eliminate
the recessionary gap. If the economy is at full employment, the increase in
aggregate demand causes an inflationary gap with increased real GDP and inflation.
B. Long-Run Macroeconomic Effects of Higher Budget
Deficits: Increases in aggregate demand have no effect on real GDP. They only
cause inflation. An increase in government spending redistributes a larger share
of real GDP to government provided goods and services.
For a Different Viewpoint:
We Ignore the Debt at Our Peril
C. How Could the Government Reduce All Its Red
1. Increasing Taxes for Everyone: The office
of Budget and Management estimated the 2004 budget deficit at about $521
billion. To have eliminated the deficit by raising taxes, every worker in
the US would have had to pay $3,750 more in taxes.
2. Taxing the Rich: Currently 84% of federal
income taxes is paid by the top 25% of families. The bottom 50% of families
(below $60,000 per year) pay about 4% of federal income taxes. The top 5%
pay about 57% of income taxes and the richest 1% pay about 37% of all income
taxes paid. An increase in the top marginal tax rate from 35% to 45% will
raise about $30 billion in additional taxes. The data do not support the
notion that tax increases result in reduced deficits. Since World War II,
for every dollar increase in taxes legislated, federal spending has increased
3. Reducing Expenditures: Reduced spending
will reduce the deficit. Entitlements are legislated payments that anybody
who qualifies is entitled to receive. They are the most important component
of the federal budget today. Entitlements, such as welfare, Social Security,
Medicare, and Medicaid, change automatically without direct action by the
4. Is It Time to Start Whittling Away at
disburse money according to fixed formulas to citizens who fall into
designated categories. Because entitlements do not require annual
congressional appropriations, their cost tends to rise steadily.
Entitlement programs provide guaranteed benefits for those who qualify
under government transfer programs such as Social Security or Medicare.
In 1960, entitlements represented 10% of the federal budget. Today they
make up more than half. In the last two decades, real spending on
entitlements grew between 7% and 8% per year, while the economy grew by
less than 3% per year. Entitlement programs are believed to be
necessary, and it is difficult to cut government benefits once they are
the Federal Budget
Where the Current National Debt Comes From
US National Debt Clock
The Attack on Aggregate Demand: Get Ready for Austerity
We, the Economy Films: Chapter
3: What is the role of our government?
Why is our tax system so complicated? -- Can a cartoon conquer a challenge
like today’s tax system, with its ever-changing, 75,000 pages of laws? With
retro flair, "Taxation Nation" looks into how our tax system does – and doesn’t
Where do our tax dollars go? -- Uncle Sam takes a cut of our earnings every
April. But what does he spend our hard-earned money on? The answers will truly
surprise you in this vérité odyssey.
Why does the US fund foreign aid? -- The US spends approximately $37 billion
dollars a year on foreign aid - just under 1% of our federal budget. "The Foreign
Aid Paradox" zeroes in on food aid to Haiti and how it affects American farming
and shipping interests as well as Haiti’s own agricultural markets. The result:
a surprising study in unintended consequences.
Why do we have budget deficits and a national debt? -- In this free-wheeling
animated film, you’ll see how Congress and public officials use and manage debt,
and why it matters to you.
Test Yourself: Government Deficits