The government budget balance

The government’s budget balance is the difference between the government’s revenues and its expenditures. A budget surplus occurs if government revenues exceed expenditures. A budget deficit occurs if government expenditures exceed revenues. The minus sign is often omitted when reporting a deficit. If the budget surplus equals zero, we say the government has a balanced budget.

The national debt

The national debt is the sum of all past federal deficits, minus any surpluses. The national debt is usually taken as a percentage of GDP. If the percentage is over 70-80, the government is said to be in trouble.

Key concepts

· A transfer payment is the provision of aid or money to an individual who is not required to provide anything in exchange.

· A budget surplus occurs if government revenues exceed expenditures.

· A budget deficit occurs if government expenditures exceed revenues.

· The government’s budget balance is the difference between the government’s revenues and its expenditures.

· The national debt is the sum of all past federal deficits minus any surpluses

 

 

Unit 7.2 The Use of Fiscal Policy to Stabilize the Economy

Learning objectives

1. Define automatic stabilizers and explain how they work.

2. Explain and illustrate graphically how discretionary fiscal policy works and compare the changes in aggregate demand that result from changes in government purchases, income taxes, and transfer payments.

Fiscal policy – the use of government expenditures and taxes to influence the level of economic activity – is the government counterpart to monetary policy. Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap.

Fiscal policy in practice

In the 1970s, there were campaigns for cutting government spending in many countries. The reason for it was that high levels of government spending were believed to exhaust resources that could be used productively in the private sector. Lower incentives to work were also believed to result from social security payments and unemployment benefits.

However, trends often change. Tax burden may be raised when governments need to reduce the budget deficit or cut spending, for example, to encourage private investment after recessions.

The spending, tax, and transfer policies of local, state, and federal agencies affect aggregate demand and aggregate supply and thus affect the level of real GDP and the price level. An expansionary policy tends to increase real GDP. Such a policy could be used to close a recessionary gap. A contractionary fiscal policy tends to reduce real GDP. A contractionary policy could be used to close an inflationary gap.

Government purchases of goods and services have a direct impact on aggregate demand. An increase in government purchases shifts the AD curve by the amount of the initial change in government purchases times the multiplier. Changes in personal income taxes or in the level of transfer payments affect disposable personal income. They change consumption, though initially by less than the amount of the change in taxes or transfers. They thus cause somewhat smaller shifts in the AD curve than do equal changes in government purchases.

There are several issues in the use of fiscal policies for stabilization purposes. They include lags associated with fiscal policy, crowding out, the choice of which fiscal policy tool to use, and the possible burdens of accumulating national debt.

Automatic Stabilizers

Certain government expenditure and taxation policies tend to insulate individuals from the impact of shocks to the economy. Transfer payments have this effect. Because more people become eligible for income supplements when income is falling, transfer payments reduce the effect of a change in real GDP on disposable personal income and thus help to insulate households from the impact of the change. Income taxes also have this effect. As incomes fall, people pay less in income taxes.

Any government program that tends to reduce fluctuations in GDP automatically is called an automatic stabilizer. Automatic stabilizers tend to increase GDP when it is falling and reduce GDP when it is rising.

To see how automatic stabilizers work, consider the decline in real GDP that occurred during the recession of 1990–1991. Real GDP fell 1.6%. The reduction in economic activity automatically reduced tax payments, reducing the impact of the downturn on disposable personal income. Furthermore, the reduction in incomes increased transfer payment spending, boosting disposable personal income further. Real disposable personal income thus fell by only 0.9% during the 2001 recession, a much smaller percentage than the reduction in real GDP. Rising transfer payments and falling tax collections helped cushion households from the impact of the recession and kept real GDP from falling as much as it would have otherwise.

Automatic stabilizers have emerged as key elements of fiscal policy. The advantage of automatic stabilizers is suggested by their name. As soon as income starts to change, they go to work. Because they affect disposable personal income directly, and because changes in disposable personal income are closely linked to changes in consumption, automatic stabilizers act swiftly to reduce the degree of changes in real GDP.

It is important to note that changes in expenditures and taxes that occur through automatic stabilizers do not shift the aggregate demand curve. Because they are automatic, their operation is already incorporated in the curve itself.