1. Macro
ECON
McEachern 2010-
2011
CHAPTER
12
Designed by
Amy McGuire, B-books, Ltd.
Federal
Budgets and
Public Policy
Chapter 13 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1

2. The Federal Budget Process
 Federal budget
 Federal government – shifted focus
LO1
– Outlays
• Government purchases
• Transfer payments
– Revenues
– Specific period
– From national defense
– To redistribution
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3. Exhibit 1
LO1
Defense’s Share of Federal Outlays Declined
Since 1960 and Redistribution Increased
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4. LO1
Presidential and
Congressional Roles
 The President
– Budget proposal
• Budget request from each agency
• “The budget of U.S. government” to
Congress
– Council of Economic Advisors
• “Economic report of the President”
 House and Senate
– Budget committees: Budget resolution
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5. LO1
Presidential and
Congressional Roles
 Budget deficit: Outlays > Revenues
– Stimulates AD in short run
– Reduces national saving
– Long run: hinder economic growth
 Budget surplus: Revenues > Outlays
– Dampens AD in short run
– Boosts domestic saving
– Long run: promote economic growth
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6. LO1
Problems with
Federal Budget Process
 Continuing resolutions
– Instead of budget decisions
 Lengthy budget process
 Uncontrollable budget items
 No separate capital budget
 Overly detailed budget
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7. LO1
Possible Budget Reforms
 Biennial budget (two-year budget)
 Simplify the budget document
 Federal spending
– Capital budget
– Operating budget
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8.  Rationale for deficits
 Budget philosophies and deficits
LO2
Fiscal Impact of the
Federal Deficits
– Outlays that increase economy’s
productivity
– Annually balanced budget
– Cyclically balanced budget
– Functional finance
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9.  Federal deficits: since birth of the nation
LO2
Fiscal Impact of the
Federal Deficits
– 1789-1930
– Deficit: 33% of years (war)
– Since the Great Depression
– Deficit: 85% of years
– 1980s relatively large deficits
– Large tax cuts
– High defense spending
– 1990s: improved economy
– Decreasing deficits
– By 1998: surplus
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10.  Federal deficits: since birth of the nation
LO2
Fiscal Impact of the
Federal Deficits
– 2001 recession
– Tax cuts
– Higher federal spending
– Deficits
– Weak recovery
– War against terrorism
– 2003, deficit 3.5% of GDP
– 2007 stronger economy
– Rising stock market
– Deficit 1.2% of GDP
– 2009 deficit of $1.8 trillion projected
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11. LO2 Exhibit 2
After Decades of Federal Budget Deficits,
Surpluses Appeared from 1998 to 2001, But
Deficits Are Back
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12.  Why have deficits persisted?
LO2
Fiscal Impact of the
Federal Deficits
– Tax cuts
– Spending increase
– Federal officials
• Not required to balance the budget
– Elected officials
• Big spending programs
• Small taxes
• Pork-barrel spending
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13.  Increase federal deficits
LO2
Fiscal Impact of the
Federal Deficits
– National saving – reduced
– Interest rates – higher
– Investment
• Discouraged (crowding
out)
• Stimulated (crowding in)
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14. Crowding-Out Effect
 Crowding-out effect in an open economy:
Larger budget deficits and higher real interest
rates lead to an inflow of capital, appreciation
in the dollar, and a decline in net exports.
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15. Crowding-Out in an Open Economy
Increase in
budget
deficit
Higher
real
interest
rates
Decline in
private
investment
Inflow of financial
capital from abroad
Appreciation
of the dollar
Decline in
net exports
• An increase in government borrowing to finance an enlarged
budget deficit places upward pressure on real interest rates.
• This retards private investment and Aggregate Demand.
• In an open economy, high interest rates attract foreign capital.
• As foreigners buy more dollars to buy U.S. bonds and other
financial assets, the dollar appreciates.
• The appreciation of the dollar causes net exports to fall.
• Thus, the larger deficits and higher interest rates trigger
reductions in both private investment and net exports, which
limit the expansionary impact of a budget deficit.
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16. Conclusion of Crowding-Out
 2 factors: Private spending and attract inflow of
capital
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17.  The twin deficits
LO2
Fiscal Impact of the
Federal Deficits
– Finance huge deficits
• U.S. Treasury – sells IOUs
• High interest rates
• Greater demand for $
• U.S. trade deficit increase
• Foreigners buy U.S. assets
– Increase I
– Decline S
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18.  The short-lived budget surplus
LO2
Fiscal Impact of the
Federal Deficits
– Tax increases
– 1990, spending cuts
– Decrease deficits
– Slower growth in federal outlays
– 1990-2000 reduced U.S. military abroad
– Interest rates decreased
– A reversal of fortune in 2001
– Recession + Terrorist attacks
– Great federal spending
– 2002 federal deficit
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19. During the 1990s, Federal Outlays
Declined Relative to GDP and Revenues
Increased, Turning Deficits into Surpluses,
But Not for Long
LO2
Exhibit 3
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20. LO2
Case Study
Reforming Social Security and Medicare
 Social Security
 From: current workers,
employees
 To: current retirees (pensions)
 $1,000 per month
 Medicare
 From: payroll taxes
 To: short-term medical care
for the elderly
 $11,000 per beneficiary in 2007
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21. LO2
Case Study
Reforming Social Security and Medicare
 76 million baby boomers
 1940: 42 workers per retiree
 2007: 3.3 workers per retiree
 2030: 2.1 workers per retiree
 Reforms
 Increase taxes
 Reduce benefits
 Raise the eligibility age
 Smaller annual increases
 Reduce benefits to
wealthy retirees
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22. Government Outlays as a Percentage
of GDP Declined Between 1994 and 2008
in Most Major Economies
LO2
Exhibit 4
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23. The National Debt
LO3
 National debt
– Net accumulation of past deficits
 Measuring the national debt
– Gross debt
• U.S. Treasury notes – by federal
agencies
– Debt held by the public
• U.S. Treasury securities
– Households; Firms
– Banks (include the Fed)
– Foreign entities
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24. LO3 Exhibit 5
Federal Debt Held by the Public as a
Percentage of GDP Since 1940
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25. The National Debt
LO3
 International perspective on public
debt
– Different economies
• Different fiscal structures
– 40% of GDP
– Australia
• No debt
– Japan
• Debt: 88% of GDP
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26. Relative to GDP, U.S. Net Public Debt in 2008
Was LO Above Average for Major Economies 3
Exhibit 6
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27. The National Debt
LO3
 Interest on the national debt
– Buyers of federal securities
• Individuals, $25
• Institutions, $1 million
• Increasing interest rates
• 1 percentage point
increase in nominal
interest rate
– Interest cost increase $58
billion per year
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28. LO3 Exhibit 7
Interest Payments on Federal Debt Held by the Public
as a Percentage of Federal Outlays Peaked in 1996
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29. The National Debt
LO3
 Who bears the burden of debt?
– Billing future taxpayers
• For current spending
– We owe it to ourselves
• Future generations
– Service the debt
– Receive the payments
– Foreign ownership of debt
• Increase burden of debt
– Future generations of Americans
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30. Foreign Holders of U.S. Treasury
Securities
LO3
Exhibit 8
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31. The National Debt
LO3
 Crowding out and capital formation
– Deficit spending, long run
– Borrowed funds – invested in
public capital
• Increased productivity
• Increased standard of living
– Borrowed funds – current
expenditures
• Less capital formation
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32. The National Debt
LO3
 Intergenerational view of deficits and
debt
– Welfare of generations
• Tied together
– Parents now
• Consume less
• Save more
• Reduce the burden on next
generation
– Issues
• People with no children
• Informed of federal spending
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