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ECO 204--Part Two Notes


Now that we have some understanding of basic macroeconomic variables, we begin to construct some ideas 
as to what determines their magnitude--and what forces govern the business cycle.  This is a technical 
part of the course and some relationships are certainly not intuitively clear.  You will not end up with 
definitive answers to macroeconomic issues, because there is not agreement among economists as to 
all causes and effects.  You will, however, have more insights than you do now--or at least I think so!


The business cycle  

An overview

Everyone has heard of the "great depression" which started in 1929 and lasted until at least 
1933.  The great depression embodies the worst part of what's called a business cycle.  
What was it like just prior to and during that great depression?

The roaring twenties were great!  The economy had eight years of prosperity.  
For the first time, many American households were able to buy automobiles and radios.  
They could afford to go to the movies.  They could afford the bootleggers! The 
stock market went up fourfold.  Then something went wrong. . .

Black Thursday

On October 24, 1929, the stock market crashed.  It was huge:

  • Rich people became poor.

  • Many lost their homes.

  • Others committed suicide.

  • Many farms folded.

  • Banks were closed in March, 1933 to stop the cash drain.

  • Real GDP declined 52.4 percent by 1933.

  • Unemployment went from 2 percent in early 1929 to nearly 25 percent in 1933.

  • In 1938, there were still 20 percent unemployed.

Did the stock market crash cause the depression--or was it a symptom of underlying problems.  
Why have we never had another downturn that bad?  Will we sometime in the future?  
We now begin a tedious discussion to understand what this is all about.

Phases of the business cycle

Economic activity--income, employment etc--moves in an irregular cyclical fashion through time.
There are four phases of a business cycle, shown through time for real GDP, as follows:

Macroeconomics tries to understand the business cycle, and then use government policy to 
minimize problems resulting from the cycle.   There is nothing mystical or predetermined 
about the business cycle.  Anything that rises and falls through time can be called a cycle.
It is important to understand that business cycles are irregular and therefore cannot 
be predicted.

What is a recession?

The National Bureau of Economic Research (an independent organization) has been 
empowered to determine the beginning and end of recession.   They base their 
determination on a number of monthly indicators.  A common definition, often cited in
financial publications, is that a recession is when real GDP declines for two successive quarters.
If real GDP goes down in one calendar quarter, then up the next quarter, and then down the next 
quarter--that's not usually a recession.  One thing which confounds policy makers is that we're 
always in a recession long before we know it.  If a recession starts tomorrow, we would not 
know that for a number of months.  The last recession, according to the National Bureau,
started in March 2001 and ended in November, 2001.  There have been 13 recessions 
since the great depression in 1929. 

How long do recessions last?

Recessions have lasted from 6 to 16 months (not counting the great depression), with an 
average of about 10 months.  The last two recessions (1990-1991 and in mid 2001) both 
lasted 8 months, which is comparatively short in duration.

The average duration of a whole cycle--from trough to trough--is about 5 years.  On 
average, the expansion phase is about 4 times as long as the recession phase.

How severe have recessions been?

The severity of a recession refers to how steep the decline in real GDP was.  Since the 
early 1930s, the decrease in real GDP has ranged from 0.6 percent to 38.3 percent.  The 
38.3 percent was in 1945 and resulted from the decreased demand for war goods and the 
transition to peace time production.  The 2001 recession involved a decline in real GDP of
0.6 percent--a very mild recession. 

In the early 1980s there were two recessions.  A six month recession in 1980 involved 
a decline in real GDP of 8.7 percent.  Then in 1981-82 we had a recession lasting 16 
months with a decline of 12.3 percent.  That reinforces the fact that recessions 
are irregular in nature.

Recessions notwithstanding, the United States has had a long term annual growth rate in 
real GDP of 3.2 percent.

What's a "growth recession?"

A new term sprung up a few years ago, that being a "growth recession."  That is when the 
economy grows more than zero percent but less than the 3 percent long term average.   It's 
really an odd term!  If we grow only 2 percent, some call that a growth recession.  
Obviously, if the average GDP growth rate is 3 percent, we will grow 
faster than that in some years and slower in other years.  The out-of-office political party 
of course loves that term.  Another useless term is "mini-recession."  That term is used 
but it's not precisely defined.  Economists like to have precise definitions of economic phenomena!

What causes a recession?

We will spend a lot of time in subsequent classes trying to figure out what causes a recession, 
but we can make some preliminary observations to keep in mind as we proceed.  Here are 
some things that factor in to producing a recession:

The investment component of GDP is very unstable--far more than other components.  That's our first clue.
The demand for durable consumer goods is also unstable.  That's a second clue.
Foreign economic events can also contribute to recession--e.g. oil price hikes in the mid 1970s
Waves of optimism and pessimism can also contribute. Remember, economics is a study of human behavior.

Is there something missing from the above list?  Some think domestic political issues can 
cause recession.  Some think that the President of the United States or Congress can 
either cause (or cure) a recession.  I didn't put that on the list, because I don't think they 
can play a  major role in causing recession.  You will see why as we proceed in the course.


Is the macro economy inherently stable or unstable?

We begin by looking at a little history as to how economists have viewed the macro economy, in 
particular whether it is inherently stable or not.  We first look briefly at classical economists, 
those who wrote in the 19th and early 20th century.  Then we look at the "Keynesian revolution," 
occurring in the 1930s which differed sharply with the classicists.  From that we synthesize a 
modern approach to understanding the macro economy.

The classical economists

The picture above is that of Adam Smith who, in 1776, who wrote a famous book entitled 
An Enquiry into the Nature and Causes of the Wealth of Nations.  That book is regarded as 
the treatise that still underlies microeconomics. Smith, and his classical successors, largely 
believed the macro economy was inherently stable.  During Smith's time and much of the 19th 
century, there were not major macro calamities.  There were recessions and banking problems, 
but nothing like the 1930s.  Classicists thought that the economy would automatically self 
adjust to deviations from long term growth.

Why did they think it was inherently stable?  There are two reasons.  The first was a belief in 
flexible wages and prices
.   If a recession developed, producers would simply lower prices to 
clear out their inventories.  If, at the same time, unemployment rose workers would simply 
receive lower wages and that would get rid of unemployment.  Lower prices and lower wages 
would leave real income unchanged and the economy would return to normal.  A second reason,
stemming from the first, is  Say's Law.   J. B. Say, a French economist, postulated that 
supply creates its own demand.  Therefore everything produced would be sold. The minute 
I produce something, that gives rise to a demand for something else.  Therefore there 
could not be overproduction.  In the same way, all workers seeking employment would 
be hired.  These two factors led classicists to believe the economy would self correct 
to any undesired macro outcomes.  But then came the great depression--and the Keynesian 

The Keynesian revolution

John Maynard Keynes, a British economist, wrote a famous book in 1936 entitled The General 
Theory of Employment, Interest and Money
.  Note the date of the book.  It was composed 
during the great depression.  Keynes rejected the tenants of the classical economists and 
argued that the private sector is inherently unstable.  He argued that flexible wages and prices 
no longer existed and that Say's Law was naive.  Looking at the great depression, Keynes believed 
that government must intervene to improve macroeconomic outcomes.  (Oh--that picture above 
is Lord Keynes, duly knighted by the United Kingdom and therefore entitled to be called "Lord.")

Most contemporary economists-not all--believe there is some instability in the private sector 
and there is a need for public policy.  There is, however, considerable disagreement about 
unstable the private sector  is and how much and what kind of government policy is 
needed.  There are now some "modern classicists," who believe Keynes went overboard 
in his zealousness for government policy and that there is more inherent stability than 
Keynes and post Keynesians think.

Contemporary view of macro instability

We set up a simple framework for how economists now look at the macro economy.  First we ask 
about the nature of macroeconomic outcomes; then we offer a simple macro model; then we look 
at the kinds of macro failures; then we look at competing theories; and finally we try to make 
sense of it all!

Determinants of macroeconomic outcomes

We earlier identified the three chief macro variables that concern us:  income (or output), 
employment and the price level.

What are the forces that determine these variables?  Broadly, there are three sets of such forces:

Internal market forces--spending behavior, innovation, population, growth and 
anything else stemming from market activities.

External forces--wars, natural disasters, trade disruptions, etc

Government policy--government spending, tax policy, monetary policy and 
other policy actions.

A basic macroeconomic model: aggregate demand and aggregate supply

To see how these three forces work, we use a simple--but very powerful--aggregated demand 
and aggregate supply model.  This model parallels the microeconomic demand and supply model 
we used to look at individual goods and services.

Aggregate demand

An aggregate demand function looks at the total demand for all goods and services
expressed in dollars as a function of the price index (in this case the GDP deflator.  
Remember that?)  Total demand can be viewed as "output," or "real GDP."  
Aggregate demand (AD) slopes downward, as follows:

Why does AD slope downward?  Partially for the same reasons that the demand curve 
for an individual good or service slopes downward.  There are at least three other macro considerations
that explain the negative slope:

1.  Real balances effect.  This means simply that lower prices make each dollar of
income more valuable--you can buy more goods and services with a given income.  
A lower price level leads to larger "real" balances and therefore more spending. 
(Remember what we mean by "real" income, as opposed to nominal income.)

2.  Foreign trade effect.  Lower domestic prices mean that we will export more goods and services.  That also means more domestic output to satisfy foreigners' demands for our lower priced goods and services.

3.  Interest rate effect.  Lower price levels also lead to lower interest rates.  
(That may not be intuitively clear--but it will be later on.)  Lower interest rates encourage
both consumers and businesses to borrow more.  What do they do when they borrow
more?  They spend more on consumption and investment goods and that, too,
increases output.

Aggregate supply

Aggregate supply (AS) is the dollar amount of goods and services business firms product.  
It slopes upward because higher prices induce more output from suppliers.  Microeconomics 
spends time explaining why higher prices induce higher outputs, and we will not diverge 
into the details.  (Those who have taken microeconomics may remember that supply 
curves slope upward because marginal cost rises as output increases.  The same thing is 
true in the aggregate.  If you haven't had microeconomics, don't worry about it!)

Macroeconomic equilibrium

Guess what?  Equilibrium is where AD = AS, illustrated below:

Equilibrium output could not be at Y1 and P1 because AS would exceed AD and price would 
fall.  (All the lines aren't shown in the diagram, but it should be obvious.)  Likewise 
equilibrium output could not be at Y2 and P2 because AD would exceed AS and price 
would rise.  Equilibrium can only be at Ye and Pe.   Also note, as we did earlier in our 
review of micro demand and supply, what happens if demand or supply changes.  
An increase in AD (a shift to the right) will result in a higher price and a larger output.  
An increase in AS will result in a lower price and a larger output.  What happens if AD 
shifts to the left? What happens if AS shifts upward (or to the left)?  Make sure you 
understand these shifts.

What is a macroeconomic "failure?"

There are two types of macroeconomic failure that may give rise to government intervention:

1.  Undesirability

In the AD/AS model above, we described equilibrium output.  What if, however, that 
equilibrium does not provide full employment?  There is some level of output, given 
all prices and wages, which will ensure full employment of all resources.  Keynes 
pointed out that there is no guarantee that equilibrium and full employment will 
coincide.  If the full employment level is greater than the equilibrium level, we 
have a very undesirable outcome.  That's what Keynes saw and why he insisted 
on government intervention.  Classical economists never thought about possible 
differences between equilibrium and full employment outputs.

2.  Instability

Suppose, at some time, we do have equilibrium and full employment at the same 
output level.  Then suppose something happens that causes AD to fall and, consequently, 
equilibrium output also falls.  That is a recession and unemployment will occur.  If AS 
shifts to the left, that will also create recession and unemployment.  Keynes saw all 
kinds of things that could cause AD and/or AS to shift leading to instability 
and macroeconomic problems. 


Competing theories of instability

As noted earlier in the course, there is not agreement among economists as to what causes instability 
or what should be done about it.  At this point, we want to survey briefly the three major theories that have 
been advocated and tried by government policy makers since the beginning of the Keynesian revolution 
in the 1930s.  The major types are: Keynesian, monetary and supply side theories.

Keynesian theory

What kind of theory is it?  It's a demand side theory--problems and solutions come from the 
behavior of aggregate demand (AD).

What causes instability?  We've really already seen this.  Recessions come from declines in AD 
caused by consumer spending, business investment or government.

How is instability cured?  It's up to government through altering purchases, taxes and/or 
transfer payments.

Has it been tried historically?  Oh yes.  Its heyday was in the 1960s.  Subsequently it didn't 
work as well and became less popular with policy makers.  In the 1970s, we had both 
unemployment and inflation.  That's called stagflation.  You don't get stagflation by 
shifts in the AD curve.

Monetary theory

What kind of theory is it?  It's also a demand side theory.  Problems come from AD but for 
much different reasons than Keynesian theory.

What causes instability?  The amount of money in circulation and the amount of borrowing in 
the economy must be appropriate to ensure neither recession nor inflation.  Instability comes 
from inappropriate policies undertaken by the Federal Reserve System, the nation's central 
bank, which can adversely affect AD.

How is instability cured?  That's easy.  If the Federal Reserve System causes problems, 
only the Federal Reserve can fix them.  The Federal Reserve has a number of powers it can 
use to control money and credit.

Has it been tried historically?  Monetary policy had its big heyday in the 1970s when the 
Federal Reserve tried many policy actions recommended by proponents of the importance 
of money and credit.  It hasn't worked as well since then, although money and credit still have 
an important effect on inflation--as we will see later.

Supply side theory

What kind of theory is it?  As its name implies, and different from the first two, it's a supply 
side theory.  Shifts in AS cause problems and policies affecting AS will cure them.

What causes instability?  When aggregate supply shifts to the left, the result is both inflation 
and a smaller output--stagflation.  (That's very different from AD shifting to the left.)

How is instability cured?  The key is to shift AS back to the right and that's done with 
incentives for business to produce more--e.g., tax cuts, deregulation and government 
support of research and development.

Has it been tried historically?  Yes.  The tax cuts of the 1980s were supply side policies.  
"Reaganomics," a term applied to President Reagan's economic policies, is really supply side stuff.

As noted, all of these have been used and it may be that some are appropriate to different times and 
different economic conditions.  We will see more about how each works after we have acquired some 
technical information about how the macro economy operates.

Aggregate spending  

We begin now a technical and detailed examination of consumption, then investment--the principal 
components of aggregate demand and output. 


Consumption (as defined earlier) depends on disposable income (as also defined earlier).  
Consumers can do only two things with disposable income--either spend it on consumption  
or don't spend it on consumption. That portion which is not spent on consumption is 
defined as saving.  So saving would include buying a stock or a bond, paying into a 
retirement plan--or anything else that is not consumption.  Hence a simple 
relationship results:

YD = C + S

where YD is disposable income, C is consumption and S is saving.

Keynes was interested in how consumers split their disposable income between consumption 
and saving.  He was interested in the proportion of their total income spent on C and S and, 
more importantly, was interested in how much of a change in income would be spent on C and 
how much on S.  This gives rise to several new definitions:

Average propensity to consume (APC) = C/YD.  This is simply the proportion of total 
disposable income spent on consumption, and is typically something over .95 in the 
United States.

Average propensity to save (APS) = S/YD.  This is the proportion of total disposable 
income spent on saving.

It follows, since all income is either consumed or saved, that:

APC +APS = 1

Marginal propensity to consume (MPC) = DC/DYD.This is the proportion of a change 
in income consumed.  If income changes by $100 billion and, as a result, people 
spend $90 billion of the additional income on consumption, then the MPC is .90.

Marginal propensity to save (MPS) = DS/DYD.  Using the same illustration, if income changes 
by $100 billion and people save $10 billion of the additional income, then the MPS = .1

                Obviously then, MPC + MPS = 1

The consumption function

Now we want to study the consumption function, by which we mean exactly how 
consumption is related to disposable income.  The proposition appears simple 
enough--as disposable income increases, so does consumption--but consumption 
does not rise as rapidly as disposable income.  Consider the following simplified table:

Disposable income Consumption
$   0 $  50
  100   125
  200   200
  300   275
  400   350
  500   425

Notice that at an income of 200, consumption and disposable income are equal.  At that 
point the APC = 1.  Notice that there is a $50 expenditure on consumption at $0 
disposable income.   Let's draw a picture of the above, adding a 45 degree line as 
a reference point:

There are several important things about this diagram:

  • The $50 expenditure at zero income can be viewed simply as the intercept
    of the consumption function.  It can also be viewed as the amount of
    consumption which is independent of the level of income.  Disposable
    income isn't the only determinant, so the $50 captures other determinants.
    That's often called "autonomous" consumption, which means "independent."

  • The 45 degree line shows points where C and YD would be equal.  In fact 
    C and YD are equal only at one point, that being where both equal $200.  
    It's also a visual aid to help see that, as income rises, consumption 
    rises--but not as rapidly.

  • Look at the point where YD equals $400.  Consumption at that level of income
    is $350.  What's the remaining $50?  That's saving.  Remember the definition?

  • The marginal propensity to consume is .75 at all levels of disposable income.
    (See the table above.)  It is the slope of the consumption line and, as long as
    consumption is a straight line, the slope will be constant.

  • The average propensity to consume falls as disposable income rises.  Confirm
    that by calculating it from the table.

The consumption function can also be stated algebraically as:  C = a + bYD, where C is 
consumption, a is the intercept (or autonomous consumption), b is the marginal 
propensity to consume and YD is disposable income.

Autonomous consumption, as noted above, reflects other things bearing on consumption.  
These include wealth, credit conditions, price expectations and others.  The contention 
is that disposable income is the major determinant of consumption.

Changes in consumption

Although consumption is relatively stable, it can shift--as with other economic 
variables.  If autonomous consumption increased from $50 to $100 in the above 
example, the consumption function would shift upward.  If this happened, the 
aggregate demand curve would then shift to the right.

The savings function

This is easy.  We can derive a savings function simply by subtracting consumption from 
disposable income in the above table and diagram.  Using the same data as above, a graph 
of the savings function would then look like this:

Notice how this fits with the consumption diagram above.   Where disposable income is 
$400, saving is $50.  Where disposable income is $200, saving is zero.  At income less 
than $200, saving is negative.  Also note that if consumption increased, the savings 
function would shift downward.  Draw that to make sure you comprehend it.


We have spent time characterizing consumption and now we move to characterizing investment, another 
major component of aggregate demand.  This, in turn, will permit us to explore another way of explaining 
equilibrium income and examine some interesting features of equilibrium.


Remember our definition of investment.  It is what business firms spend for capital assets.  Also 
remember our earlier observation that investment is very volatile--the most unstable component 
of output.

What determines investment?

The chief determinant of investment is expected profitability.  The reason a business 
firm purchases a capital asset is because they expect it to ultimately enhance profits.  (If they 
didn't expect that, they wouldn't buy it, would they?)  A firm's investment decision is always 
based on the firm's expectation of the future.  That expectation may not always turn out to 
be correct, but it's the expectation that determines the decision.  Expectations, in turn, 
can be influenced by almost anything.  That's why investment is such a volatile component 
of output.

There are at least two other important determinants.  One is interest rates.  (This is explored in 
more depth in microeconomics, but it's an easy concept.)  Investment and interest rates are 
inversely related.  If interest rates fall, it is cheaper for firms to acquire the money needed 
to finance a capital equipment purchase and therefore they will purchase more equipment--
ceteris paribus
, of course.  A third determinant is technology.  Technology improvements 
lead businesses to acquire more capital equipment for fairly obvious reasons.

Note that investment does not depend on current income, as consumption did.  For that 
reason investment is typically regarded as autonomous with respect to income and is graphed 
as a horizontal line.  If, at some point in time, investment is $50 (gazillion or whatever), 
the graph looks like this:

(If income is rising, however, that may make businesses formulate more optimistic 
expectations about the future.  For that reason, investment is sometimes drawn with 
an upward slope.)

Equilibrium income

C + I

There are several different ways of explaining equilibrium income or output.  Earlier we 
demonstrated how aggregate demand and aggregate supply explain equilibrium output in 
terms.  A second way is to use income components--consumption and investment.  
(We omit government and the foreign sectors for now.)  Using this approach we explain 
equilibrium income  measured in nominal (or current), not real, dollars.  (If we are talking about 
a very short run, or a period in which there is no inflation, there is not a significant 
difference between current and real dollars.)  Equilibrium is achieved where 
everything being produced is being sold.  It's the "at rest" position which, once achieved, 
will be sustained--until, of course, some parameter changes and the equilibrium 
position changes.

Following that definition, equilibrium would be achieved if total consumption plus 
investment expenditures are equal to total income.  Look at the following diagram,
where income (output) is in NOMINAL terms:

The diagram shows consumption (C), as earlier.  The autonomous amount of investment is 
added to the C line to give a C + I line.  Equilibrium is where the C + I line crosses the 45 
degree line, at an income (or output) of YE.  That's where all of disposable income is spent 
on consumption plus investment goods.  Why couldn't equilibrium be greater than YE?  If so, 
total expenditure on C + I would be less than output, so output would subsequently fall back 
to the equilibrium level.

S = I

Still another approach is that equilibrium is where saving equals investment (again, omitting 
government and the foreign sectors).  This condition is true by definition.  Remember how we 
defined income?  One way is that Y = C + S.  Another is that Y = C + I.  If these are both true, 
then C + S = C + I and, subtracting C from both sides, S = I.  This approach to equilibrium is 
also described using nominal income.

The equilibrium income is the same magnitude as in the earlier C + I diagram.  If income 
was higher than YE in the above diagram, producers would be producing more consumption 
goods than consumers are willing to purchase and that would reduce income back to the 
equilibrium level.

Changes in equilibrium output

It is very important to learn to determine how various changes will affect equilibrium conditions, 
as we did with our review of microeconomic equilibrium conditions.  Let's consider three examples 
of such changes.

1.  Business firms become more pessimistic about the future.

What happens?  The investment function will shift downward.  Let's show this using 
the C+ I equilibrium condition, the I = S equilibrium condition and the AD = AS 
equilibrium.  Look carefully at each of the diagrams below.

In the first two, Y is in NOMINAL terms.   In the third diagram, Y is in REAL terms.

The conclusion--equilibrium output falls and the equilibrium price level falls.

2.  The average propensity to save falls.

That's the same thing as saying the average propensity to consume increases.  That shifts consumption upward.  Equilibrium income will now be higher--the opposite from the 
case above.  The equilibrium price level will also be higher.  Draw these diagrams on 
your own to make sure you understand what's happening.

3.  Interest rates fall.

Think carefully.  What was the connection between interest rates and investment?  
Lower rates lead to higher investment in capital goods by business firms.  With higher investment, equilibrium Y and P both increase. Work through that one too.  (Lower 
rates might also induce consumers to borrow and spend more on consumption 
which would further increase equilibrium Y and P.)

The paradox of thrift

Here is a curious outcome that stems from our analysis of equilibrium.  Suppose the economy expects 
that a recession is going to develop in the near future.  Some will worry that they may become 
unemployed as the recession develops.  What's a logical think for someone worried about loosing 
their job to do?  The answer is to increase their saving (and reduce their consumption) as a hedge 
against job loss.  What if this happens in many households throughout the economy?  The increase 
in saving will reduce income and a lower income results in less saving.  The paradox is that an 
increased desire to save more might actually lead to less saving.  This is most dramatically shown by 
using an upward sloping investment curve, as mentioned earlier.  Here's what it looks like:

The initial savings function is S1 and the initial equilibrium is at Y1.  Then as people desire to 
save more the savings functions shifts upward to S2.  That produces a new equilibrium at Y2  
which is obviously a lower level of income.  Note that initially the dollar amount of saving is 
shown by S1 on the horizontal axis.  The increased desire to save actually led to less saving 
shown by S2 on the horizontal axis.  That's a real paradox.  The paradox does not, however, 
imply that less (or zero) saving is a good idea in the long run.  
Saving must occur for capital formation to take place.

In the 1930s (during the great depression), Lord Keynes was touring the United States.  He noted that many churches had signs outside saying "Jesus Saves."  Being aware of the paradox of thrift, and worried about the short term effects of increased saving, Keynes allegedly urged all clergy and politicians to change those signs to read "Jesus Consumes."


Answers to quiz #2--2/9/07--10:00 section

1.  false          6.   B
2.  true           7.   C
3.  C               8.   B
4.  A               9.   D
5.  E             10.   C

Answers to quiz #2--2/9/07--1:00 section

1   false         6.   A
2.  true          7.   D
3.  C              8.   B
4.  C              9.   E
5.  A            10.   B



The multiplier

Everyone knows how to multiply--or at least I think so.  But, in macroeconomics, the multiplier is 
not as simple as that.  It is, however, of great significance.  Here, in simple terms, it what it means in 

A shift in investment (or consumption) has a multiple effect 
on income.  If investment (or consumption) increases by, say, 
$50 billion then income will rise by
more than $50 billion. 
And if either investment or consumption decreases by,
say, $50 billion than income will fall by
more than  
$50 billion.

How can this be?  Suppose we have that mini-economy we've talked about before.  Suppose also 
that one of us spends $1000 on a new capital investment.  What happens?  The producer of 
that new capital investment receives an increase in her income of $1000.  What does she do 
with that increase in income?  If the MPC is .8, she will spend 80 percent of that increase 
on consumption goods.  Then someone else receives $800 as an increase in his income.  
He spends 80 percent of that on some other consumption goods, which increases someone 
else's income by $640.  This process keeps happening and, when it's all said and done, income 
for the whole mini-economy has increased by more than the initial $1000 increase in investment.

Here comes an important illustration.  Assume, for this illustration, three things:  (1) the MPC = .8 for 
everyone in our mini-economy; (2) investment in the initial period (year) is $100 and then rises to $200 
in the second period (year) and stays at $200 in subsequent periods; and (3) that changes in 
consumption lag changes in income by one period (year).  That last assumption is realistic.  When 
income changes, it takes some time for people to respond with an increase in consumption dictated 
by the marginal propensity to consume.

The illustration needs a careful explanation.   In period 1, consumption is $400 and investment is 
$100, so total income is $500.  (That look okay, so far?)  In period 2, investment rises to $200. 
Consumption doesn't change yet--because it takes a while for households to adjust to the increased 
income.  So in period 2, income is $600.  Watch carefully what happens in period 3.  Since income 
increased by $100 in period 2, consumption will increase by $80 in period 3.  (That's because the 
MPC of .8 determined that consumption would increase by $80 in period 3.)  Now income in 
period 3 is the $480 worth of consumption and $200 worth of investment, for a total income 
of $680.  One more step.  In period 4, consumption increases by $64 to a total of $544--because 
income increased by $80 in period 3.  So total income in period 4 is $744.  This process continues 
until the effect on consumption spins out.  What's the bottom line here?

Look!  Income eventually went from $500 to $1000.  That's an increase of $500.  And that all came from an increase in investment of $100.  So income went up by five times the amount of the initial increase in investment.  That's called the multiplier and it's defined as the change in income divided by the change in investment.  The multiplier is therefore equal to 5.

What determines the size of the multiplier?  It's the marginal propensity to consume.  If the MPC had 
been .9 instead of .8, the size of the multiplier would have been greater.  Here are two important 

The multiplier, as stated above, is equal to DY/DI.

The size of the multiplier is equal to 1/(1 MPC).

The assumed value of the MPC of .8 is why the value of the multiplier was 5.  Here's the complex arithmetic: 1/(1 - .8) = 1/(.2) = 5.   If the MPC was .9, the multiplier would be equal to 10.

Three other comments about the multiplier.  First, it works both for increases and decreases  
in investment.  Above I showed how an increase in investment will increase income with a 
multiplier of 5.  If I had shown a decrease in investment then income would fall with a multiplier of 5.  
Second, I illustrated this for an increase or decrease in investment.  If the consumption function shifts 
up or down, there will also be a multiplier effect.  Finally, the illustration produced a multiplier of 5.  
The full formula for the multiplier includes a lot of other behaviors, so a real life value of the multiplier 
is generally estimated at something between 2 and 2.5.

Recessionary gap

 A recessionary gap is, as its name implies, a condition which leads to recession.  It's a simple 
concept and occurs when full employment  exceeds equilibrium income.  Consider the following table, 
where income (or output) is expressed in current (or nominal) dollars:

Income Consumption Saving Investment
$400 $400 $0 $300
$800 $700 $100 $300
$1200 $1000 $200 $300
$1600 $1300 $300 $300
$2000 $1600 $400 $300

Note some characteristics of the table.  Equilibrium income is $1600; that's where saving 
and investment are equal.  Note also that the MPC is .75 and, therefore, the multiplier is 4.  
Now suppose that full employment income is $2000--full employment exceeds equilibrium by 
$400.  That means unemployment and recession--a recessionary "gap."

With a multiplier of 4, an increase in investment of $100  would elevate equilibrium to full 
employment.  Keynes argued that if some policy or event would just increase investment 
by $100, we would have equilibrium at full employment--the optimal outcome.

But, alas, Keynes did not really come to the right conclusion! If we look at the recessionary gap using 
the aggregate demand and aggregate supply model, we will see that a $100 increase in investment 
is not enough, because prices will rise.  Remember, Keynes did not look much at price level changes.  
Look at the following AD-AS model to see what happens when income is expressed in real terms and 
we take stock of price level changes:

Keynes said if you increase investment by $100, AD will shift from AD1 to AD2--a shift of $400.  
It will shift to the right by $400 because of the multiplier.  But equilibrium income will not  
increase by $400--because the price level increased.  As shown above by the vertical middle 
dotted line, income will increase but not by the whole amount needed to attain equilibrium at 
full employment.  And, as we will see, that partially complicates government policy designed 
to equate equilibrium and full employment income.  It is difficult to estimate how big a drag 
the increased price level is on equilibrium output.

Inflationary gap

An inflationary gap is where equilibrium income is (temporarily) above full employment.  
That can't persist because you can't produce more than full employment income.  Full 
employment is the economy's capacity at a given point in time.  In the diagram below, suppose 
we begin by assuming the economy is in equilibrium at full employment--the best of all worlds.  
Then suppose AD increases.  What happens?

Initially AD is shown by AD1 and equilibrium is where YE = YF, that is where equilibrium and 
full employment coincide.  The initial equilibrium price level is at P1.  Now suppose aggregate 
demand increases to AD2.  Income is supposed to rise to where AD2 is equal to AS.  But that's 
not possible--we can't produce above capacity.  That's why that intersection is labeled Yimpossible.  
So what happens?  Inflation results and the price level rises to P2.  That's inflation and that's 
another problem for government policy makers.


Government and equilibrium output

When we include government spending in our national income components, our models of 
equilibrium income must be revised so as to include the government sector.  In the aggregate 
demand--aggregate supply model, government expenditure is simply another component of 
aggregate demand.  So aggregate demand now consists of consumption plus investment 
plus government spending
.  The diagram doesn't look any different, but it is important to 
remember that government spending is now part of aggregate demand.

If we look at the approach where equilibrium output (in nominal terms) is where C + I 
crosses the 45 degree line, we have to add government to that as well.  Government 
spending is determined by the legislative branches of government and, like investment, is 
independent of the level of income.  (Many transfer payments do depend on current income but, 
remember, transfer payments aren't included in our measures of national income and output.)  
So now equilibrium is where C + I + G crosses the 45 degree line.  

Government policy


The basic rationale for government policy does come from Keynes (even though he didn't have 
it all together!)  Keynes, as noted earlier, wrote during the great depression and firmly 
believed that government had to intervene to ensure that equilibrium and full employment 
were the same.  That's called government fiscal policy and that's what we investigate next.

The role of fiscal policy was affirmed with the 1946 Employment Act which said, simply, 
that it was the duty of government to promote full employment.  In 1978 another act was 
passed, the Humphrey-Hawkins Act, which provided a goal of 3 percent unemployment, 
price stability and "reasonable" economic growth. 

How does government affect output?  Three ways:

Changes in government spending

Changes in taxes

Changes in transfer payments

How can government fight recession?

Increase spending

Obviously if government increases spending, aggregate demand shifts to the right 
and income will increase toward the level of full employment.  Look at the diagram 
below.  AD is initially at AD1 which shows equilibrium income as being $11trillion, while
full employment income is $12 trillion. 

Assume an MPC of .75 and a multiplier therefore of 4.  How much does government
have to increase spending so that equilibrium is at full employment.   Initially you might
conclude that government spending should increase by $0.25 trillion.  
With a multiplier of 4, that would shift AD1 to AD2  and we should end up at the 
$12 trillion level which is full employment.  That's not the case, however.  We will 
end up with equilibrium at point c, because the resulting increase in the price 
level would not allow the full effect.
  (The specific equilibrium at point c is not 
shown above, but obviously it's between $11 and $12 trillion.)  That was one 
error Keynes made, as noted earlier, in not paying attention to price increases.  
AD must shift to AD3 to obtain an equilibrium at the full employment level of 
$12 trillion.  So, even though Keynes was naive about price changes, increasing 
G will increase Y--maybe!  A little later we will examine other complications 
to this reasoning.

Reduce taxes

First we consider a tax cut for households.  A tax cut increases consumers' disposable 
income, which leads to higher consumption and a shift in AD.  Consumers, however, 
won't consume all of a tax cut; they will consume part of it and save part of it.  
Using the same data in the diagram above, what would happen if taxes were cut 
by $.25 trillion?  Consumption would increase by $.1875 trillion--because the MPC 
is .75.  Enter the multiplier and AD would shift to the right by $.75 trillion--
$.1875 trillion times the multiplier of 4.  Would that get to full employment?  
No.  AD must shift to AD3, as we saw above.  Notice also that a tax cut of 
$.25 trillion is not as powerful as a spending increase of $.25 trillion.

Tax cuts for businesses will typically increase investment because of higher after 
tax earnings.  This would also shift AD to the right and help bring about 
full employment.

Increase transfer payments

If government increases veterans' benefits or social security benefits or 
unemployment benefits (and so on), that will increase AD when the proceeds 
are spent.  Not all of the proceeds are consumed, however; some is saved.  
So the general effect is the same as for increasing government purchases 
and reducing taxes.

To fight inflation

What if the objective of government fiscal policy is to fight inflation?  The appropriate fiscal 
policies are essentially the oppose of the ones we just described to fight recession.  Suppose 
the economy has "too much" aggregate demand, causing prices to be higher than they would 
be at full employment?  Consider the following illustration:

Equilibrium is at $6.4 trillion, while full employment output is $6.0 trillion. As a result, prices 
are also higher at full employment, shown by PE.  To conquer the inflation, AD needs to shift from its 
initial equilibrium position of AD1 to AD2.  That would cause equilibrium and full employment 
income to coincide.  One way to battle inflation is to reduce government spending.  
How much?  The distance from AD1 to AD2 is $400 billion.  Assuming the multiplier is 4, 
reducing government spending by $100 billion would reduce AD by the necessary $400 billion.

Increasing taxes would also work, at least theoretically.  If taxes were increased on households, 
the tax increase would be "financed" partially with reduced consumption and partly with 
reduced saving.  If taxes were increased by $400b, AD would shift to the left by $300 billion.
So, again, tax changes are not quite as powerful (theoretically) as spending changes.  
Transfer payments could also be reduced but, given the nature of politics and entitlements, 
that isn't a likely policy to be tried.

The "balanced budget multiplier"

One more curious thing stems from the above considerations, that being the "balanced budget 
multiplier."   Suppose government wants to increase spending by $400 billion on some program 
and that, to pay for the program, taxes are also raised $400 billion.  This is politically popular, 
because politicians and others believe this has no effect on income or prices.  It's often touted 
as a pay-as-you-go program, and involves a balanced budget operation.  The "neutral" effect, 
however, is not so.  The program will increase both income and prices--because of differing 
multiplier effects.

Continuing to assume the MPC = .75 and a resulting multiplier of 4, the increased spending would 
by itself
increase income by $1600 billion.  What does the increase in taxes do?  That, taken 
by itself
, reduces income.  How much?  The tax increase of $400 x .75 (MPC) x 4 (the 
multiplier) = $1200 reduction in income.  The net effect is that income rises by $400 
billion--the amount of the spending and tax program.  Hence the balanced budget multiplier 
is one--income rises by the amount of the expenditure.  Because AD increased, there will 
also be an increase in the price level.

   Well--are you ready for lighter and more policy oriented stuff? Coming up next . . .



A critique of fiscal policy

We have now seen theoretically how fiscal policy is supposed to work.  Most of the theory is 
Keynesian (even though Keynes didn't pay much attention to the price level, as we have seen).  
But many economists are skeptical that it doesn't really work as the theory envisions.  
Let's see what the critics say and if we can formulate any conclusions about fiscal policy.

Changes in government spending

Suppose government wants to fight recession and unemployment.  That's simple 
enough, as we saw earlier.  Just increase spending to increase aggregate demand 
and income and thereby reduce unemployment.  But an important issue is this:

Does increased public spending lead to decreased private spending?

If government increases spending, and doesn't increase taxes. government has to 
borrow those funds from financial institutions, households or business firms.  That 
means less financing is available for private consumption and investment.  That means 
private consumption and investment will fall, which offsets the increase in income 
intended by the increase in government spending.  This effect is called "crowding out," 
and the question is how much crowding out occurs.  If crowding out was complete, 
the increased public spending would have no effect on anything.  Although opinions 
differ, the evidence suggests that the crowding out effect is real even if not complete.

(That's a government bureaucrat frustrated by crowding out!)

Another concern surrounding fiscal policy is the efficiency with which government conducts 
its business.  Through the years many have studied the wastes associated with government 
spending.  Even if increased spending doesn't involve much crowding out, those same funds 
would likely be more productive if spent in the private sector.  In the 1980s, President Reagan 
asked Peter Grace (a successful industrialist who was a democrat) to head a commission to 
recommend how to improve spending efficiency.  He came up with hundreds of suggestions--
e.g. reduce the number of military bases, reduce the number of government offices and quit 
sending social security checks to dead people. 

Related to that is what has come to be called the "content" issue.  Fiscal policy doesn't say 
anything about the kinds of spending that would be appropriate, i.e. the content of expenditure 
program.  Again, if there isn't much crowding out, fiscal policy might work even if you pay 
people to dig holes and then pay them to fill the holes back up again.  Government would do 
better to look at the benefits and costs of various programs instead of just rushing in to spend 
our way out of recession.

What about cutting expenditure to fight inflation?  Theoretically, as we saw above, that 
might work--but it isn't very realistic.  Government rarely, if ever, actually passes legislation 
to reduce expenditure.  For reasons we will see later, Federal Reserve policy is a better 
way to battle inflation.

Changes in taxes

Let's look first at the logic of tax increases to fight inflation.  Remember, the idea was 
to shift AD to the left and achieve equilibrium at full employment. That analysis hinged on 
the value of the MPC and the multiplier.  But there is another consideration.  Suppose 
households (and/or business firms) view the tax increase as temporary rather than 
permanent.  If it's temporary, people might respond by decreasing their saving by a large 
fraction of the tax increase and continue to consume at their same level.  If a tax cut was 
financed entirely by reduced saving--nothing would happen.  If there was zero effect on 
consumption, then there would be no change in AD.  In effect, the economy can veto the 
intended effect of the tax increase.

to the effects of a tax increase!

What if the tax hike is perceived as permanent?  It's more likely to be effective in fighting 
inflation as people would be more likely to reduce consumption over time.  But the 
whole idea of fiscal policy is to "fine tune"--raise taxes some times; lower them other times.

What about tax cuts to fight recession?  This looks like a more fruitful fiscal policy!  Tax cuts 
may stimulate spending by consumers.  Tax cuts for business firms are significant; taxes 
are very important in business' decisions about capital investment.  Once again a 
distinction is needed between tax changes perceived as temporary vs. those perceived 
as permanent.  A temporary tax cut may have some effect, especially on consumers.  
Temporary tax cuts for business, however, might not be effective since capital 
investment  decisions are made over longer horizons.  If, however, a tax cut is 
perceived as permanent that might really work.  The tax cuts in 1964, 1981 1986, 2001
and 2003 all were accompanied by increases in aggregate demand.  

There is another very significant issue about changing taxes, either increasing or 
decreasing them. When Congress (or state and local governments) change tax rates  
there may be an unintended effect on tax revenues.

 An increase in tax rates may not lead to an increase in tax revenues!  When tax rates were cut in 1964, tax revenues subsequently increased.  When a surtax was levied in 1969 (to help fight the Vietnam war), tax revenues fell.  In both tax rate cuts of the 1980s, revenue subsequently rose.  And when a modest tax rate increase was passed in 1990, tax revenues fell.  

An interesting question is what will happen to the tax cuts of 2001?  Government agencies are predicting that this will NOT increase revenues this time.  But already, tax revenues have been increasing more rapidly than anticipated.

How could this happen?  Incentives.  When tax rates are cut, it sometimes provides an 
incentive for expenditure which will increase income which increases tax revenues.  
When tax rates are increased, there are sometimes disincentives so that expenditure 
falls and tax revenues also fall.  It may not always happen that way, but it certainly 
has sometimes.  That further frustrates attempts to deploy tax changes to counter 
business cycles.  It is a very important point!

Changing transfer payments

As noted briefly above, government can also change transfer payments to fight 
recession or inflation.  Increasing transfer payments typically takes money from 
households with lower propensities to consume (more affluent households) and 
transfers it to households with higher propensities to consume (less affluent 
households).  That would increase the aggregate propensity to consume so that 
AD would shift to the right and income would rise.  This is not, however, likely 
to be of any great magnitude.  Congress doesn't really view transfer payments 
as a big weapon against adverse macroeconomic conditions.  And cutting transfer 
payments to fight inflation would be politically suicidal.

Automatic stabilizers

There is one other aspect of government fiscal policy and that are so-called "automatic stabilizers."  
These programs automatically stabilize by moving counter-cyclically.  There are two main ones, 
one on the expenditure side and one on the receipts side.

Unemployment compensation

Unemployment compensation is an expenditure program which provides cash payments 
to those who involuntarily lose their jobs.  When unemployment increases, unemployment 
compensation automatically increase.  It doesn't require any action by anyone--no 
Congressional intervention--and there is no time lag.  And these payments do have the 
effect of increasing consumption and therefore aggregate demand.

As worthwhile as the program may be for some, there are also some problems with 
the unemployment compensation program:

  • There may be adverse incentives for finding a job.  If money is still coming in
    from the program, some will not be inclined to look for work.

  • The program likely increases the duration of unemployment.  If people stay
    unemployed longer, that will increase the unemployment rate at any moment
    in time.

  • The payments are not related to the income of the recipients.  Some people
    may have annual incomes of, say, $50,000 and then lose their jobs.  They
    will receive unemployment benefits, even though their income is high enough
    that they didn't really seem to need a government transfer payment.

Income taxes

Another automatic stabilizer, on the revenue side, is simply the federal personal income 
tax.  Receipts automatically fall during recession because of lower incomes.  The income 
tax receipts fall more than proportionately because it is, remember, a progressive tax.  
The reduction in tax receipts shifts AD to the right and helps combat unemployment.  
The tax receipts automatically rise during inflation which may put a brake on expenditure 
and be anti-inflationary.  (Portions of the income tax are, however, indexed to the 
inflation rate.)

A final comment on fiscal policy

The essence of fiscal is that it is discretionary.  Government intervenes when necessary, altering 
spending and taxes as needed--increasing them sometimes and reducing them other times.  But 
many government expenditures are the result of prior decisions.  Remember the large part of 
expenditure that is mandatory--the entitlements.  Things like social security, medicare and 
veteran's benefits are in place because of Congressional decisions made long ago.  There are 
also rising payments on the public debt which are not subject to discretionary fiscal policy.  
Or consider a construction project in progress--would you just abandon it if you wanted to 
fight inflation?

Some think there is really very little room for pure discretionary policy.  Fiscal policy is by its nature 
very slow
.  Fiscal policy must be based on forecasts which are complex and may not be accurate.  
We are always well into a recession before we know it, because of time lags.  And it takes a long 
time for Congress to respond.  In same cases, Congress may design a fiscal policy to fight 
recession (for example), but by the time the policy is executed we are way past the recession and 
into an upswing. That further debilitates the execution of fiscal policy.

Can fiscal policy really do much? 

That's a good question, but there isn't a good answer.  Like many, I am a bit skeptical!  Except, that is, for permanent tax cuts.  They seem to me to be effective.

Answers to quiz #3--2/16/07--
10:00 section

1. true               6.  B
2. false              7.  A 
3. D                   8.  B 
4. D                   9.  E 
5. C                 10.  E 

Answeers to quiz #3--2/16/07--
1:00 section

1.  false             6.  B
2.  false             7.  E
3.  E                  8   A  
4.  D                  9.  B 
5.  D                10.  B 



Budget deficits


We look now at budget deficits and surpluses resulting from annual government expenditure.  
When, in a given year, government spends more than it receives--whether as a result of 
deliberate fiscal policy or not--the result is a deficit.  Later we focus on the national debt--
which is the sum of a series of government deficits.  Don't confuse the two.

We had annual government deficits from 1969 through 1997 and then, in from fiscal 1998
through fiscal 2001, we had government surpluses.  We need to look at both, because there 
is a lot of misunderstanding about what these deficits and surpluses mean.  In 1991, the 
annual deficit was $269 billion.  Then by 1995 it had fallen to $164 billion and by 1997 it was 
only $22 billion. We had a $56 billion surplus in 1998 and the surplus was $236 billion 
in fiscal 2000, and $127 billion in 2001.  We then began encountering deficits again, and in 
fiscal 2002 (ending October 1, 2002) the deficit was $152 billion.  For fiscal 2004 the deficit 
grew to $413 billion; in 2005 it fell to $317 billion and in 2006 it was $248 billion. 

Measurement problems

Unlike in the private sector, the government does not have a capital budget.  Everything 
government does is an operating budget.  A capital budget is used by private firms to 
account for benefits that last for many years.  If General Motors purchases some heavy 
capital equipment, the cost of that equipment is not recorded all in one year.  It is 
recorded over the expected life of the asset.  Government doesn't do that.  That 
means that past deficits may be overstated and that current surpluses may be understated.

There are actually eight different budget deficit or surplus calculations.  There is the "base 
line" deficit (or surplus), the "on budget" deficit, a deficit that includes the social security 
surplus and so on.  The details of these don't matter.  The point is simply that no one number 
gives a complete picture of deficits or surpluses.  Then there are some government liabilities 
that don't show up in any of these measures.  Civilian and military employee pension plans are 
liabilities that don't show up, and there are others.  Some estimates suggest the value of all 
this stuff is several trillion dollars.  So how big is the deficit or surplus?  I don't know; neither 
does anyone else.

Where did the deficits come from?

There are two types of deficits which will help us understand where they came from.

Cyclical deficits

A cyclical deficit, as its name implies, arises from cyclical influences--i.e. recession 
and unemployment.  During recession, tax receipts automatically fall and 
expenditure automatically rises, which leads to a larger cyclical deficit.  One study 
shows that if unemployment increases by one percent, the deficit will increase 
by $42 billion--$5 billion more in transfer payments and $37 billion less in tax 
receipts.  A cyclical deficit does not reflect fiscal policy or any actions by Congress.

Structural deficits

A structural deficit reflects fiscal policy maneuvers.  What happens is that outlays 
and receipts are measured that would occur if the economy was at full employment.  
This technique eliminates any budget impacts due to cyclical conditions, so the 
resulting changes in outlays and receipts are assumed to be due to policy decisions.  
That is a little illusory, however, because the structural deficit also reflects 
Congressional actions that probably have nothing do with fiscal policy objectives.

From the mid 1980s until the last deficit in 1996, about 75 percent of deficits were 
structural.  They were largely cyclical in the early 1980s because of a recession.  
During the 1930s the deficit was cyclical; it couldn't reflect fiscal policy because 
we really hadn't tried it yet. 

A note on budget "philosophies"

Politicians and others mouth the importance of having an annually balanced budget--that the 
budget should be in balance every single year.  That's a little perverse because in recession, 
when tax receipts fall, you would have to raise taxes to balance the budget.  Some advocate a 
cyclically balanced budget
which means you should balance it over the course of the business 
cycle--run surpluses in prosperity and deficits in depression.  Others advocate what is called 
functional finance
.  That means it's never important if the budget is balanced or not--it depends 
entirely on what policy function is desired.  We don't really subscribe to any of these.  Budget 
deficits and surpluses have a lot of randomness in them.

Past deficits and income

Looking at the size of the pre-1997 deficits is puzzling.  When we noted earlier that the deficit 
in 1991 was $269 billion, what does that mean?  Is that large or small or what?  It makes more 
sense to express the deficit (or the surplus as well) as a percentage of annual GDP.  In 1991, 
the deficit as a percentage of GDP was 4.6 percent; in 1997 it was 0.3 percent of GDP.  The
fiscal 2006 deficit is 1.9 percent of GDP.  Compared to other countries, our deficits 
were not terribly large.  In 1995, for example, the U.S. deficit as a percentage of GDP was 
2.3 percent.  In Canada it was over 4 percent; in the U.K. it was almost 5 percent; an in 
Greece and Sweden it was about 9 percent of GDP.

This from a 1992 edition of The Reader's Digest:

"I'm thinking of leaving my husband," complained the economist's wife.

"All he ever does is stand at the end of the bed and tell me how good things are going to be."

Effects of an annual deficit

When government borrows, for whatever reason, what happens and what are the effects of 
an annual deficit?  To finance the deficit, government borrows by selling government 
securities to individuals, firms, pension funds, corporations and many others.  These 
securities are risk free; the federal government has never defaulted on a security.  The 
securities are a financial asset to those who buy the securities.  They receive a market 
rate of interest.  Obviously those who buy the securities are helped, not harmed.

Are taxpayers harmed?  Not really.  People who lend to the government do so voluntarily; 
I would rather that happen than for my taxes to be raised.  There is no effect on the 
nation's net worth for the deficit that is internally held.  Government incurs a liability,
but the lenders receive an asset.  There is no way this process bankrupts the nation! 
 As we will see more clearly when we look at the total national debt, there is a subtle 
effect.  If lenders had not lent to government, perhaps they would have used that money to 
purchase private securities that would be more likely to enhance the country's productivity 
and growth.  There is, in other words, an opportunity cost associated with the annual deficit.

Budget surpluses

We look now at the more recent issue of budget surpluses.  These surpluses are cyclical in nature 
(not structural) and, as pointed out earlier, arose from increased tax receipts which in turn reflect 
the very long period of expansion we have witnessed in the United States.  As touched on earlier, 
there is no certainty as to how long these surpluses will last.  

During the four years of budget surpluses, the big discussion was what to do with the surplus. 
Members of Congress and many others held widely divergent views as to what to do with 
the surplus.  There are four principal ideas about the surplus as follows:

  • Cut taxes.  Those with this view believe that, in effect, we have been overcharged for government services.  We paid for more than we got, so give back the overcharge.  We have already done this partially with the 2001 and 2003 tax cuts.
  • Increase transfer payments.  Proponents here think this is a good opportunity to move in the direction of greater income equality.  The most common proposal here is to use the surplus to bolster the social security system.
  • Finance new expenditure programs.  Former President Clinton and others have proposed all kinds of new federal government initiatives.  In other words, get rid of the surplus by increasing spending.
  • Pay down part of the accumulated national debt.  (Evaluating that best waits on our next topic about the national debt.)

What's the best alternative?  Since this was a brief phenomenon there hasn't been much opportunity for a 
lot of discussion, so there is no consensus.  I have a normative opinion, however!  Can you guess 
which one I would favor??


The national debt

We look next at the national debt--the accumulations of past deficits.   

Some facts

How big is it?

Here is the magnitude of the total public debt at various periods since the start of 
World War II:

Year Amount (billions)
1941 $58 billion
1946 $259 billion
1980 $914 billion
1990 $3,163 billion
2000 $5,674 billion
2006 $8,700 billion

You can see that the debt increased almost 80 percent during the 1990s.  That in itself is why some 
people are so concerned about the level of the debt.  Shortly we will learn how to assess the impact 
of the debt.  Will the debt fall because of the government surpluses?  Not unless Congress decides 
on legislation specifically to reduce the debt.

What is the mechanism by which the debt is handled?

As noted earlier, when government incurs debt it finances it by selling securities to a variety 
of agents.  Those government securities (variously called bill, notes or bonds dependent on the 
maturity) are then bought and sold constantly in a "secondary market."  If I bought a $10,000 
government bond last year which matures in 20 years, I don't have to keep it for 20 years.  I can 
sell it to someone else any time I want.  The price I could sell it for depends on current interest 
rates.  The secondary market for government securities is huge.

When a government security matures, government must pay the face amount of the security to 
whoever holds it.  But what happens is the government refinances that security by issuing a new one.  
Oddly enough that's called "refunding," but a better word is refinancing.

Who owns the national debt?

Who are the ones who lend to government--i.e. who owns the national debt?  The following is 
an approximate percentage breakdown of the lenders/owners:

Private firms 10%
Individuals 7%
Other federal agencies 52%
State and local
Foreign entities 25%

Most are surprised that over half of the total debt is owned by other federal agencies and state and 
local governments.  Some are disturbed that 25 percent is owned by foreign firms, individuals 
or governments.

Where did the debt come from?

The earlier table showing the size of the debt indicates that debt started to rise significantly during 
World War II.  That's not surprising; governments can't fight a major war without borrowing.  A second 
source of the debt is presumably fiscal policy.  But the third and largest origin of the debt is simply an 
expanded demand for and supply of government services.  That certainly happened during the 1990s.

We now want to find out what the national debt means, and we begin by asking if the debt is a matter that 
concern us and, if so, how.  We will take this in two segments, first analyzing the effects of that portion 
of the debt which is held internally (75 percent).

Is the internally held debt a matter of concern?

There are at least six reasons why some think the internally held debt is a matter of concern.  We look at 
each of these and try to figure out what is fact and what is fiction.  (Hint:  Many of the six reasons 
are fiction.)

1.  It has been growing and therefore is evil.

As we saw when we looked at annual deficits, the size of the national debt was be 
related to something else--income.  What if we look at the ratio of debt to GDP.  In 1946, 
after the end of World War II when the debt was $259 billion, that amounted to about 130 
percent of GDP.  By 1981, the proportion had fallen to 35 percent.  In 1997, total debt was 
about 60 percent of GDP.  Currently it is about 65 percent of GDP.  Even though it has grown 
since 1981, it isn't nearly as large a proportion of GDP that it was in 1946.  So there is doubt 
as to whether its sheer size is the problem.  Many households have debt that is in excess of 
their annual income.  A household earning $50,000 often purchases a residence for, say, 
$100,000 and borrows most of the price of the residence.  We don't see that as a problem.  
(Public and private debt aren't strictly comparable, but it does make a point.)  Even with 
the rapid growth of the debt in the 1990s, we have managed to go through the longest 
period of prosperity in our history.

2.  It will eventually bankrupt the economy.

If an individual borrows and spends the money on things that are not assets, or depreciable 
assets, bankruptcy can occur.  That's because an individual can eventually face a negative 
net worth and that's what leads to bankruptcy.  But the internally held public debt does not 
affect net worth.  We saw that when we looked at the annual deficits.  The same is true here.  
Government debt creates a liability for the government, but an asset for the lenders.  So 
the analogy between private and public debt is flawed.

3.  The burden of the debt is shifted to future generations.

In a word, no.  This is one of the most common fears about the public debt.  When government 
borrows (and doesn't repay it as explained above), future generations will inherit the debt.  
That's where some people's logic stops.  Why?  Because the future generations will also acquire 
the financial assets--those government securities used to create the debt. So future generations 
get both the liabilities and the assets.  Again, the net worth of future generations is unaffected.

The debt could involve redistribution effects.  Debt holders--individuals and the owners of firms 
who have government securities--typically have higher incomes than those who don't have any 
claim on the debt.  Interest on the debt is an expense to taxpayers, so the payment of interest 
could involve a movement of money from lower income entities to higher income ones.  If 
that's the case, it's a "wrong way" redistribution.  That, however, can--and probably is--easily 
offset by other government income redistribution programs.

4.  The debt causes higher interest rates and inflation.

Many years ago, even economics texts used to say this!  If that was true, we should have 
inflation many times its current low level and interest rates several fold larger than they 
are now.   If everything else remained equal, government borrowing would increase interest 
rates.  When government borrows, that is an increase in the demand for loan funds.  
That increase in demand would, ceteris paribus, increase interest rates.  But other things 
just don't stay equal here.  Experience suggests something is wrong with this reasoning. 
What's wrong is that Federal Reserve policy easily overwhelms any effects of government 
borrowing.  (We will see that in part three of the course.)

5.  The national debt impairs economic growth.

his is a possibility--even though we have experienced significant growth during the last 
decade.  There is an opportunity cost to the public debt.  We noted this briefly in our 
discussion of annual deficits.  If I am one who lends to government and increases the debt, 
the question is what would I have done with that money had I not lent it to the government.  
Perhaps I would have lent it to a private party.  Almost everyone agrees that private expenditure 
is more efficient than public expenditure.  So if I lent that money a private party and it was 
used for more productive activities, then economic growth would likely have been greater 
in the economy.  More public spending means less private spending (think of a production 
possibilities curve) and that's the opportunity cost of the debt.  And that holds even though 
we have had rapid growth.

6.  Servicing the debt is a problem.

Servicing the debt, i.e. paying the required interest on it, now costs about $207 billion per year.  
That, in turn, is about 1.7 percent of GDP.  What happens is that some people and institutions 
who don't own any of the public debt find that part of their tax payments are transferred to 
those who do own some public debt to pay the interest.  It's a transfer payment and, as such, 
doesn't affect output.  But, as we saw in point 3 above, this might be a "wrong way" 
redistribution of income.

What about the externally held public debt?

It is possible, but not entirely clear, that the externally held public debt could be shifted to future 
generations.  But this is a little tricky!  When foreigners (individuals, firms or governments) lend 
to the United States government, initially we can finance more expenditure without reducing 
domestic private expenditure. 
There is initially no opportunity cost in the form of reduced 
domestic expenditure and that, obviously, is a benefit.  So what do foreigners do with these IOUs?  
(Well call them IOUs because they are a U. S. liability.)  When those IOUs become due, foreigners 
can redeem them for cash or for U. S. products.  That's where a burden might be imposed.  
But foreigners may be willing to refinance those IOUs with new government securities, or they 
may invest the proceeds in other U. S. private investments.  So the result is not entirely certain 
about externally held debt.

What then are the REAL problems with the national debt?

Looking back at all that discussion above, there are three problems with the debt--one is 
for certain and two are possibilities:

There IS an opportunity cost to the debt, which may impair economic growth.
There MIGHT be a wrong way redistribution of income.
There MIGHT be a burden imposed by foreign held public debt.

  Proposals for debt and spending limits

Finally, we look briefly at four proposals to limit government spending and thereby control the 
deficit.  For many years, legislation has been proposed to impose spending limits.  Actually, 
the first three have often been proposed--the last one is not as serious.

Zero deficit proposals

The most famous of these proposals, although now old, was the Gramm-Rudman Act 
of 1985.  This legislation, passed by Congress, required that the annual deficit must be 
reduced until the annual deficit hit zero in 1991 and was to stay at zero after that.  
The provision of the act was that automatic spending proposals would be required to 
achieve a balanced budget.  (Congress was buying into the annually balanced budget 
philosophy discussed earlier.)  Although Congress passed it, the Supreme Court found 
it unconstitutional on grounds that it took away Congressional authority.

After it was struck down, Congress and President Reagan said they would comply with 
the spirit of the legislation anyway.  That didn't work.  Congress and Reagan could 
never reach agreement on what should happen.  Reagan was not willing to cut defense 
spending (or raise taxes); Congress was not willing to reduce non-defense spending.  
So nothing happened!

Balanced budget constitutional amendment

Until the last few years, almost every Congress has proposed an amendment to the 
constitution to require a balanced budget.  It has always been a popular proposal.  
The constitutionality of such legislation is not clear since it has never happened.  
A constitutional amendment certainly couldn't say how this would happen.  If it ever 
passed, it's important to remember that a budget is always a projection--a tentative 
plan as to how expenditures are determined.  Such projections are full of assumptions 
of all kinds.  If such an amendment was passed, it is likely that all kinds of objections 
would be mounted and law suits filed.  God help us, but some judge might end up 
deciding whether or not the budget was balanced!  If there is any virtue to fiscal policy, 
it would obviously be outlawed by such an amendment.  (My projection: This will 
never happen!)

Spending and debt ceilings

Congress always legislates a debt ceiling.  There is always legislation that specifies a 
maximum to the national debt.  At present, the ceiling is $9 trillion.  When that 
ceiling is reached (which will likely have happened by the time you read this), a 
temporary problem might emerge.  The problem is made that non-essential 
government services (whatever those are) will be shut down, government workers will be laid 
off, and income transfer programs will grind to a halt.  Often in the 1990s we approached this 
limit and Congress had to pass emergency legislation to raise the limit--lest the whole 
government fall apart.  In case you can't tell, I view this as pretty comical.  Spending and 
deficit ceilings are never real.  And when and if deficits appear again, debt ceiling legislation
will again make news headlines.


This has been considered in the United States, but not very seriously.  The proposal is to 
reduce spending and the debt by selling off some government services to the private 
sector, thereby reducing government expenditure.  What are some services that might 
be sold off?  A few examples:

  • Sell Conrail and Amtrack
  • Get rid of federal power projects--e.g. the Tennessee Valley Authority
  • Sell Dulles airport
  • Get rid of the Federal Housing Authority
  • And so on . . . .

Interestingly enough, the United Kingdom has done some of this.  It's not likely to reduce 
spending or the debt very much, but it may be a good idea anyway!

To review last year's second exam, click here: 

Part Two Test

Once again, I hope you do very well on the second exam!