Now that we have some
understanding of basic macroeconomic variables, we begin to construct
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
Everyone has heard of the "great
depression" which started in 1929 and lasted until at
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
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. .
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
Did the stock market crash cause
the depression--or was it a symptom of underlying
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
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
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.
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
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
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
A new term sprung up a few years ago,
that being a "growth recession." That is when
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
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:
investment component of GDP is very unstable--far more
than other components. That's our first clue.
demand for durable consumer goods is also unstable.
That's a second clue.
economic events can also contribute to recession--e.g. oil
price hikes in the mid 1970s
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
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
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
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 stable.
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
how 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
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:
innovation, population, growth and
anything else stemming from market activities.
natural disasters, trade disruptions, etc
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.
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
Real balances effect.
This means simply that lower prices make each dollar of
more valuable--you can buy more goods and services with a given
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.)
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.
Interest rate effect.
Lower price levels also lead to lower interest
(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,
Aggregate supply (AS) is the dollar
amount of goods and services business firms product.
It slopes upward because higher prices induce more output from
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!)
Guess what? Equilibrium is
where AD = AS, illustrated below:
Equilibrium output could not be at
Y1 and P1 because AS would exceed AD and
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
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
There are two types of macroeconomic
failure that may give rise to government intervention:
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
pointed out that there is no guarantee that equilibrium and full
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.
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
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
What kind of
theory is it? It's a demand side
theory--problems and solutions come from the
behavior of aggregate demand (AD).
We've really already seen this. Recessions come from declines
caused by consumer spending, business investment or government.
It's up to government through altering purchases, taxes and/or
Has it been
Oh yes. Its heyday was in the 1960s. Subsequently it
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.
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.
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.
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.
What kind of
theory is it? As
its name implies, and different from the first two, it's a
side theory. Shifts in AS cause problems and policies
affecting AS will cure them.
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.)
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.
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
defined as saving.
So saving would include buying a stock or a bond, paying into
retirement plan--or anything else that is not consumption.
Hence a simple
= 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:
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
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:
+APS = 1
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.
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
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
enough--as disposable income increases, so does consumption--but
does not rise as rapidly as disposable income. Consider the
following simplified table:
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 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
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,
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
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
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
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
What determines investment?
The chief determinant of investment is expected
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
There are at least two other important
determinants. One is interest rates. (This is explored
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
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.)
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
real 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
Following that definition, equilibrium would be
achieved if total consumption plus
investment expenditures are equal to total income. Look at the
where income (output) is in NOMINAL
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
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
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
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
carefully. What was the connection between interest rates
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
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
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
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
|Answers to quiz #2--2/9/07--10:00
5. E 10. C
Answers to quiz #2--2/9/07--1:00
Everyone knows how to multiply--or at
least I think so. But, in macroeconomics, the multiplier
not as simple as that. It is, however, of great
significance. Here, in simple terms, it what it means in
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
than $50 billion.
And if either investment or consumption decreases by,
say, $50 billion than income will fall by
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
$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
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.
A recessionary gap is, as its
name implies, a condition which leads to recession. It's a
concept and occurs when full employment exceeds equilibrium
income. Consider the following table,
where income (or output) is expressed in current (or nominal) dollars:
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
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
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
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
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.
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
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
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
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
price stability and "reasonable" economic growth.
How does government affect
output? Three ways:
How can government fight recession?
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
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
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
G will increase Y--maybe! A little later we will examine
to this reasoning.
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.
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
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
Tax cuts for businesses will
typically increase investment because of higher after
tax earnings. This would also shift AD to the right and help
Increase transfer payments
If government increases veterans'
benefits or social security benefits or
unemployment benefits (and so on), that will increase AD when the
are spent. Not all of the proceeds are consumed, however;
some is saved.
So the general effect is the same as for increasing government
and reducing taxes.
To fight inflation
What if the objective of government
fiscal policy is to fight inflation? The appropriate
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,
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
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
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
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
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
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
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
and income and thereby reduce unemployment. But an important
issue is this:
increased public spending lead to decreased private
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.
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
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
households (and/or business firms) view the tax increase as temporary
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.
as permanent. A temporary tax cut may have some effect,
especially on consumers.
Temporary tax cuts for business, however, might not be effective
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
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.
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
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
How could this happen?
Incentives. When tax rates are cut, it sometimes
incentive for expenditure which will increase income which increases
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
transfers it to households with higher propensities to consume (less
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
as a big weapon against adverse macroeconomic conditions. And
payments to fight inflation would be politically suicidal.
There is one other aspect of government
fiscal policy and that are so-called "automatic
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 is an
expenditure program which provides cash payments
to those who involuntarily lose their jobs. When 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
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
will receive unemployment benefits, even though their income
is high enough
that they didn't really seem to need a government transfer
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
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
A final comment on fiscal policy
The essence of fiscal is that it is
discretionary. Government intervenes when necessary,
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
Some think there is really very little
room for pure discretionary policy. Fiscal policy is by its
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
Can fiscal policy really do much?
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--
|Answeers to quiz #3--2/16/07--
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,
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
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.
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
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.
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
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.
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
That is a little illusory, however, because the structural deficit
Congressional actions that probably have nothing do with fiscal
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
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
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:
thinking of leaving my husband," complained the
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
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,
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
and growth. There is, in other words, an opportunity cost
associated with the annual deficit.
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
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.
How big is it?
Here is the magnitude of the total
public debt at various periods since the start of
World War II:
You can see that the debt increased
almost 80 percent during the 1990s. That in itself is why
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
Who owns the national debt?
Who are the ones who lend to
government--i.e. who owns the national debt? The following
an approximate percentage breakdown of the lenders/owners:
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
Where did the debt come from?
The earlier table showing the size of
the debt indicates that debt started to rise significantly
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
There are at least six reasons why some
think the internally held debt is a matter of concern. We look
each of these and try to figure out what is fact and what is
fiction. (Hint: Many of the six reasons
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
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
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
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
Servicing the debt, i.e. paying the
required interest on it, now costs about $207 billion per
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
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:
IS an opportunity cost to the debt, which may
impair economic growth.
MIGHT be a wrong way redistribution of income.
MIGHT be a burden imposed by foreign held public
Proposals for debt and spending
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
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
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
So nothing happened!
Balanced budget constitutional
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
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
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
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!