CHAPTER

The Business
Cycle

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 Learning Objectives
After reading this chapter, you should know:

. The nature and history of business cycles.

. The difference between Classical and Keynesian
views of macro stability.
. The major macro outcomes and their
determinants.
. The nature of aggregate demand (AD) and
aggregate supply (AS).
. How changes in AD and AS affect macro
outcomes.
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 Chapter Goals

This chapter focuses on three central

questions:
• How stable is a market driven economy?
Loading…
• What forces cause instability?

• What, if anything, can the government do to

promote steady economic growth?
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 The Business Cycle

A basic purpose of macroeconomic theory is to

explain the business cycle.

Macroeconomics is the study of aggregate

economic behavior, of the economy as a whole.

The business cycle refers to the alternating

periods of economic growth and contraction.

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 Classical Theory
Prior to the 1930s, the belief was that:

• A market-driven economy was inherently stable.

• There was no need for government intervention.
• Loading…
The laissez faire view seemed reasonable.

Laissez faire is the doctrine of “leave it alone” and

nonintervention by government in the market mechanism.

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 A Self-Regulating Economy
According to the classical view, the economy “self-
adjusts” to deviations from its long-term growth trend.

Economic downturns were viewed as temporary setbacks,

not permanent problems

According to Say’s Law, supply creates its own demand.

Unsold goods and unemployed labor would disappear as

soon as people had time to adjust prices and wages.

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 Macro Failure

The classical self-regulating mechanism did not

work during the Great Depression.

The Depression persisted and unemployment grew

despite falling prices and wages.

The credibility of classical economic theory was

destroyed.

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Figure 8.1 Inflation and Unemployment
(1900 – 1940)
In the 1930s, unemployment
rates rose to unprecedented
heights and stayed high for a
decade.

Falling wages and prices

(deflation) did not restore
full employment.

This macro failure prompted

calls for new theories and
policies to control the
business cycle.

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 The Keynesian Revolution
John Maynard Keynes developed an alternate view of the macro
economy.

He believed that the private economy was inherently unstable.

According to him, the Great Depression was not a unique event.

It would recur if we relied on the market-mechanism to self

adjust.

He concluded that the government must intervene by increasing

aggregate demand.
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 The Keynesian Revolution

John Maynard Keynes concluded that self-

adjustment could not occur because of an
“insufficiency of effective demand.”

He believed that a market driven economy was

inherently unstable.

He concluded that the government must intervene

by increasing aggregate demand.
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 The Business Cycle

The upswings and downturns of the business cycle

are gauged in terms of changes in total output.

An economic upswing (expansion) is an increase

in the volume ofLoading…
goods and services produced.

An economic downturn (contraction) is when the

total volume of production declines.

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 Figure 8.2 The Business Cycle
The model business
cycle resembles a
roller coaster.

Output first climbs to

a peak, then
decreases.

After hitting a trough,

the economy
recovers, with real
GDP again
increasing.
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 Historical Cycles
From 1929 through 2020, the U.S. economy expanded at an
average rate of 3 percent per year.

But we didn’t grow at this rate every year.

There were lots of years when real GDP grew by less than 3
percent.

There were many years of negative growth, with real GDP

declining from one year to the next.

These successive short-run contractions and expansions are the

essence of the business cycle.
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Figure 8.3 The Business Cycle in U.S.
History

From 1929 to 2020, real GDP increased at an average rate of 3 percent a year.

Years of above-average growth seem to alternate with years of sluggish growth

(growth recessions) and actual decreases in total output (recessions).
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 The Great Depression
Between 1929 and 1933, total U.S. output steadily
declined.

Real GDP contracted a total of nearly 30 percent.

During 1938 and 1939, output again contracted

and more people lost their jobs.

At the end of the 1930s, GDP per capita was lower

than it had been in 1929.
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 World View: Global Depression
Decline in Industrial Output between 1929 and
1932

CRITICAL ANALYSIS: International trade and financial flows tie

nations together.

When the U.S. economy tumbled into a recession in the 1930s, other
nations lost export sales.
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 World War II
World War II greatly increased the demand for goods and
services.

It ended the Great Depression.

Output grew at unprecedented rates.

• Almost 19 percent in one year (1942).

Virtually everyone was employed.

Our productive capacity was strained to the limit.

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 The Post War Years
After World War II, the U.S. economy resumed a
pattern of alternating growth and contraction.

The contracting periods are called recessions.

The term recession is used to mean a decline in

total output (real GDP) for two or more
consecutive quarters.

There have been 12 recessions since 1944.

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 The 1980s and 1990s
The 1980s started with two recessions.
• The second lasting 16 months (July 1981–November
1982).

In 1981 the U.S. experienced a growth recession.

A growth recession is a period during which real GDP grows

but at a rate below the long-term trend of 3 percent.

In November 1982, the U.S. economy began an economic

expansion that lasted more than seven years.
• Real GDP increased by more than $1 trillion.
• 20 million new jobs were created.
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 Great Recession of 2008–2009
In mid-2007 home prices and stock market prices started falling.

Consumer wealth and confidence fell.

A credit crisis made loans hard to obtain.

Sales of homes, autos, and other big-ticket items plummeted,

causing GDP to again contract.

The Great Recession of 2008–2009 was the worst since 1981–

1982.

The unemployment rate peaked at 10 percent.

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McGraw workers
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reserved. No reproduction tothefind
distribution without jobs.
prior written consent of McGraw Hill LLC.
 Sluggish Recovery
The Great Recession officially ended in June 2009

But economic growth was excruciatingly slow.

• The best year of that recovery (2015) exhibited only 2.9
percent growth.
• The worst year (2011) had a pace of 1.6 percent GDP
growth.

Unemployment stayed high for five years.

Tax cuts enacted in 2017 accelerated growth

• GDP growth stayed a bit below the long-run average of 3
percent.
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 Coronavirus Shutdowns
The coronavirus pandemic threw the U.S. economy off its
growth track in 2020.

Governments issued orders for lockdown:

• Consumers had to shelter in place.
• All nonessential businesses had to close.

The decline in output was immediate and severe.

• More than 20 million Americans became unemployed
in only two months.
• Total output plunged by more than 30 percent.
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 Coronavirus Shutdowns
A massive policy response kept the economy from plunging
further.

About half of the lost jobs returned within a couple of months.

The economy continued to grow at a rapid pace in 2021.

Unemployment remained at record lows.

Things slowed down in the first months of 2022

• But not enough to be a recession.

Worries about another downturn resurfaced again in 2023.

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 Table 8.1 Business Slumps

The U.S. economy has experienced 15 business slumps since 1929.

The©typical recession lasts around 10 months.

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 A Model of the Macro Economy
The primary outcomes of the macro economy are:

• Output.
• Jobs.
• Prices.
• Growth.
• International Balances.

The determinants of macro performance are:

• Internal market forces.
• External shocks.
• Policy levers.
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 Figure 8.4 Macro Economy

The primary outcomes of the macro economy are output of goods and
services, jobs, prices, economic growth, and international balances.

These outcomes result from the interplay of internal market forces, external
shocks, and policy levers.
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 Aggregate Demand and Aggregate
Supply
The macro economy can be best understood
in the framework of supply and demand.

Any influence on macro outcomes must be

transmitted through supply or demand.

Economists have developed a remarkably

simple model of how the economy works.
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 Aggregate Demand
Aggregate Demand is the total quantity of output
demanded at alternative price levels in a given time
period, ceteris paribus.

Our view here includes the collective demand for all

goods and services rather than the demand for any single
good.

Total quantity of output refers to Real GDP.

The price level refers to the average price level.

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 Figure 8.5 Aggregate Demand
The aggregate demand curve illustrates how the volume of purchases
varies with average prices.

The aggregate demand curve is downward sloping.

• With a given level of income, people will buy more goods and services
at lower prices.
Loading…
lower
prices
- more out
put

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 Aggregate Demand Curve

The aggregate demand curve slopes

downward due to the following
forces:

• Real balances effect.

• Foreign trade effect.
• Interest rate effect.
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 Real Balances Effect
The real value of money is measured by how many goods and services each
dollar will buy.

When the price level falls:

• The cash balances you hold are worth more.

• You can buy more goods, even though your nominal income hasn’t
changed.

• The quantity of goods and services demanded at any given income level
will increase.

• This creates an inverse relationship between the price level and the real
value of output demanded.
• A downward-sloping aggregate demand curve.
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 Foreign Trade Effect
When American-made products
become cheaper:

• Americans buy fewer imports and

more domestic output.
• Foreigners buy more American-
made goods.
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 Interest Rate Effect
Changes in price levels affect how much money
people need to borrow.

At lower price levels:

• I

Consumer borrowing needs are smaller.

• (
Demand for loans diminishes.
• S
Interest rates tend to decline.
• S
Lower rates stimulates more borrowing and
loan-financed purchases.
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 Aggregate Supply
Aggregate supply (AS) is the total quantity of
output (real GDO) producers are willing and able
to supply at alternative price levels in a given time
period, ceteris paribus.

We expect the rate of output to increase when the

price level rises.

This is reflected in the upward slope of the

aggregate supply curve.
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Upward Slope of the Aggregate Supply Curve

The upward slope of the aggregate supply curve

can be explained by:

Profit margins: As output prices rise, profit

margins increase. So, producers want to produce
more.

Costs: Costs tend to increase as production

increases. Producers must charge higher prices to
recover the higher costs.
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 Figure 8.6 Aggregate Supply

The aggregate supply curve is upward sloping.

We expect the rate of output to increase when the price level rises.
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 Macro Equilibrium
Aggregate supply and aggregate demand
curves summarize the market activity of
the whole macro economy.

Equilibrium (macro) is the

combination of price level and real
output that is compatible with both
aggregate demand and aggregate supply.
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 Figure 8.7 Macro Equilibrium
The aggregate demand and
supply curves intersect at
only one point (E).

At that point, the price

level (PE) and output (QE)
combination is compatible
with both buyers’ and
sellers’ intentions.

At any other price level, the

behavior of buyers and
sellers is incompatible.
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 Macro Failures
There are two potential problems with a macro
equilibrium:

• Undesirability: The equilibrium price or

output level may not satisfy our
macroeconomic goals.

• Instability: Even if the designated macro

equilibrium is optimal, it may not last long.
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 Undesirability
Full-employment GDP is the rate of real
output (GDP) produced at full employment.

Producing less than full employment GDP

results in unemployment.

The equilibrium price level may also exceed

the desired price level, resulting in inflation.

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Figure 8.8 An Undesired Equilibrium

The equilibrium price level (PE) is too high (above P*).

The equilibrium output rate (QE) falls short of full

employment (QF).
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 Instability
Even if a macro equilibrium is desirable, it may not
persist due to:

• Aggregate demand shifts.

• Aggregate supply shifts.
• Multiple shifts.

Business cycles are likely to result from recurrent

shifts of the aggregate supply and demand curves.

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 AD Shifts
The aggregate demand curve may shift due to
changes in changes in:

• Expectations.
• Taxes.
• Export demand.
• Consumer sentiment.
• Other events.

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 AS Shifts
The aggregate supply curve may shift due to
changes in:

• Import prices.
• Tax policy.
• Expectations.
• Natural Disasters.
• Other events.

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 Multiple Shifts
Aggregate supply and aggregate demand curves can shift repeatedly
in different directions.

A leftward shift of the AD curve can cause the rate of output to fall.

A rightward shift of the AD curve can cause real GDP (and

employment) to increase.

Shifts of the aggregate supply curve can cause similar upswings and
downswings.

Business cycles are likely to result from recurrent shifts of the

aggregate supply and demand curves.
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 Figure 8.9 Macro Disturbances

Shifts in (a) aggregate supply or (b) aggregate

demand may result in an undesirable equilibrium.
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Competing Theories of Short-Run Instability

The AS/AD model provides a

framework for comparing different
theories about how the economy works.

Macro controversies focus on the shape

of aggregate supply and demand curves
and the potential to shift them.

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 Demand Side Theories
There are two prominent demand-side
theories that try to explain the economy:

• Keynesian theory.
• Monetary theory.

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 Keynesian Theory
Keynesian theory is the most prominent of the demand-
side theories.

Keynes argued that a deficiency of spending tends to

depress an economy.

Inadequate aggregate demand would cause persistently

high unemployment.

Changing government taxes and spending to shift the

aggregate demand curve in whatever direction is desired.
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 Monetary Theories
Monetary theory emphasizes the role of money in
financing aggregate demand.

Money and credit affect the ability and willingness

of people to buy goods and services

Monetary theories focus on the control of money

and interest rates as mechanisms for shifting the
aggregate demand curve.

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Figure 8.10 Demand-Side Theories

Demand-side theories emphasize how inadequate or

excessive AD can cause macro failures.
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 Supply-Side Theories
Supply-side theories believe that inadequate supply can:

• Keep the economy below its full-employment potential.

f
• Cause prices to rise.

Producers may be unwilling to provide more goods at existing prices

due to:

• Rising costs.

·
•
•
•
Resource shortages.
Profit motive.
Changes in government taxes and regulations.

These theories
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No reproduction thewithout
or distribution aggregate supply
the prior written consent curve
of McGraw Hill LLC. outward.
Figure 8.11 Supply-Side Theories
Inadequate supply can
keep the economy
below its full-
employment potential
and cause prices to
rise as well.

AS1 leads to
equilibrium output Q3
and increases the price
level from P0 to P3.

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 Eclectic Explanations
The various macro theories tell us that either AS or AD can
cause us to achieve or miss our policy goals.

Various shifts of the AS and AD curves can achieve any

specific output or price level.

One could shift both the AS and AD curves to explain

unemployment, inflation, or recurring business cycles.

Such eclectic explanations of macro failure draw from both

sides of the market.
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 Long-Run Self Adjustment
Some economists argue that short-run instability is not as important
as the long-run trend in economic growth.

Monetarists and neoclassical theorists believe that the level of output

is fixed at the natural rate and determined by:

• Demographics.
• Technology.
• Market Structure.
• Institutional infrastructure of the economy.

Fluctuations in aggregate demand affect the price level but not real
output in the long-run.
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Figure 8.12 The “Natural” Rate of
Output
The vertical long-run
AS curve is anchored at
the natural rate of
output QN.

Shifts of the aggregate

demand curve affect
prices but not output in
the long run.

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 Short- vs. Long-Run Perspectives
We live in the short run.

Short-run variations affect our current economic situation.

We care about short-run changes in job prospects and

prices.

The short-run aggregate supply curve is likely to be

upward-sloping.

This implies that both AS and AD influence short-run

macro outcomes.
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 Policy Decisions: Ending A Recession
In the AS/AD model, there are only three strategy options
for macro policy:

• Shift the aggregate demand curve to the right.

• Stimulate total spending.

• Shift the aggregate supply curve to the right.

• Stimulate more output at every price level.

• Laissez faire.
• Let markets self-adjust.
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Policy Decisions: Ending A Recession
Classical Laissez Faire is to rely on the self-adjustment mechanism
of the market without any intervention.

Fiscal policy is the use of government taxes and spending to alter

macroeconomic outcomes.

Monetary policy is the use of money and credit controls to influence

macroeconomic activity.

Supply-side policy is the use of tax rates, (de)regulation, and other

mechanisms to increase the ability and willingness to produce.

Trade Policy refers to using trade barriers and exchange rates to

influence the value of imports and exports.
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 Policy Decisions: Ending A Recession
President Biden’s interventions to end the 2020 recession:

• Massive monetary policy stimulus.

• A massive fiscal policy package:

• Increased government spending and income transfers (the $1.9
trillion American Rescue Plan).

• Vaccinations and other health initiatives:

• Enabled businesses to reopen.

The result was a rapid return to full employment.

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 CHAPTER
9

Aggregate
Demand

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 Learning Objectives

After reading this chapter, you should know:

. What the major components of aggregate

demand are.
. What the consumption function tells us.
. The determinants of investment spending.
. How and why AD shifts occur.
. How and when macro failure occurs.

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 Chapter Goals
This chapter looks at the details of aggregate
demand.
• What are the components of aggregate demand?
Loading…
• What determines the level of spending for each
component?

• Will there be enough demand to maintain full

employment?
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 Macro Equilibrium
Macro equilibrium is the combination of price level and
real output that is compatible with both aggregate demand
and aggregate supply.

Aggregate demand (AD) is the total quantity of output

(real GDP) demanded at alternative price levels in a given
time period, ceteris paribus.

Aggregate supply (AS) is the total quantity of output (real

GDP) producers are willing and able to supply at alternative
price levels in a given time period, ceteris paribus.
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Figure 9.1 Escaping a Recession
Macro equilibrium occurs at
E1, where AD1 and AS1
intersect.

Equilibrium output, QE ,is short

Loading… of the economy’s full
employment potential at QF.

This short run macro failure

would disappear if the AD
curve shifted rightward to AD2.

The central question is whether

andthe prior
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consent AD curve
of McGraw Hill LLC. will shift
 Components of Aggregate Demand

The four components of Aggregate

Demand are:

• Consumption (C)
• Investment (I)
• Government spending (G)
• Net exports (X – M)

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 Income and Consumption
Consumption is defined as expenditure by consumers on
final goods and services.

Disposable income (DI) is the after-tax income of

households.

Saving is that part of disposable income not spent on current

consumption.

All disposable income is either consumed or saved.

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 Figure 9.2 U.S. Consumption and
Income
U.S. Consumption and Disposable Income (1980 – 2000)

Consumption rises
with income.

Consumers spend
almost every extra
dollar they receive.

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 Consumption vs. Saving
Two ways to know what fraction of disposable income will be
consumed and how much will be saved:

Average Propensity to consume (APC) is the total consumption in

a given period divided by total disposable income.

Marginal Propensity to Consume (MPC) is the fraction of each

additional (marginal) dollar of disposable income spent on
consumption.

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Front Page Economics: Overspending
Percentage of Adults Who Say They Spend More Than They Earn
(June 2022)

CRITICAL ANALYSIS: When consumer spending exceeds disposable income,

consumer saving is negative; households are dissaving.

Dissaving is financed with credit or prior savings

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Figure 9.3 The Marginal Propensity to
Save
Marginal propensity to save (MPS) is the fraction of each additional
(marginal) dollar of disposable income not spent on consumption.

MPS = 1 – MPC

Loading…
If MPC = 0.80, 80 cents out of any extra dollar get spent and 20
cents get saved.

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 Autonomous and Income-Dependent Consumption

Keynes distinguished between two kinds of consumer spending:

Autonomous consumption: Spending not influenced by current

income.
Income-dependent consumption: Spending that is determined by
current income.

The level of autonomous spending depends on:

Expectations.
Wealth effects.
Credit.
Taxes.
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 The Consumption Function
The various determinants of consumption are summarized in an
equation called the consumption function.

The consumption function is a mathematical relationship indicating the

rate of desired consumer spending at various income levels.

C = a + bYD

where,
C = current consumption
a = autonomous consumption
b = marginal propensity to consume
YD = disposable income.
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 The Consumption Function

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Figure 9.4 The Consumption Function
The consumption function can be expressed in a table.

Row B indicates that this consumer wants to spend $125 per week
when income is $100 per week.
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Figure 9.4 The Consumption Function
The consumption function can also be expressed in a graph.

C = YD everywhere on the
45-degree line.

When C > YD, dissaving

occurs.

When C < YD, saving

occurs.

The slope of the consumption

function equals the MPC.
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 Figure 9.5 A Shift in the Consumption
Function
A change in “a” or autonomous consumption shifts the consumption
function up or down.

A change in “b” or marginal propensity to consume alters the slope of

the function.

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 Figure 9.6 AD Effects of Consumption
Shifts
A downward shift of the consumption function implies a leftward shift
of the aggregate demand curve.

An upward shift of the consumption function implies an increase (a

rightward shift) in aggregate demand.

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 Ad Shift Factors

The AD curve will shift in response to:

• Changes in income.
• Changes in expectations (consumer confidence).
• Changes in wealth.
• Changes in credit conditions.
• Changes in tax policy.

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 Investment
Investment is defined as expenditures on
(production of) new plants, equipment, and
structures (capital) in a given time period, plus
changes in business inventories.

The main determinants of investment are:

• Expectations.
• Interest Rates.
• Technology and Innovation.
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 Figure 9.7 Investment Demand
The rate of desired investment depends on expectations, the rate
of interest, and innovation.
A change in
expectations will shift
the investment
demand curve.

A change in the rate

of interest will lead to
movements along the
existing investment
demand curve.
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 Shifts of Investment
When investment spending changes, the
aggregate demand curve shifts.

• When investment spending declines, AD

shifts left.
• When investment spending increases, AD
shifts right.

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Figure 9.8 Volatile Investment Spending
Investment is far more volatile than consumption.

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 Government Spending
The government sector spends nearly $15 trillion on goods and services.

About 2/3 of all government spending occurs at the state and local levels.

State and local governments cannot deficit spend.

• State and local spending is slightly pro-cyclical.
• Expenditures rise as the economy (and tax receipts) expends.
• Expenditures decline as the economy slumps.

The federal government can borrow money.

• Federal spending can exceed tax receipts.
• Can help reverse AD shifts by changing its own spending.

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 Net Exports
Net exports is the fourth component of aggregate
demand.

Economic downturns in other lands lead to a decrease in

U.S. exports (X), and vice versa.

Economic downturns in the U.S. lead to a decrease in

U.S. imports (M), and vice versa.

If net exports decrease, AD shifts left.

If net exports increase, AD shifts right.
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 Figure 9.9 Building an AD Curve
Spending on C, I, G and X – M adds up to aggregate demand.

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 Macro Failure
There are two chief concerns about macro equilibrium:

• Undesirability

• The market’s macro equilibrium might not give us

full employment or price stability.

• Instability

• Even if the market’s macro equilibrium were

perfectly positioned, it might not last.
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 Undesired Equilibrium
Because market participants make
independent spending decisions, they may not
generate exactly the right amount of aggregate
demand.

Aggregate demand may be:

• Too small, causing cyclical unemployment.
• Too great, causing demand-pull inflation.

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 Figure 9.10 Macro Failures

Loading…

The real GDP produced in figure:

(a) is optimal.
(b) is too small, causing cyclical unemployment.
(c) is too great, causing demand-pull inflation.
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 Recessionary Gap GDP
The amount by which equilibrium GDP falls
short of full-employment GDP is called a
recessionary GDP gap.

This gap represents unused productive

capacity.

A recessionary GDP gap results in cyclical

unemployment.
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Figure 9.11 A Recessionary Gap GDP
At the actual
equilibrium, (E),
GDP (QE)is lower
than full-
employment GDP
(QF).

This results in a
recessionary GDP
gap of $1 trillion
(QF − QE).
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 Inflationary Gap GDP

The amount by which equilibrium GDP exceeds

full-employment GDP is called an inflationary
GDP gap.

An inflationary GDP gap can result in demand-pull

inflation.

Demand-pull inflation is an increase in the price

level initiated by excessive aggregate demand.
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 Unstable Equilibrium
Even when the economy at the desired macro equilibrium,
the outcome may not last.

Market participants may change their behavior abruptly

and shift AD.

Recurrent shifts of aggregate demand could even cause a

business cycle.

A business cycle is defined as alternating periods of

economic growth and contraction.
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 Self-Adjustment
The critical question is whether undesirable outcomes will
persist.

• How do markets respond to GDP gaps?

If markets self-adjust, then macro failures would be temporary.

Macro self-adjustment requires that any shortfalls in one

component of AD be offset by spending in another component.

If such offsetting shifts occurred, then the desired macro

equilibrium could be maintained.
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Policy Decisions: Can Macro Failures By Predicted?

Abrupt changes in aggregate demand could ruin even the

best of economic times.

Policymakers need some way of peering into the future—

to foresee shifts of aggregate demand.

The Index of Leading Economic Indicators (LEI) is a list

of 10 gauges that are supposed to indicate in what
direction the economy is moving.

The LEI is not perfect but has a good track record.

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Policy Decisions: Can Macro Failures By Predicted?

Table 9.2 The Leading Economic Indicators

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 CHAPTER
10

Self-Adjustment or
Instability?

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 Learning Objectives

After reading this chapter, you should know:

. The sources of circular flow leakages

and injections.
. What the multiplier is and how it
works.
. How recessionary and inflationary GDP
gaps arise.
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 Chapter Goals

This chapter focuses on how markets

respond to an undesirable outcome.
• Why does anyone think the market might self-
Loading…
adjust (returning to a desired equilibrium)?

• Why might markets not self-adjust?

• Could market responses actually worsen macro

outcomes?
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 Self-Adjustment or Instability

Keynes believed that macro failure is likely

to occur in a market-driven economy.

There would be no automatic self-

adjustment.

The economy could suffer from:

• Persistent unemployment
• Continuing inflation.
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 Leakages and Injections
If the economy were producing at full-employment GDP,
then enough income would be available to buy everything
the economy produces.

But aggregate demand isn’t so certain. Loading…

• Market participants may choose to not spend all their
income, leaving some goods unsold.

• They might try to buy more than full-employment

output, pushing prices up.
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 Leakages and Injections
To see how such imbalances might arise, Keynes
distinguished leakages from the circular flow and
injections into that flow.

A leakage refers to income not spent directly on domestic

output but instead diverted from the circular flow—for
example, saving, imports, taxes.

An injection is an addition of spending to the circular

flow of income.

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Figure 10.1 Leakages and Injections
Consumer saving, imports,
taxes, and business saving
all leak from the circular
flow, reducing potential
aggregate demand.

Business investment,
government purchases of
goods and services, and
exports inject spending into
the circular flow, adding to
aggregate demand.
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 Leakages
Leakages from the circular flow may be due to:

Consumer Saving: Consumers tend to save some of their

disposable income which results in a leak in the circular flow.

Imports: When consumers buy imported goods, their spending

leaves the domestic circular flow and goes to foreign producers.

Taxes: The federal, state, and local taxes paid by households are
also a form of leakage.

Business Saving: The income businesses hold back in the form of

depreciation allowances and retained earnings also represents
leakage.
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 Figure 10.2 Leakage and AD
Leakages cause consumers
to demand less output at the
current price level (P = 100)
than the economy produces
at full-employment GDP
(QF).

$3,000 billion of output

(income) is produced (F).

But consumers demand

only $2,350 billion of
output at the price level P =
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of McGraw Hill LLC.
 Injections
An addition of spending to the circular flow of income is
called an injection.

Some examples of injections are:

• Investment
• Government spending
• Exports
Injections must equal leakages if all the output supplied is
to equal the output demanded (macro equilibrium).

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 Figure 10.3 Leakages and Injections

Loading…
Macro equilibrium occurs only when leakages equal injections.

The relationship between saving and investment reveals whether a

market-driven economy will self-adjust to a full-employment
equilibrium.
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 Self-Adjustment?
Classical economists assumed that spending injections would
always equal spending leakage.

The mechanism they counted on for equalizing leakages and

injections was the flexible interest rate.

• If saving (leakage) exceeds investment (injection), then available

funds to borrow increase and interest rates fall, which
encourages more investment borrowing.

• If investment (injection) exceeds saving (leakage) then available

funds to borrow decrease and interest rates rise, which inhibits
investment borrowing.
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 Self-Adjustment?
Keynes argued that classical economists ignored the role
of changing expectations.

The whole investment function shifts when business

expectations change.

According to Keynes, declining consumers sales would

alter the expectations of businesses.

Investment is more likely to decline rather than rise.

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 Self-Adjustment?
Classical economists believed that flexible prices would
make self-adjustment possible.

Any rising inventory of goods (unsold goods) would

trigger falling prices.

This would lead to consumers demanding more output.

If prices fell far enough, consumers might buy all the

output produced at full employment

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 Self-Adjustment?

Keynes argued that lower prices would

change business expectations.

Lower prices would make them rethink their

production and investment plans.

Declining prices would prompt businesses

to invest less.
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 The Multiplier Process
Keynes argued that the economy would get
worse, not better, once a spending shortfall
emerged.

What starts off as a relatively small

spending shortfall quickly snowballs into a
much larger problem.

This is referred to as the multiplier process.

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 The Multiplier Process
Steps in the multiplier process from a decline in
investment:

. ①
Investment starts to decline.
. ②
Output remains unsold.
. ③
This leads to a cutback in production and income.
. A reduction in total income will in turn lead to a
reduction in consumer spending.
. ⑧ These additional cuts in spending cause a further
increase in unsold output, decrease in income,
leading to additional spending reductions, and so
on.
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Figure 10.5 The Multiplier Process

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 The Multiplier
The multiplier process is a sequence of related events, not
a one-time change in spending.

The eventual decline in spending will be much larger than

the initial (autonomous) decrease in aggregate demand.

The ultimate impact of an AD shift on total spending can

be determined by using the multiplier.

The multiplier is the multiple by which an initial change

in aggregate spending will alter total expenditure after an
infinite number of spending cycles.
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 The Multiplier
The multiplier can be computer as:

Example: If MPC = 0.75, the multiplier is: 1 /(1 – 0.75) =

4.

The size of the multiplier depends on the value of the

MPC:

• If the MPC decreases, the multiplier gets smaller.

• If the MPC increases, the multiplier gets larger.
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 The Multiplier
If the initial change in government spending is $100
billion per year and the MPC = 0.75:

= 1/(1 – MPC) x $100 billion per year.

= 1/(1 – 0.75) x $100 billion per year.

= 4 x $100 billion per year.

= $400 billion per year.

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 Table 10.1 The Money Multiplier at
Work

The cumulative decrease in total spending ($400 billion per year) resulting
from an abrupt decline in aggregate demand at full employment is equal to
the initial decline ($100 billion per year) multiplied by the multiplier (4).
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World View: Asian Economies Hurt by U.S. Recession

CRITICAL ANALYSIS: Multiplier effects

can spill over national borders.

The 2008–2009 recession in the United States

reduced U.S. demand for Asian exports.

It set off a sequence of spending cuts in Japan,

Korea, China, and other Asian nations.

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 Macro Equilibrium Revisited
The key features of the Keynesian adjustment process are:

• Producers cut output and employment when output exceeds AD

at the current price level (leakage exceeds injections).

• The resulting loss of income causes a decline in consumer

spending.

• Declines in consumer spending lead to further production

cutbacks, more lost income, and still less consumption.

• The decline in household income caused by investment cutbacks

sets off the multiplier process, causing sequential shifts of the
AD curve.
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 Figure 10.6 Multiplier Effects
A decline in investment
spending reduces
household income, setting
off negative multiplier
effects.

The initial shift of AD0 to

AD1 is followed by a
series of aftershocks that
ultimately ends up at AD2.

The shift from AD1 to

AD2 represents reduced
consumption.
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 Price and Output Effects
The impact of a shift in aggregate demand is reflected in
both output and price changes.

A recessionary GDP gap is the amount by which

equilibrium GDP falls short of full-employment GDP.

It represents the amount by which the economy is

underproducing during a recession.

This is a case of cyclical unemployment.

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Figure 10.7 Recessionary GDP Gap
The real GDP gap is
the difference
between equilibrium
GDP (QE) and full-
employment GDP
(QF).

It represents the lost

output due to a
recession.
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Short-Run Inflation—Unemployment Trade-Off

Because the AS curve is upward sloping, when AD

increases, both output and prices go up.

So long as the short-run AS is upward-sloping,

there’s a trade-off between unemployment and
inflation.

We can get lower rates of unemployment (more

real output) only if we accept some inflation.
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 “Full” vs. “Natural” Unemployment
Full employment is the lowest rate of unemployment compatible
with price stability.

• It is typically defined as a 4 to 6 percent rate of unemployment.

Loading…
Neoclassical and monetarist economists believe that the long-run AS
curve is vertical.

• There is no unemployment-inflation trade-off.

• An AD shift doesn’t change the “natural” rate of unemployment
but does alter the price level.
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Figure 10.8 The Unemployment-
Inflation Trade-Off
If the short-run AS curve is
upward-sloping, an AD
increase will raise output and
prices.

If AD increases by the
amount of the recessionary
GDP gap only (AD2 to AD3),
full employment (QF) won’t
be reached.

Macro equilibrium moves to

point g, not point f.
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 The Coronavirus Shutdown
In early 2020, the coronavirus had everyone worried about the short-
term health dangers and the risks to the economy.

The consensus was that government intervention was a dire necessity.

In response, governments around the world shut down their economies,

causing unemployment and loss of incomes.
• The sudden loss of income, fueled by the multiplier, could have
wreaked havoc on economies around the world.

To offset those negative multiplier effects governments everywhere

stepped up their spending.
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Adjustment to an Inflationary GDP Gap
A sudden shift in AD can have a cumulative effect on
macro outcomes that is larger than the initial imbalance.

This multiplier process works in both directions.

• A decrease in investment (or any other AD component)

can send the economy into a recession tailspin.

• An increase in investment might initiate an inflationary

spiral.
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 Adjustment to an Inflationary GDP Gap
An increase in investment might initiate an inflationary
spiral.

• This can lead to inventory depletion.

• Inventory depletion is a warning sign of potential
inflation.

Household incomes will get a boost.

Consumer spending will increase by a multiple of the

initial income change.
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 Adjustment to an Inflationary GDP Gap
An increase in investment or other autonomous spending
sets off multiplier effects shifting AD to the right.

AD shifts to the right twice:

• First because of increased investment
• Second because of increased consumption.

The increased AD moves the economy up the short-run AS

curve, causing some inflation.

This is a case of demand-pull inflation or an increase in

the price level initiated by excessive aggregate demand.
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Figure 10.9 Demand-Pull Inflation
An increase in investment shifts AD to
the right.

AD shifts to the right twice:

• AD0 to AD5 due to increased

investment.
• AD5 to AD6 due to increased
consumption.

The increased AD moves the economy

up the short-run AS curve, causing
some inflation.

The inflationary GDP gap equals the

difference between equilibrium GDP
(QE) and full-employment GDP (QF).
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 Booms and Busts
The basic conclusion of the Keynesian analysis is that:

The economy is vulnerable to abrupt changes in spending

behavior.

It won’t self-adjust to a desired macro equilibrium.

The responses of market participants to an abrupt AD shift

are likely to worsen rather than improve market outcomes.

The combination of alternating AD shifts and multiplier effects

also causes recurring business cycles.
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Policy Decisions: How Important is Consumer Confidence?

The multiplier process can originate with a change in

consumer spending.

Changes in consumer confidence can be an AD shift factor

by:

Changing the value of autonomous consumption.

Changing the marginal propensity to consume.

These AD shifts can be substantial.

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 Policy Decisions: How Important is Consumer Confidence?

Consumer spending is the largest component of aggregate demand.

Public officials strive to maintain consumer confidence in the

economy tomorrow.

• The “rosy outlook” is still the official perspective on the economy

tomorrow.
• The White House is always upbeat about prospects for the
economy.

If it weren’t, consumer and investor confidence might wilt.

• Then the economy might quickly turn ugly.

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 Figure 10.10 Consumer Confidence

Consumer confidence is affected by various financial, political, and

international events.
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 CHAPTER
11

Fiscal Policy

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 Learning Objectives
After reading this chapter, you should know:

. How and why the real GDP gap and the AD

shortfall differ.
. The tools of fiscal stimulus and their desired
scope.
. What AB excess measures.
. The tools of fiscal restraint and their desired
scope.
. How the multiplier affects fiscal policy.
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 Chapter Goals

This chapter examines the fiscal policy tools

an Economist in Chief has available:
1. Can government spending and tax policies
Loading…
ensure full employment?
2. What policy actions will help fight inflation?
3. What are the risks of government
intervention?

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 Taxes and Spending

Before 1913, most government revenue came

from taxes on imports, whiskey, and tobacco.

The Sixteenth Amendment to the U.S.

Constitution (1913) extended the government’s
taxing powers to incomes.

Today, the federal government collects nearly $5

trillion a year in tax revenues.
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 Taxes and Spending
Government can spend money on:

• Purchases of real goods and services in product markets.

• Defense, highways, and health care.
• Part of aggregate demand.
Loading…
• Income Transfers.
• Payments to individuals for which no current goods or
services are exchanged.
• Social Security, welfare, and unemployment benefits.
• Not part of aggregate demand until the recipients decide
to spend that income.
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 Fiscal Policy
The government can alter aggregate demand by:

• Purchasing more or fewer goods and services.

• Raising or lowering taxes.
• Changing the level of income transfers.

Fiscal policy entails the use of government taxes and

spending to alter macroeconomic outcomes.

From a macro perspective, the federal budget is a tool

that can shift aggregate demand and thereby alter
macroeconomic outcomes.
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 Figure 11.1 Fiscal Policy

Fiscal policy refers to the use of the government tax and spending
powers to alter macro outcomes.

Fiscal policy works principally through shifts of the aggregate

demand curve.
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 Fiscal Stimulus
The market’s short-run macro equilibrium may be
undesirable.

A recessionary GDP gap occurs when equilibrium GDP

falls short of full-employment GDP.

The Keynesian strategy is to spend more on goods and

services.

Fiscal stimulus refers to tax cuts or spending hikes

intended to increase (shift) aggregate demand.
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 Figure 11.2 The Policy Goal
The economy is in a
recessionary
equilibrium (point a).

The policy goal is

to increase output to full
employment (QF).

Keynes urged the

government to use fiscal
policy to shift the AD
curve rightward.
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 Fiscal Stimulus
If the AS curve was horizontal:
• A rightward shift in AD would not cause prices to rise.
• Shifting the AD curve by the amount of the recessionary gap
would be sufficient.

If the AS is upward sloping:

• Shifting the AD curve to the right causes both output and prices
to increase.
• We must increase AD by more than the size of the recessionary
GDP gap to achieve full employment.

The amount of additional aggregate demand needed to achieve full

employment after allowing for price level changes is called the AD
shortfall.
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 Figure 11.3 The AD Shortfall
If AD increased by the
amount of
the recessionary GDP
gap, we would get a
shift from AD1 to AD2.
Loading…
The resulting
equilibrium (point c),
would leave the
economy short of full
employment (QF).
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 Figure 11.3 The AD Shortfall
Because AS is upward
sloping, some of the
increased demand
pushes up prices instead
of output.

To reach full-
employment
equilibrium (point d),
the AD curve must shift
to AD3.
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 More Government Spending
Increased government spending is a form of fiscal stimulus.

Every dollar of new government spending has a multiplied impact

on AD.

The multiple by which an initial change in aggregate spending will

alter total expenditure after an infinite number of spending cycles is
called the multiplier.

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 Sequential Shifts
The impact of fiscal stimulus on aggregate demand includes both:

• The new government spending.

• All subsequent increases in consumer spending triggered by

multiplier effects.

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 Figure 11.4 Multiplier Effects
Fiscal stimulus will set
off the multiplier
process.

AD will increase (shift)

in two distinct steps:

(1) the initial fiscal

stimulus (AD1 to AD2)
(2) induced changes in
consumption
(AD2 to AD3).

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 The Desired Stimulus
Multiplier effects make changes in government spending a
powerful policy lever.

The multiplier also increases the risk of error.

• Too little fiscal stimulus may leave the economy in a recession.

• Too much can rapidly lead to excessive spending and inflation.

The general formula for computing the desired stimulus is:

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 Tax Cuts
The fiscal stimulus can also come from an increase in:

• Autonomous consumption.
• Investment spending.
• Demand for our imports.

Fiscal policy can encourage such changes by lowering

taxes.

• Increasing the disposable income.

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 Taxes and Consumption
A tax cut that increases disposable incomes stimulates
consumer spending and shifts AD to the right.

But by how much?

If taxes were cut by $200 billion, the resulting initial

increase in spending would be:

Initial increase in consumption = 0.75 × $200 billion

= $150 billion
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 Multiplier Effects

me &

=>
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 Multiplier Effects
A tax cut contains less fiscal stimulus than an increase in
government spending of the same size.

The initial spending injection is less than the size of the

tax cuts.
• Only part of a tax cut gets spent.
• Consumers save the rest.

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 Multiplier Effects

met

am
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Figure 11.5 The Tax Cut Multiplier
Only part of a tax cut is used
to increase consumption.

The remainder is saved.

The initial spending injection is

less than the tax cut.

This makes tax cuts less

stimulative than government
purchases of the same size.

The multiplier still works on that

new consumer spending, however.
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 The Balanced Budget Multiplier
An increase in government spending paid for by an increase in taxes of equal
size isn’t really neutral.

A “balanced budget” shifts aggregate demand to the right.

The cumulative (ultimate) change in total spending is:

The balanced budget multiplier is equal to 1.

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 Taxes and Investment
A tax cut may also be an effective mechanism for
increasing investment spending.

If a cut in corporate taxes raises potential after-tax

profits, it should encourage additional investment.

Once additional investment spending enters the

circular flow, it too has a multiplier effect.
automatic discretionary

↓
↓

defect structural deficit

Budget Deficit cyclical
+
=

for
12 3
table ↑
Expending
.

↓ revenues
+

Budget
=

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 Increased Transfers
A third fiscal policy option for stimulating the economy is to
increase transfer payments.

Increasing transfer payments raises recipients’ disposable income

and spending increases.

The initial fiscal stimulus (AD shift) of increased transfer

payments is represented by:

This initial stimulus sets the multiplier in motion, shifting the AD

curve repeatedly to the right.
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Figure 11.6 GDP Impact of CARES Act

The CARES Act of

March 2020 put $2.2
trillion into the hands of
consumers.

These income transfers

boosted GDP over the
following calendar
quarters, demonstrating
the multiplier effect.
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 Fiscal Restraint
An inflationary GDP gap occurs when equilibrium GDP exceeds
full-employment GDP.
• Policy makers are concerned about inflation.
• The goal is to reduce aggregate demand.

Fiscal restraint refers to tax hikes or spending cuts intended to

reduce (shift) aggregate demand.
• Reduce government spending.
• Increase taxes.
• Decrease transfer payments.

The amount by which AD must be reduced to achieve full-

employment equilibrium after allowing for price level changes is
called the AD
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Figure 11.7 Excess Aggregate Demand
Too much aggregate demand
(AD1) causes the price level
to rise (PE) above its desired
level (PF).

Loading…
To restore price stability, the
AD curve must shift leftward
by more than the inflationary
GDP gap:

It must shift by the entire

amount of the AD excess
(Q1 − Q2).
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 Desired Fiscal Restraint
We can compute the desired fiscal restraint as:

There are two distinct steps in this policy process:

1. Determine how far we want to shift the AD curve to the left.

• The size of the AD excess.

2. Compute how much government spending or taxes must be

changed to achieve the desired shift.

• Take the multiplier effects into account.

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 Budget Cuts
Decreased government spending is a form of fiscal
restraint.

Budget cuts have a multiplied effect on aggregate demand.

The budget cuts should equal the size of the desired fiscal
restraint.

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 Front Page Economics: Defense Cuts Kill Jobs
The Budget Control Act of 2011:

Cut defense spending from $837 billion in 2011 to $770 billion in 2013.

Cuts in:
Hardware procurement.
Department of Defense civilian employment.
Active-duty forces.

The resulting loss of jobs and output:

261,000 fewer jobs in 2014.
0.2 percentage point shaved off GDP.

CRITICAL ANALYSIS: Reductions in governmental spending on goods and

services directly decrease AD.

Multiplier effects induce additional cutbacks in consumption, further reducing AD.

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 Tax Hikes
Tax increases can also be used to shift the AD curve to the left.

The direct effect of a tax increase is a reduction in disposable income.

Only the reduced consumption results in less aggregate demand.

As consumers spend less, they set off the multiplier process.

This leads to a much larger, cumulative shift of aggregate demand.

Taxes must be increased more than a dollar to get a dollar of fiscal

restraint.

How© McGraw
much larger
Hill LLC. depends
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No reproduction the MPC. without the prior written consent of McGraw Hill LLC.
 Tax Hikes

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 Reduced Transfers
A cut in transfer payments works like a tax hike.

• Reducing the disposable income of transfer recipients.

• With less income, consumers spend less, as reflected in the
MPC.

The appropriate size of the transfer cut can be computed in

the same way as the desired tax increase.

Transfer cuts are rarely proposed.

Sometimes used to reduce the rate of increase in transfers.

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 Fiscal Guidelines
Crowding out refers to a reduction in private sector
borrowing (and spending) caused by increased government
borrowing.

If fiscal stimulus funding is financed by government

borrowing from the private sector:

• Less credit may be available to finance consumption and

investment.
• Creates an offsetting reduction in private demand.

Some of the intended fiscal stimulus may be offset by the

crowding out of private expenditure.
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Table 11.2 Fiscal Policy Primer

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Table 11.2 Fiscal Policy Primer

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 A Warning: Crowding Out
Fiscal policy involves deliberate shifting of the AD
curve.

The steps required to formulate fiscal policy are:

• Specify the amount of the desired AD shift (AD

excess or AD shortfall).

• Select the policy tools needed to induce the desired

shift.

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 Time Lags
Another limitation of fiscal policy is time.

It takes time to:

• Recognize that a problem exists.
• Develop a policy strategy.
• Pass the required legislation.
• Implement the policy.
• Generate the many steps in the multiplier process.

Might take months for fiscal policy to have its desired effects.

Other shocks to the economy may change the nature of our macro
problems.
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 Pork Barrel Politics
Fiscal policy is designed and implemented by the U.S. Congress.

Members of Congress are reluctant to sacrifice any spending

projects in their own districts.

They want their constituents to get the biggest tax savings.

No one in Congress wants a tax hike or spending cut before the

election.

This kind of pork barrel politics can alter the content and timing of
fiscal policy.

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Policy Decisions: What Kind of Spending Should be Targeted?

Fiscal policy guidelines don’t specify how the

government spends its revenue or whom it taxes.

Fiscal policy has great influence on:

• Full employment and price stability.

• The mix of output produced.
• Distribution of income.
• Prospects for long-term economic growth.

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Policy Decisions: What Kind of Spending Should be Targeted?

Using government spending to stabilize the economy can

lead to an even larger public sector.

Keynes never said that government spending was the

only lever of fiscal policy.

Tax policy can be used to alter consumer and investor

spending as well.

Fiscal policy can also focus on changing the level of

private sector spending.
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 CHAPTER
12

Deficits and Debt

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 Learning Objectives

After reading this chapter, you should know:

. The origins of cyclical and structural

deficits.
. How the national debt has accumulated.
. How and when “crowding out” occurs.
. What the real burden of the national
debt is.
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 Chapter Goals

This chapter tries to understand how fiscal

stimulus is financed.
• How do deficits arise?
Loading…
• What harm, if any, do deficits cause?

• Who will pay off the accumulated national debt?

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 Budget Effects of Fiscal Policy
Use of the budget to stabilize the economy implies that federal
expenditures and receipts won’t always be equal.

Deficit spending is the use of borrowed funds to finance

government expenditures that exceed tax revenues.

The amount by which government spending exceeds

government revenue in a given time period is called the budget
deficit.

An excess of government revenues over government expenditures

in a given time period is a budget surplus.
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 Table 12.1 Budget Deficits and
Surpluses

Loading…
Budget deficits arise when government outlays
(spending) exceed revenues (receipts).

When revenues exceed outlays, a budget surplus exists.

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 Figure 12.1 A String of Deficits
A budget surplus
was achieved in
only four years
(1998–2001) since
1970.

Deficits result from

both cyclical
slowdowns and
discretionary
policies.
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Front Page Economics: Americans Worried About Uncle Sam’s Debt

The Congressional Budget

Office estimates that the
American Rescue Plan will add
close to $3 trillion to the
national debt.

Three out of four voters say that

is worrisome.

Two out of three say the debt is

an unfair burden on the next
generation.
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 Keynesian View
The goal of macro policy is not to balance the budget
but to balance the economy (at full employment).

If a budget deficit or surplus is needed to shift

aggregate demand to the desired equilibrium, then so
be it.

A balanced budget is appropriate only if all other

injections and leakages were in balance and the
economy was in full-employment equilibrium.

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 Discretionary vs. Automatic Spending
Discretionary fiscal spending are those elements of the budget not
determined by past legislative or executive commitments.
• Accounts for 20% of the federal budget.

80% of the federal budget is a result of decisions made in prior

years and known as automatic spending or “uncontrollable.”

To a large extent, current revenues and expenditures are the result

of decisions made in prior years.

The potential for changing budget outlays in any year is much

smaller than it might at first appear.

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 Automatic Stabilizers
Income transfers are payments to individuals for which
no current goods or services are exchanged.

• Social Security, welfare, and unemployment benefits

An automatic stabilizer is a federal expenditure or

revenue item that automatically responds
countercyclically to changes in national income.

• Unemployment benefits and income taxes.

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 Cyclical Deficits
The size of the federal budget deficit or surplus is sensitive to
expansion and contraction of the macro economy.

Actual budget deficits and surpluses may arise from economic

conditions as well as policy.
Loading…
That portion of the budget deficit attributable to unemployment or
inflation is known as the cyclical deficit.

The cyclical deficit widens when GDP growth slows or inflation

increases.

The cyclical deficit shrinks when GDP growth accelerates or inflation

decreases.
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 Cyclical Deficits
When the GDP Growth rate decreases by one percentage point :

• Government spending (G) automatically increases for:

• Unemployment insurance benefits.
• Food stamps.
• Welfare benefits.
• Social Security benefits.
• Medicaid.

• Government tax revenues (T) automatically decline for:

• Individual income taxes.
• Corporate income taxes.
• Social Security payroll taxes.

The deficit increases in $71 billion.

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 Cyclical Deficits
When the inflation rate increases by one percentage point:

• Government spending (G) automatically increases for:

• Indexed retirement and Social Security benefits.
• Higher interest payments.

• Government tax revenues (T) automatically increase for:

• Corporate income taxes.
• Social Security payroll taxes.

The deficit increases by $92 billion.

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 Structural Deficits
Part of the deficit arises from cyclical changes in the
economy.

The rest is the result of discretionary fiscal policy.

The structural deficit reflects fiscal policy decisions.

Structural deficit refers to federal revenues at full

employment minus expenditures at full employment under
prevailing fiscal policy.

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Table 12.3 Cyclical vs. Structural Budget Balances
(in billions of dollars)
The budget balance
includes both cyclical
and structural
components.

Changes in the structural

component result from
policy changes.

Changes in the cyclical

component result from
changes in the economy.
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 Structural Deficits
To isolate the impact of policy decisions, we must
focus on changes in the structural deficit, not the total
deficit.

Fiscal stimulus is measured by an increase in the

structural deficit (or shrinkage in the structural surplus).

Fiscal restraint is gauged by a decrease in the structural

deficit (or increase in the structural surplus).

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Economic Effects of Deficits: Crowding
Out
If the government borrows funds to finance deficits,
the availability of funds for private sector spending
may be reduced.

Crowding out refers to a reduction in private sector

borrowing (and spending) caused by increased
government borrowing.

Crowding out implies less private sector output.

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 Figure 12.2 Crowding Out
A deficit-financed increase in
government expenditure moves the
economy from point a to point b.

In the process, the quantity h1 − h2

of private sector output is crowded
out to make room for the increase in
public sector output (from g1 to g2).

If the economy started at point c,

however, with unemployed
resources, crowding out need not
occur.
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Economic Effects of Deficits: Opportunity Cost

Opportunity cost is the most desired goods or

services that are forgone in order to obtain something
else.

There’s an opportunity cost to government spending.

We have to decide whether the private sector output

crowded out by government expenditure is more or
less desirable than the increased public sector output.

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Economic Effects of Deficits: Interest Rate Movements

When the government borrows more funds to finance larger deficits,

it puts pressure on financial markets.

That added pressure may cause interest rates to rise.

• Households will be less eager to borrow money to buy cars,

houses, and other debt-financed products.

• Businesses will be more hesitant to borrow and invest.

Hence, rising interest rates are both a symptom and a cause of

crowding out.

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Economic Effects of Surpluses: Crowding In
There are four potential uses for a budget surplus:

• Spend it on goods and services.

• Enlarges the private sector.

• Cut taxes.
• Increase income transfers.
• Puts money into the hands of consumers.
• Enlarges the private sector.

• Pay off old debt (“save it”).

• Puts money in the hand of the debt holders (crowding in).
• Private sector output may expand.
• Reduces
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or distribution without the prior written consent of McGraw Hill LLC.
 The Accumulation of Debt
The national debt is the accumulated debt of the federal
government.

It is equal to the sum total of our accumulated deficits, less any

repayments in those years when a budget surplus existed.

The U.S. Treasury acts as the fiscal agent of the U.S.

government.

• Collects tax revenues.

• Signs checks for federal spending.
• Borrows funds to cover budget deficits.
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 Debt Creation/Bonds
The Treasury borrows funds by issuing Treasury bonds.

Treasury bonds are promissory notes (IOUs) issued by the U.S.

Treasury.

The total stock of all outstanding bonds represents the national debt.

The national debt is a stock of IOUs created by annual deficit flows

When there’s a budget deficit, the national debt increases.

When a budget surplus exists, the national debt can be pared down.

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 Early History, 1790–1900
During the period 1790–1812, the U.S. often incurred debt but
typically repaid it quickly.

But the War of 1812 caused a massive increase in the national debt.

By 1816 the national debt was more than $129 million.

It amounted to 13 percent of national income in 1816.

After 1812, the government used recurrent budget surpluses to repay

its debt.

In 1835 and 1836, the U.S. had no budget deficit or national debt.
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 Early History, 1790–1900
During the Civil War (1861–1865), both sides needed debt
financing.

By the end of the Civil War, the North owed over $2.6 billion or
half its national income.

The South used newly printed Confederate currency.

It relied on bonds for only one-third of its financial needs.

When the South lost, neither Confederate currency nor

Confederate bonds had any value.
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 Twentieth Century
World War I increased the national debt from 3 percent of
national income in 1917 to 41 percent in 1918.

The national debt declined during the 1920s because the

federal government was consistently spending less revenue
than it took in.

Budget surpluses disappeared quickly when the economy

fell into the Great Depression and the cyclical deficit
widened.

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 Twentieth Century
During World War II, the national debt increased from 45 percent in
1940 to more than 125 percent in 1946.

During the 1980s, the national debt jumped by nearly $2 trillion.

Recessions (1980-81 and 1981-1982).

Massive tax cuts (1981-1984).
Increased defense spending.

In the early 1990s, the national debt increased by another $1 trillion.

The budget deficits of 1993-1997 pushed the national debt to more

than $5 trillion.
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 Recent Years
The accumulated debt exceeded $5.6 trillion in 2002.

The Bush tax cuts and defense buildup increased the

structural deficit by nearly $300 billion in only three years.

By January 2009 the debt exceeded $10 trillion.

The Great Recession and the Obama stimulus caused a

further surge in the national debt.

The trillion-dollar-plus deficits on 2009-2012 increased the

debt to almost $20 trillion by 2016.
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 Recent Years
Tax cuts and military spending introduced by President Trump
increased the budget deficit and added to the national debt.

The deficit and debt also increased due to the federal response to the
coronavirus in 2020.
Loading…
By the end of 2020, the national debt had climbed to $27 trillion.

During the first two years of the Biden administration, Congress

approved more than $4 trillion in new spending.

Those structural deficits brought the accumulated debt to more than

$33 trillion in 2023.
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Figure 12.3 Historical View of the Debt/GDP Ratio

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 Table 12.4 The National Debt

It took nearly a century for the national debt to reach $1 trillion.

The debt tripled in a mere decade (1980–1990) and then quintupled again in 20 years.

The accumulated debt now totals more than $27 trillion.

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 Who Owns the Debt?
The national debt represents not only a liability but an asset as well.

A liability is an obligation to make future payment.

An asset is anything having exchange value in the marketplace.

When the U.S. Treasury borrows money, it issues bonds.

• Bonds are a liability for the federal government.

• An asset to the people who hold them.

National debt creates as much wealth (for bondholders) as liabilities

(for the U.S. Treasury).
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 Who Owns the Debt?
The largest bondholder is the U.S. government itself.

• Federal agencies hold nearly 50 percent of all outstanding Treasury

bonds.

• Social Security Administration.

• The Federal Reserve System.

• State and local governments own 5 percent of the national debt.

• The private sector in the U.S. holds 21 percent of the debt.

• Foreigners own 24 percent of the debt.

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 Who Owns the Debt?
U.S. government debt (Treasury bonds) held
by U.S. households and institutions is called
internal debt.

• 75 percent of the national debt is internal.

U.S. government debt (Treasury bonds) held
by foreign households and institutions is
called external debt.

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 Figure 12.4 Debt Ownership
Debt Ownership (2022 data)
About 50 percent of
national debt is held by the
U.S. government itself.

The private sector in the

United States holds only
21 percent of the debt.

Foreigners own 24 percent.

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 Burden of the Debt
The government has been able to pile debt upon debt through the
process of refinancing.

Refinancing refers to the issuance of new debt in payment of debt

issued earlier.

When a debt becomes due, new funds are borrowed to pay it off.

Eternal refinancing makes it look as though government borrowing

has no cost.

There are two flaws in this way of thinking that relate to:
• Interest charges that accompany debt.
• The realHilleconomic
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written consent of McGraw Hill LLC.
 Debt Service
The U.S. government must make enormous interest payments every
year.

Debt service refers to interest required to be paid each year on

outstanding debt.

Interest payments restrict the government’s ability to balance the

budget or fund other public sector activities.

Most debt servicing is simply a redistribution of income from

taxpayers to bondholders.

Interest payments themselves have virtually no direct opportunity

cost for the economy as a whole.
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 Opportunity Cost
Opportunity costs are incurred only when real resources
(factors of production) are used.

The process of debt servicing absorbs few resources and so

has negligible opportunity cost.

The true burden of the debt is the opportunity cost of the

activities financed by the debt.

The opportunity cost of government purchases is the true

burden of government activity, however financed.
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 The Real Trade-offs
Deficit financing changes the mix of output in the direction
of more public sector goods.

The burden of the debt is really the opportunity cost

(crowding out) of deficit-financed government activity.

The public sector expands at the expense of the private

sector.

The primary burden of the debt is incurred when the debt-

financed activity takes place.
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 The Real Trade-offs
If debt-financed government spending crowds out private investment,
future generations will bear some of the debt burden.

Their burden will take the form of smaller-than-anticipated productive

capacity

The whole debate about the burden of the debt is really an argument
over the optimal mix of output.

Permitting deficit spending promotes more public sector activity.

Limiting deficit financing curtails growth of the public sector.

Battles over deficits and debts are a proxy for the more fundamental
issue of private versus public spending.
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 The Real Trade-offs
Future generations will have to pay interest on the debts we incur
today.

They might even have to pay off some of the debt.

When we die, we leave behind not only the national debt but also the
bonds that represent ownership of that debt.

Future grandchildren will be both taxpayers and bondholders.

Future interest payments entail a redistribution of income among

taxpayers and bondholders living in the future.

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 External Debt
When we borrow funds from abroad, we increase our ability to
consume, invest, and finance government activity.

External borrowing allows us to:

• Enjoy a mix of output that lies outside our production possibilities

curve.

• Get more public sector goods without cutting back on private

sector production (or vice versa) in the short run.

As long as outsiders are willing to hold U.S. bonds, external

financing imposes no real cost.
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 External Debt
But foreign investors may not be willing to hold U.S. bonds
indefinitely.

To do this, they will cash in (sell) their bonds, and then use
the proceeds to buy U.S. goods and services.

The United States will be exporting goods and services to

pay off its debts.

External debt must be repaid with exports of real goods and

services.
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 Figure 12.5 External Financing
A closed economy must forsake
some private sector output to
increase public sector output.

External financing temporarily

eliminates that opportunity cost.

Instead of having to move from a

to b, external borrowing allows us
to move from a to d.

At point d we have more public

output and no less private output.
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 Deficits and Debt Limits
The only way to stop the growth of the national debt is to eliminate
the budget deficits that create debt.

A balanced budget will at least stop the debt from growing further.

A deficit ceiling is an explicit, legislated limitation on the size of the

budget deficit.

A debt ceiling is an explicit, legislated limit on the amount of

outstanding national debt.

Deficit ceilings and debt ceilings are just political mechanisms for
forging compromises on how best to reduce budget deficits.
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Policy Decisions: Can We Keep Social Security Afloat?

The payroll (FICA) tax generates revenue for the Social Security
Trust Fund.

The Fund, in turn, pays monthly benefits to retired workers.

For more than 40 years the annual tax inflow exceeded the benefit
outflow.

The Fund used its surplus revenues to purchase Treasury bonds.

Social Security Trust Fund surpluses helped finance federal

government deficits.

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Policy Decisions: Can We Keep Social Security Afloat?

The future is not as rosy.

The Baby Boomers who paid a big part of the payroll tax
are retiring.

They are living longer in retirement.

The annual flow of tax revenues and benefit outlays has

changed direction.

The Trust Fund balance shifts from annual surpluses to

annual deficits.
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 Policy Decisions: Can We Keep Social Security Afloat?

Social Security will be able to pay promised benefits only if:

1. The U.S. Treasury pays all interest due on bonds held by the
Trust Fund.

2. The U.S. Treasury redeems the bonds the Trust Fund will then
be holding.

To pay back Social Security loans, Congress will have to:

• Raise future taxes significantly.

• Make substantial cuts in other (non–Social Security) programs.
• Sharply increase budget deficits.
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Table 12.5 Changing Worker/Retiree Ratios
Changing Worker/Retiree
Ratios

70 years ago, there were over 16 taxpaying workers for every retiree.

Today there are only 2.5, and the ratio slips further as more Baby
Boomers retire.
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