Chapter 5
The Government
Budget, Foreign
Borrowing, and
the Twin Deficits
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Key Questions
• How does fiscal policy affect the budget surplus or
deficit?
• How is the government budget interact with net
exports and foreign lending?
• Why does a negative current account deficit
generally lead to an increase in American
indebtedness to foreigners?
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-2
Figure 5-1 Real Government Expenditures, Real
Government Revenues, and the Real Government
Budget Deficit, 1900–2008 (1 of 2)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-3
Figure 5-1 Real Government Expenditures, Real
Government Revenues, and the Real Government
Budget Deficit, 1900–2008 (2 of 2)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-4
Figure 5-1 Real Government Expenditures,
Real Government Revenues, and the Real
Government Budget Deficit, 1900–2008
Source: Bureau of Economic Analysis, Historical Statistics of
the United States: Millennial Edition. Details in Appendix C-4
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-5
Budget Deficit (and Surplus)
Definitions
• The Structural Deficit is the what the deficit of the
economy would be if the economy were operating at
natural real GDP.
– The structural deficit is sometimes call the Natural Employment
Deficit (NED).
– The CBO uses “Standardized Budget Deficit” for the structural
budget deficit.
• The Cyclical Deficit is the amount by which the actual
government budget deficit exceeds the structural deficit.
– The Structural Surplus (or equivalently, the Natural Employment
Surplus (NES)) and the Cyclical Surplus are the same as the
deficit concepts with the signs reversed.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-6
Effects of a Budget Deficit
• Recall the “Magic Equation” from Chapter 2:
T – G = (I + NX) – S
• The Magic Equation suggests 3 ways to finance a budget
deficit (i.e. T – G < 0)
– Private saving (S) can go up
– Investment (I) can fall
– Foreign investment (NX) can fall
• Because an increase in the budget deficit increases the
total public debt, persistent budget deficits can lead to
higher taxes in the future.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-7
Automatic vs. Discretionary Fiscal
Policy
• Algebraically, the Budget surplus = T – G = tY – G
(where t = the average net tax rate).
• Automatic stabilization of the budget deficit occurs
because government tax revenues depend on income.
– If Y  T which helps to restrain expansions
– If Y  T which helps to dampen recessions
•
Discretionary fiscal policy alters tax rates and/or
government expenditures in a deliberate attempt to
influence real output and unemployment.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-8
Figure 5-2 The Relation Between the
Government Budget Surplus or Deficit and
Real Income
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-9
Figure 5-3 Effect on the Budget
Line of an Increase in Government
Expenditures
Source: Bureau of Economic Analysis, and Congressional
Budget Office. Details in Appendix C-4
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-10
Figure 5-4 A Comparison of the
Actual Budget and the Natural
Employment Budget, 1960–2007
Source: Bureau of Economic Analysis, and Congressional Budget Office. Details in Appendix C-4
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-11
National Saving
• National Saving is the sum of private and
government saving: NS = S + (T – G)
• Recall the Magic Equation:
T – G = (I + NX) – S
Rearranging yields  S + (T – G) = I + NX
 NS = I + NX
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-12
National Saving, Investment, and r
• Recall: Investment depends negatively on r.
• National saving has two components:
– (T – G) does not depend on r
– S increases with a higher r
• In a closed economy, NS = I at equilibrium.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-13
Figure 5-5 National Saving and Domestic
Investment in a Closed Economy
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-14
Figure 5-6 Effect of a Fiscal Expansion
in a Closed Economy
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-15
Fiscal Policy in a Small Open
Economy
• Recall: An Open Economy sells exports to other nations,
buys imports, and experiences capital flows in and out of
the country.
– A Small Open Economy (or SOE) is considered too small for its
domestic policies to affect the world interest rate.
• Therefore, the local r must equal the world interest rate, rf .
• The “Magic Equation” written to reflect changes in its
component parts is: ∆NS = ∆I + ∆NX
– But since r = rf is unaffected by domestic policies  ∆I = 0
 ∆NS = ∆NX
• Implication: If G  NS  NX, but I unaffected
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-16
Figure 5-7 Effect of a Fiscal Expansion in
an Open Economy (1 of 2)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-17
Figure 5-7 Effect of a Fiscal Expansion in
an Open Economy (2 of 2)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-18
Figure 5-7 Effect of a Fiscal
Expansion in an Open Economy
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-19
The Current Account and the BOP
• The Current Account (CA) records the nation’s current
international transactions including exports and imports of
goods and services (i.e. NX), net income from abroad and
net unilateral transfer payments.
• The Capital Account (KA) records international capital
flows, which consist of purchases and sales of foreign
assets by domestic residents, as well as purchases and
sales of domestic assets by foreign residents.
• The Balance of Payments (BOP) is the record of a
nation’s international transactions.
– Algebraically: BOP = CA + KA
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-20
Foreign Borrowing and Int’l
Indebtedness
• A current account deficit must be financed either by:
– Net borrowing from foreigners
• This is recorded as a capital account surplus.
– Net borrowing from foreign central banks
• This is recorded as a balance of payments deficit.
• A nation’s Net International Investment Position is the
difference between all foreign assets owned by a nation’s
citizens and domestic assets owned by foreign citizens.
• ∆ Net Int’l Investment Position = CA Balance +
Net Revaluations
(where Net Revaluations is the change in the dollar value of financial assets
due to fluctuations in financial markets and the exchange rate)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-21
Figure 5-8 Components of Net Saving
and Investment, 1960–2006
Source: See Appendix C-4
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-22
Figure 5-9 The U.S. Current Account
Balance and Its Net International Investment
Position, 1975–2006
Source: Bureau of Economic Analysis, NIPA tables
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-23
International Perspective Saving,
Investment, and Government Budgets
Around the World (1 of 3)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-24
International Perspective: Saving,
Investment, and Government Budgets
Around the World (2 of 3)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-25
International Perspective: Saving,
Investment, and Government Budgets
Around the World (3 of 3)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-26
International Perspective: Saving,
Investment, and Government Budgets
Around the World
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-27
Solutions to the National Saving
Squeeze
• How can U.S. national saving be increased to
stimulate domestic investment and long-run
economic growth?
• Two Obvious Solutions:
– Raise the private saving rate
– Raise the government saving rate by:
• Increasing T and/or
• Decreasing G
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-28
Table 5.1 The U.S. Balance of
Payments, Selected Years
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-29
Chapter Equations
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
5-30
Chapter Equations
T  G  ( I  NX )  S
T  tY
(5.1)
(5.2)
budget surplus  T  G  tY  G
natural employment surplus  tY N  G
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
(5.3)
(5.4)
5-31
Chapter Equations
S  (T  G)  I  NX , or NS  I  NX
NS  I  NX
NX  NS
(5.6)
(5.7)
(T  G)  I  NX  S
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
(5.5)
(5.8)
5-32
Chapter Equations
G  T   NX  ( S  I )
(5.9)
 NX  I  ( S  T  G)  I  NS
(5.10)
Current account balance  capital account balance 
balance of payments outcome
(5.11)
Change in net international investment position 
current account balance  net revaluations
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
(5.12)
5-33