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structural deficit rose. Worries about the burden of the national debt, once mostly
federal budget.”
myths, became all too realistic.
2. How did we get rid of the deficit in the 1990s? In part, we did it the old-fashioned
way: by raising taxes and reducing spending in three not-so-easy steps. There
was a contentious but bipartisan budget agreement in 1990, a highly partisan
deficit-reduction package in 1993 (which passed without a single Republican
vote), and a smaller bipartisan budget deal in 1997.
Taxing more and spending less produces a contractionary fiscal policy that re-
duces aggregate demand. This effect did not hurt the U.S. economy in the 1990s
because fiscal and monetary policies were well coordinated. If fiscal policy turns
contractionary to reduce the deficit, monetary policy can turn expansionary to
counteract the effects on aggregate demand. In this way, we can hope to shrink the
deficit without shrinking the economy. Such a change in the policy mix should
also bring down interest rates, because both tighter budgets and easier money
tend to have that effect. Indeed, that is just what happened in the 1990s. Interest
rates fell, and the Fed made sure that aggregate demand was sufficient to keep the
economy growing.
In addition, surprisingly rapid economic growth in the late 1990s generated
much more tax revenue than anyone thought likely only a few years earlier. And
the so-called off-budget surplus also increased. Both of these developments
helped the federal budget turn rapidly from deficit into surplus.
3. How did the surplus give way to such large deficits so rapidly? As we have just noted,
the answer comes in three parts: recession, tax cuts, and higher levels of spending,
especially on national defense and homeland security. It is hardly a mystery that
sharply rising expenditures and rapidly falling revenue push the budget from the
black into the red.
4. What are the future prospects for the federal budget deficit? In a word, not very good.
Beginning in 2011, baby boomers born in the years after 1946 will start reaching
the magic age of 65”making them eligible for Medicare and, soon thereafter, for
full Social Security benefits. So it is all but certain that federal spending will start
to rise sharply. But as of now, Congress has not enacted the future tax increases
that will be needed to fund these expanding retirement and health-care programs.
Nor has it cut the promised benefits. So, if nothing changes, the budget deficit will
start to grow again. Economists are not terribly concerned about the triple-digit
budget deficits of 2007 and 2008. But they are worried about how the U.S. govern-
ment will pay its bills in 2020, 2030, and 2040.




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Licensed to:

Chapter 15 315
Budget Deficits in the Short and Long Run



| SUMMARY |
8. Unless the deficit is substantially monetized, deficit
1. Rigid adherence to budget balancing would make the
spending forces interest rates higher and discourages
economy less stable, by reducing aggregate demand (via
private investment spending. This process is called the
tax increases and reductions in government spending)
crowding-out effect. If a great deal of crowding out oc-
when private spending is low and by raising aggregate
curs, then deficits impose a serious burden on future
demand when private spending is high.
generations by leaving them a smaller capital stock with
2. Because both monetary and fiscal policy influence
which to work.
aggregate demand, the appropriate budget deficit or
9. But higher government spending (G) may also produce
surplus depends on monetary policy. Similarly, the ap-
a crowding-in effect. If expansionary fiscal policy suc-
propriate monetary policy depends on budget policy.
ceeds in raising real output (Y), more investment will be
3. The same level of aggregate demand can be generated
induced by the higher Y.
by more than one mix of fiscal and monetary policy.
10. Whether crowding out or crowding in dominates largely
But the composition of GDP will be different in each
depends on the time horizon. In the short run, and espe-
case. Larger budget deficits and tighter money tend to
cially when unemployment is high, crowding in is proba-
produce higher interest rates, a smaller share of invest-
bly the stronger force, so higher G does not cause lower
ment in GDP, and slower growth. Smaller budget
investment. But, in the long run, the economy will be near
deficits and looser monetary policy lead to a larger in-
full employment, and the proponents of the crowding-out
vestment share and faster growth.
hypothesis will be right: High government spending will
4. One major reason for the large budget deficits of the
mainly displace private investment.
early 1980s and early 1990s was the fact that the econ-
11. Larger deficits may spur growth (via aggregate demand)
omy operated well below full employment. In those
in the short run but deter growth (via aggregate supply
years, the structural deficit, which uses estimates of
and potential GDP) in the long run.
what the government™s receipts and outlays would be at
full employment to correct for business-cycle fluctua- 12. Whether or not deficits create a burden depends on how
tions, was much smaller than the official deficit. and why the government incurred the deficits in the first
place. If the government runs deficits to fight recessions,
5. The need to make future interest payments on the pub-
more investment may be crowded in by rising output
lic debt is a burden only to the extent that the national
than is crowded out by rising interest rates. Deficits con-
debt is owned by foreigners.
tracted to carry on wars certainly impair the future capi-
6. The argument that a large national debt can bankrupt a
tal stock, although they may not be considered a burden
country like the United States ignores the fact that our
for noneconomic reasons. Because these two cases ac-
national debt consists entirely of obligations to pay U.S.
count for most of the debt the U.S. government con-
dollars”a currency that the government can raise by
tracted until the mid-1980s, that debt cannot reasonably
increasing taxes or create by printing money.
be considered a serious burden. However, some of the
7. Budget deficits can be inflationary because they expand
deficits since 1984 are more worrisome on this score.
aggregate demand. They are even more inflationary if
they are monetized”that is, if the central bank buys
some of the newly issued government debt in the open
market.




| KEY TERMS |
Mix of monetary and National debt 303 Crowding out 310
fiscal policy 301 Structural budget deficit or Crowding in 311
Budget deficit 303 surplus 306 Burden of the national debt 311
Budget surplus 303 Monetizing the deficit 309




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Part 3
316 Fiscal and Monetary Policy



| TEST YOURSELF |
1. Explain the difference between the budget deficit and 3. If the Federal Reserve lowers interest rates, what will
the national debt. If the deficit gets turned into a sur- happen to the government budget deficit? (Hint: What
plus, what happens to the debt? will happen to tax receipts and interest expenses?) If the
government wants to offset the effects of the Fed™s ac-
2. Explain in words why the structural budget might show
tions on aggregate demand, what might it do? How will
a surplus while the actual budget is in deficit. Illustrate
this action affect the deficit?
your answer with a diagram like Figure 5 (page 306).




| DISCUSSION QUESTIONS |
Fed to lower interest rates. In view of your answer to Test
1. Explain how the U.S. government managed to accumu-
Yourself Question 3, why do you think that might be?
late a debt of over $9 trillion. To whom does it owe this
debt? Is the debt a burden on future generations? 4. Explain the difference between crowding out and
crowding in. Given the current state of the economy,
2. Comment on the following: “Deficit spending paves the
which effect would you expect to dominate today?
road to ruin. If we keep it up, the whole nation will go
bankrupt. Even if things do not go this far, what right 5. Given the current state of the economy, what sort of
have we to burden our children and grandchildren with fiscal-monetary policy mix seems most appropriate to
these debts while we live high on the hog?” you now? (Note: There is no one correct answer to this
question. It is a good question to discuss in class.)
3. Newspaper reports frequently suggest that the adminis-
tration (regardless of who is president) is pressuring the




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Licensed to:




The Trade-Off between Inflation
and Unemployment
We must seek to reduce inflation at a lower cost in lost output and unemployment.
J IMMY CA RTE R



I magine that you were Ben Bernanke, Chairman of the Federal Reserve Board, cut-
ting interest rates in 2007 and 2008 in order to boost aggregate demand. Two things
you would have liked to know is how much your actions were likely to speed up real
GDP growth, and hence reduce unemployment, and how much they were likely to
increase inflation”because monetary policy normally moves unemployment and
inflation in opposite directions in the short run.
This is an idea we first encountered in our list of Ideas for Beyond the Final Exam in
Chapter 1. Back then, we noted that there is a bothersome trade-off between inflation and
unemployment: High-growth policies that reduce unemployment tend to raise inflation,
and slow-growth policies that reduce inflation tend to raise unemployment. We subse-
quently observed, in Chapter 14, that the trade-off looks rather different in the short
run than in the long run because the aggregate supply curve is fairly flat in the short
run but quite steep (or vertical) in the long run. A statistical relationship called the
Phillips curve seeks to summarize the quantitative dimensions of the trade-off between
inflation and unemployment in both the short and long runs. This chapter is about the
Phillips curve; that is, it is about one of the things that Chairman Bernanke was won-
dering in 2007 and 2008.




CONTENTS
ISSUE: IS THE TRADE-OFF BETWEEN INFLATION WHAT THE PHILLIPS CURVE IS NOT THE THEORY OF RATIONAL EXPECTATIONS
AND UNEMPLOYMENT A RELIC OF THE PAST? What Are Rational Expectations?
FIGHTING UNEMPLOYMENT WITH FISCAL
Rational Expectations and the Trade-Off
DEMAND-SIDE INFLATION VERSUS AND MONETARY POLICY
An Evaluation
SUPPLY-SIDE INFLATION: A REVIEW
WHAT SHOULD BE DONE?
WHY ECONOMISTS (AND POLITICIANS)
ORIGINS OF THE PHILLIPS CURVE The Costs of Inflation and Unemployment
DISAGREE
The Slope of the Short-Run Phillips Curve
SUPPLY-SIDE INFLATION AND THE
THE DILEMMA OF DEMAND MANAGEMENT
The Efficiency of the Economy™s Self-Correcting
COLLAPSE OF THE PHILLIPS CURVE
Mechanism
Explaining the Fabulous 1990s ATTEMPTS TO REDUCE THE NATURAL RATE
INFLATIONARY EXPECTATIONS AND THE OF UNEMPLOYMENT
ISSUE RESOLVED: WHY INFLATION AND
PHILLIPS CURVE
UNEMPLOYMENT BOTH DECLINED INDEXING




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Licensed to:

Part 3
318 Fiscal and Monetary Policy



ISSUE: IS THE TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT
A RELIC OF THE PAST?
In the late 1990s, unemployment in the United States fell to extremely low
levels”the lowest in 30 years. Yet, in stark contrast to prior experience, infla-
tion did not rise. In fact, it fell slightly. This pleasant conjunction of events,
which was nearly unprecedented in U.S. history, set many people talking
about a glorious “New Economy” in which there was no longer any trade-off
between inflation and unemployment. The soaring stock market, especially for tech-
nology stocks, added to the euphoria.
Is the long-feared trade-off really just a memory now? Can the modern economy
speed along without fear of rising inflation? Or does faster growth eventually have in-
flationary consequences? These are questions the Federal Reserve wrestled with in 2007
and 2008, and they are the central questions for this chapter. Our answers, in brief, are:
no, no, and yes. And we will devote most of this chapter to explaining why.



DEMAND-SIDE INFLATION VERSUS SUPPLY-SIDE INFLATION: A REVIEW
We begin by reviewing some of what we learned about inflation in earlier chapters. One
major cause of inflation, although certainly not the only one, is rapid growth of aggregate
demand. We know that any autonomous increase in spending”whether initiated by con-
sumers, investors, the government, or foreigners”has multiplier effects on aggregate
F I GU R E 1
demand. So each additional $1 of C or I or G or (X 2 IM) leads to more than $1 of addi-
Inflation from the
tional demand. We also know that firms normally find it
Demand Side
profitable to supply additional output only at higher prices;
that is, the aggregate supply curve slopes upward. Hence, a

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