Week 9: Budget Deficits and the Public Debt

Write the formula for a budget deficit.

Budget deficit = government spending - tax revenues

Suppose the gross domestic product is $10 trillion, the budget deficit is $100 billion, and the unemployment rate is seven percent, or one percent above the assumed full employment rate. Suppose further that the marginal tax rate is 30%. Which portion of the $100 billion deficit is structural and which portion is cyclical?

Get $200billion GDP income if unemployment drops by 1%. Government gets $60billion in tax revenue. So, $40billion would exist even if the economy were at full employment; $40billion is structural.

Summarize the major arguments, pro and con in the budget deficit debate.

Hawks (deficits and rising national debt are serious threat) chronic budget deficts have been responsible for crowding out private investment and chronic budget deficits have led to America's huge trade deficits over the last several decades deficit → higher interest rates → decline in domestic investment + increased foreign demand for US securities → increased US external debt + increased value of the dollar → trade deficit difference b/w external and internal debt | external is dangerous -- tax on US citizens by foreigners deficits constrain fiscal policy when it's most needed, reducing economic growth Doves (deficits and public debt are relatively harmless) internal debt is fine debt from infrastructure investment benefits future generations (who will pay off the debt) private sector productivity benefits from public investment in roads, bridges, education, IS deficits functions as a stimulus to economic growth -- productive investment in public goods and infrastructure debt is manageable relative to GDP

Use the Keynesian model to illustrate crowding out.

If the Treasury is selling bonds to finance a budget deficit, they are competing in the private market. They have to raise their interest rates to be competitive. Funds to finance the deficit is a zero sum game as generally funds would have been spent on private sector investment if the Treasury hadn't entered the market. Treasury crowds out private investment. Crowding out applies only to structural debt

Define automatic stabilizers and provide three examples.

Income transfers: payments to individuals by the government for which no goods or services are exchanged. SS, unemployment, welfare.

Why do economists like to compare the debt to the size of the nation's gross domestic product or GDP?

It's a good yardstick for comparing size of debt across countries or across time Using the debt-to-GDP ratio gives us a good measure of a nation's ability to produce and therefore its ability to pay off its debt

What is the difference between government debt and a budget deficit or surplus?

National debt = total dollar value of the bonds owned by the public (aggregated over time, not just for one year)

Suppose the nominal deficit is $100 billion, inflation is 10 percent, and total debt is $5 trillion. What is the real deficit?

Real =100billion - .1*5trillion = -400billion

What is the difference between the real and nominal budget deficit?

Real: the actual or nominal deficit adjusted for inflation Nominal: Real deficit = Nominal deficit - (Inflation*Total debt)

What is the difference between the structural and the cyclical or passive deficit?

Structural: the part of the budget deficit that would exist even if the economy were at full employment. DUe to the structure of tax and spending policies -- considered active as it is determined by discretionary budget decisions Cyclical/passive: the part of the deficit attributable to recession. Partly due to automatic stabilizers. Primarily from shortfall of tax revenues when economy's resources are underutilized.

What is the primary problem with the "print money" option of financing the deficit?

The Fed buys the Treasury securities itself by printing new money. Increase in M can cause inflation. If inflation drives interest rates up and private investment down, crowding out can happen indirectly.

Why is it important to estimating correctly the natural rate of unemployment important?

The calculation of the structural deficit is sensitive to the natural rate of unemployment. Okun's Law: 1% unemployment = 2% GDP. Different policy prescriptions for structural vs. cyclical.

Why does the balanced budget multiplier have a value of one?

When you simultaneously increase government expenditures and increase taxes by the same amount, you get an economic expansion exactly equal to the increase in government expenditures.

What are the three main ways of financing a budget deficit?

raise taxes borrow money print money