Chapter 12-Deficits & Debt

Federal agencies hold roughly percent of all outstanding Treasury bonds.

✓ 40 Approximately 40 percent of the U.S. debt is held by U.S. federal agencies.

(Figure 12.1) The concept of crowding in suggests that a government budget surplus would move the economy from Point

✓ A to Point C. If the government budget is in surplus, interest rates may decrease, causing crowding in, or an increase in private sector borrowing (and spending) caused by decreased government borrowing. In this case, the increased private sector borrowing will move the economy from Point A to Point C.

Which of the following is true regarding the "American Recovery and Reinvestment Plan"?

✓ Critics argued that the massive deficits generated by President Obama's plan would undermine America's financial stability. President Obama's 2009 stimulus package was designed to jump-start the recession-bound economy. Critics argued about both the content and size of that package and said it would ultimately do more harm than good. Those critics asserted that the massive deficits generated by Obama's American Recovery and Reinvestment Act would undermine America's financial stability because eventually taxes would have to be raised or government expenditures would need to be cut to pay off the deficits incurred.

The fiscal year for the federal government begins on

✓ October 1. The fiscal year (FY) is the 12-month period used for accounting purposes. It begins October 1 for the federal government.

An obligation to make future payment is

✓ a liability. A liability is an obligation to make future payment; it's debt.

Policies designed to pay off the national debt will result in

✓ a smaller level of aggregate demand. Policies such as tax hikes or spending cuts will cause the budget deficit to decrease but will also cause aggregate demand to decrease.

If the structural deficit is zero, then

✓ at full employment, the budget is balanced. Because the structural portion of the deficit is equal to federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy, a value of zero would mean that if the economy were at full employment, the budget would be balanced.

If Congress failed to keep the deficit below the ceiling, then the Gramm-Rudman-Hollings Act required

✓ automatic spending cuts. The Gramm-Rudman-Hollings Act set a lower ceiling on each year's deficit until budget balance was achieved, and it called for automatic cutbacks in spending if Congress failed to keep the deficit below the ceiling.

At the time it occurs, external financing of the debt allows the economy to

✓ consume beyond the production possibilities curve. The debt held by foreign households and institutions is known as the external debt. At the time the debt is sold externally, there are no internal opportunity costs. Instead of having to move along the internal production possibilities curve, external borrowing allows us to consume foreign production. In summary with external financing, an economy can consume more than it produces.

The annual interest payments the federal government makes each year on the national debt are known as

✓ debt service. Debt servicing is the payment of interest to those holding mature bonds.

Which of the following is an appropriate fiscal policy prescription for the government to follow?

✓ deficit expansion when there is an AD shortfall The appropriate policy when the economy is experiencing a recessionary GDP gap is fiscal stimulus. Policies such as tax decreases and increases to government spending will both expand the size of the deficit.

Debt accumulation by the U.S. government in the 1980s

✓ exceeded the debt the country had accumulated over the preceding 200 years. The 10-year increase in the debt exceeded all the net debt accumulation since the country was founded.

The burden of the debt is passed on to future generations when the debt is held by

✓ foreign households. External financing temporarily eliminates the opportunity cost of financing increased government expenditures. At some point, foreign debt holders will want to collect their bills. To do this, they will cash in (sell) their bonds, and then use the proceeds to buy U.S. goods and services. When this happens, the United States will be exporting goods and services or selling financial or real assets to pay off its debts.

Deficit spending occurs when

✓ government spending becomes greater than the tax revenues collected. Deficit spending refers to the use of borrowed funds or sale of government assets to finance government expenditures that exceed tax revenues.

Automatic stabilizers tend to stabilize the level of economic activity because they

✓ increase spending during recessions and reduce spending during inflationary periods. Automatic stabilizers are federal expenditure or revenue items that automatically respond countercyclically to changes in national income. In other words, during a recession, tax revenue will decrease and entitlement spending will increase without government intervention. During an expansion, tax revenue will increase and expenditures will decrease automatically.

The cost of servicing the debt may increase if

✓ interest rates rise. Debt service is the interest required to be paid each year on outstanding debt. Therefore, if interest rates rise, the cost of servicing the debt may rise.

U.S. Treasury bonds owned by U.S. households, institutions, and government entities are referred to as

✓ internal debt. Internal debt is U.S. government debt held by U.S. households and institutions, whereas external debt is debt held by foreign households and institutions.

The U.S. federal debt that accumulated between 1970 and 2010

✓ is an asset and a liability for the U.S. economy. National debt creates an equivalent amount of wealth (for bondholders), as it does in the form of liabilities (for the U.S Treasury). When the U.S Treasury borrows money, those bonds become a liability for the federal government, while at the same time they are an asset to the people who hold them.

The opportunity cost of the debt is

✓ less of an issue if the economy is below full employment since crowding out is less likely to occur. If the economy is in recession, it's possible to get more public sector output (like highways, schools, or defense) without cutbacks in private sector output. Crowding out is problematic only if the economy is at full employment.

Much of each year's federal budget is considered "uncontrollable" because

✓ most of the current revenues and expenditures are the result of decisions made in prior years. At present, uncontrollable spending decisions are locked in by prior legislative commitments account for roughly 80 percent of the federal budget.

Discretionary expenditures account for approximately

✓ one-fifth of the federal budget. At present, uncontrollable spending accounts for roughly 80 percent of the federal budget. This leaves only 20 percent for discretionary fiscal spending.

Crowding out is most likely to occur when the federal government

✓ runs a deficit and sells bonds to make up the difference while at full employment. Crowding out is a reduction in private sector borrowing (and spending) caused by increased government borrowing. Increased borrowing occurs when the government runs a budget deficit. Selling bonds is how the government borrows money.

Suppose the economy is at a full employment GDP of $600 billion and the tax revenue received by the federal government is always 28% of GDP. If planned government expenditure is $90 billion, The structural

✓ surplus is $78 billion The structural portion of the deficit is equal to federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy. Therefore, the structural portion of the deficit is $78 billion: (0.28 × $600 billion − $90 billion).

A measure of the burden of continual deficit financing over time is the ratio of

✓ the debt to the GDP. The debt to GDP ratio measures the burden of deficit financing over time.

To reduce the U.S. debt,

✓ the government should spend less than it collects in tax revenues. The only way to stop the growth of the national debt is to eliminate the budget deficits that create debt. To reduce the debt, budget surpluses would be needed.

If deficit spending does not contribute to public investment and crowds out private investment, then have.

✓ the rate of economic growth will decline, ceteris paribus. Government deficits might crowd out private investment. Investment is essential to enlarging our production possibilities and attaining higher living standards in the future. If federal deficits and debt- servicing requirements crowd out private investment, the rate of economic growth will slow, leaving future generations with less productive capacity than they would otherwise have.

Selling bonds to finance new government debt leads to an opportunity cost that is

✓ the same as financing government debt with taxes. Taxes are a more visible and unpopular way to pay for government expenditures. By borrowing rather than taxing, the federal government's claim on scarce resources is less apparent. However, either financing method allows the public sector to expand at the expense of the private sector.

If the budget deficit is $41 billion and the structural deficit is $224 billion, then

✓ there was a cyclical surplus of $183 billion. The budget balance is determined by the sum of the structural balance and cyclical balance.

Deficit spending results whenever the government

✓ uses borrowed funds to finance expenditures that exceed tax revenue. Deficit spending is the use of borrowed funds to finance current government expenditures that exceed current tax revenues.