Module 9

Public Debt

Debt owned by non-government groups (the public)

The U.S. government must pay interest on the outstanding debt. Which group is ultimately responsible for paying this expense?

The U.S. taxpayers; The debt imposes a net interest burden on the U.S. government and, by extension, the U.S. taxpayers.

With a cyclically balanced budget,

surpluses during the expansion phase of the business cycle offset deficits incurred in the recession phase.

When the economy is in a recession, running a budget deficit

can help end the recession by increasing spending; Higher government spending and higher private spending resulting from lower taxes creates a budget deficit, but also helps end the recession.

While this doesn't sound large, small differences in growth rates over time lead to large differences in GDP due to percentages ____________

compounding;Compounding percentages year by year amplifies the effects of the rate.

Cutting the government's budget deficit is a form of

contractionary fiscal policy; Contractionary fiscal policy involves reducing government spending and/or raising taxes, both of which lead to a leftward shift of aggregate demand.

national debt

cumulative total of all past budget deficits minus all past surpluses

Economists have studied the effects of a large _______ on the growth rate of an economy and they have found that when the ratio is over _______, there is approximately 1% decrease in the growth rate.

debt; Economists studied the effects of a large debt on the growth rate of the economy. 90%; A debt to GDP ratio over 90% slows economic growth by 1%.

In 1983, the Social Security system was reformed because

policymakers noted that there would have to be increased outlays in the period after the year 2000, as the baby boomers began to reach retirement age.

Effects of National Debt

positive or negative? depend on three factors: how large the debt is relative to the size of the economy, who owns the debt, and what the debt was spent on positive = if debt level is small relative to the size of the economy, owned primarily by citizens of the country, &was spent on items that will improve a country's productivity negative = if debt is large relative to the size of the economy, owned primarily by foreigners, & was spent on current consumption

unfunded liabilities

promises the government has made for future payments, but that the government does not have the funds available to pay for (excluded from debt) ex: social security payments and medicare

real interest rate

real interest rate = market interest rate minus the expected rate of inflation.

If most government bondholders are rich, repaying the debt will ____________income from __________

redistribute; When the government repays its debt, it must raise taxes or cut spending, which changes the amount of a household's income. poor to rich; Taxes or spending cuts will lower poor household's income, while repayment will add to the bondholders, who are mostly rich.

The national debt is a _________ concept, whereas the annual budget deficit is a __________ concept.

stock; The national debt is the total amount owed at a particular time. flow; The annual budget deficit is the amount added to the national debt each year.3.

The __________deficit is the part of a deficit that would persist even if the economy were at the full-employment level. The _____________ deficit is that part of a deficit that is due to a downturn in economic activity.

structural; A structural deficit of zero would reflect the goal of policy makers in the 1960s and 1970s, and suggest that fiscal policy is neutral. A deficit greater than zero would imply the direction of fiscal policy is expansionary, while a deficit less than zero would imply that fiscal policy is contractionary. cyclical; When the economy is in a downturn, automatic fiscal policy creates a deficit. Since this deficit is the result of business cycle activity, it is called a cyclical deficit.

Which government spending programs are easy to cut?

t's very difficult to find a specific type of government spending program that is easy to cut.; Every program, every subsidy, every agency has a constituency—the employees, customers, and suppliers that depend on its survival for their economic futures.

cyclical deficit

that part of a deficit that is due to a downturn in economic activity.

Comparing the size of the debt to the size of the economy by using the percentage of GDP is more meaningful than just looking at the absolute value of the debt because

the capacity to repay the debt grows as the economy grows; Incomes are rising when the economy is growing, so anticipated tax revenues are up. Similarly, a household can afford to take on more debt when income is higher.

When the Federal Reserve buys government bonds,

the money supply increases.; The Federal Reserve is able to create new money to pay for bonds, and purchasing bonds puts new money into circulation, so the money supply increases.

structural deficit

the part of a deficit that would persist even if the economy were at the full-employment level. A structural deficit of zero would reflect the goal of policy makers in the 1960s and 1970s, and suggest that fiscal policy is neutral. A deficit greater than zero would imply the direction of fiscal policy is expansionary, while a deficit less than zero would imply that fiscal policy is contractionary.

True or false. An annually balanced budget would force Congress to collect taxes to pay for spending programs and, thus, restrict the growth of government.

true; During the recession phase, when tax revenue automatically falls and transfer programs are more expensive, there is a deficit, which would have to be reduced through higher taxes or lower spending under an annually balanced budget rule.

True or false. During the Great Depression, there was support for spending more on social projects during economic downturns and cutting back when the economy returned to full employment.

true; Economic downturns are often the result of weak spending, so spending more on social projects is a way to prevent a downturn from becoming more severe.

True or false. When budget deficits are not controlled, there is no constraint on the size of the public sector.

true; It is much easier for everyone to support government spending when they do not have to face the burden of higher taxes.

True or false. The actual deficit is not known until after the fiscal year is over.

true; One of the problems with taming the deficit is that its size is difficult to predict and control.

True or false. When the Federal Reserve buys federal debt, it is monetizing the debt.

true; The Federal Reserve is able to pay for government bonds using newly created money, which increases the money supply.

True or false. As a result of the Great Depression and World War II, the national debt increased significantly.

true; The Great Depression caused a sharp drop in output, leading to lower tax revenues and an increase in government borrowing. World War II brought a large increase in output, but an even larger increase in government borrowing.

True or false. If output falls far below full employment, progressive income taxes and transfer programs will create a deficit, as tax revenues fall and transfer payments rise, but these changes will help increase spending and output.

true; These automatic stabilizers help to smooth out the ups and downs of the business cycle.

True or false. If the government must cut spending programs in order to use tax revenues to repay the debt, the people who would benefit from those spending programs will essentially be "taxed" to pay back the debt.

true;A cut in government spending could involve a cut in welfare spending programs.

True or false. Reducing the deficit requires raising taxes and/or lowering government spending and both of these have political difficulties.

true;The deficit can only be reduced if the government raises taxes, cuts spending, or some of each.

Keynesian economics recommends the use of active fiscal policy. Specifically, policymakers should increase spending to reduce _________ and decrease spending to reduce _________

unemployment; Firms are more likely to hire workers when spending is strong, motivating them to increase output. inflation; Producers are more likely to stop raising prices when spending is slowed.

Federal Debt

Social Security Trust Fund & Federal Reserve Public debt examples Private individual businesses. Citizens of the United States or other countries can own U.S. debt. For example, a grandma can buy a $50 saving bond for her grandchild or she can buy a T-bill (treasury bill) for thousands of dollars to fund her retirement. Foreign governments' central banks. This debt is often short-term debt. These banks buy T-bills for 3 or 6 months and then usually just roll the debt over into new T-bills. Central banks of other countries use U.S. t-bills as secondary reserves.

What happens when foreign investors lose confidence in a nation's ability to repay the loans?

They will no longer want to hold that country's debt; When a country's debt is too large, foreign investors find it too risky to hold the debt.

When can running a deficit cause a problem for future generations?

When resources may be diverted away from productive investment; If the government increases spending when the economy is at full employment, resources may be diverted away from productive investment.

If the government ___________ money to expand the productive capacity of the economy and puts _____________ resources to work, then future generations will inherit a _________capital stock and enjoy a higher output.

borrows; The government increases spending by borrowing. employed;Production capacity is expanded by increasing the use of resources. larger; A larger capital stock will produce a higher output.

Who is the largest holder of the U.S. debt?

China

trade deficit

Americans bought more currently produced goods and services from foreigners than they sold to the rest of the world. A trade deficit also means that net exports are negative, depressing aggregate expenditures and aggregate demand so that output, employment, and prices are lower than they would otherwise be.

Which is an example of an unfunded liability of the U.S. federal government?

Medicare payments for those who are retiring this year; Government has been using past contributions to Medicare to fund medical expenses for past retirees. The medical expenses of those who are retiring now must be funded out of money that has not yet been collected.

Which two presidential candidates lost their elections due to the public's dislike of tax increases?

Walter Mondale and George H.W. Bush; In 1984, Democratic presidential candidate Walter Mondale admitted that, if elected, he would raise taxes. He carried two states and the District of Columbia. In 1988, George H. W. Bush promised no new taxes. He was elected, agreed to raise taxes, and lost the election in 1992.

deficit

amount by which the federal government's expenditures exceed its revenues in a given year (the federal fiscal year runs from October 1 to September 30)

Potential output

another name for the output the economy could produce if all its resources were fully employed.a number or range of numbers that corresponds to the full-employment level of output (Y*) from the aggregate supply and demand and Keynesian models. If the structural deficit is zero, then the entire budget deficit is due to the economy falling short of its potential—that is, there are many idle resources.

In order to eliminate a budget deficit, the government must________ spending and/or __________ taxes. However, it is politically very difficult to do either of these during the expansionary phase of the business cycle.

decrease; Spending less will reduce the size of the deficit. increase; Bringing in more tax revenue will reduce the size of the deficit.

Active fiscal policy results in budget _________ when used to combat recession and in budget __________when used to combat inflation.

deficits; Recession-fighting policy includes increased government spending and/or reduced taxes surpluses; Inflation-fighting policy includes reduced government spending and/or increased taxes, which results in budget surpluses.

True or false. Actual deficit reduction may be larger than planned because the economy may suffer from slow growth and high unemployment.

false; Cutting the deficit is a form of contractionary fiscal policy. Out of a lower level of output, tax revenues will fall and transfer payments will rise as the automatic stabilizers kick in.

True or false. If actual output is equal to potential output, the cyclical deficit is larger than the structural deficit.

false; If actual output is equal to potential output, the cyclical deficit is zero.

True or false. If a deficit exists, the government must be pursuing an expansionary fiscal policy.

false; The deficit may simply be the result of automatic stabilizers and recessionary conditions.

True or false. The deficits of the 1970s and 1980s were largely due to attempts by the federal government to implement Keynesian policies to combat recessions.

false; The deficits of the 1970s and 1980s were incurred even during years when the economy was booming.

True or false. The national debt is the amount by which the federal government's expenditures exceed its revenues in a given year.

false; The national debt is the cumulative total of all past budget deficits minus all past surpluses. It is the amount owed to lenders by the federal government.

true or false. During a period of inflation, the real value of the debt increases.

false; The real deficit measures the federal budget deficit as the change in the real (inflation-adjusted) value of the national debt from one year to the next.

True or false. Politically, it is much easier to raise taxes than it is to lower them.

false; Voters are generally supportive of tax cuts.

Indirect crowding out occurs when

government competes for funds in the credit market, causing interest rates to rise for all borrowers; Private sector borrowers, such as a corporation seeking to finance a new factory, are less able to borrow when government borrows available funds and causes higher interest rates.

Example of indirect crowding out

in selling bonds, the government competes for funds in the credit market, possibly driving up interest rates for all borrowers.

An increase in the budget deficit is expected to ____ interest rates, so funds will be attracted from abroad. The inflow of funds will cause the demand for U.S. dollars to ______, driving the price of the dollar in terms of foreign currency _____ .

increase; An increase in the budget deficit means government's demand for loans increases, causing the equilibrium interest rate to rise. increase; High interest rates attract foreign money, so foreign investors seek to convert their currencies into dollars. higher;Stronger demand for dollars causes the equilibrium price of the dollar to increase.

One of the main benefits of active fiscal policy is__________ The main cost of active fiscal policy is_____________

increased employment; active fiscal policy means raising government spending and/or lowering taxes to combat recession. If successful, this policy increases output and employment. a budget deficit;The negative effect of using active fiscal policy to combat recession is a budget deficit. Since it is politically difficult to cut spending or raise taxes, there is a bias in favor of deficits.

The Federal Reserve is able to monetize debt by creating new money. If the Federal Reserve creates too much money, the result is

inflation;if too much new money is created, the value of the currency decreases and leads to inflation.

True or false. In 2015, the majority of foreign investors are not worried about the United States defaulting. This has allowed the U.S. government to issue government bonds with very low interest rates.

interest rates in the United States are still very low, thanks also to the confidence of investors.

Given the existence of automatic stabilizers, if the budget is balanced when the economy is at full employment,

it will be in deficit when the economy is in recession and in surplus when the economy is booming; . Government will automatically take in less tax revenue when recessions lower income and more tax revenue during upturns. Likewise, transfer programs like unemployment compensation are more expensive during recession.

The federal government is

less likely to declare bankruptcy than a city government, since it has a broader tax base; the federal government has the power to tax over 300 million people and has access to other revenue sources as well.

Successful deficit reduction is likely to result in

lower interest rates and a reduction in the international value of the dollar; Lower interest rates will reduce the price of the dollar and stimulate export sales while curtailing import purchases.

real deficit

measures the federal budget deficit as the change in the real (inflation-adjusted) value of the national debt from one year to the next.

A high price for the dollar makes exports _____ and imports ___________, resulting in a trade _________, assuming imports and exports were balanced from the start.

more expensive; Domestic firms that export goods and services are paid in dollars, so foreign consumers must pay more for dollars and for U.S. exports. cheaper;A stronger dollar purchases more foreign currency, effectively reducing the dollar price of goods and services sold in foreign countries. deficit; Since exports are more expensive, exports will decrease; since imports are cheaper, imports will increase. Lower exports and higher imports lead to a trade deficit.