Download Chapter 31 Fiscal Policy, Monetary Policy, and Growth

Chapter 31
Fiscal Policy, Monetary Policy, and
Growth
1.
The budget deficit is a flow concept. It is the excess of government expenditures over government
revenues in a year. The national debt is a stock. It is increased each year by the deficit, or reduced
by the surplus. If the deficit becomes a surplus, the debt will fall (although the accumulated debt is
still very large).
2.
Until 1980, the United States had accumulated a national debt of just under $1 trillion, most of it
resulting from government deficits during wars or recessions. The wartime debt corresponded to a
reduction in investment for peacetime uses, but few would regard this as a true burden, since
unless the nation had devoted itself completely to the war effort it might have been defeated. The
deficits incurred during recessions probably did not constitute a burden either, because during
periods of slack aggregate demand they did not crowd out investment, and may actually have
encouraged investment. Since 1980, however, tax rates had been reduced to such an extent that
even when the economy has been operating at its full-employment level the deficits have been
large, and the national debt had mushroomed. This part of the debt probably is a burden on future
generations, since it led to higher interest rates and at least a partial crowding out of investment.
About half of the national debt is owed to American residents, 30 percent to agencies of the federal
government and 20 percent to foreigners. The part of the debt held by foreigners is a burden to
Americans, since Americans have to transfer resources abroad to make the interest payments.
3.
This quote is filled with “bogus arguments.” The speaker does not understand the difference
between a firm or a family on the one hand, and the government on the other. The government will
not go bankrupt, since it has the authority to tax and/or to create money to pay its debt obligations,
and furthermore it need never pay back the principal but can continue to roll it over. Future debt
payments will not burden our children and grandchildren (unless foreigners hold the debt): some
Americans (taxpayers) will make interest payments to other Americans (bond holders). Our children
and grandchildren will be burdened only if the deficit causes investment to be cut and the future
capital stock to be lower. Whether this happens depends mostly upon how much slack there is in
the economy at the time the deficits occur.
4.
The government’s budget may be in deficit while the economy is in a recession. In Figure 31-1,
when GDP is at a relatively low level, Y0 , government spending, A, exceeds tax receipts, B. If GDP
were at the full employment level, Yf, and if fiscal policy were not changed, then government
spending would not change, but net taxes would automatically rise to C, and the structural budget
might be in surplus.
FIGURE 31-1
5.
Contractionary monetary policy will lower GDP, and this will lower tax receipts. The increase in
raise interest rates will increase the government’s interest payments. Both changes will raise the
government’s budget deficit. If the government tries to counteract the Fed’s effect on aggregate
demand it will institute a more expansive fiscal policy by increasing government spending or
transfers, or cutting taxes. The deficit will increase still more.
6. Faster monetary growth would raise GDP (hence raising tax receipts) and lower interest
rates (hence lowering government spending), and therefore lower the deficit.
7.
Crowding out occurs when an increase in the government deficit increases the demand for money
and raises interest rates, and this in turn reduces investment. The stimulating effect of the deficit is
partially reversed. Crowding in occurs when an increase in the deficit leads to an increase in GDP,
and the resulting pressures on industrial capacity lead firms to increase investment. The
stimulating effect of the deficit is enhanced by investment. Crowding in cannot happen unless
there is slack in the economy, and room for GDP to grow; under these circumstances, crowding in
may dominate crowding out. If the economy is close to full employment, crowding out will
dominate.
8.
Students may have different answers to this question, depending in part upon the current state of
the economy. If they think monetary policy should be more expansive, they will argue that the Fed
should monetize more of the debt.