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
The focus in this chapter is on the following
questions:
◦ How do deficits and surpluses arise?
◦ What harm (good) do deficits (surpluses) cause?
◦ Who will pay off the accumulated national debt?

The federal budget is a key policy lever for
controlling the economy.
Use fiscal stimulus to eliminate
unemployment.
 Use fiscal restraint to control inflation.



Reducing tax revenues and increasing federal
government spending throws the budget out
of balance.
Creates a budget deficit through deficit
spending.

Deficit spending is the use of borrowed funds
to finance government expenditures that
exceed tax revenues.

Budget deficit is the amount by which
government spending exceeds government
revenue in a given time period.
Budget deficit = government spending
– tax revenues > 0


If the government spends less than its tax
revenues, a budget surplus is created.
Budget Surplus is an excess of
government revenues over government
expenditures in a given time period.

At the beginning of each year, the President
and Congress put together a budget blueprint
for next fiscal year.
 Fiscal
Year (FY) is the twelve-month period
used for accounting purposes – begins on
October 1 for the federal government.


To a large extent, most current revenues and
expenditures are a result of decisions made
in prior years.
In this sense, much of each year’s budget
is “uncontrollable”.


Discretionary fiscal spending account for only
20% of the federal budget.
Discretionary fiscal spending are those
elements of the federal budget not
determined by past legislative or executive
commitments.

If most of the budget is uncontrollable, fiscal
restraint or fiscal stimulus are less effective.
 Fiscal
restraint – tax hikes or spending cuts
intended to reduce (shift) aggregate demand.
 Fiscal stimulus – tax cuts or spending hikes
intended to increase (shift) aggregate demand.


Most of the uncontrollable line items in the
federal budget change with economic
conditions.
Examples include unemployment
compensation and other income transfers.

Income transfers are payments to individuals
for which no current goods or services are
exchanged, such as social security, welfare,
unemployment benefits.


Acting as automatic stabilizers, transfer
payments increase during recessions.
Automatic stabilizers are federal expenditure
or revenue items that automatically respond
counter-cyclically to changes in national
income.

Automatic stabilizers also exist on the
revenue side of the budget.
Income taxes move up and down with the
value of spending and output.
 Being progressive, personal taxes siphon
off increasing proportions of purchasing
power as incomes rise.


The size of the federal deficit is sensitive to
expansion and contraction of the macro
economy.

The cyclical deficit is that portion of the
budget deficit attributable to unemployment
or inflation.


The cyclical deficit widens when GDP growth
slows or inflation decreases.
The cyclical deficit shrinks when GDP
growth accelerates or inflation increases.

To isolate effects of fiscal policy, the deficit is
broken down into cyclical and structural
components.
Total budget deficit = Cyclical
deficit + Structural deficit

The structural deficit is federal revenues at
full-employment minus expenditures at full
employment under prevailing fiscal policy.

Fiscal policy is categorized as follows:
 Fiscal
stimulus is measured by the increase in
the structural deficit (or shrinkage in the
structural surplus).
 Fiscal restraint is gauged by the decrease in
the structural deficit (or increase in the
structural surplus).



If government borrows funds to finance
deficits, the availability of funds for private
sector spending may be reduced.
Crowding-out is the reduction in privatesector borrowing (and spending) caused by
increased government borrowing.
Chances of crowding-out rise when the
economy gets closer to full employment.

There are four potential uses for a budget
surplus:
◦
◦
◦
◦
Cut taxes.
Increase income transfers.
Spend it on goods and services.
Pay off old debt (“save it”).


The first two options effectively wipe out the
surplus but give consumers more disposable
income and change the public-private mix of
output.
The third option, spending the surplus, wipes
out the surplus and enlarges the relative size
of government.


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A reduction in debt takes pressure off
market interest rates.
Crowding in is the increase in private sector
borrowing (and spending) caused by
decreased government borrowing.
As interest rates drop, consumers are
willing and able to purchase more bigticket items like cars, appliances, and
houses.


Crowding in depends on the state of the
economy.
In a recession, a decline in interest rates is
not likely to stimulate much spending if
consumer and investor confidence is low.


The United States has accumulated a large
national debt.
The national debt is the accumulated debt of
the federal government.



When the Treasury borrows funds it issues
treasury bonds.
Treasury bonds are promissory notes (IOUs)
issued by the U.S. Treasury.
The national debt is a stock of IOUs created
by annual deficit flows.


Whenever there is a budget deficit, the
national debt increases.
In years when a budget surplus exists, the
national debt can be pared down.
140
130
120
110
100
90
80
70
60
50
40
30
20
10
1800
World War II
Civil War
1850
1990-91
recession
Reagan
tax cuts
Great Depression
World War I
1900
1950
2000

National debt represents a liability as well as
an asset in the form of bonds.
◦ Liability – An obligation to make future payment;
debt.
◦ Asset – Anything having exchange value in the
marketplace; wealth.

The national debt creates as much wealth (for
bondholders) as liabilities (for the U.S.
Treasury).

The national debt creates as much wealth (for
bondholders) as liabilities (for the U.S.
Treasury).

Federal agencies hold roughly 50 percent of
the outstanding Treasury bonds.
◦ The Federal Reserve acquires Treasury bonds in its
conduct of monetary policy.
◦ The Social Security Trust Fund is the largest owner
of U.S. debt.



State and local governments hold 7 percent
of the national debt.
The general public directly owns about 6% of
the national debt.
The general public indirectly owns over 22%
through banks, insurance companies,
corporations, etc.


Internal debt is the U.S. government debt
(Treasury bonds) held by U.S. households and
institutions.
Internal debt equals approximately 80% of
the total.


The remaining 20% of the national debt is
held by foreign households and institutions.
The external debt is U.S. government
debt (Treasury bonds) held by foreign
households and institutions.
Public Sector
Federal Reserve 9%
Federal
agencies
17%
Social
Security 13%
State and local
governments 8%
Foreigners
20%
Foreigners
Individuals
6%
Banks,
corporations,
insurance
companies,
Private Sector
etc, 8%


The debt has historically been refinanced by
issuing new bonds to replace old bonds that
have become due.
Refinancing is the issuance of new debt in
payment of debt issued earlier.


Debt service is the interest required to be
paid each year on outstanding debt.
Interest payments restrict the government’s
ability to balance the budget or fund other
public sector activities.



Opportunity costs are incurred only when
real resources (factors of production) are
used.
The process of debt servicing uses few
resources, and has negligible opportunity
costs.
The true burden of the debt is the
opportunity costs of the activities financed
by the debt.


Deficit financing tends to change the mix of
output in the direction of more public-sector
goods.
The burden of the debt is the opportunity
costs (crowding out) of deficit-financed
government activity.


The primary burden of the debt is incurred
when the debt-financed activity takes place.
The real burden of the debt cannot be
passed on to future generations.


Future generations will bear some of the debt
burden if debt-financed government
spending crowds out private investment.
The debate about the burden of the debt is
an argument over the optimal mix of output.

External debt presents some special
opportunities and problems.


External financing allows us to get more
public-sector goods without cutting back on
private-sector production.
As long as foreigners are willing to hold U.S.
bonds, external financing imposes no real
cost.
Public-sector Output (units per year)
g2
b
d
a
g1
h2
Extra output
(imports)
financed with
external debt
h1
Private-sector Output (units per year)

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Foreigners may not be willing to hold bonds
forever.
External debt must be paid with exports of
real goods and services.

Deficit ceilings are an explicit, legislated
limitation on the size of the budget deficit.


A debt ceiling is another mechanism for
curbing the national debt.
A debt ceiling is an explicit, legislated limit
on the amount of outstanding national debt.

Like deficit ceilings, debt ceilings are just
political mechanisms for forging political
compromises on how to best use budget
surpluses or deficits.