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Chapter 16
Deficits, Surpluses, and Debt: Past, Present, and Future
What's in this Chapter and Why
This chapter covers the federal government's deficit and debt problems. After defining different
types of budget deficits, the size of the deficit is discussed.
The size of the national debt is discussed, and its effects are noted. The long-run outlook for
budget deficit and debt are explored in detail. The effects of deficits are discussed. It is
emphasized that the effects depend on the means by which the deficit is financed (issuing bonds
versus issuing money) and whether the economy is at full employment.
The measurement issues in calculation of budget deficits are considered, and it is noted that the
deficit and debt picture may not be as gloomy as the forecasted projections.
Finally, the burden of debt on the present and future generations is evaluated under various
assumptions.
Instructional Objectives
After completing this chapter, your students should know:
1.
2.
3.
4.
5.
6.
7.
8.
9.
216
The budget concepts and definitions completely.
About recent trends in the federal government's deficit and debt.
About the projected deficits and debt behaviors during the 2002-2012 period.
The shortcomings of the measurement of budget deficits and debt.
That running deficits during recessions has some beneficial effects, but the justification
disappears when the economy is at full employment.
That depending on the circumstances deficits can (1) cause inflation, (2) reduce the nation's
growth rate because they raise interest rates and therefore lower investment, and (3) increase
the balance-of-payments deficit by altering the value of the dollar.
That the effects of a deficit vary depending on whether it is financed by issuing bonds or by
issuing money and whether the economy is at less than full employment or at full employment.
That the national debt has harmful effects both to present and future generations.
That reducing the relative future burdens of Social Security and federal health programs is
critical to promoting a sustainable budget for the very long run.
Instructor's Manual  217
Key Terms
These terms are introduced in this chapter:
Budget
Unified budget
Net budget balance
Budget surplus
Budget deficit
Off-budget-surplus
On-budget-surplus
Gross federal debt
Public debt
Burden of the public debt
Structural deficit
Actual deficit
Loanable funds
Suggestions for Teaching
This chapter introduces students to the federal government's deficit and debt problems. It will take
two or three class sessions to cover the chapter. Instructors may wish to use a historical approach
to develop some of the topics in this chapter.
In covering the effects of deficits, it is important to emphasize that the effects depend upon the
circumstances. The effect of budget deficits on exports and imports could be covered in
conjunction with Chapter 17.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Mario I. Blejer and Adrienne Cheasty, "The Measurement of Fiscal Deficits: Analytical and
Methodological Issues, Journal of Economic Literature 29 (December 1991), pp. 1644-1678.
2. James M. Buchanan and Richard E. Wagner, Democracy in Deficit: The Political Legacy of
Lord Keynes (New York: Academic Press, 1977).
3. Phillip Cagan, ed., Essays in Contemporary Economic Problems, 1985: The Economy in
Deficit (Washington, D.C.: American Enterprise Institute, 1985).
4. Robert Eisner, How Real Is the Federal Deficit? (New York: The Free Press, 1986).
5. _____, "Will the Real Federal Deficit Stand Up?" Challenge 29 (May-June 1986), pp. 13-21.
6. _____ and Paul J. Pieper, "A New View of the Federal Debt and Budget Deficits," American
Economic Review 74 (March 1984), pp. 11-29.
7. Richard H. Fink and Jack C. High, eds., A Nation in Debt: Economists Debate the Federal
Budget Deficit (Frederick, Md.: University Publications of America, Inc., 1987).
8. Laurence J. Kotlikoff, Generational Accounting (New York: The Free Press, 1992).
9. Daniel B. Suits and Ronald C. Fisher, "A Balanced Budget Constitutional Amendment:
Economic Complexities and Uncertainties," National Tax Journal 38 (December 1985), pp.
467-477.
10. "Symposium on Generational Accounting," Journal of Economic Perspectives 8 (Winter
1994), pp. 73-111.
11. Daniel L. Thornton, "Do Government Deficits Matter?" Federal Reserve Bank of St. Louis,
Review 72 (September/October 1990), pp. 25-39.
218  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
Outline
I. BUDGETS AND BUDGET CONCEPTS
A. Definitions and General Comments
1. the Federal budget is a statement of income (or receipts) and expenditures (or outlays)
for a specific period of time (a year).
2. The unified budget of the Federal Government includes Social Security receipts and
outlays.
3. A budget deficit occurs when government expenditures exceed government revenue
over some relevant time span.
4. A budget surplus occurs when government revenue exceeds government expenditures
over some relevant time span.
5. The net budget balance is total revenues minus total outlays.
6. The Social Security portion of the budget surplus is called the off-budget surplus. The
non-Social Security portion of the budget surplus is called the on-budget surplus. The
unified budget surplus is equal to the sum of theses two items.
II. HISTORICAL BUDGET PERSPECTIVE
A. U.S. budget, over the past 40 years, has been dominated by deficits, with surpluses realized
only in 1969 and 1998-2001.
B. The inclusion of the Social Security net balance made the unified budget surplus larger in
2001. According the inclusion of Social Security in the unified budget made the unified
budget deficit smaller from 1985 to 1997. People who argue that Social Security should not
be included in the Federal budget do so partly on the grounds that its inclusion helps
Congress to understate the size of the budget deficit.
III. THE PUBLIC DEBT
A. The total outstanding debt of the federal government - the gross federal debt - stood at
approximately $6.2 trillion in November 2002. That figure consists of $3.5 trillion in debt
that the government owes to the public and $2.7 trillion in debt that the government owes
to itself.
B. The portion of the debt that the government owes itself largely consists of federal securities
credited to various trust fund accounts. Like federal securities sold to the public, they are
legal obligations of the government and are backed by its full faith and credit. However,
unlike federal securities sold to the public, which are assets of the holder, Treasury
obligations held by federal trust funds are not assets of the government as a whole.
C. Although there has been tremendous growth in the public debt over the past 40 years, the
burden of the public debt, as measured by size of the debt relative to GDP, is smaller today
than it was in 1962. This reflects not only the budget surpluses attained from 1998 through
2001, but also the rapid growth in GDP experienced by the U.S. in the 1990s.
IV. LONG-RUN BUDGET AND DEBT PROJECTIONS
A. The Incredible Shrinking Surplus
1. Given the progress made in reducing the deficit between 1992 and 1997 many,
including the analysts at the Congressional Budget Office (CBO), thought that we
turned the corner in the battle against budget deficits. CBO forecasted total surpluses
of over $5.6 trillion for 2002-2011 period.
Instructor's Manual  219
2. In 2000 the Bush administration got congressional approval for a tax cut amounting to
nearly $1.3 trillion over the next decade. In January 2001, the economy slipped into a
recession and then terrorists struck the World Trade Center in September. The first two
of these events - the tax cut and the recession - combined to drastically reduce tax
revenues, while the last event - the terrorist attack on the world trade center - served as
a catalyst for additional spending on international military ventures and homeland
security.
3. These events led to a $5.6 trillion 2002-2011 surplus to shrink to a 2002-2012 surplus
of only $859 billion.
B. The Deficit and the Debt in the Coming Decade
1. The law requires Social Security to use its surpluses to purchase U.S. Government
securities from the Treasury. The Treasury will use the proceeds from the sale of
securities to Social Security to finance a significant portion of the on-budget deficit 77.6 percent from 2002 to 2010. The Treasury will fund the remaining 22.4 percent of
the 2002-2010 on-budget deficit by selling securities to the public.
2. During the period 2002-2005, all of the Social Security surplus must be used to help
finance the on-budget deficit These surpluses are not large enough, however, to finance
all of the on-budget deficits and it is necessary to borrow also from the public. Hence,
the public debt will increase. During this period, none of the Social Security surplus
will be saved. The Social Security surplus is considered saved whenever it results in a
reduction in the public debt.
3. During the period 2006-2010, the Social Security surplus will be larger than the
on-budget deficit so all of the latter will be financed by Treasury sales of bonds to
Social Security. The excess Social Security surpluses will also be sold to the Treasury
and the Treasury will use these proceeds to refinance the existing public debt instead of
borrowing the funds from the public. Thus, the public debt will fall by the same
amount as the excess Social Security surpluses and the excess Social Security
surpluses will be saved.
4. During the period 2011-2012, both the on-budget and Social Security surpluses will
replace borrowing from the public, the public debt will fall and the federal budget
(including Social Security) will be the source of significant savings.
C. The Really Long Run
1. The CBO has a long-run projection model that provides the general parameters of what
we might expect. This model combines historical data from 1950-2002 and
assumptions about future revenues and expenditures to produce the actual and
projected trend in the unified budget from 1950 to 2075.
2. The CBO's projections are not very optimistic. According to the long-run trajectory of
the unified budget's net balances, surpluses are expected to begin in 2006 and last until
2025. After that, the unified budget balance will turn negative and the deficit will
continue to grow as a percent of GDP for the next 50 years.
V. MEASUREMENT ISSUES
A. Some economists argue that federal budget deficits are overstated since current
computations do not account for some important factors that make the deficit less onerous.
These factors are: (1) inflation, (2) business cycles, (3) government investment, and (4)
state and local government net balances.
B. Inflation
220  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
1. The federal government does not calculate the effect of inflation on its accounts, but it
is an important adjustment where the deficit is concerned.
2. Adjusted for inflation, deficits are smaller than they are under current accounting
procedures.
C. Business Cycles
1. Economists discuss two types of deficits: the structural deficit and the actual deficit.
a. The structural deficit is the deficit that would occur if the economy were operating
at full employment.
b. The actual deficit is the difference between the government's actual revenue and
expenditures.
2. Economists are more concerned with the structural deficit.
a. The automatic increases in government expenditures and decreases in government
revenue that occurs when the economy enters a recession play a positive role in
stabilizing the economy.
b. The structural deficit will remain even after the economy returns to full
employment.
D. Government Investment
1. Concern about the deficit is rooted in the notion that federal government borrowing is a
bad thing. Generally speaking, the federal government can borrow for two purposes:
a. to pay for consumption-type expenditures (e.g., food stamps, farm subsidies, and
armaments), and
b. to pay for investment-type expenditures (e.g., education, research, and highways).
1. Outside the federal government, borrowing to pay for investment-type
purchases is viewed as a sound business practice. The same standard should be
applied to the federal government.
2. The investment component of budget deficit is the lager component.
E. State and Local Government Deficits and Surpluses
1. One reason the federal government runs a deficit is the large amounts that it gives to
state and local governments in the form of grants-in-aid. This has enabled state and
local governments to run substantial budget surpluses in 37 of the 40 years between
1962 and 2001.
2. The combined deficits of all levels of government have therefore been smaller than the
deficits of the federal government, alone. If the deficit is intended as a measure of
government borrowing from the public, the relevant deficit is the combined deficit, and
state and local governments surpluses should be added to federal government deficits
to get a true picture of government borrowing.
VI. Economic Effects of Deficit
A. The Keynesian View: A Deficit Can Help to Cure a Recession
1. Over the years, attitudes toward budget deficits have changed.
2. Prior to the 1930s, economists believed that the government's budget should be
balanced.
3. With the advent of the Great Depression and the publication of John M. Keynes's The
General Theory of Employment, Interest, and Money in 1936, this view faded.
Instructor's Manual  221
4. After the 1930s, running deficits during times of recession was viewed as desirable.
The spread of Keynesian economics gave birth to a new philosophy: Run deficits
during recessions to stimulate the economy, and run surpluses during periods of
inflation to restrain the economy.
B. The Modern View: The Strength of the Cure Depends on How the Deficit is Financed.
1. Bond Sales to the Public Sector
a. If the government finances the deficit by issuing bonds, interest rates will increase,
thereby mitigating the expansionary effects of the deficit.
1. The interest rate will increase because the issuance of bonds increases the
demand for loanable funds.
2. As the interest rate increases, investment will fall and the economy will grow
less rapidly.
3. As the interest rate increases, the demand for U.S. dollars increases, driving up
the relative price of net exports and increasing the trade deficit.
b. If the economy is operating at less than full employment, the increase in the
interest rate may be small.
1. If the economy is operating at less than full employment, there is some
justification for running a deficit.
2. Bond Sales to the Federal Reserve
a. If government finances the deficit by issuing money (selling U.S. Treasury
securities to the Federal Reserve), the effect of the deficit will be more
expansionary than if the deficit was financed by issuing Treasury bonds.
1. The increase in the money supply is expansionary, and reinforces the effect of
an increase in government spending.
2. The increase in the money supply tends to lower interest rates, offsetting the
increase in the interest rate caused by an increase in government spending.
b. If the economy is operating at less than full employment, an increase in
government spending financed by issuing money has no harmful effects on the
economy and running a deficit is justified.
VII. THE BURDEN OF THE DEBT
A. Should the Government Borrow?
1. There are times when it may be desirable for the federal government to borrow.
a. It is desirable for the federal government to borrow if the money is spent on
projects that will yield a flow of benefits in the future sufficient to repay the loan.
B. Repaying the Debt
1. Because the Treasury typically borrows to pay the portion of the national debt that
matures, the national debt need not be repaid in the sense of ultimately being reduced
to zero.
a. More important than reducing the debt to zero is reducing deficits so that the debt
becomes a smaller percentage of GDP.
C. The Burden of the Debt
1. One theory is that so long as the debt is held domestically, repayment simply
redistributes income among citizens.
a. Income is redistributed from taxpayers in general to debt holders.
222  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
b. Since taxpayers generally have lower incomes than debt holders, income is
redistributed from lower-income to higher-income individuals.
2. The portion of the debt held by foreigners represents their potential claim against
goods and services produced in the United States.
a. If foreigners use the dollars to purchase goods produced in the United States, a
burden in imposed on both present and future generations because they will have
fewer goods and services available to them.
3. If the debt causes interest rates to be higher than they otherwise would be, the nation's
capital stock will grow less rapidly and output in the future will be lower than it
otherwise would be.
a. In this instance, the debt imposes a burden on future generations as they will
experience a lower standard of living.
4. In order to pay interest on the debt marginal tax rates are higher than they otherwise
would be.
a. These higher marginal tax rates can reduce incentives to work, save, and invest,
thereby reducing the nation's output and productive capacity and imposing a
burden on present and future generations.
VIII. TAKING STOCK
A. Comments
1. The debt can't be reduced, of course, unless Congress achieves tight control over future
deficits.
2. Federal budget deficits are potentially serious problems, even though their magnitudes
have often been overestimated.
3. Congress can do a better job of measuring the deficit by incorporating the adjustments
suggested above. A useful step in this direction would be the establishment of separate
capital and operating budgets, similar to those used in most state governments and in
private businesses.
B. The expected 20 years of surpluses will be realized, moreover, only if:
1. Congress allows the 2001 tax cut to expire as scheduled
2. the economy stays on a steady growth path
3. here are no new major program initiatives.
C. There are three principal ways to channel both the expected on-budget and Social Security
surpluses (Social Security will have positive net balances through 2016, according to the
intermediate projections in the 2002 Annual Report of the Social Security Trustees) into
productive investment:
1. by using them to reduce the public debt
2. by using them to finance government investment
3. by turning them into tax relief that increases private investment.
D. Reducing the relative future burdens of Social Security and federal health programs is
critical to promoting a sustainable budget for the very long run. While much of the public
debate concerning the Social Security and Medicare programs focuses on trust fund
balances, the net cash impact of the trust funds on the budget-not trust fund solvency-is the
important measure.
Instructor's Manual  223
Answers to Review Questions
1. Explain the differences between the unified budget and the non-Social Security budget.
Like all budgets, the Federal budget is a statement of income (or receipts) and expenditures (or
outlays) for a specific period of time (a year). The unified budget of the Federal Government
includes Social Security receipts and outlays. The remainder of the outlays and receipts are the
non-Social Security budge. See Table 16.1 in the textbook for details of all of the items.
2. How are a unified budget deficit, an on-budget deficit, and an off-budget deficit related?
The net budget balance is total revenues minus total outlays. If receipts exceed outlays there is
a positive net balance, or budget surplus. If receipts are less than outlays, there is a negative net
balance or budget deficit. If receipts and outlays are equal, the net balance is zero and the
budget is balanced.
Congress distinguishes three net balances. One is the net balance in the unified budget. The
other net balances are: (1) the net balance in the Social Security portion of the budget, and (2)
the net balance in the non-Social Security portion of the budget. The Social Security portion of
the budget is called the off-budget deficit/surplus. The non-Social Security portion of the
budget accounts for the remainder of the unified budget deficit/surplus, which is called the
on-budget deficit/surplus. The unified budget deficit/surplus is equal, then, to the sum of the
on-budget (non-Social Security) and the off-budget (Social Security) deficit/surplus. Note that
the off-budget portion of the unified budget also includes receipts and outlays of the U.S.
Postal Service, but the Postal Service balance is so small relative to the Social Security balance
that it is not misleading to refer to the off-budget balance as the Social Security balance.
Congress distinguishes between on-budget and off-budget net balances primarily to keep
separate books on Social Security. The unified budget, however, includes all receipts and
expenditures. Thus, it presents a more accurate picture of the claims made, and programs
delivered, by the federal government.
3. Briefly describe the history of the unified budget and on-budget net balances for the
period 1962-2001.
U.S. budget, over the past 40 years, has been dominated by deficits, with surpluses realized
only in 1969 and 1998-2001. The inclusion of the Social Security net balance made the unified
budget surplus larger in 2001. Accordingly the inclusion of Social Security in the unified
budget made the unified budget deficit smaller from 1985 to 1997. People who argue that
Social Security should not be included in the Federal budget do so partly on the grounds that its
inclusion helps Congress to understate the size of the budget deficit.
4. Briefly describe what is in store for net balances in the unified budget, the non-Social
Security budget, and the public debt for the period 2002-2012. Carefully explain why the
public debt is expected to grow and then decline.
In 2001 the economy slipped into a recession and then terrorists struck the World Trade Center
in September. The first two of these events - the tax cut and the recession - combined to
drastically reduce tax revenues, while the last event - the terrorist attack on the world trade
center - served as a catalyst for additional spending on international military ventures and
homeland security. Consequently, analysts at the CBO and elsewhere began to revise their
projections of future surpluses downward. On-budget net balances are expected to be negative
224  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
through 2010, and they would remain negative through 2012 if Congress decided to extend the
2010 deadline for reversing the tax cut of 2001. Thus, the unified budget eventually records a
surplus only because of the surplus in Social Security and the lack of action by Congress to
make the tax cut of 2001 permanent.
The law requires Social Security to use its surpluses to purchase U.S. Government securities
from the Treasury. The Treasury will use the proceeds from the sale of securities to Social
Security to finance a significant portion of the on-budget deficit—77.6 percent from 2002 to
2010. The Treasury will fund the remaining 22.4 percent of the 2002-2010 on-budget deficit by
selling securities to the public.
During the period 2002-2005, all of the Social Security surplus must be used to help finance
the on-budget deficit. These surpluses are not large enough, however, to finance all of the
on-budget deficits and it is necessary to borrow also from the public. As a result, the public
debt will increase, and none of the Social Security surplus will be saved.
During the period 2006-2010, the Social Security surplus will be larger than the on-budget
deficit so all of the latter will be financed by Treasury sales of bonds to Social Security. The
excess Social Security surpluses will also be sold to the Treasury and the Treasury will use
these proceeds to refinance the existing public debt instead of borrowing the funds from the
public. Thus, the public debt will fall by the same amount as the excess Social Security
surpluses and the excess Social Security surpluses will be saved.
In the last two years both the on-budget and Social Security surpluses will replace borrowing
from the public, the public debt will fall and the federal budget (including Social Security) will
be the source of significant savings.
5. Explain how the public debt can decline while the gross federal debt grows (as is expected
to happen from 2006 to 2012).
The total outstanding debt of the federal government, the gross federal debt, consists of public
debt (debt that the government owes to the public) and debt that the government owes to itself.
The public debt - is the value of all the federal securities that have been sold to the public and
are still outstanding-it represents the government's borrowing from the public to finance past
deficits less past surpluses that have been used to retire the public debt. The portion of the debt
that the government owes itself largely consists of federal securities credited to various trust
fund accounts. Those securities represent the balances of either excess receipts collected to
finance specific programs (for example, Social Security taxes) or reserve spending authority
that has been allocated for a particular activity (for example, appropriations for the military
retirement system). Thus, gross federal debt can grow while public debt declines, if more of it
is financed by the government itself.
During the period 2006-2010, the Social Security surplus will be larger than the on-budget
deficit so all of the latter will be financed by Treasury sales of bonds to Social Security. The
excess Social Security surpluses will also be sold to the Treasury and the Treasury will use
these proceeds to refinance the existing public debt instead of borrowing the funds from the
public. Thus, the public debt will fall by the same amount as the excess Social Security
surpluses and the excess Social Security surpluses will be saved. In 2010-2012 both the
on-budget and Social Security surpluses will replace borrowing from the public, the public debt
will fall and the federal budget (including Social Security) will be the source of significant
savings.
Instructor's Manual  225
6. Suppose that the public debt is $3 trillion at the end of a year, that during that year the
unified budget deficit was $200 billion and the rate of inflation was 3 percent. What is the
real value of the deficit after adjusting for inflation ?
If the value of public debt is $3 trillion at the end of the year with an inflation rate of 3%, its
real value would be $2912.62 billion ($3,000/1.03 billion). Thus, in effect, has given the
government $87.38 billion in inflation taxes. The adjusted value of deficit for inflation is
$112.62 that is $200-$87.38 billion.
7. When are the structural and actual deficits the same? How do these deficits differ if the
economy is experiencing a recession? Suppose the economy is temporarily producing
beyond its full employment capacity. How will these deficits differ?
The structural deficit is the difference between the federal government's full employment levels
of expenditures and revenue. The actual deficit is the difference between the federal
government's actual expenditures and revenue. These deficits will be the same if the economy
is producing at full employment.
If the economy is experiencing a recession, the actual deficit will exceed the structural deficit.
The actual deficit will increase due to the automatic increases in government expenditures
(increases in unemployment compensation and other government transfer payments) and the
automatic decreases in government revenues (the fall in taxes that occurs as profits and income
fall and as workers are laid off) triggered by the recession.
If the economy is temporarily producing beyond its full employment capacity, the actual
budget deficit will be less than the structural budget deficit. In this instance, tax revenue
automatically rises in response to increased employment and income. At the same time,
government expenditures are likely to fall as government will pay less in unemployment
compensation and other transfers. As a result, the actual deficit will fall.
8. Is it possible for budget deficits and surpluses to stabilize the economy? On the basis of
your response, evaluate the argument for an annually balanced federal budget.
Budget deficits and surpluses can help to stabilize the economy. If the economy enters a
recession taxes will fall as income and employment fall. At the same time, government
spending will increase as people are given unemployment compensation and other transfers
such as welfare payments. Such automatic changes in revenue and expenditures work to
increase the deficit. At the same time, they also work to mitigate the decrease in disposable
income that households are experiencing. This maintains consumption at a higher level than
would otherwise be the case. As discussed in Chapter 12, this helps to maintain the level of
aggregate demand and thereby soften the effects of recession.
If the economy is in an expansion and experiencing inflation, a budget surplus works to
stabilize the economy. In this instance taxes increase in response to the increase in
employment and income. At the same time, government expenditures fall as fewer individuals
receive unemployment compensation and other transfer payments. These changes work to
lower the level of consumption and hence the level of aggregate demand. Thus, the surplus
works to stabilize the economy during inflationary periods.
On the above grounds, it is possible to argue that an annually balanced budget may actually
work to destabilize the economy. In particular, such a requirement may work to worsen
226  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
recessions and inflations. In the case of recession, we have already seen that revenue falls
while expenditures rise thereby creating a deficit. In order to balance the budget, government
must raise more revenue (by increasing taxes) and cut expenditures. Both of these actions will
lower disposable income. As a result, consumption and aggregate demand will fall. As
aggregate demand falls, the recession worsens.
In the case of inflation, we find that revenue rises automatically while expenditures fall. It is
possible that such changes would create a surplus. In order to eliminate the surplus,
government must lower revenue (by cutting taxes) and increase expenditures. Both actions
would work to increase disposable income. This increase in disposable income will then work
to increase consumption and hence aggregate demand. As aggregate demand rises, the price
level will increase further thereby worsening inflation. Hence, if one is concerned with
stabilizing the economy, an annually balanced federal budget would be undesirable.
9. Suppose the economy is currently at full employment and the federal government's
budget is showing a surplus. How would balancing the budget (eliminating the surplus)
affect the economy?
If the federal government needed to eliminate a surplus, it could undertake the following
policies. A politically popular policy would be to cut taxes. A second action would be to
increase government expenditures. Either of these policies (or some combination of the two)
would work to lower revenue and/or raise expenditures and thereby eliminate the surplus. At
the same time, both policies will work to increase aggregate demand. Because the economy is
already at full employment, any increase in aggregate demand will work only to increase the
price level (output and unemployment will be unaffected). Such an increase will result in
inflation in the economy.
10. Carefully describe the differences in the effects on the economy of financing a deficit by
selling Treasury bonds to the private sector and selling bonds to the Federal Reserve.
Suppose the economy is presently suffering from a recession. In an attempt to stabilize the
economy, the government decides to incur a deficit. The method of financing this deficit
(selling Treasury bonds to the private sector or to the Federal Reserve) will affect its economic
impact. If the deficit is financed by selling bonds, the effect is expansionary. However,
because selling bonds to the public will increase the rate of interest, the effect is less
expansionary than the effect obtained by financing the deficit through selling bonds to the
Federal Reserve (which is effectively the same as issuing money). To understand this, one
must examine the market for loanable funds. The following figure represents this market.
Instructor's Manual  227
D0 represents the demand for loanable funds and is negatively related to the interest rate. As
the interest rate falls, it becomes less expensive to borrow. Firms and households wish to
borrow more funds. As the interest rate rises, it becomes more expensive to borrow. Firms
and households wish to borrow fewer funds.
S represents the supply of loanable funds. It is positively related to the interest rate. As the
interest rate falls, firms and households are less willing to loan funds. On the other hand, as the
interest rate rises, firms and households will receive more for their funds and are willing to
lend a greater amount.
Given D0 and S the equilibrium rate of interest is i0. Suppose the government increases
expenditures, resulting in a deficit. Suppose this deficit is financed by issuing bonds to the
private sector. The initial impact of the increase in expenditures is to raise aggregate demand.
This increase, however, is mitigated by the rise in interest rates that is caused by an increase in
government borrowing. The increase in borrowing increases the demand for loanable funds,
thereby shifting the demand curve to the right to, say, D1. This increase in demand will cause
the equilibrium rate of interest to increase to i1.
The increased interest rate has several impacts on the economy. First, because the interest rate
is higher, firms will be less likely to borrow and investment will fall. Likewise, households
will be less willing to purchase new homes and residential construction will slow. This
reduction in investment will lower aggregate demand. This decrease in demand will mitigate
the initial increase in aggregate demand caused by the increase in government expenditures. In
addition, the drop in investment will slow the growth of the nation's capital stock. As a result,
the nation's output and employment will grow more slowly and productivity gains will lag.
Our standard of living will be lower than would otherwise be the case. Finally, the higher
interest rates will have an impact on exports and imports. As interest rates in the United States
rise relative to other countries, foreign investors will be attracted to financial investments in the
United States. This will cause the demand for dollars to rise. With flexible exchange rates the
dollar will appreciate. As the dollar appreciates, exports from the United States will become
relatively more expensive. Exports will fall, thereby adversely affecting output and
employment in the export-producing sector of the economy. Foreign goods, on the other hand,
will become relatively less expensive; hence, imports into the United States will rise. This has
228  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
an adverse impact on output and employment in the import competing sector (e.g. automobiles)
of the economy.
The above does not mean that the increase in government expenditures will not be
expansionary. It is true that a deficit financed by selling bonds to the private sector will
increase the interest rate, which will discourage investment and reduce aggregate demand and
the nation's growth rate. If the economy is operating at less than full capacity, however, it is
possible that the increase in the interest rate will be minimal. During a recession, firms are
experiencing excess capacity and have less incentive to borrow. As a result, the increase in the
demand for loanable funds will be less. Given the increases in output and employment that
occur due to increased government spending, and provided that there is only a minimal
increase in the interest rate, there is some justification for running a budget deficit during times
of recession.
Suppose that instead of financing the deficit through the sale of bonds to the private sector, the
government sells bonds to the Federal Reserve (issues money). Both the increase in
government expenditures and the increase in the money supply have expansionary effects.
Hence, this method of finance is more expansionary than the previous method of issuing bonds.
The increase in government expenditures tends to increase aggregate demand; it also tends to
raise interest rates. However, increasing the money supply works to increase aggregate
demand and lower interest rates. The net result of the two is a rise in aggregate demand and
little or no change in interest rates. This means there will be little or no change in investment
and little or no change in the value of the dollar. Hence, if the economy is operating at a point
less than full capacity there is some justification for running the deficit.
11. Why is it undesirable for the federal government to run a deficit with the economy at full
employment.
If the government runs a deficit during times of full employment it can lead to inflation.
Suppose the economy is currently at full employment and government increases expenditures.
Suppose this results in a deficit that is financed through the issuance of bonds. The increase in
government expenditures will result in an increase in aggregate demand and a higher price
level. (Note this increase in aggregate demand will be less than in the case of the issuance of
money due to the offsetting effect of the fall in investment on aggregate demand) Because the
economy is already at full employment, there will be no increase in output. Further, the
increase in borrowing by the government is likely to lead to a relatively large increase in the
demand for loanable funds. As discussed previously, this will lead to a relatively large rise in
the rate of interest. As a result, investment will fall, the capital growth rate will fall,
productivity will lag, and living standards will be lowered. Further, there will be negative
effects on both the export sector and the import competing sector of the economy.
If the deficit is financed through the issuance of money there will be relatively little effect on
the interest rate. However, the expansionary effect of the increase in government expenditures
will be compounded by the expansionary effect of the increase in the money supply. As a
result there will be a relatively large increase in aggregate demand. Because the economy is
already at full employment there will be no increase in output. Instead, the increase in
aggregate demand will be reflected in a relatively large increase in the price level.
12. Briefly explain economists are more concerned about the public debt than about the gross
federal debt, although the latter is significantly larger than the former.
Instructor's Manual  229
The total outstanding debt of the federal government is the gross federal debt ($6.2 trillion in
November 2002). Public debt is the portion of the gross federal debt that government owes to
the public ($3.5 trillion in November 2002), and the remainder is the debt that the government
owes to itself. The public debt is the value of all the federal securities that have been sold to the
public and are still outstanding. It represents the government's borrowing from the public to
finance past deficits less past surpluses that have been used to retire the public debt. Businesses
and the financial markets pay close attention to the public debt (but not the gross federal debt)
because of its impact on the economy. When the Department of the Treasury sells securities or
borrows from the public it acquires resources that otherwise might be invested in the private
sector. Conversely, when the Treasury Department redeems securities, it increases the
resources available for private investment.
In other words, adding federal securities to and subtracting them from the government's trust
fund accounts have no direct impact on businesses and the financial markets. Such activity
does not cause money to flow between the government and individuals, private businesses, or
other institutions; it has no impact on bond prices and yields; and consequently on the level of
business investment and output.
13. Explain how the federal government saves the Social Security surplus.
The Social Security surplus is considered saved whenever it results in a reduction in the public
debt. The reason is straightforward. When the public debt is falling, the Treasury can reduce
the amount it borrows each year to refinance the portion of the debt that comes due that year
(the government bonds that have matured). When the Treasury borrows less, it indirectly
increases the amount of money that can be used to finance private investment, instead. The act
of borrowing less is equivalent to providing new funds for private investment, or what is the
same thing, equivalent to an increase in the supply of savings to the private sector.
14. The federal government has two important advantages over households and firms when it
comes to reducing or financing deficits. What are these advantages? With these
advantages in mind, evaluate the following statement: "Like households that go too
deeply in debt, the federal government with its large deficits may be forced into
bankruptcy."
Households generally receive income through the employment of resources and use this
income to finance any deficit they incur. Firms generally receive income through the
production of goods and services and use this income to finance their deficits. Government has
two additional methods of raising income: taxes and printing money. This gives the
government an advantage when it comes to financing and reducing deficits. This advantage
means that the likelihood of the government being forced into bankruptcy is practically nil. If
it is unable to make its deficit payments, it can always raise taxes or print additional money.
Households, on the other hand may be unable to employ their resources and firms may be
unable to sell their products. In this case, their revenue source dries up, and they will be forced
into bankruptcy.
15. During the 1980s and 1990s, there was an increase in the proportion of the national debt
held by foreigners. How is this likely to affect the burden of the debt?
If the debt is held internally, it, in and of itself, will cause no reduction in society's resources.
Instead, there is simply a redistribution of resources from taxpayers to debt holders. In the case
of debt held by foreigners, interest payments and the repayment of principal involve the
230  Chapter 16/Deficits, Surpluses, and Debt: Past, Present, and Future
transfer of real output to foreigners. This results in a reduction of goods and services available
to our society and represents a burden to both present and future generations. The increase in
the proportion of the national debt held by foreigners during the 1980s means that there is an
increased burden associated with our national debt.
16. Describe the ways in which the Social Security surplus can be channeled into productive
investment.
Generally speaking, the federal government’s borrowing is used for two types of spending: (1)
to pay for consumption-type expenditures (e.g., food stamps, farm subsidies, and armaments),
and (2) to pay for investment-type expenditures (e.g., education, research, and highways).
Outside the federal government, borrowing to pay for investment-type purchases is viewed as a
sound business practice. If the same standard were applied to the federal government and
surpluses were turned into productive investments, future deficits can be viewed as being
smaller. There are three principal ways to channel both the expected on-budget and Social
Security surpluses (Social Security will have positive net balances through 2016) into
productive investment: (1) by using them to reduce the public debt, (2) by using them to
finance government investment, and (3) by turning them into tax relief that increases private
investment. These are not necessarily equivalent alternatives, but they all deserve serious
consideration; reducing the public debt is not the only way to achieve higher future living
standards.
17. Explain why Social Security and Medicare are more immediate problems when viewed in
the context of the federal budget than when they are viewed as independent programs.
Reducing the relative future burdens of Social Security and federal health programs is critical
to promoting a sustainable budget for the very long run. Absent prior reform, the impact of
federal health and retirement programs on budget choices will be felt as the baby boom
generation begins to retire. While much of the public debate concerning the Social Security and
Medicare programs focuses on trust fund balances, the net cash impact of the trust funds on the
budget-not trust fund solvency-is the important measure. The Social Security Trust Fund
(OASDI), for example, is projected to be exhausted in 2040 and virtually all of the long-run
attention to Social Security focuses on that date. Under the trustees' intermediate assumptions,
however, Social Security is projected to have cash deficits beginning in 2018. At that point, the
program becomes a net claimant on the federal budget; that is, the Treasury will have to start
borrowing from the public, or Congress will have to increase taxes or reduce other spending, in
order to pay the interest on the debt held by Social Security. In another 5 or 6 years after that,
the Treasury will have to borrow even more to buy back the debt that Social Security will have
to sell to finance the growing obligations to the baby-boom generation of retirees.
The truth is that, when the long-run prospects for Social Security (and Medicare and Medicaid,
as well) are viewed in the context of the federal budget, Congress has much less time to deal
with the long-run financing problems of these programs than is commonly thought. The
accumulation of federal securities in trust funds will not mitigate the future strains that
programs such as Social Security and Medicare will impose on the federal budget and the
economy. When trust fund balances are drawn down, these programs will not be using
resources that have been saved for a rainy day, as is commonly believed. They will be using
resources generated at that time and those resources can only be provided either from a surplus
in the rest of the federal budget or by borrowing from the public.