Macroeconomics
ECON 2301
Fall 2009
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 14
nd
2
Exam
 Monday, November 2
 Expect it to be structured the same way as
Exam 1.
Chapter 14: Deficit Spending and the
Public Debt
Learning Objectives:
 Explain how federal government budget deficits occur
 Define the public debt and understand alternative measures
of the public debt
 Evaluate circumstances under which the public debt could
be a burden to future generations
 Discuss why the federal budget deficit might be measured
incorrectly
 Analyze the macroeconomic effects of government budget
deficits
 Describe possible ways to reduce the government budget
deficit
14-4
Did You Know That...
 The U.S. federal government spends a total
of more than $3 billion per day on Social
Security, Medicare, and Medicaid.
 Each of these guaranteed spending
programs is individually nearly as large as
the entire discretionary portion of the
federal government’s budget.
Public Deficits and Debts:
Flows versus Stocks
 Government Budget Deficit: situation in
which the government spends more
than it receives in taxes during a given
period of time
Is financed by the selling of government
securities (bonds)
14-6
Public Deficits and Debts:
Flows versus Stocks (cont'd)
 The federal deficit is a flow variable, one
defined for a specific period of time, usually
one year.
 If spending equals receipts, the budget is
balanced.
 If receipts exceed spending, the government
is running a budget surplus.
14-7
Public Deficits and Debts:
Flows versus Stocks (cont'd)
 Balanced Budget: situation in which the
government’s spending is exactly equal
to the total taxes and revenues it collects
during a given period of time
 Government Budget Surplus: excess of
government revenues over government
spending during a given period of time
14-8
Public Deficits and Debts:
Flows versus Stocks (cont'd)
 Public Debt: total value of all outstanding
government securities
A stock variable
14-9
Government Finance: Spending
More than Tax Collections
 Since 1940, the U.S. federal government
has operated with a budget surplus in 13
years.
 In all other years, the shortfall of tax
revenues below expenditures has been
financed with borrowing.
14-10
Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
14-11
Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
14-12
Policy Example: Explaining a $109
Billion Deficit Projection Turnaround
 Why was the government’s 2005 deficit
projection off by $109 billion?
 Federal tax revenues turned out to be more than
15% higher in 2005.
 Economic growth caused taxable incomes, hence
revenues, to be much higher than anticipated.
14-13
Evaluating the Rising Public Debt
 Gross Public Debt: All federal government
debt irrespective of who owns it
 Net Public Debt: Gross public debt minus
all government interagency borrowing
14-14
Evaluating the Rising Public Debt (cont'd)
 Some government bonds are held by government
agencies.
In this case, the funds are owed from one
branch of the federal government to another.
To arrive at the net public debt, we subtract
interagency borrowings from the gross public
debt.
14-15
Evaluating the Rising Public Debt (cont'd)
 Tax revenues tend to be stagnant during times of
slow economic growth.
 Tax revenues grow more quickly when overall
growth enhances incomes.
 As long as spending exceeds revenues, the
budget deficit will persist.
14-16
Table 14-1 The Federal Deficit, Our Public
Debt, and the Interest We Pay on It
14-17
Figure 14-3 Net U.S. Public Debt
as a Percentage of GDP
14-18
Net U.S. Public Debt as a Percentage of GDP
 During World War II, the net public debt grew
dramatically.
 After the war
It fell until the 1970s
Started rising in the 1980s
Declined once more in the 1990s
And recently has been increasing again
14-19
Evaluating the Rising Public Debt (cont'd)
 The government must pay interest on the public debt
outstanding.
The level of these payments depends on the market
interest rate.
Interest payments as a percentage of GDP are likely to
rise in the future.
14-20
Evaluating the Rising Public Debt (cont'd)
 As more of the public debt is held by foreigners, the
amount of interest to be paid outside the United States
increases.
Foreign residents, businesses and governments hold
nearly 50% of the net public debt.
Thus, we do not owe the debt just to ourselves.
Evaluating the Rising Public Debt (cont'd)
 If deficits lead to slower growth rates future generations
will be poorer.
 Both present and future generations will be economically
better off if…
Government expenditures are really investments
The rate of return on such public investments exceeds
the interest rate paid on the bonds
Evaluating the Rising Public Debt (cont'd)
 If the economy is already at full employment, then
further provision of government goods will crowd out
some private goods.
 Deficit spending may raise interest rates, which in turn
will discourage capital formation in the private sector.
14-23
Evaluating the Rising Public Debt (cont'd)
 Crowding-out may place a burden on future generations.
Increased present consumption may crowd out
investment and reduce the growth of capital goods,
which could reduce a future generation’s wealth.
Taxes may have to be increased, imposing higher
taxes on future generations in order to retire the debt.
Evaluating the Rising Public Debt (cont'd)
 Paying off the public debt in the future
If the debt becomes larger, each person’s share would
increase.
Taxes would be levied, and may not be assessed
equally.
A special tax could be levied based on a person’s
ability to pay.
14-25
Evaluating the Rising Public Debt (cont'd)
 Our debt to foreign residents
We do not owe all the debt to ourselves.
Future U.S. residents will be taxed to repay principal
and interest.
Portions of U.S. incomes will be transferred abroad.
14-26
Evaluating the Rising Public Debt (cont'd)
 If deficits lead to slower growth rates future
generations will be poorer.
 Both present and future generations will be
economically better off if…
Government expenditures are really investments
The rate of return on such public investments exceeds
the interest rate paid on the bonds
14-27
International Example: Where Are Most
Treasury Securities Held Abroad?
 More than $2 trillion in U.S. Treasury securities
of the $5 trillion in net outstanding debt is held
outside the United States.
 Japan accounts for more than one-third of all
foreign holdings of the U.S. net public debt.
14-28
Figure 14-4 The Distribution of Foreign
Holdings of U.S. Treasury Securities
14-29
International Example: Where Are Most
Treasury Securities Held Abroad? (cont'd)
 For critical analysis:
Why might the fact that market interest rates
in Japan have hovered very close to 0%
during the 2000s help explain relatively
large holdings of U.S. Treasury securities by
residents of that country?
14-30
Federal Budget Deficits
in an Open Economy
 Question: Is there a connection between the
U.S. trade deficit and the federal government
budget deficit?
 A trade deficit exists when the value of imports
exceeds the value of exports.
 Some say it appears that there is a relationship
between trade and budget deficits; at least there
is a statistical correlation between the two.
14-31
Figure 14-5 The Related U.S. Deficits
Sources: Economic Report of the President; Economic Indicators, various issues;
author’s estimates.
14-32
Federal Budget Deficits in an
Open Economy (cont'd)
 If foreigners are using the dollars they hold to
buy U.S. government bonds, then they will have
fewer dollars to spend on U.S. exports.
 This means that a U.S. budget deficit can
contribute to a trade deficit.
14-33
Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
 Which government deficit is the true deficit?
The government may report distorted measures
of its own budget.
• Government has not adopted a business-like
approach to tracking its expenditures and receipts.
• Official government “measures” yield lowest
possible deficits and highest reported surpluses.
14-34
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 An operating budget includes current outlays
for on-going expenses, such as salaries and
interest payments.
 A capital budget, includes expenditures on
investment items, such as machines, buildings,
roads and dams.
14-35
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Question
How do higher deficits affect the economy in the
short run?
 Answers:
If the economy is below full-employment, the deficit
can close the recessionary gap.
If the economy is already at full-employment, the
deficit can create an inflationary gap.
14-36
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 In the long run, higher government budget
deficits have no effect on equilibrium real GDP.
 Ultimately, spending in excess of receipts
redistributes a larger share of real GDP to
government-provided goods and services.
14-37
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Thus, if the government operates with higher
deficits over an extended period:
The ultimate result is a shrinkage in the share
of privately produced goods and services
By continually spending more than it collects,
the government takes up a larger portion of
economic activity.
14-38
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 How could the government reduce all its red ink?
Increasing taxes for everyone
Taxing only the rich
Reducing expenditures
Whittling away at entitlements
14-39
Policy Example: How Rich Taxpayers Avoid Part
of a Tax-Rate Increase
 Some estimates show increasing the top bracket from
35% to 39.6% would reduce total taxable income by at
least 4%.
 Such projections show this increase as giving the
highest income taxpayers a greater incentive to
incorporate and pay lower corporate-profit tax rates.
 Thus, raising the income tax rate by 4.6% would result
in less than a 4.6% increase in government tax
collections – but an increase, not a decrease, as some
suggest.
14-40
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 In considering how expenditures might be
reduced, it is important to look at entitlements,
the federal government payments that are
legislated obligations and cannot be reduced or
eliminated.
 What are some of these entitlements?
14-41
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Entitlements: Guaranteed benefits under a
government program such as Social
Security, Medicare, or Medicaid
 Noncontrollable Expenditures: Government
spending that changes automatically
without action by Congress
Figure 14-5 Components of Federal Expenditures
as Percentages of Total Federal Spending
Source: Office of Management and Budget.
14-43
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Entitlements are the largest component of the
U.S. federal budget.
 To make a significant cut in expenditures,
entitlement programs would have to be revised.
14-44
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Question
What are the political costs of reducing
entitlement payments for Social Security,
Medicare, and Medicaid???
14-45
Summary of Learning Objectives
 Federal government budget deficits
Whenever the flow of government expenditures
exceeds the flow of government revenues a budget
deficit occurs.
 The public debt
Total value of all government bonds outstanding
The federal budget deficit is a flow, whereas
accumulated deficits are a stock, called the
public debt.
14-46
Summary of Learning Objectives(cont'd)
 How the public debt might prove a burden to
future generations
Higher taxes will reduce private consumption.
Crowding out might reduce economic growth.
 Why the federal budget deficit might be
incorrectly measured
No distinction between capital expenses and operating
expenses
Each estimate is based on a set of assumptions.
14-47
Summary of Learning Objectives (cont'd)
 The macroeconomic effects of government
budget deficits
Because higher government deficits are caused by
increased government spending or tax cuts, they
contribute to a short-run rise in total planned
expenditures and aggregate demand.
In the long run, increased deficits only redistribute
resources from the private sector to the public sector.
14-48
Summary of Learning Objectives (cont'd)
 Possible ways to reduce the government
budget deficit:
Increase taxes
Reduce expenditures by revising the terms
of entitlement programs
14-49
Assignment to be completed before
class November 2: Study for Exam 2!
Assignment to be completed before class
November 4:
Pre-read Chapter 15 & these end-of-chapter
Problems:
14th ed: 15-2, 15-4, 15-6, 15-8, 15-13, 15-14 & 15-15, on pp.
389-391.
15th ed: 15-2, 15-4, 15-6, 15-8, 15-13, 15-14 & 15-15, on pp.
391-393.