Macroeconomics
ECON 2301
Spring 2011
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 14
nd
2
Exam: Chs. 6, 7, 8 & 14
 Section 003 (10 a.m.): Friday, April 1
 Section 004 (5:30 p.m.): Wed., Mar. 30(?)
 Expect this exam to be structured the
same way as Exam 1.
Chapter 14: Deficit Spending and the Public Debt
Learning Objectives:
1. Explain how federal government budget deficits occur
2. Define the public debt and understand alternative
measures of the public debt
3. Evaluate circumstances under which the public debt could
be a burden to future generations
4. Discuss why the federal budget deficit might be measured
incorrectly
5. Analyze the macroeconomic effects of government
budget deficits
6. 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 only 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 – rather
dramatically since 2009
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
approx. 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)
 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.
14-25
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
14-26
Figure 14-4 The Distribution of Foreign
Holdings of U.S. Treasury Securities
14-27
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?
14-28
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.
14-29
Figure 14-5 The Related U.S. Deficits
Sources: Economic Report of the President; Economic Indicators, various issues;
author’s estimates.
14-30
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.
14-31
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.
14-32
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.
14-33
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.
14-34
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.
14-35
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.
14-36
Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 How could the government reduce all its red ink?
Some suggestions you may have heard:
Increasing taxes for everyone
Taxing only the rich
Reducing expenditures
Whittling away at entitlements
14-37
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.
14-38
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?
14-39
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
 Non-controllable 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.
14-41
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.
14-42
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???
14-43
Summary of Learning Objectives
1.
Federal government budget deficits
Whenever the flow of government expenditures
exceeds the flow of government revenues a budget
deficit occurs.
2.
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.
14-44
Summary of Learning Objectives(cont'd)
3.
How the public debt might prove a burden to future
generations
Higher taxes will reduce private consumption.
Crowding out might reduce economic growth.
4.
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.
14-45
Summary of Learning Objectives (cont'd)
5.
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.
14-46
Summary of Learning Objectives (cont'd)
6. Possible ways to reduce the government
budget deficit:
Increase taxes
Reduce expenditures by revising the terms
of entitlement programs
14-47
Assignment to be completed before our
next class: Study for Exam 2!
Assignment to be completed before our next regular
class after the exam:
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, pp. 391-393.