Chapter 14 Deficit Spending and the Public Debt

Chapter 14 Deficit Spending and the Public Debt Learning Objectives After you have studied this chapter, you should be able to 1. define government budget deficits and surpluses, a balanced budget, the public debt, the gross public debt, the net public debt, entitlements, and noncontrollable expenditures; 2. explain why government budget deficits and surpluses are flows and why measures of the public debt are stocks; 3. distinguish between the gross public debt and the net public debt; 4. explain in what ways that government budget deficits and an accumulating public debt might be burdensome to society; 5. recognize why there can be a relationship between government budget deficits and trade deficits; 6. discuss the macroeconomic effects of government budget deficits; and 7. enumerate ways in which the federal government could reduce its budget deficits. Outline 1. The government s accounts include both flows and stocks. a. Government budget deficits or surpluses are flows during a period of time, such as a year. i. A government budget deficit occurs whenever government spending exceeds government revenues during a given period of time. ii. A government budget surplus occurs whenever government revenues exceed government spending during a given period of time. iii. The federal government experiences a balanced budget whenever government spending is exactly equal to the government s total revenues from taxes and other sources during a given period. b. The public debt is a stock measured at a given point in time. i. The public debt is the total value of all outstanding federal government securities. ii. The public debt is the accumulation of past government budget deficits. 2. There are two ways to measure the public debt. a. The gross public debt consists of all federal government debt irrespective of who owns it. b. The net public debt is equal to the gross public debt minus all government interagency borrowings.

164 Miller Economics Today, Sixteenth Edition 3. There are two ways that government budget deficits and an accumulating public debt might be burdensome to society. a. A higher public debt can burden future generations if the government purchases that federal deficits are used to finance do not lead to increases in real GDP and if the federal deficits crowd out investment spending and thereby lead to a smaller future capital stock. b. To the extent that the public debt is purchased by residents of other nations, a higher public debt can be burdensome if its accumulation leads to less domestic growth, so that future generations that repay the debt will transfer a larger share of their incomes abroad when they incur higher taxes to repay the debt. 4. A trade deficit, a situation in which the value of imports of goods and services exceeds the value of exports, will often accompany a government budget deficit. a. If domestic consumption and investment remain unchanged percentages of GDP when government spending increases or taxes decrease, then funds to finance the government budget deficit must come from abroad. b. Foreign households, businesses, and governments will have an incentive to purchase domestic government debt if domestic interest rates rise, but if they buy more domestic bonds they will purchase fewer domestic exports of goods and services. Domestic exports decline, and the domestic trade deficit rises. 5. The macroeconomic consequences of government budget deficits depend on whether we consider their short-run or long-run effects. a. The short-run effects of government budget deficits depend on the economy s situation during the short-run period in which the deficits occur. i. If the economy experiences a recessionary gap at the time that the government operates with a deficit, then the increase in aggregate demand resulting from higher government spending or lower taxes pushes real GDP toward its full-employment level. ii. If the economy is already at full-employment real GDP, then an increase in aggregate demand resulting from a deficit-inducing rise in government spending or fall in taxes results in an inflationary gap. b. In the long run, after all adjustments have occurred, a higher government budget deficit has no effect on equilibrium real GDP, so the only effect of a higher deficit is the redistribution of a larger share of real GDP to government-produced goods and services. 6. There are two basic ways that the federal government could attempt to reduce budget deficits. a. With government spending unchanged, tax increases could reduce federal budget deficits. b. With taxes unchanged, reduced government spending could reduce federal budget deficits, but spending on entitlement programs such as Social Security complicate this approach, because these forms of spending are noncontrollable expenditures. Key Terms Balanced budget Entitlements Government budget deficit Government budget surplus Gross public debt Net public debt Noncontrollable expenditures Public debt

Chapter 14 Deficit Spending and the Public Debt 165 Key Concepts Burdens of the public debt Flow Stock Completion Questions Fill in the blank, or circle the correct term. 1. The government budget deficit is measured (over time, at a point in time) and consequently is a (flow, stock). 2. The public debt is measured (over time, at a point in time) and consequently is a (flow, stock). 3. The public debt arises from (an accumulation, a subtraction) of past (deficits, balanced budgets). 4. An excess of government spending over total government revenues is a. An excess of total government revenues over government spending is a. A situation in which government spending exactly equals total government revenues is a. 5. The public debt includes all federal government debt irrespective of who owns it, and the public debt excludes all government interagency borrowing. 6. If government budget deficits result in crowding out of investment and thereby reduce growth in the nation s (consumption, capital stock), then the resulting debt can be a burden for (current, future) generations. 7. A higher public debt can be a burden if it results in more purchases of government bonds by (domestic, foreign) households, businesses, and governments, thereby resulting in a burdensome transfer from (this nation to foreign countries, foreign nations to this country). 8. In an open economy, a higher government budget deficit is often associated with a higher deficit. 9. If the economy is initially in a recessionary-gap situation and the government s budget is balanced, then cutting taxes while keeping government spending unchanged will result in a government budget (deficit, surplus) and, in the short run, cause equilibrium real GDP to (remain unchanged, rise toward its full-employment level). 10. If all macroeconomic adjustments have occurred, real GDP is initially at its full-employment level, and the government s budget is balanced, then increasing government spending while keeping taxes unchanged will result in a government budget (deficit, surplus) and, in the long run, cause equilibrium real GDP to (remain unchanged, rise above its full-employment level). 11. Spending on entitlements such as Social Security, Medicare, and other government-provided health care are (controllable, noncontrollable) expenditures that currently account for (more than, less than) half of all federal government spending.

166 Miller Economics Today, Sixteenth Edition True-False Questions Circle the T if the statement is true, the F if it is false. Explain to yourself why a statement is false. 1. An excess of government spending over total government tax revenues is measured as a stock at a point in time. 2. If the federal government operates with a surplus during the current year that exceeds any interest it owes on the outstanding public debt, then the public debt will decline during that year. 3. Since 1940, the federal government has experienced budget surpluses in more years than it has experienced budget deficits. 4. The most recent period in which the federal government officially operated with annual budget surpluses was from 1998 to 2001. 5. The net public debt equals the gross public debt minus government interagency borrowing. 6. Government budget deficits and resulting increases in the public debt necessarily impose burdens on future generations. 7. If foreign residents respond to higher U.S. interest rates by purchasing more U.S. government bonds, then, if all other things are equal, they will purchase fewer U.S. exports, thereby contributing to a higher U.S. trade deficit. 8. If real GDP is initially at its full-employment level and the federal government experiences an increase in its budget deficit, then the long-run effect of the higher budget deficit will be an increase in real GDP. 9. If real GDP is initially below its full-employment level and the federal government experiences an increase in its budget deficit, then the short-run effect of the higher budget deficit will be an increase in real GDP. 10. In the long run, higher government deficits leave equilibrium real GDP unchanged and simply redistribute a larger share of real GDP to government-provided goods and services. 11. Spending on entitlements such as Social Security, Medicare, and other health programs currently accounts for almost 60 percent of total U.S. federal government expenditures. 12. Government spending on Social Security, Medicare, and other health programs are examples of noncontrollable expenditures that change automatically without action by Congress.

Chapter 14 Deficit Spending and the Public Debt 167 Multiple Choice Questions Circle the letter that corresponds to the best answer. 1. If federal government spending and total government revenues from taxes and other sources during a given period of time equal the same dollar amounts, then the government experiences a. a budget deficit. b. a budget surplus. c. a balanced budget. d. None of the above. 2. An excess of government spending over total government revenues from taxes and other sources during a given period of time is a. a flow. b. a stock. c. the net public debt. d. the gross public debt. 3. The total value of all outstanding federal government securities at a point in time is a. the public debt. b. a balanced budget. c. a government budget deficit. d. a government budget surplus. 4. During the period from 1998 to 2001, the U.S. federal government officially operated with a. annual balanced budgets. b. annual budget surpluses. c. annual budget deficits. d. no public debt. 5. Since 2001, the federal government has experienced a. a stock of government spending in excess of a stock of government revenues. b. a stock of government revenues in excess of a stock of government spending. c. annual balanced budgets. d. a growing public debt. 6. Which one of the following should be included in the gross public debt? a. U.S. Treasury securities purchased by an office of the federal government s Department of Housing and Urban Development b. U.S. Treasury securities purchased by a federal government agency called the Government National Mortgage Association c. U.S. Treasury securities purchased by the parents of a college student d. All of the above.

168 Miller Economics Today, Sixteenth Edition 7. Which one of the following should not be included in the net public debt? a. U.S. Treasury securities held by a private bank b. U.S. Treasury securities held by a small business based in Houston, Texas c. U.S. Treasury securities held by the Internal Revenue Service, which is part of the U.S. Treasury Department d. All of the above. 8. How can higher interest rates induced by increased U.S. government budget deficits contribute to the potential for these deficits to be burdensome to future generations? a. The higher interest rates discourage foreign households, businesses, and governments from purchasing U.S. government securities. b. The higher interest rates discourage U.S. households, businesses, and governments from purchasing U.S. government securities. c. The higher interest rates crowd out consumption spending, so that the net effects of higher deficit spending are a decrease in total planned expenditures and a reduction in real GDP. d. The higher interest rates crowd out investment spending, and as a result the nation s capital stock and real GDP will be lower for future generations than it would have been otherwise. 9. Which one of the following can correctly help to explain why higher U.S. federal budget deficits that boost the U.S. public debt might prove burdensome to future U.S. taxpayers? a. Foreign holders of the U.S. public debt will receive transfers from future U.S. taxpayers. b. Future U.S. taxpayers will receive transfers from foreign holders of the U.S. public debt. c. A portion of deficit spending by the federal government is on capital goods. d. None of the above. 10. Which of the following can correctly help to explain why U.S. government budget deficits can be directly related to U.S. trade deficits? a. Higher U.S. interest rates induced by government budget deficits discourage foreign residents from purchasing U.S. government securities, and as a consequence foreign residents purchase more U.S. exports. b. Higher U.S. interest rates induced by government budget deficits encourage foreign residents to purchase U.S. government securities, and as a consequence foreign residents purchase fewer U.S. exports. c. Higher U.S. import spending increases the portion of domestic goods and services available for the government to purchase, which contributes to the occurrence of government budget deficits. d. Higher U.S. import spending reduces the portion of income available for the government to tax, which contributes to the occurrence of government budget deficits. 11. Suppose that the government initially had a balanced budget but then experiences a budget deficit. If the results are a rise in the equilibrium price level but no change in equilibrium real GDP, then the economy was initially in a. a long-run equilibrium situation and has remained in this situation. b. a recessionary-gap situation and has now attained a long-run equilibrium. c. an inflationary-gap situation and has now attained a long-run equilibrium. d. a long-run equilibrium situation but now operates with a recessionary gap.

Chapter 14 Deficit Spending and the Public Debt 169 12. Suppose that the government initially had a balanced budget but then experiences a budget deficit. If the results are an increase in the equilibrium price level and a rise in equilibrium real GDP to its full-employment level, then the economy was initially in a. a long-run equilibrium situation and has remained in this situation. b. a recessionary-gap situation and has now attained a long-run equilibrium. c. an inflationary-gap situation and has now attained a long-run equilibrium. d. a long-run equilibrium situation but now operates with a recessionary gap. 13. Which of the following is true of the distribution of U.S. federal government expenditures? a. Since the early 1950s, government spending on Social Security, Medicare, and other health programs as a percentage of total government spending has risen from less than 10 percent to nearly 60 percent. b. Since the early 1950s, government spending on national defense as a percentage of total government spending has risen from about 20 percent to almost 70 percent. c. Since the early 1950s, noncontrollable expenditures have decreased as a percentage of total government spending. d. There has been almost no change in the distribution of government spending among national defense and entitlements. Matching Choose an item in Column (2) that best matches an item in Column (1). (1) (2) (a) government budget deficit (h) excess of government spending over (b) net public debt government revenues (c) balanced budget (i) noncontrollable expenditures (d) entitlement (j) government budget surplus (e) Medicare and other government health spending (k) equality of spending and revenues (f) government revenues in excess of spending (l) Social Security program (g) total value of all outstanding federal government (m) public debt securities (n) excludes government interagency borrowing

170 Miller Economics Today, Sixteenth Edition Working with Graphs 1. Consider the diagram below when answering the following questions, and assume that the government s budget is balanced at the initial equilibrium point, which is Point E. a. What situation a recessionary gap, an inflationary gap, or a long-run equilibrium exists at Point E? b. If the government s tax revenues remain constant but the government s expenditures increase, what will take place on the diagram? c. What will happen to equilibrium real GDP in the short run? Will it rise, fall, or remain d. What will happen to the equilibrium price level in the short run? Will it rise, fall, or remain 2. Consider the diagram below when answering the following questions, and assume that the government s budget is balanced at the initial equilibrium point, which is Point E. a. What situation a recessionary gap, an inflationary gap, or a long-run equilibrium exists at Point E? b. If the government s tax revenues remain constant but the government s expenditures increase, what will take place on the diagram? c. What will happen to equilibrium real GDP in the short run? Will it rise, fall, or remain

Chapter 14 Deficit Spending and the Public Debt 171 d. What will happen to the equilibrium price level in the short run? Will it rise, fall, or remain e. What will happen to equilibrium real GDP in the long run? Will it rise, fall, or remain f. What will happen to the equilibrium price level in the long run? Will it rise, fall, or remain Answers Completion Questions 1. over time; flow 2. at a point in time; stock 3. an accumulation; deficits 4. deficit; surplus; balanced budget 5. gross; net 6. capital stock; future 7. foreign; this nation to foreign countries 8. trade 9. deficit; rise toward its full employment level 10. deficit; remain unchanged 11. noncontrollable; more than True-False Questions 1. F This is a situation of a government budget deficit, which is a flow. 2. T 3. F In fact, government budget deficits have been much more common. 4. T 5. T 6. F There may not be a burden if government spending yields sufficiently high economic growth. 7. T 8. F In the long run, after all adjustments, a higher budget deficit results in a redistribution of a larger share of full-employment real GDP to government-provided goods and services. 9. T 10. T 11. T 12. T Multiple Choice Questions 1. (c) 8. (d) 2. (a) 9. (a) 3. (a) 10. (b) 4. (b) 11. (a) 5. (d) 12. (b) 6. (d) 13. (a) 7. (c)

172 Miller Economics Today, Sixteenth Edition Matching (a) and (h) (b) and (n) (c) and (k) (d) and (l) (e) and (i) (f) and (j) (g) and (m) Working with Graphs 1. a. There is a recessionary gap at Point E. b. Deficit spending will cause aggregate demand to increase, so the AD curve will shift rightward. c. Equilibrium real GDP will rise in the short run. d. The equilibrium price level will rise in the short run. 2. a. There is a long-run equilibrium at Point E. b. Deficit spending will cause aggregate demand to increase, so the AD curve will shift rightward. c. Equilibrium real GDP will rise in the short run. d. The equilibrium price level will rise in the short run. e. Equilibrium real GDP will end up at the level determined by LRAS in the long run. f. The equilibrium price level will rise in the long run. Glossary Balanced budget A situation in which the government s spending is exactly equal to the total taxes and other revenues it collects during a given period of time. Entitlements Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid. Government budget deficit An excess of government spending over government revenues during a given period of time. Government budget surplus An excess of government revenues over government spending during a given period of time. Gross public debt All federal government debt irrespective of who owns it. Net public debt Gross public debt minus all government interagency borrowing. Noncontrollable expenditures Government spending that changes automatically without action by Congress. Public debt The total value of all outstanding federal government securities.