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Chapter 30 - Fiscal Policy, Deficits, and Debt

chapter Thirty

fiscal policy, deficits, and debt

CHAPTER OVERVIEW


This chapter explores the tools of government stabilization policy in terms of the aggregate demand-aggregate (AD-AS) model. Next, the chapter examines fiscal policy measures that automatically adjust government expenditures and tax revenues when the economy moves through the business cycle phases. The recent use and resurgence of fiscal policy as a tool are discussed, as are problems, criticism, and complications of fiscal policy.

The material on the public debt is designed to explode two popular misconceptions as to the character and problems associated with a large public debt: (1) the debt will force the U.S. into bankruptcy; and (2) the debt imposes a burden on future generations. The debt discussion, however, also entails a look at substantive economic issues. Potential problems of a large public debt include greater income inequality, reduced economic incentives, and crowding out of private investment.

The chapter concludes with a Last Word on the leading economic indicators, identifying the specific components of the index and explaining how they combine to help forecast the future direction of the economy.

COMMENTS


  1. Fiscal policy, especially tax policy, is one of the subjects that students usually find very interesting. The chapter provides an excellent opportunity to establish the ties between theory and real world applications.

  2. To give a more human dimension to this chapter, students may identify current members of the Council of Economic Advisers (end-of-chapter question #1). You could assign excerpts from the latest Economic Report of the President, which the Council helps to prepare.

  3. Current federal tax or spending issues can illustrate the timing, administrative, and political problems with discretionary fiscal policy. The series of Bush tax cuts illustrate many of these issues.

  4. Current data on the federal budget can be obtained from the Federal Reserve Bulletin, Economic Indicators, the Survey of Current Business, or the Economic Report of the President or website given in web-based question #2.

  5. Remind students of the multiplier impacts that result from changes in government spending and/or taxes. Most students can understand these concepts without reference to the numerical examples. Numbers often confuse those with “math anxiety,” and if you skipped Chapter 9, they will benefit from a brief overview of the concept.

  6. In the discussion of myths about the debt, remind students that the debt is not completely harmless. Explode the myths, but also discuss the substantive impact of the debt. Also, note the Global Perspectives on debt in other nations.

  7. The Last Word for the chapter is on the “leading indicators.” The stock market often reacts immediately to changes in various indicators. One assignment could focus on the impact of the latest report.

LECTURE NOTES


I. Introduction

A. Learning objectives – In this chapter students will learn:

1. The purposes, tools, and limitations of fiscal policy.

2. The role of built-in stabilizers in moderating business cycles.

3. How the standardized budget reveals the status of U.S. fiscal policy.

4. About the size, composition, and consequences of the U.S. public debt.

B. One major function of the government is to stabilize the economy (prevent unemployment or inflation).

C. Stabilization can be achieved in part by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation.

D. This chapter will examine a number of topics.

1. It explores the tools of government fiscal stabilization policy using AD-AS model.

2. Both discretionary and automatic fiscal adjustments are examined.

3. The problems, criticisms, and complications of fiscal policy are addressed.

4. The size of and concerns about the public debt are identified and explored.

II. Fiscal Policy and the AD/AS Model

A. Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth. “Discretionary” means the changes are at the option of the Federal government.

B. Discretionary fiscal policy changes are often initiated by the President, on the advice of the Council of Economic Advisers (CEA).

C. Changes not directly resulting from congressional action are referred to as nondiscretionary (or “passive”) fiscal policy.

D. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples illustrated in Figure 30.1).


  1. Expansionary Policy needed: In Figure 30.1, a decline in investment has decreased AD from AD1 to AD2 so real GDP has fallen and also employment declined. Possible fiscal policy solutions follow:

a. An increase in government spending (shifts AD to right by more than change in G due to multiplier),

b. A decrease in taxes (raises income, and consumption rises by MPC x the change in income; AD shifts to right by a multiple of the change in consumption).



  1. A combination of increased spending and reduced taxes.

  2. If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.

2. Contractionary fiscal policy needed: When demand pull inflation occurs as illustrated by a shift from AD3 to AD4 up the short-run aggregate supply curve in Figure 30.2. Then contractionary policy is the remedy:

E. Policy options: G or T?

1. Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure.

2. Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.



III. Built-In Stability

A. Built in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary. Figure 30.3 illustrates how the built-in stability system behaves.

1. Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.

2. Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.

B. The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built in stability. In Figure 11.3 line T is steepest with a progressive tax system.

1. The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur.



  1. Automatic stability reduces instability, but does not eliminate economic instability.

IV. Evaluating Fiscal Policy

  1. A standardized budget in Year 1 is illustrated in Figure 30.4(a) because budget revenues equal expenditures when full employment exists at GDP1.

  2. At GDP2 there is unemployment and assume no discretionary government action, so lines G and T remain as shown.

  1. Because of built in stability, the actual budget deficit will rise with decline of GDP; therefore, actual budget varies with GDP.

  2. The government is not engaging in expansionary policy since budget is balanced at full- employment output.

  3. The standardized budget measures what the Federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full employment.

  4. Actual budget deficit or surplus may differ greatly from standardized budget deficit or surplus estimates.

C. In Figure 30.4b, the government reduced tax rates from T1 to T2, now there is a standardized deficit.

  1. Structural deficits occur when there is a deficit in the standardized budget as well as the actual budget.

  2. This is expansionary policy because true expansionary policy occurs when the standardized budget has a deficit.

D. If the standardized deficit of zero was followed by a standardized budget surplus, fiscal policy is contractionary.

E. Recent U.S. fiscal policy is summarized in Table 30.1.



  1. Observe that standardized deficits are less than actual deficits.

  2. Column 3 indicates expansionary fiscal policy of early 1990s became contractionary from 1999 to 2001.

  3. The 2003 Bush tax cut increased the standardized budget deficit as a percentage of potential GDP (to -2.7 percent in 2003).

  4. Federal budget deficits are expected to persist at least until 2012. The absolute size of the deficit is shown in Figure 30.5.

  5. Surpluses and deficits shown in Figure 30.5 include payroll tax revenues obligated for future Social Security payments. Some economists believe that because these revenues are committed to future Social Security payments, they should not be included in calculating current deficits or surpluses.

F. Global Perspectives 30.1 gives a fiscal policy snapshot for selected countries.

V. Problems, Criticisms and Complications

A. Problems of timing

1. Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.

2. Administrative lag is the difficulty in changing policy once the problem has been recognized.

3. Operational lag is the time elapsed between change in policy and its impact on the economy.

B. Political considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy.



  1. A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions.

2. State and local finance policies may offset federal stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse. In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.

3. The crowding out effect may be caused by fiscal policy.

a. “Crowding out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.

b. Some economists argue that little crowding out will occur during a recession.

c. Economists agree that government deficits should not occur at F.E., it is also argued that monetary authorities could counteract the crowding out by increasing the money supply to accommodate the expansionary fiscal policy.


  1. Current thinking on fiscal policy

  1. Some economists oppose the use of fiscal policy, believing that monetary policy is more effective or that the economy is sufficiently self-correcting.

  2. Most economists support the use of fiscal policy to help “push the economy” in a desired direction, and using monetary policy more for “fine tuning.”

3. Economists agree that the potential impacts (positive and negative) of fiscal policy on long-term productivity growth should be evaluated and considered in the decision-making process, along with the short-run cyclical effects.

VI. The Public Debt

  1. The national or public debt is the total accumulation of the Federal government’s total deficits and surpluses that have occurred through time.

  2. Deficits (and by extension the debt) are the result of war financing, recessions, and lack of political will to reduce or avoid them.

  3. The public debt was $9.01 trillion in 2007.

  4. Ownership of the public debt (Figure 30.6)

1. 47 percent held by the public and 53 percent by Federal government agencies, including the Federal Reserve.

2. Foreigners held about 25 percent of the public debt in 2007.

3. The Federal debt held by the public was 31.6 percent of GDP in 2007, higher than in 2001 (27.7%) but less than in the 1990s. (Figure 30.7)

E. Public debt as a percentage of GDP in 2005 for a number of countries can be seen in Global Perspective 30.2. Although the U.S. has the highest public debt in absolute terms, a number of countries owe more relative to their ability to support it (through income, or GDP).

F. Interest charges are the main burden imposed by the debt.

1. Interest on the debt was $237 billion in 2007, and is the fourth largest item in the Federal budget.

2. Interest payments were 1.7 percent of GDP in 2007. The percentage is important because it represents the average tax rate necessary just to cover annual interest on the debt. Low interest rates brought the percentage down from the 1990s.

VII. False Concerns

False concerns about the federal debt include several popular misconceptions:

A. Can the federal government go bankrupt? There are reasons why it cannot.

1. The government does not need to raise taxes to pay back the debt, and it can borrow more (i.e. sell new bonds) to refinance bonds when they mature. Corporations use similar methods—they almost always have outstanding debt.

2. The government has the power to tax, which businesses and individuals do not have when they are in debt.

B. Does the debt impose a burden on future generations? In 2007 the per capita federal debt in U.S. was $29,987. But the public debt is a public credit—your grandmother may own the bonds on which taxpayers are paying interest. Some day you may inherit those bonds that are assets to those who have them. The true burden is borne by those who pay taxes or loan government money today to finance government spending. If the spending is for productive purposes, it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline. Borrowing allows growth to occur when it is invested in productive capital.



VIII. Substantive Issues

A. Repayment of the debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality.

B. Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.

C. A higher proportion of the debt is owed to foreigners (about 25 percent) than in the past, and this can increase the burden since payments leave the country. But Americans also own foreign bonds and this offsets the concern.

D. Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear (see Figure 30.8).

E. There are some positive aspects of borrowing even with crowding out.

1. If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.

2. Public investment makes private investment more attractive. For example, new federal buildings generate private business; good highways help private shipping, etc.



IX. LAST WORD: The Leading Indicators

A. This index comprises 10 variables that have indicated forthcoming changes in real GDP in the past.

B. The variables are the foundation of this index consisting of a weighted average of ten economic measurements. A rise in the index predicts a rise in the GDP; a fall predicts declining GDP.

C. Ten components comprise the index:

1. Average workweek: A decrease signals future GDP decline.

2. Initial claims for unemployment insurance: An increase signals future GDP decline.

3. New orders for consumer goods: A decrease signals GDP decline.

4. Vendor performance: Better performance by suppliers in meeting business demand indicates decline in GDP.

5. New orders for capital goods: A decrease signals GDP decline.

6. Building permits for houses: A decrease signals GDP decline.

7. Stock market prices: Declines signal GDP decline.

8. Money supply: A decrease is associated with falling GDP.

9. Interest-rate spread: when short-term rates rise, there is a smaller spread between short-term and long-term rates which are usually higher. This indicates restrictive monetary policy.

10. Index of consumer expectations: Declines in consumer confidence foreshadow declining GDP.

D. None of these factors alone is sufficient to predict changes in GDP, but the composite index has correctly predicted business fluctuations many times (although not perfectly). The index is a useful signal, but not totally reliable.

ANSWERS TO END-OF-CHAPTER QUESTIONS


30-1 What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? Class assignment: Determine the names and educational backgrounds of the present members of the CEA.

The CEA advises the President on economic matters, and provides recommendations for discretionary fiscal policy action.

Try www.whitehouse.gov for information on CEA.

30-2 (Key Question) Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal.

In this problem, the multiplier is 1/.2 or 5 so, the required increase in government spending = $5 billion.

For the tax cut question, initial spending of $5 billion is still required, but only .8 (= MPC) of a tax cut will be spent. So .8 x tax cut = $5 billion or tax cut = $6.25 billion. Part of the tax reduction ($1.25 billion) is saved, not spent.

One combination: a $1 billion increase in government spending and a $5 billion tax cut. Alternatively, one could raise both government spending and taxes by $25 billion.

30-3 (Key Question) What are government’s fiscal policy options for ending severe demand-pull inflation? Which of these fiscal policy options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? How does the ‘ratchet effect’ affect anti-inflationary policy.

Options are to reduce government spending, increase taxes, or some combination of both. See Figure 30.2. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person wanting to preserve the size of government might favor a tax hike and would want to preserve government spending programs. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. The ratchet effect implies that prices are rigid downward.

30-4 (For students who were assigned Chapter 28) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap (Figure 28.7). Explain how equal-size increases in G and T could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an inflationary gap.



Equal-size increases (decreases) in G and T could eliminate a recessionary (inflationary) expenditure gap because the multiplier effects of a change in government spending are greater than they are for a change in taxes. The effect of a change in G is found by taking the change in G times the spending multiplier. To find the effect of a change in T, the change must first be multiplied by the MPC (because the tax change will affect both consumption and saving), and then by the spending multiplier.

Example: Recessionary (inflationary) expenditure gap of $1000 billion, MPC of 0.5. An increase (decrease) in G of $1000 billion will generate a $2000 billion increase (decrease) in GDP [$2000 = $1000(1/[1-0.5])]. An increase (decrease) in T of $1000 billion will generate a $1000 billion decrease (increase) in GDP [-$1000 = ($1000 x 0.5)(1/[1-0.5])]. Adding the effects of the two changes together will result in a $1000 billion increase (decrease) in GDP, just sufficient to close the gap.

30 5 Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy’s built-in stability?

In a phrase, “net tax revenues vary directly with GDP.” When GDP is rising so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation, and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP.

A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability. This follows from the previous paragraph. A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline.

30-6 (Key Question) Define the “standardized budget,” explain its significance, and state why it may differ from the “actual budget.” Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 30.3. If the economy is operating at GDP2 instead of GDP3, what is the status of its standardized budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?

The standardized budget measures what the Federal deficit or surplus would be if the economy reached full-employment level of GDP with existing tax and spending policies. If the standardized budget is balanced, then the government is not engaging in either expansionary or contractionary policy, even if, for example, a deficit automatically results when GDP declines. The “actual” budget is the deficit or surplus that results when revenues and expenditures occur over a year if the economy is not operating at full-employment.

Looking at Figure 30.3, if full-employment GDP level was GDP3, then the standardize budget is contractionary since a surplus would exist. Even though the “actual” budget has no deficit at GDP2, fiscal policy is contractionary. To move the economy to full-employment, government should cut taxes or increase spending. You would raise G line or lower T line or combination of each until they intersect at GDP3.

30-7 Some politicians have suggested that the United States enact a constitutional amendment requiring that the Federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experienced a severe recession.

When the economy enters a recession, net tax revenue falls. Specifically, revenues from income and excise taxes decline as unemployment rises and consumer spending falls. At the same time, transfer payments to help the poor and/or unemployed rise. If tax revenue falls and the government is required to balance the budget, they will be forced to either cut spending or increase taxes – both of which are contractionary policies likely to worsen the recession.

30 8 (Key Question) Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the notion of a political business cycle. How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowding out effect and why might it be relevant to fiscal policy? In view of your answers, explain the following statement: “Although fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely.”

It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation.

A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability.

A decrease in tax rates might be enacted to stimulate consumer spending. If households receive the tax cut but expect it to be reversed in the near future, they may hesitate to increase their spending. Believing that tax rates will rise again (and possibly concerned that they will rise to rates higher than before the tax cut), households may instead save their additional after-tax income in anticipation of needing to pay taxes in the future.

The crowding-out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending, financed by borrowing. The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the impact of the expansionary fiscal policy may be reduced.

As suggested, the other answers help explain the quote. While fiscal policy is useful in combating the extremes of severe recession with its built-in “safety nets” and stabilization tools, and while the built-in stabilizers can also dampen spending during inflationary periods, it is undoubtedly not possible to keep the economy at its full-employment, noninflationary level of real GDP indefinitely. There is the problem of timing. Each period is different, and the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation. Fiscal policy operates in a political environment in which the unpopularity of higher taxes and specific cuts in spending may dictate that the most appropriate economic policies are ignored for political reasons. Finally, there are offsetting decisions that may be made at any time in the private and/or international sectors. For example, efforts to revive the economy with more government spending could result in reduced private investment or lower net export levels.

Even if it were possible to do any fine tuning to get the economy to its ideal level in the first place, it would be virtually impossible to design a continuing fiscal policy that would keep it there, for all of the reasons mentioned above.

30 9 (Advanced analysis; For students assigned Chapter 28) Assume that, without taxes, the consumption schedule for an economy is as shown below:








GDP,

Billions

Consumption,

billions













$100

200

300

400

500

600

700




$120

200

280

360

440

520

600










a. Graph this consumption schedule and determine the size of the MPC.

b. Assume that a lump sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule, and compare the MPC and the multiplier with those of the pretax consumption schedule.

c. Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule, and note the MPC and the multiplier.

d. Finally, impose a progressive tax system such that the tax rate is zero percent when GDP is $100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC and multiplier.

e. Explain why proportional and progressive tax systems contribute to greater economic stability, while a regressive tax does not. Demonstrate using a graph similar to Figure 30.3.

(a)



(b)

















GDP,

billions


Tax,

billions


DI,

billions


Consumption

after tax

Tax rate,

percent

billions































$100

200

300

400

500

600

700




$10

10

10

10

10

10

10




$ 90

190

290

390

490

590

690




$112

192

272

352

432

512

592




10%

5.0

3.33

2.5

2.0

1.67

1.43



















The MPC is 0.8 [= ($192-$112) billion / ($200-$100) billion = 80/100], as before the tax increase. The spending multiplier remains 5 [= 1/(1-0.8) = 1/0.2]

(c)















GDP,

billions


Tax,

billions


DIs

billions

Consumption

after tax,

billions

























$100

200

300

400

500

600

700







10%

10

10

10

10

10

10

$90

180

270

360

450

540

630




$112

184

256

328

400

472

544


















(d)





















GDP

billions


Tax,

billions


DI,

billions


Consumption

after tax

Tax rate,

percent

billions



MPC





































$100

200

300

400

500

600

700




$ 0

10

30

60

100

150

210




$100

190

270

340

400

450

490




$120

192

256

312

360

400

432







0%

5

10

15

20

25

30

undefined

0.72

0.64

0.56

0.48

0.40

0.32



















(e) The MPC decreases as shown in the right hand column above. Proportional and (especially) progressive tax systems reduce the size of the MPC and, therefore, the size of the multiplier. A lump sum tax does not alter the MPC or the multiplier.

NOTE: For instructors who assign the graphs, the following would be true. For each graph (a) through (d), plot the consumption schedule against the GDP. Graph (a) will have a slope of .8 and will cross the 45 degree line at C = GDP = 200. Graph (b) is parallel to (a) but $10 billion below it and will cross the 45 degree line at C = GDP = 150, indicating the multiplier of 5 ($10 billion loss in income leads to $50 billion drop in equilibrium GDP). Graph (c) will not be as steep as (a) or (b) with a slope of .72 and equilibrium between GDP = 200 and GDP = 300 on the diagram. Graph (d) has a decreasing slope so it will not be a straight line. Equilibrium is just beyond GDP = 200. The multiplier is illustrated by noting the change in equilibrium GDP if any curve were to be shifted by a given amount. The multiplier is the ratio of change in equilibrium GDP to the vertical shift.

30-10 (Key Question) How do economists distinguish between the absolute and relative sizes of the public debt? Why is the distinction important? Distinguish between refinancing the debt and retiring the debt. How does an internally held public debt differ from an externally held public debt? Contrast the effects of retiring an internally held debt and retiring an externally held debt.

There are two ways of measuring the public debt: (1) measure its absolute dollar size; (2) measure its relative size as a percentage of GDP. The distinction is important because the absolute size doesn’t tell you about an economy’s capacity to repay the debt. The U.S. has the largest public debt of any country, but as a percentage of GDP has a smaller debt than some other nations. This means that the U.S. has greater ability (more income) to service that debt than those countries whose debt is a higher percentage of GDP.

Refinancing the public debt simply means rolling over outstanding debt—selling “new” bonds to retire maturing bonds. Retiring the debt means purchasing bonds back from those who hold them or paying the bonds off at maturity.

An internally held debt is one in which the bondholders live in the nation having the debt; an externally held debt is one in which the bondholders are citizens of other nations. Paying off an internally held debt would involve buying back government bonds. This could present a problem of income distribution because holders of the government bonds generally have higher incomes than the average taxpayer. But paying off an internally held debt would not burden the economy as a whole—the money used to pay off the debt would stay within the domestic economy. In paying off an externally held debt, people abroad could use the proceeds of the bonds sales to buy products or other assets from the U.S. However, the dollars gained could be simply exchanged for foreign currency and brought back to their home country. This reduces U.S. foreign reserves holdings and may lower dollar exchange rate.

30-11 True or false? If false, explain why.



  1. The total public debt is more relevant to an economy than the public debt as percentage of GDP.

  2. “An internally held debt is like a debt of the left hand to the right hand.”

  3. The Federal Reserve and Federal government agencies hold more than three-fourths of the public debt.

  4. The portion of the U.S. debt held by the public (and not by government entities) was larger as a percentage of GDP in 2007 than it was in 1995.

  5. In recent years, Social Security payments to retirees have exceeded Social Security tax revenues from workers and their employers.

(a) False. See question 30-10.

(b) The statement is true about a national debt held internally, but this does not mean a large debt is entirely problem free.

(c) False, the Federal Reserve and Federal government held only 51 percent of the public debt in 2005.

(d) False, the public debt was 30.6% of GDP in 2007, about 44.1% in 1995.

(e) False, there is a surplus of funds in the Social Security system that is being used to help offset the deficit in the rest of the Federal budget.

30-12 Why might economists be quite concerned if the annual interest payments on the debt sharply increased as a percentage of the GDP?

The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing were automatic, there would be no debt load at all. But interest does have to be paid. Lenders expect that, and to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP is a measure of total national income or how much the government can raise in taxes to pay the interest

30-13 (Key Question) Trace the cause-and-effect chain through which financing and refinancing of the public debt might affect real interest rates, private investment, the stock of capital, and economic growth. How might investment in public capital and complementarities between public and private capital alter the outcome of the cause-effect chain?

Cause and effect chain: Government borrowing to finance the debt competes with private borrowing and drives up the interest rate; the higher interest rate causes a decline in private capital and economic growth slows.

However, if public investment complements private investment, private borrowers may be willing to pay higher rates for positive growth opportunities. Productivity and economic growth could rise.

30-14 What would happen to the stated sizes of Federal budget deficits or surpluses if the annual additions or subtractions from the Social Security trust fund were excluded?

Because the trust fund has been in surplus, excluding it from the Federal budget would increase the size of stated deficits and reduce the size of stated surpluses.

30-15 (Last Word) What is the index of leading economic indicators, and how does it relate to discretionary fiscal policy?

The index of leading indicators is a monthly composite index of a group of variables that in the past has provided advance notice of changes in GDP. Changes in the index provide a clue to the future direction of the economy and may shorten the length of the “recognition lag” associated with the implementation of discretionary fiscal policy.



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