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Baumol & Blinder MACROECONOMICS (11th ed)

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CHAPTER 15

Budget Deficits in the Short and Long Run

307

On-Budget versus Off-Budget Surpluses

When you read about the budget in the newspapers, you may see references to the “off-budget” surplus or deficit and the “on-budget” surplus or deficit. What do those terms mean?

Because Social Security benefits are financed by an earmarked revenue source—the payroll tax—Social Security and a few minor items have traditionally been segregated in the federal fiscal accounts. Specifically, both Social Security expenditures and the payroll tax receipts that finance them are treated as off-budget items, whereas most other expenditures and receipts are classified as on-budget. Thus:

Overall budget deficit 5 Off-budget deficit 1 On-budget deficit

Because the Social Security System has been running sizable surpluses in recent years, the difference between the overall and on-budget deficits has been substantial. For example, in fiscal year 2007, the overall budget showed a $162 billion deficit (column 1). But this was composed of a whopping $344 billion on-budget deficit (column 3) less a $182 billion Social Security surplus (column 4). Some people claim that such a large discrepancy must mean that the Social Security surplus is “hiding” the “true” deficit. That’s a matter of semantics. Nothing is really hidden; the facts are as given in Table 1. But you need to interpret the facts correctly. If you are interested in knowing how much the federal government must borrow each year, the total deficit (column 1) gives the number you want.

Conclusion: What Happened after 1981?

Table 1 helps us understand the remarkable ups and downs of the federal budget deficit since the early 1980s. Column 1 shows the overall surplus (if positive) or deficit (if negative) every other year from 1981 to 2007, and column 2 shows the corresponding structural surplus. Finally, columns 3 and 4 break the overall surplus into its on-budget and off-budget components. The table tells the following story about the evolution of the budget deficit.

The large Reagan tax cuts in the early 1980s ballooned the budget deficit from $79 billion to $212 billion, and more than 100 percent of this deterioration was structural (see column 2). Late in the 1980s, the deficit started rising again—even though Social Security began to run sizable surpluses (see column 4). The overall deficit reached $269 billion in 1991, but then began to shrink. One reason was the burgeoning Social Security surplus, which increased by $115 between 1993 and 2001. The strong economy helped, too. Notice that the actual surplus rose more than the structural surplus. But most of the deficit-reducing “work” was on-budget and structural, as tax increases and expenditure restraint during the Clinton years finally got the budget under control—briefly, as it turned out.

By 2003, a combination of large tax cuts, a burst of spending on antiterrorism and the war in Iraq, and weaker economic growth had pushed the deficit up to a record $378 billion—a record that was topped in fiscal year 2004. But both the actual budget deficit (column 1) and the structural budget deficit (column 2) have fallen since then.

WHY IS THE NATIONAL DEBT CONSIDERED A BURDEN?

Now that we have gained some perspective on the facts, let us consider the charge that budget deficits place intolerable burdens on future generations. Perhaps the most frequently heard reason is that future Americans will be burdened by heavy interest payments, which will necessitate higher taxes. But think about who will receive those interest payments: mostly the future Americans who own the bonds. Thus, one group of future Americans will be making interest payments to another group of future Americans— which cannot be a burden on the nation as a whole.3

3 However, the future taxes that will have to be raised to pay the interest may reduce the efficiency of the economy.

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But there is a future burden to the extent that the debt is held by foreigners. The share of the net U.S. national debt owned by foreign individuals, businesses, and governments has been rising rapidly and is now over 52 percent. Paying interest on this portion of the debt will indeed burden future Americans in a very concrete way: For years to come, a portion of America’s GDP will be sent abroad to pay interest on the debts we incurred in the 1980s, 1990s, and 2000s. For this reason, many thoughtful observers are becoming concerned that the United States is borrowing too much from abroad.4 Thus, we conclude that

If the national debt is owned by domestic citizens, future interest payments just transfer funds from one group of Americans to another. But the portion of the national debt owned by foreigners does constitute a burden on the nation as a whole.

Many people also worry that every nation has a limited capacity to borrow, just like every family and every business. If it exceeds this limit, it is in danger of being unable to pay its creditors and may go bankrupt—with calamitous consequences for everyone. For some countries, this concern is indeed valid and serious. Debt crises have done major damage to many countries in Latin America, Asia, and Africa over the years.

But the U.S. government need not worry about defaulting on its debt for one simple reason. The American national debt is an obligation to pay U.S. dollars: Each debt certificate obligates the Treasury to pay the holder so many U.S. dollars on a prescribed date. But think about where those dollars come from. The U.S. government prints them up! So, in the worst case, if the U.S. government had no better way to pay off its creditors, it could always print whatever money it needed to do so. In a word, no nation need default on debts that call for repayment in its own currency.5 However, printing up the necessary money is not an option for countries whose debts call for payment, say, in U.S. dollars, as a number of Southeast Asian countries learned in 1997 and as Argentina learned in 2001.

It does not, of course, follow that acquiring more debt through budget deficits is necessarily a good idea for the United States. Sometimes, it is clearly a bad idea. Nonetheless:

There is a fundamental difference between nations that borrow in their own currency (such as the United States) and nations that borrow in some other currency (which is, normally, the U.S. dollar). The former need never default on their debts; the latter might have to.

BUDGET DEFICITS AND INFLATION

We now turn to the effects of deficits on macroeconomic outcomes. It often is said that deficit spending is a cause of inflation. Let us consider that argument with the aid of Figure 6, which is a standard aggregate supply-and-demand diagram.

Initially, equilibrium is at point A, where demand curve D0D0 and supply curve SS intersect. Output is $7,000 billion, and the price index is 100. In the diagram, the aggregate demand and supply curves intersect precisely at potential GDP, indicating that the economy is operating at full employment. Let us also assume that the budget is initially balanced.

Suppose the government now raises spending or cuts taxes enough to shift the aggregate demand schedule outward from D0D0 to D1D1. Equilibrium shifts from point A to point B, and the graph shows the price level rising from 100 to 106, or 6 percent. But that is not the end of the story, because point B represents an inflationary gap. We know from previous chapters that inflation will continue until the aggregate supply curve shifts far enough inward that it passes through point C, at which point the inflationary gap is gone. In this example, deficit spending will eventually raise the price level 12 percent.

Thus, the cries that budget deficits are inflationary have the ring of truth. How much truth they hold depends on several factors. One is the slope of the aggregate supply curve.

4We will discuss the linkages between the federal budget deficit and foreign borrowing in greater detail in Chapter 19.

5However, Russia astounded the financial world in 1998 by defaulting on its ruble-denominated debt.

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309

Figure 6 clearly shows that a steep supply curve would lead to more inflation than a flat one. A second factor is the degree of resource utilization. Deficit spending is more inflationary in a fully employed economy (such as that depicted in Figure 6) than in an economy with lots of slack.

Finally, we must remember that the Federal Reserve’s monetary policy can always cancel out the potential inflationary effects of deficit spending by pulling the aggregate demand curve back to its original position. Once again, the policy mix is crucial.

				Aggregate supply
		D1	Potential	curve shifts
		D1	Potential	inward as wages rise
			GDP	inward as wages rise
			GDP
	D0				S
	112
			C
Level	106
Price	106
				B

	100
			A		D1
					D1
		S			Deficit spending
					boosts aggregate
				D0	demand
	$5,000	$6,000	$7,000	$8,000
			Real GDP

NOTE: Real GDP amounts are in billions of dollars.

FIGURE 6

The Monetization Issue

The Inflationary Effects

But will the Federal Reserve always neutralize the expansionary effect of a higher budget

of Deficit Spending

deficit? This question brings up another reason why some people worry about the infla-

tionary consequences of deficits. They fear that the Federal Reserve may feel compelled to

“monetize” part of the deficit by purchasing some of the newly issued government debt.

The central bank is said to

Let us explain, first, why the Fed might make such purchases and, second, why these pur-

monetize the deficit

chases are called monetizing the deficit.

when it purchases bonds

Deficit spending, we have just noted, normally drives up both real GDP and the price

issued by the government.

level. As we emphasized in Chapter 13, such an economic expansion shifts the demand

curve for bank reserves outward to the right—as depicted by the movement from D0D0

to D1D1 in Figure 7. The diagram shows that, if the Federal Reserve takes no action to

shift the supply curve, interest rates will rise as equilibrium moves from point A to

point B.

Suppose now that the Fed does not want interest

rates to rise. What can it do? To prevent the incipient

rise in r, it would have to engage in expansionary mone-

FIGURE 7

tary policy that creates new bank reserves, thereby

shifting the supply curve for reserves outward to the

Fiscal Expansion and Interest Rates

right—as indicated in Figure 8 on the next page. With

the blue supply curve S1S1, equilibrium would be at

point C rather than at point B, leaving interest rates un-

changed. Because the Federal Reserve usually pursues

expansionary monetary policy by purchasing Treasury

For given

bills in the open market, deficit spending might there-

Fed policy

fore induce the Fed to buy more government debt.

Rate

But why is this process called monetizing the deficit?

Interest

The reason is simple. As we learned in Chapter 12,

Shift in demand

creating more bank reserves generally leads, via the

for reserves caused

multiple expansion process, to an increase in the money

by rising Y and P

supply. By this indirect route, then, larger budget deficits

may lead to a larger money supply. To summarize:

If the Federal Reserve takes no countervailing ac-

tions, an expansionary fiscal policy that increases

the budget deficit will raise real GDP and prices,

Quantity of Bank Reserves

thereby raising the demand for bank reserves and

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FIGURE 8

Monetization and Interest Rates

D0	D1	S0	S1
Rate		B
Interest	A	C	Expansionary
			Expansionary
			Fed policy

Quantity of Bank Reserves

driving up interest rates (Figure 7). If the Fed does not want interest rates to rise, it can engage in expansionary open-market operations; that is, it can purchase more government debt. If the Fed does so, both bank reserves and the money supply will increase (Figure 8). In this case, we say that part of the deficit is monetized.

Monetized deficits are more inflationary than nonmonetized deficits for the simple reason that expansionary monetary and fiscal policies together are more inflationary than expansionary fiscal policy alone. But is this a real worry? Does the Fed actually monetize any substantial portion of the deficit? Normally, it does not. The clearest evidence is the fact that the Fed managed to reduce inflation in the 1980s, and again in the early years of this decade, even as the government ran huge budget deficits. But over the years, monetization of deficits has been a serious cause of inflation in many other countries, ranging from Latin America to Russia, Israel, and elsewhere.

DEBT, INTEREST RATES, AND CROWDING OUT

Crowding out occurs when deficit spending by the government forces private investment spending to contract.

So far, we have looked for possible problems that the national debt might cause on the demand side of the economy. But the real worry comes on the supply side. In brief, large budget deficits discourage investment and thereby retard the growth of the nation’s capital stock.

The mechanism is easy to understand by presuming (as is generally the case) that the Fed does not engage in any substantial monetization. In that case, we have just seen, budget deficits tend to raise interest rates. But we know from earlier chapters that the rate of interest (r) is a major determinant of investment spending (I). In particular, higher r leads to less I. Lower investment today, in turn, means that the nation will have less capital tomorrow—and the size of potential GDP will be smaller. This, according to most economists, is the true sense in which a larger national debt may burden future generations—and, conversely, a smaller national debt may help them:

A larger national debt may lead a nation to bequeath less physical capital to future generations. If they inherit less plant and equipment, these generations will be burdened by a smaller productive capacity—a lower potential GDP. By that mechanism, large deficits may retard economic growth. By the same logic, budget surpluses can stimulate capital formation and economic growth.

Phrasing this point another way explains why this result is often called the crowding-out effect. Consider what happens in financial markets when the government engages in deficit spending. When it spends more than it takes in, the government must borrow the rest. It does so by selling bonds, which compete with corporate bonds and other financial instruments for the available supply of funds. As some savers decide to buy government bonds, the funds remaining to invest in private bonds must shrink. Thus, some private borrowers get “crowded out” of the financial markets as the government claims an increasing share of the economy’s total saving.

Some critics of deficit spending have taken this lesson to its illogical extreme by arguing that each $1 of government spending crowds out exactly $1 of private spending, leaving “expansionary” fiscal policy with no net effect on total demand. In their view, when G rises, I falls by an equal amount, leaving the total of C 1 I 1 G 1 (X 2 IM) unchanged. Under normal circumstances, we would not expect this to occur. Why? First, moderate budget deficits push up interest rates only slightly. Second, private spending is only moderately

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311

sensitive to interest rates. Even at the higher interest rates that government deficits cause, most corporations will continue to borrow to finance their capital investments.

Furthermore, in times of economic slack, a counterforce arises that we might call the crowding-in effect. Deficit spending presumably quickens the pace of economic activity. That, at least, is its purpose. As the economy expands, businesses find it more profitable to add to their capacity in order to meet the greater consumer demands. Because of this induced investment, as we called it in earlier chapters, any increase in G may increase investment, rather than decrease it as the crowding-out hypothesis predicts.

The strength of the crowding-in effect depends on how much additional real GDP is stimulated by government spending (that is, on the size of the multiplier) and on how sensitive investment spending is to the improved business opportunities that accompany rapid growth. It is even conceivable that the crowding-in effect could dominate the crowding-out effect in the short run, so that I rises, on balance, when G rises.

But how can this be true in view of the crowding-out argument? Certainly, if the	Journal—	Syndicate
government borrows more and the total volume of private saving is fixed, then private	Journal—	Syndicate

industry must borrow less. That’s just arithmetic. The fallacy in the strict crowding-	WallTheFromSOURCE:Street	FeaturesCartoonPermission,
out argument lies in supposing that the economy’s flow of saving is really fixed. If	WallTheFromSOURCE:Street	FeaturesCartoonPermission,

government deficits succeed in raising output, we will have more income and there-

fore more saving. In that way, both government and industry can borrow more. Which effect dominates—crowding out or crowding in? Crowding out stems from the

increases in interest rates caused by deficits, whereas crowding in derives from the faster real economic growth that deficits sometimes produce. In the short run, the crowding-in effect—which results from the outward shift of the aggregate demand curve—is often the more powerful, especially when the economy is at less than full employment.

In the long run, however, the supply side dominates because, as we have learned, the economy’s self-correcting mechanism pushes actual GDP toward potential GDP.

When the economy is approximately at potential, the crowding-out effect takes over: Higher interest rates lead to less investment, causing the capital stock and potential GDP to grow more slowly. Turned on its head, this is the basic long-run argument for reducing the budget deficit: Smaller budget deficits should raise investment and speed up economic growth.

Crowding in occurs when government spending, by raising real GDP, induces increases in private investment spending.

“Would you mind explaining again how high interest rates and the national deficit affect my allowance?”

The Bottom Line

Let us summarize what we have learned so far about the crowding-out controversy.

•The basic argument of the crowding-out hypothesis is sound: Unless the economy produces enough additional saving, more government borrowing will force out some private borrowers, who are discouraged by the higher interest rates. This process will reduce investment spending and cancel out some of the expansionary effects of higher government spending.

•But crowding out is rarely strong enough to cancel out the entire expansionary thrust of government spending. Some net stimulus to the economy remains.

•If deficit spending induces substantial GDP growth, then the crowding-in effect will lead to more income and more saving—perhaps so much more that private industry can borrow more than it did previously, despite the increase in government borrowing.

•The crowding-out effect is likely to dominate in the long run or when the economy is operating near full employment. The crowding-in effect is likely to dominate in the short run, especially when the economy has a great deal of slack.

THE MAIN BURDEN OF THE NATIONAL DEBT: SLOWER GROWTH

This analysis of crowding out versus crowding in helps us understand whether or not the national debt imposes a burden on future generations:

When government budget deficits take place in a high-employment economy, the crowding-out effect probably dominates. So deficits exact a toll by leaving a smaller

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capital stock, and hence lower potential GDP to future generations. However, deficits in an economy with high unemployment may well lead to more investment rather than less. In this case, in which the crowding-in effect dominates, deficit spending increases growth and the new debt is a blessing rather than a burden.

Which case applies to the U.S. national debt? To answer this question, let us go back to the historical facts and recall how we accumulated all that debt prior to the 1980s. The first cause was the financing of wars, especially World War II. Because this debt was contracted in a fully employed economy, it undoubtedly constituted a burden in the formal sense of the term. After all, the bombs, ships, and planes that it financed were used up in the war, not bequeathed as capital to future generations.

Yet today’s Americans may not feel terribly burdened by the decisions of those in power in the 1940s, for consider the alternatives. We could have financed the entire war by taxation and thus placed the burden on consumption rather than on investment. But that choice would truly have been ruinous, and probably impossible, given the colossal wartime expenditures. Alternatively, we could have printed money, which would have unleashed an inflation that nobody wanted. Finally, the government could have spent much less money and perhaps not have won the war. Compared to those alternatives, Americans of subsequent generations probably have not felt burdened by the massive deficit spending undertaken in the 1940s.

A second major contributor to the national debt prior to 1983 was a series of recessions. But these are precisely the circumstances under which budget deficits might prove to be a blessing rather than a burden. So it was only in the 1980s that we began to have the type of deficits that are truly burdensome—deficits acquired in a fully employed, peacetime economy.

This sharp departure from historical norms is what made those budget deficits worrisome. The tax cuts of 1981–1984 blew a large hole in the government budget, and the recession of 1981–1982 ballooned the deficit even further. By the late 1980s, the U.S. economy had recovered to full employment, but a structural deficit of $100–$150 billion per year remained. This persistent deficit was something that had never happened before. Such large structural deficits posed a real threat of crowding out and constituted a serious potential burden on future generations. After a brief interlude of budget surpluses in the late 1990s, large structural deficits reemerged in the early years of this decade, caused by a combination of large tax cuts and rapid spending growth. Current projections also foresee very large deficits in the future, which worries economists and budget analysts.

Let us now summarize our evaluation of the actual burden of the U.S. national debt:

•The national debt will not lead the nation into bankruptcy. But it does impose a burden on future generations to the extent that it is sold to foreigners or contracted in a fully employed, peacetime economy. In the latter case, it will reduce the nation’s capital stock.

•Under some circumstances, budget deficits are appropriate for stabilization-policy purposes.

•Until the 1980s, the actual public debt of the U.S. government was mostly contracted as a result of wars and recessions—precisely the circumstances under which new debt does not constitute a burden. However, the large deficits of the 1980s and 2000s were not mainly attributable to recessions, and are therefore worrisome.

•The shift from budget surpluses back to deficits in this decade may retard capital formation and future economic growth.

ISSUE REVISITED:

IS THE BUDGET DEFICIT TOO LARGE?

We are now in a position to address the issue posed at the beginning of this chapter: Is the federal budget deficit too large? To tackle this question, we need to understand how and why fiscal policy changed, and we need to distinguish between the short-run (demand side) and long-run (supply side) effects of budget deficits.

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CHAPTER 15	Budget Deficits in the Short and Long Run	313
The federal budget was in surplus by $236 billion in fiscal year 2000 (which ended
September 30, 2000). By fiscal 2003, there was a deficit of $378 billion—a swing of
$614 billion in just three years. How did this happen? Three main factors
contributed.
One was the tax cuts of 2001 and 2003, which were even larger than George W. Bush
had proposed as a candidate in the 2000 campaign. As we have noted in this chapter,
whether such large tax cuts were wise or foolish policy is still hotly debated. But this
much is clear: Given the 2001 recession and the weak economy that followed it, the
stimulus to aggregate demand from the tax cuts was welcome. The debate is over
whether the government should have reduced the fiscal stimulus when the economy

strengthened in 2004–2006.

The second major factor was the recession of 2001 and its

aftermath—a period of time during which GDP was consis-

FIGURE 9

tently below potential. As we have emphasized in this chap-

The Short-Run Effect of Larger Deficits or Smaller

ter (see especially Figure 5 on page 306), it is perfectly natural

Surpluses

for the budget to deteriorate when the economy does—and

then to improve when the economy does.

The third major factor was a surge in federal spending

during President Bush’s first term. From fiscal year 2001 to

fiscal year 2005, total federal spending increased by 33 per-

cent while nominal GDP rose by just 22 percent. Some of

this additional spending was on the war in Iraq, another

Level

policy whose wisdom is hotly debated. But other types of

Price

spending rose, too.

Those were the fiscal policies. What were their effects?

In the short run, aggregate demand factors dominate

economic performance, and the stimulus from both higher

spending and tax cuts provided an expansionary force just

when the economy needed one. Moving from surpluses to

deficits probably cushioned the recession and sped up the

recovery by boosting aggregate demand, as shown in

Figure 9.

Real GDP

But in the long run, however, output gravitates toward

potential GDP, no matter what happens to aggregate

demand. So aggregate supply rules the roost. And that is

FIGURE 10

where the long-run costs of fiscal stimulus emerge. Large

The Long-Run Effect of Larger Deficits or Smaller

budget deficits lead to higher real interest rates and hence

Surpluses

to lower levels of private investment. That makes the na-

tion’s capital stock grow more slowly, thereby retarding the

Potential

growth rate of potential GDP. This slower growth is

GDP

depicted in Figure 10, which shows budget deficits leading

to a potential GDP of Y1 instead of Y0 in the future. With

the same aggregate demand curve, DD, the result is lower

real GDP.

So, on balance, were the deficits appropriate? The answer

Level

is not clear. In the short run, the economy clearly did need

stimulus in 2001–2003, as it did once again in 2008. But be-

Price

cause large deficits deter some investment spending, they

slow down the economy’s potential growth rate in the long

S 1

run. That is why thoughtful proponents of fiscal stimulus in

2001 urged the government to make any increases in spend-

ing or reductions in taxes temporary. We should reduce the

budget surplus in the short run, they argued, but maintain it

in the long run. That advice was not heeded in 2001. But it

was heeded when the government enacted a large stimulus

Real GDP

package in 2008, which was explicitly temporary.

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THE ECONOMICS AND POLITICS OF THE U.S. BUDGET DEFICIT

“The ‘Twilight Zone’ will not be seen tonight, so that we may bring you the followng special on the federal budget.”

Given what we have learned in this chapter about the theory and facts of budget deficits, we can now address some of the major issues that have been debated in the political arena for years.

		1. Have the deficits of the 1980s, 1990s, and 2000s been a problem? In 1981–1982,
WallTheFromSOURCE:Street	JournalCartoon—Permission, SyndicateFeatures	1990–1991, and again in 2001, the U.S. economy suffered through recessions.
WallTheFromSOURCE:Street	JournalCartoon—Permission, SyndicateFeatures	And in late 2007-2008, the economy was very weak again. Under such circum-

		stances, crowding out is not a serious concern, and actions to close the deficit
		during or right after these recessions would have threatened the subsequent
		recoveries. According to the basic principles of fiscal policy, growing deficits
		were appropriate in each case.
		But in each case, crowding out became a more serious issue as the economy
		recovered toward full employment. Budget deficits should decline under such
		circumstances—as they did in the 1990s and again from 2004 to 2007. But the
		deficit did not fall in the 1980s nor in the period from 2002 to 2004. Instead, the
		structural deficit rose. Worries about the burden of the national debt, once mostly
		myths, became all too realistic.

2.How did we get rid of the deficit in the 1990s? In part, we did it the old-fashioned way: by raising taxes and reducing spending in three not-so-easy steps. There was a contentious but bipartisan budget agreement in 1990, a highly partisan

deficit-reduction package in 1993 (which passed without a single Republican vote), and a smaller bipartisan budget deal in 1997.

Taxing more and spending less produces a contractionary fiscal policy that reduces aggregate demand. This effect did not hurt the U.S. economy in the 1990s because fiscal and monetary policies were well coordinated. If fiscal policy turns contractionary to reduce the deficit, monetary policy can turn expansionary to counteract the effects on aggregate demand. In this way, we can hope to shrink the deficit without shrinking the economy. Such a change in the policy mix should also bring down interest rates, because both tighter budgets and easier money tend to have that effect. Indeed, that is just what happened in the 1990s. Interest rates fell, and the Fed made sure that aggregate demand was sufficient to keep the economy growing.

In addition, surprisingly rapid economic growth in the late 1990s generated much more tax revenue than anyone thought likely only a few years earlier. And the so-called off-budget surplus also increased. Both of these developments helped the federal budget turn rapidly from deficit into surplus.

3.How did the surplus give way to such large deficits so rapidly? As we have just noted, the answer comes in three parts: recession, tax cuts, and higher levels of spending, especially on national defense and homeland security. It is hardly a mystery that sharply rising expenditures and rapidly falling revenue push the budget from the black into the red.

4.What are the future prospects for the federal budget deficit? In a word, not very good. Beginning in 2011, baby boomers born in the years after 1946 will start reaching the magic age of 65—making them eligible for Medicare and, soon thereafter, for full Social Security benefits. So it is all but certain that federal spending will start to rise sharply. But as of now, Congress has not enacted the future tax increases that will be needed to fund these expanding retirement and health-care programs. Nor has it cut the promised benefits. So, if nothing changes, the budget deficit will start to grow again. Economists are not terribly concerned about the triple-digit budget deficits of 2007 and 2008. But they are worried about how the U.S. govern-

ment will pay its bills in 2020, 2030, and 2040.

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| SUMMARY |

1.Rigid adherence to budget balancing would make the economy less stable, by reducing aggregate demand (via tax increases and reductions in government spending) when private spending is low and by raising aggregate demand when private spending is high.

2.Because both monetary and fiscal policy influence aggregate demand, the appropriate budget deficit or surplus depends on monetary policy. Similarly, the appropriate monetary policy depends on budget policy.

3.The same level of aggregate demand can be generated by more than one mix of fiscal and monetary policy. But the composition of GDP will be different in each case. Larger budget deficits and tighter money tend to produce higher interest rates, a smaller share of investment in GDP, and slower growth. Smaller budget deficits and looser monetary policy lead to a larger investment share and faster growth.

4.One major reason for the large budget deficits of the early 1980s and early 1990s was the fact that the economy operated well below full employment. In those years, the structural deficit, which uses estimates of what the government’s receipts and outlays would be at full employment to correct for business-cycle fluctuations, was much smaller than the official deficit.

5.The need to make future interest payments on the public debt is a burden only to the extent that the national debt is owned by foreigners.

6.The argument that a large national debt can bankrupt a country like the United States ignores the fact that our national debt consists entirely of obligations to pay U.S. dollars—a currency that the government can raise by increasing taxes or create by printing money.

7.Budget deficits can be inflationary because they expand aggregate demand. They are even more inflationary if they are monetized—that is, if the central bank buys some of the newly issued government debt in the open market.

8.Unless the deficit is substantially monetized, deficit spending forces interest rates higher and discourages private investment spending. This process is called the crowding-out effect. If a great deal of crowding out occurs, then deficits impose a serious burden on future generations by leaving them a smaller capital stock with which to work.

9.But higher government spending (G) may also produce a crowding-in effect. If expansionary fiscal policy succeeds in raising real output (Y), more investment will be induced by the higher Y.

10.Whether crowding out or crowding in dominates largely depends on the time horizon. In the short run, and especially when unemployment is high, crowding in is probably the stronger force, so higher G does not cause lower investment. But, in the long run, the economy will be near full employment, and the proponents of the crowding-out hypothesis will be right: High government spending will mainly displace private investment.

11.Larger deficits may spur growth (via aggregate demand) in the short run but deter growth (via aggregate supply and potential GDP) in the long run.

12.Whether or not deficits create a burden depends on how and why the government incurred the deficits in the first place. If the government runs deficits to fight recessions, more investment may be crowded in by rising output than is crowded out by rising interest rates. Deficits contracted to carry on wars certainly impair the future capital stock, although they may not be considered a burden for noneconomic reasons. Because these two cases account for most of the debt the U.S. government contracted until the mid-1980s, that debt cannot reasonably be considered a serious burden. However, some of the deficits since 1984 are more worrisome on this score.

		\| KEY TERMS	\|
Mix of monetary and		National debt 303	Crowding out	310
fiscal policy 301		Structural budget deficit or	Crowding in	311
		Structural budget deficit or	Crowding in	311
Budget deficit	303	surplus 306	Burden of the national debt 311
			Burden of the national debt 311
Budget surplus	303	Monetizing the deficit 309

316

PART 3

Fiscal and Monetary Policy

| TEST YOURSELF |

1.Explain the difference between the budget deficit and the national debt. If the deficit gets turned into a surplus, what happens to the debt?

2.Explain in words why the structural budget might show a surplus while the actual budget is in deficit. Illustrate your answer with a diagram like Figure 5 (page 306).

3.If the Federal Reserve lowers interest rates, what will happen to the government budget deficit? (Hint: What will happen to tax receipts and interest expenses?) If the government wants to offset the effects of the Fed’s actions on aggregate demand, what might it do? How will this action affect the deficit?

| DISCUSSION QUESTIONS |

1.Explain how the U.S. government managed to accumulate a debt of over $9 trillion. To whom does it owe this debt? Is the debt a burden on future generations?

2.Comment on the following: “Deficit spending paves the road to ruin. If we keep it up, the whole nation will go bankrupt. Even if things do not go this far, what right have we to burden our children and grandchildren with these debts while we live high on the hog?”

3.Newspaper reports frequently suggest that the administration (regardless of who is president) is pressuring the

Fed to lower interest rates. In view of your answer to Test Yourself Question 3, why do you think that might be?

4.Explain the difference between crowding out and crowding in. Given the current state of the economy, which effect would you expect to dominate today?

5.Given the current state of the economy, what sort of fiscal-monetary policy mix seems most appropriate to you now? (Note: There is no one correct answer to this question. It is a good question to discuss in class.)

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