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14.6 End-of-Chapter Material

In Conclusion

We started this chapter by asking whether the United States should adopt a balanced-budget amendment to the constitution. This question has both political and economic ramifications.

It is not our purpose in this book to answer this question, or others like it, for you. Most interesting questions do not have easy answers. Instead, they come down to assessments of costs and benefits and judgments about which frameworks best describe the world that we live in. Our intent here was to provide you with the ability to assess the arguments about a balanced-budget amendment and, more generally, the effects of deficit spending on the economy.

We saw in this chapter that there are certainly both benefits and costs associated with deficit finance. Key benefits include the ability to spread out the payments for large government purchases and the opportunity to use deficits to stimulate economies in recession. The main cost of deficits is that they increase real interest rates, thus crowding out investment and slowing long-term growth.

As we also saw, these effects might be tempered by an increase in household savings in response to government deficits. The evidence suggests that the Ricardian perspective on deficits has partial validity. Changes in government savings are likely to be partially, but not completely, offset by changes in households’ saving behavior.

We also noted that a balanced-budget amendment would not absolve government of the difficult choices involved in balancing the budget. It is one thing to pass a law saying that the budget must be balanced. It is quite another to come up with the spending cuts and tax increases that are needed to make it happen.

Meanwhile, time is passing. Go and look again at the size of the debt outstanding reported at the US Treasury (http://www.treasurydirect.gov/NP/BPDLogin?application=np). How much has it changed since you first checked it? How much has your share of the debt changed?

Key Links

Exercises

  1. The following table is a table of the same form as Table 14.1 "Calculating the Deficit" but with some missing entries. Complete the table. In which years was there a balanced budget?

    Table 14.11 Calculating the Deficit

    Year Government Purchases Tax Revenues Transfers Net Taxes Deficit
    1 60 10 20 −10
    2 80 100 20
    3 120 20 100 −20
    4 140 180 0
    5 20 140 40

  2. The following table lists income and the tax rate at different levels of income. In this exercise the tax rate is different at different levels of income. For income below 500, the tax rate is 20 percent. For income in excess of 500, the tax rate is 25 percent. Calculate tax receipts for this case.

    Table 14.12 Tax Receipts and Income

    Income Marginal Tax Rate Tax Receipts
    0 0.2
    100 0.2
    500 0.2
    1000 0.25
    2000 0.25
    5000 0.25

  3. Consider the following table. Suppose that government purchases are 500, and the tax rate is 20 percent. Furthermore, suppose that real gross domestic product (GDP) takes the values indicated in the table. If the initial stock of debt is 1,000, find the level of debt for each of the 5 years in the table.

    Table 14.13 Exercise

    Year GDP Deficit Debt (Start of Year) Debt (End of Year)
    1 3,000 1,000
    2 2,000
    3 4,000
    4 1,500
    5 2,500
  4. For the example in the preceding table titled “Exercise”, are the deficits and surpluses due to variations in the level of GDP or fiscal policy? Suppose you were told that potential GDP was 4,000. Is there a full employment deficit or surplus when actual GDP is 3,000? Design a fiscal policy so that the budget is in balance when real GDP is equal to potential GDP.
  5. Draw a version of Figure 14.7 "Deficit/Surplus and GDP" using the data for tax receipts you calculated in the table titled “Tax Receipts and Income”, and assuming government purchases equal 475. At what level of GDP is the budget in balance?
  6. The text says that expansionary fiscal policy increases the deficit given the level of GDP. Would an expansionary fiscal policy necessarily increase the deficit if GDP changes as well?
  7. Compare Figure 14.14 "Ratio of US Debt to GDP, 1791–2009" (from 1940 onward) with Figure 14.2 "US Surplus and Debt, 1962–2010". Why do the figures look so different from each other?
  8. Suppose that investment is very sensitive to real interest rates. What does this mean for the slope of the demand curve in the credit market? Will it make the crowding-out effect large or small?

Economics Detective

  1. The price of government debt during the Civil War makes for a fascinating case study. Both the Union and the Confederacy were issuing debt to finance their expenditures. Try to do some research on the value of Civil War debt to answer the following questions.

    1. How much did the Union and the Confederacy rely on deficits rather than taxes to finance the war efforts?
    2. What do you think happened to the value of the Union and Confederacy debt over the course of the war?
    3. Do you think these values were positively or negatively correlated?
    4. A starting point for your research is a website (http://www.tax.org/Museum/1861-1865.htm) that summarizes the way in which the North and the South financed their war efforts.
  2. What happened to the budget deficits of European Union member countries during the financial crisis that started in 2008? Were these cyclically adjusted budget deficits?
  3. Using the CBO as a source, make a table of the budget deficits for the period 1990 to the present in constant rather than current dollars (that is, obtain figures for real receipts, outlays, and deficits). Describe the behavior of real receipts, real outlays, and the real deficit over this period. Does it differ qualitatively from the description in the text? (If necessary, check the toolkit for instructions on how to convert nominal variables into real variables.)
  4. Using the CBO as a source, make a table of the on-budget deficits for the period 1990 to the present. Compare these calculations with those reported in Table 14.2 "Recent Experience of Deficits and Surpluses (Billions of Dollars)". Explain the main differences between these tables.
  5. Each month, the Congressional Budget Office (CBO) posts its monthly budget review. Look for the most recent monthly budget review. What are the largest outlays and revenues? How large are interest payments on the debt?
  6. We saw that the government budget went from surplus to deficit in 2002. Based on the discussion in the text, try to find two different things that happened around this time that might explain this change.

  7. This exercise builds on Table 14.9 "Budget Deficits around the World, 2005*".

    1. Find the levels of GDP in 2005 for each country listed in Table 14.9 "Budget Deficits around the World, 2005*". Using this information, find the ratio of the deficit to GDP for each of the countries.
    2. Which country in the world has the highest ratio of debt to GDP? How do the countries listed in Table 14.9 "Budget Deficits around the World, 2005*" compare in terms of the debt-to-GDP ratio?
    3. For the countries listed in Table 14.9 "Budget Deficits around the World, 2005*", find the growth rate of real GDP in 2005. Do countries that grow faster have smaller deficits? Hint: The CIA Fact Book (https://www.cia.gov/library/publications/the-world-factbook/index.html) will be useful.

Spreadsheet Exercises

  1. Suppose that government purchases are 500 and the tax rate is 20 percent. Create a table to calculate the budget deficit for each level of income from 0 to 1,000, increasing by 50 each time. At what level of income does the budget balance? Compare your results to those in Table 14.8 "Deficit and Income".
  2. Create a spreadsheet to study the debt as in Table 14.5 "Deficit and Debt" using the data from Table 14.1 "Calculating the Deficit". But assume that the level of debt outstanding at the start of the first period was 100, not 0. Assume that the interest rate is 2 percent each year. Add a column to Table 14.1 "Calculating the Deficit" to indicate the payment of interest on the debt. Calculate the deficit for each year and then the debt outstanding at the start of the next year. Also calculate the primary deficit in your spreadsheet. What happens to these calculations when the interest rate increases to 5 percent?