CHAPTER 16
BUDGET DEFICITS IN THE SHORT
TEST YOURSELF
2.
The government’s budget may be in deficit while the economy is in a recession. In Figure 32-1, when
DISCUSSION QUESTIONS
1. Until 1980, the United States had accumulated a national debt of just under $1 trillion, most of it resulting from government deficits during wars or recessions. The wartime debt corresponded to a reduction in investment for peacetime uses, but few would regard this as a true burden, since unless the nation had devoted itself completely to the war effort it might have been defeated. The deficits incurred during recessions probably did not constitute a burden either, because during periods of slack aggregate demand they did not crowd out investment, and may actually have encouraged investment. Since 1980, however, tax rates had been reduced to such an extent that even when the economy has been operating at its full-employment level the deficits have been large, and the national debt had mushroomed. This part of the debt probably is a burden on future generations, since it led to higher interest rates and at least a partial crowding out of investment. About 30% of the total national debt is owed to foreign individuals, businesses, and governments, 45% percent is owed to the Federal Reserve and federal, state, and local governments and 25% is owed to American individuals and companies. When considering net national debt, just over 50% is owned by foreign individuals, businesses, and governments. The part of the debt held by foreigners is a burden to Americans, since Americans have to transfer resources abroad to make the interest payments.
2. The quotation does not consider the difference between a firm or a family on one hand, and the government on the other. The government will not go bankrupt, since it has the authority to tax and/or to create money to pay its debt obligations, and furthermore it need never pay back the principal but can continue to roll it over. Future debt payments will not burden our children and grandchildren (unless foreigners hold the debt): some Americans (taxpayers) will make interest payments to other Americans (bond holders). Our children and grandchildren will be burdened only if the deficit causes investment to be cut and the future capital stock to be lower. Whether this happens depends mostly upon how much slack there is in the economy at the time the deficits occur.
4. Crowding out occurs when an increase in the government deficit increases the demand for money and raises interest rates, and this in turn reduces investment. The stimulating effect of the deficit is partially reversed. Crowding in occurs when an increase in the deficit leads to an increase in GDP, and the resulting pressures on industrial capacity lead firms to increase investment. The stimulating effect of the deficit is enhanced by investment. Crowding in cannot happen unless there is slack in the economy, and room for GDP to grow; under these circumstances, crowding in may dominate crowding out. If the economy is close to full employment, crowding out will dominate.