Macro Economics

[Name of the Course]

[Name of the Instructor]

[Date Submitted]

Macro Economics

Introduction

A national government budget deficit occurs when expenditure exceeds tax and fee revenue in a single fiscal year. In this case, the government must borrow to make up the difference. Therefore, a deficit causes the Gross Debt to increase. For example, U.S. federal government expenditures exceeded its revenues by $363 billion in 2007. Thus, the Gross Debt increased from about $8.5 trillion at the end of 2006 to about $8.9 trillion at the end of 2007.

The official deficit reported by the U.S. Treasury in 2007 was $162 billion. Note that this is less than the $363 billion figure just cited. The smaller figure results from the fact that the official deficit includes the “surplus” in the Social Security program. The government spends Social Security surpluses each year. Because the surpluses are spent, when Social Security receipts eventually fall short of benefits paid (around 2017), the difference must be made up by public bond sales, or by increased taxes, or by decreased spending. Public finance economists argue, therefore, that a more accurate accounting of growth in the debt would exclude Social Security surpluses from the deficit. In this case, the $363 billion figure is a more precise measure of the increase in the debt than the official deficit reported by the Treasury.

Discussion

Economists generally agree that high budget deficits today will reduce the growth rate of the economy in the future. Why?

Deficit finance, implicit as well as explicit, has a potential to inefficiently reduce future production and a nation's standard of living (Altig, Auerbach, Kotlikoff, Smetters, & Walliser, 2001).

Deficits can reduce the future standard of living if they increase consumption and reduce national saving. To see this, note that national saving is the sum of private, business, and government saving. Also note that the economic effect of borrowing is equivalent to a decline in saving. For example, a household can finance a car by reducing its bank account by $25,000, reducing savings, or by retaining the bank account and borrowing $25,000: The economic effects are the same. Therefore, a deficit is a decline in government saving. If a deficit-induced decline in government saving is not accompanied by an equal increase in private saving, national saving will be lower than otherwise. Lower national saving tends to increase the interest rate: In this case, investment declines because the interest rate is a principal part of the cost of capital. The process by which increased deficits cause investment to decline is called crowding out.

If deficits crowd out private investment and the government does not use the borrowed funds to purchase productive capital, national capital investment will be lower than it otherwise would be. In this way, crowding out can reduce the amount of capital inherited by future generations, thereby lowering future standards of living. Elmendorf, D. and Mankiw, G. (1999) estimated that deficits have reduced U.S. incomes by 3% to 6% annually. In this case, unless there is an offsetting economic rationale to run deficits, ...