Chapter 12

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                                      Chapter 12

This chapter looks at the surpluses, deficits, and debt and their impact on the economy. The
focus of this chapter is on the following questions:

       1. How do deficits and surpluses arise?
       2. What harm (good) do deficits (surpluses) cause?
       3. Who will pay off the accumulated national debt?

After reading this chapter, the students should:

       1. Know the differences and relationship between the deficit (surpluses) and the debt,
          as well as the mechanics by which the government is able to float the debt.
       2. Be able to read data concerning the deficit (surpluses) and the debt, by knowing why
          it is necessary to look at the structural deficit (surpluses).
       3. Understand how changes in fiscal policy influence the deficit (surpluses) and debt.
       4. Have a historical understanding of how the U.S. achieved such a large deficit
          (surplus) and debt in this country and of the political economy of the debt.
       5. Understand what is a burden and what is not a burden of the debt.
       6. Be able to argue both sides of the politically important issue about the desirability of
          different ways to restrain deficits and the debt, such as the balanced-budget

          Note the change in the chapter title to Deficits, and Debt
          Federal budget data are updated.
          A new In the News on the impact of Bush tax cuts
          One new Question for Discussion.

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How long will this chapter take? One or two 75-minute class period(s).

Where should you start?
1. Ask students to define the national debt.
      Most students confuse the definitions of national debt and budget deficit. Many believe
      they are the same term. The national debt is the accumulation of previous year‟s
      budget deficits. This question can lead you into a discussion of the concept of budget
      surpluses and deficits that begins on page 228.

2. Ask students how large the national debt is.
       The most current number can be found using the cyber note on page 240. Most
      students will be surprised at the size of the debt. A fun technique is to divide the debt by
      the nation‟s population and then ask the students to pay their share. This will help you
      introduce the concept of the burden of the debt.

3. Students may find it interesting that the size of the debt relative to the GDP has been
   historically worse.
       During World War II, the ratio was consistently over 1.0. Still the absolute size of the
       debt is alarming.

4. Ask the students who owns the national debt.
      Figure 12.4 on page 241 is a very good graphical representation of who owns the debt.
      To a very large extent, the national debt is owned internal to the U.S.

5. Finally, discuss the consequences of paying off the debt.
           You might offer the historical argument that taxes must rise and spending must fall
           in order to pay off the debt. Under this scenario, the economy would certainly
           suffer. Put this historical thinking in perspective to how a budget surplus has
           occurred since 1998 allow for some of the debt to be retired. Use AS and AD
           analysis to discuss the macroeconomic implications of retiring the debt through
           increased taxes and reduced spending. Another point of discussion is that if the
           debt is fully retired, it would become impossible to perform monetary policy.
           Students may not want a balanced budget once they understand how the economy
           may be affected.

Students often believe the following statement is true. The correct answer is explained after the
incorrect statement is presented.

Our grandchildren will feel the burden of the deficit. Deficit and debt are concepts that are
often confused. While deficits occur because of the excess of expenditures over taxes during a
given year, the debt can be calculated at any given point in time and represents the cumulative
effect of running deficits over our entire history. It is the debt on which transfers such as
interest payments are made, not the deficit. Such transfers may result in opportunity costs.

                             Chapter 12 – Deficits, Surpluses, and Debt - Page                198
However, a deficit may reflect expenditures on capital that future generations will need and thus
may not be the source of the burden.

I. Introduction
   A. This chapter looks at the deficits (surpluses) and debt that occur when the government
      uses its tax and spending powers to shift AD. Schiller takes a closer look at how
      government spending is financed. The focus in this chapter is on the following
          1. How do deficits and surpluses arise?
          2. What harm (good) do deficits (surpluses) cause?
          3. Who will pay off the accumulated national debt?
   B. In the News: “The Bush Tax Cuts Are Sapping America’s Strength”
      President Clinton‘s economic advisor, Laura D‘Andrea Tyson, argues that the tax cuts
      passed during the G.W. Bush administration cause an unprecedented future debt burden
      that will reduce long term growth.
II. Budget Effects of Fiscal Policy
   A. Keynesian theory highlights the potential of fiscal policy to solve macro problems.
         1. Definition: Fiscal Policy – The use of government taxes and spending to
                            alter macroeconomic outcomes.
         2. The guidelines are simple.
                  Use fiscal stimulus to eliminate unemployment
                  Use fiscal restraint to control inflation.
         3. The federal budget is a key policy lever for controlling the economy.
   B. Budget Surpluses and Deficits. (Table 12.1)
         1. Use of the budget to stabilize the economy implies that federal expenditures and
            receipts will not always be equal.
         2. By reducing tax revenues and increasing spending the federal government throws
            its budget out of balance creating a budget deficit through deficit spending.
         3. Definition: Deficit Spending – The use of borrowed funds to finance
                            government expenditures that exceed tax revenues.
         4. Definition: Budget Deficit – Amount by which government spending
                            exceeds government revenue in a given time period.
         5. Formula:
                           Budget Deficit  GovernmentSpending - Tax Revenues

           6. If the government spends less than its tax revenues, a budget surplus is created.
           7. Definition: Budget Surplus – An excess of government revenues over
                             government expenditures in a given time period.
           8. The U.S. federal government ran a $70 billion surplus in 1998.
           9. A String of Deficits. (Figure 12.1)
                    Prior to 1998, the most recent budget surplus occurred in 1969.
                    Between 1982 and 1996, the deficit got as high as $290 billion (1992) and
                      never got below $100 billion.
                    There was a return to deficits in 2002.
                    World View: “Budget Imbalances Common”
                      Comparison of the US budget surplus in 2000 with deficits and surpluses

                            Chapter 12 – Deficits, Surpluses, and Debt - Page                199
                   in other countries.
      10. Keynesian View (Figure 12.1)
                From a Keynesian perspective, budget deficits and surpluses are a routine
                   feature of fiscal policy.
                In Keynes‘ view, a balanced budget would be appropriate only if all other
                   injections and leakages were in balance and the economy was in full-
                   employment equilibrium.
                The practice of fiscal policy has produced few budget surpluses.
C. Discretionary vs. automatic spending
      1. Budget analysts say Congress could not balance the budget even if it wanted to.
          If true, the policymakers may not be responsible for the long string of deficits,
          nor do they deserve credit for any budge surpluses.
      2. At the beginning of each year, the President and Congress put together a budget
          blueprint for next fiscal year.
      3. Definition: Fiscal Year (FY) – The twelve-month period used for
                            accounting purposes; begins October 1 for the federal
      4. To a large extent, most current revenues and expenditures are a result of
          decisions made in prior years. In this sense, much of each year‘s budget is
                Uncontrollables account for approximately 80% of the federal budget.
                This leaves 20% for discretionary fiscal spending.
      5. Definition: Discretionary Fiscal Spending – Those elements of the
                            federal budget not determined by past legislative or executive
      6. The force behind Keynesian fiscal policy is the ability to change tax and spending
          levels, i.e. to provide fiscal restraint or fiscal stimulus.
      7. Definition: Fiscal Restraint – Tax hikes or spending cuts intended to
                            reduce (shift) aggregate demand.
      8. Definition: Fiscal Stimulus – Tax cuts or spending hikes intended to
                            increase (shift) aggregate demand.
      9. Automatic Transfers.
                Most uncontrollable line items‘ value also changes with economic
                Income transfers, such as outlays for unemployment compensation and
                   welfare, increase during recessions, acting as automatic stabilizers.
                Definition: Income Transfers – Payments to individuals for
                                    which no current goods or services are exchanged, such
                                    as Social Security, welfare, unemployment benefits.
                Definition: Automatic Stabilizers – Federal expenditure or
                                    revenue item that automatically responds
                                    countercyclically to changes in national income, like
                                    unemployment benefits, income taxes.
                Automatic stabilizers also exist on the revenue side of the budget, e.g.,
                   income taxes move up and down with the value of spending and output.
                   In addition, the tax code is progressive.
D. Cyclical Deficits. (Table 12.2)
      1. The size of the federal deficit is sensitive to expansion and contraction of the
          macro economy.
      2. Inflation also affects the budget deficit.

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                   Social Security is automatically adjusted to inflation and federal outlays
                    increase .
                 This outlay is, however, offset by inflation-swollen tax receipts.
                 Both Social Security payroll taxes and corporate profit taxes rise
                    automatically with inflation.
                 These offsetting expenditures and revenues almost cancel each other out.
         3. Actual budget deficits and surpluses may arise from economic conditions as well
            as policy.
                 President Reagan, in his 1980 campaign, promised to balance the budget.
                    The 1981-82 recession, however, caused the deficit to soar.
                 President Bush explained the huge deficits during his presidency on an
                    increase in the nation‘s unemployment rate due to the 1990-91 recession.
                 President Clinton found the budget deficit declining during his
                    presidency, but most of the deficit reduction was due to automatic
                    stabilizers kicking in as the unemployment rate fell.
                 The reduction in unemployment from 7.4 percent in 1993 to 4.3 percent
                    in 1998 resulted in an increase in tax revenues, reduced income transfers
                    and a budget surplus.
         4. Cyclical deficit widens when unemployment or inflation increases and shrinks
            when unemployment or inflation decreases.
         5. Definition: Cyclical Deficit – That portion of the budget deficit
                            attributable to unemployment or inflation.

  E. Structural Deficits (Table 12.3)
        1. To isolate effects of fiscal policy, the deficit is broken down into cyclical and
           structural components.
        2. Formula:
                               Total Budget Deficit  Cyclical Deficit  StructuralDeficit

         3. Part of the deficit arises from cyclical changes in the economy; the rest is the
            result of discretionary fiscal policy.
         4. Definition: Structural Deficit – Federal revenues at full-employment
                            minus expenditures at full employment under prevailing fiscal
         5. Only changes in the structural deficit measure the thrust of fiscal policy.
         6. Fiscal policy is categorized as follows:
                 Fiscal stimulus is measured by the increase in the structural deficit (or
                    shrinkage in the structural surplus)
                 Fiscal restraint is gauged by the decrease in the structural deficit (or
                    increase in the structural surplus).
         7. In The News: “Fiscal Policy in the Great Depression”
            Between 1931 and 1933, the structural deficit actually decreased. This fiscal
            restraint reduced aggregate demand and deepened the Great Depression.

III. Economic Effects of Deficits
  A. Crowding Out. (Figure 12.2)
        1. If government borrows funds to finance deficits, the availability of funds for
           private sector spending may be reduced. This is known as crowding-out.
        2. Definition: Crowding-Out – A reduction in private-sector borrowing

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                          (and spending) caused by increased government borrowing.
       3. Crowding out implies less private-sector output.
       4. The risk of crowding out is greater the closer the economy is to full employment.
  B. Opportunity cost.
       1. Crowding out reminds us that there is an opportunity cost to government
       2. Definition: Opportunity Cost – The most desired goods or services that
                          are forgone in order to obtain something else.
       3. Deficits are only desirable if the resulting change in the mix of output is desired.

IV. Economic Effects of Surpluses
  A. The economic effects of budget surpluses are the mirror image of those for deficits.
  B. Crowding In
        1. Surpluses are a leakage in the circular flow.
        2. There are four potential uses for budget surplus:
                 Cut taxes
                 Increase income transfers
                 Save it
                 Spend it
        3. The first two options effectively wipe out the surplus but give consumers more
            disposable income and change the public-private mix of output.
        4. The third option entails paying back accumulated debt potentially causing a
            crowding-in effect.
                 Definition: Crowding In – An increase in private sector
                                    borrowing (and spending) caused by decreased
                                    government borrowing.
                 If the government pay s off some accumulated debt, households that were
                    holding that debt end up with more money.
                 If they use that money to buy goods and services, the private-sector
                    output will expand.
                 In addition, a reduction in debt takes pressure off market interest rates.
                    As interest rates drop, consumers are willing and able to purchase more
                    big-ticket items like cars, appliances, and houses.
        5. The fourth option, spending the surplus, wipes out the surplus and enlarges the
            relative size of government.
  C. Cyclical Sensitivity
        1. Crowding in depends on the state of the economy.
        2. In a recession, a surplus-induced decline in interest rates is not likely to stimulate
            much spending
        3. If consumer and investor confidence is low, even a surplus-financed tax cut
            might not lift private-sector spending much.

V. The Accumulation of Debt
  A. Debt Creation
       1. When the Treasury borrows funds it issues treasury bonds.
       2. Definition: Treasury Bonds – Promissory notes (IOUs) issued by the
                         U.S. Treasury.
       3. The total stock of all outstanding bonds represents the national debt.
       4. Definition: National Debt – Accumulated debt of the federal

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      5. Whenever there is a budget deficit, the national debt increases. IN years when a
         budget surplus exists, the national debt can be pared down.
B. Early History 1776-1900.
      1. By 1783, the United States had borrowed over $8 million from France and
         $250,000 from Spain to finance the Revolutionary War.
      2. During the period 1790-1812 the U.S. often incurred debt but typically repaid it
      3. The War of 1812 caused a massive increase in national debt and, by 1816, the
         national debt was over $129 million.
      4. 1835-36: Debt Free! - The U.S. was completely out of debt by 1835.
      5. The Mexican-American War (1846-48) caused a four-fold increase in the debt.
      6. By the end of the Civil War (1861-65), the North owed over $2.6 billion, nearly
         half of its national income and, after the South lost, Confederate currency and
         bonds had no value.
C. The Twentieth Century. (Figure 12.3)
      1. Spanish-American War (1898) also increased the national debt.
      2. All prior debt was dwarfed by World War I which raised the debt from 3% to 41%
         of the national income.
      3. National debt declined during the 1920‘s but rose again during the Great
      4. World War II – The greatest increase in national debt occurred during World
         War II.
              Rather than raise taxes, the government rationed consumer goods.
              U.S. War Bond purchases raised the debt from 45% of GDP to over 125%
                  in 1946.
      5. The Korean War (1950-53) added little to the national debt.
      6. Vietnam War (1965-72) increased the debt by over $100 billion largely due to the
         refusal of the President or Congress to raise taxes.
      7. The 1980s. (Tables 12.3 and 12.4)
              During the 1980s, the national debt rose by nearly $2 trillion.
              Increase was not war-related but as a result of recessions (1980-82 and
                  1990-91), a military buildup, and massive tax cuts (1981-84).
              The national debt nearly tripled in this decade.
      8. 1990s
              The early 1990s continued the same trend.
              Discretionary federal spending increased sharply in the first two years of
                  the Bush administration.
              The federal government was forced to bail out hundreds of failed savings
                  and loan associations.
              The 1990-91 recession killed any chance of achieving smaller deficits.
              The 1988-92 period saw the national debt increased by another trillion
              There was some success in reducing the structural deficit in 1993
                  however, budget deficits for 1993-96 have pushed the national debt to
                  over $5 trillion.
              This works out to nearly $20,000 of debt for every American citizen.
      9. 2000s
              With the Bush tax cuts, the structural deficit soared.

                       Chapter 12 – Deficits, Surpluses, and Debt - Page             203
VI.   Who Owns the Debt?
  A. Liabilities = Assets
        1. National debt represents a liability as well as an asset in the form of bonds.
        2. Definition: Liability – An obligation to make future payment; debt.
        3. Definition: Asset – Anything having exchange value in the marketplace;
        4. National debt creates as much wealth (for bondholders) as liabilities (for the U.S.
  B. Ownership of Debt (Figure 12.4)
        1. Federal agencies hold roughly 50 percent of the outstanding Treasury bonds.
        2. The Federal Reserve acquires Treasury bonds in its conduct of monetary policy.
        2. Social Security Trust Fund is the largest owner of U.S. debt.
        3. State and local governments hold 8 percent of the national debt.
        4. The general public directly owns about 8% in the form of U.S. Savings Bonds or
            other treasury bonds and indirectly owns another 11% in banks, insurance
            companies, corporations, etc., totaling almost half of the national debt.
        5. All debt held by U.S. households, institutions and governments is called internal
            debt and equals approximately 80% of the total.
        6. Definition: Internal Debt – U.S. government debt (Treasury bonds)
                           held by American households and institutions.
        7. The other 22% is external debt and is held by foreign households and
        8. Definition: External Debt – U.S. government debt (Treasury bonds)
                           held by foreign households and institutions.

VII. Burden of the Debt
  A. Refinancing
        1. Prior to 1998, there has been almost no reduction of the national debt since 1957.
        2. The debt has historically been refinanced by issuing new bonds to replace old
           bonds that have become due.
        3. Definition: Refinancing – The issuance of new debt in payment of debt
                           issued earlier.
        4. The ability of the U.S. Treasury to refinance its debt raises an intriguing question.
           What if the debt can be eternally refinanced?
  B. Debt service
        1. Definition: Debt Service – The interest required to be paid each year on
                           outstanding debt.
        2. Interest payments restrict the government‘s ability to balance the budget or fund
           other public sector activities.
        2. Most debt servicing is a redistribution of income from taxpayers to bondholders.
        3. Interest payments themselves have virtually no direct opportunity cost.
  C. Opportunity costs
        1. Opportunity costs are incurred only when real resources (factors of production)
           are used.
        2. The process of debt servicing uses few resources, and has negligible opportunity
        3. The true burden of the debt is the opportunity costs of the activities financed by
           the debt.
        4. Government purchases.
                The opportunity cost of government purchases is the true burden of

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                  government activity, however financed.
       5. Transfer payments.
                Only direct cost is the land, labor and capital involved in the
                  administrative process of making the transfer.
                Changes in output or prices occurring because of income transfers result
                  from indirect behavior responses (such as changes in work, saving or
                  investing patterns) and should be distinguished from the direct costs of
                  the transfer.
                The debt that originated in deficit-financed income transfers is not a
                  meaningful measure of economic burden.
  D. The Real Tradeoffs.
       1. The national debt poses no special burden to the economy, but the transactions it
           finances have a substantial impact on the question of WHAT, HOW, and FOR
           WHOM to produce.
       2. Deficit financing tends to change the mix of output in the direction of more
           public-sector goods.
       3. The burden of the debt is really the opportunity costs (crowding out) of deficit-
           financed government activity.
       4. This burden must be compared to whatever benefits society gets from
           government activity.
  E. Debt Ceilings
       1. In 2001 there were proposals before Congress to force the use of some of the
           current surplus to pay off old debt.
       2. Although the debate about the burden of the debt is really an argument over the
           optimal mix of output, future interest payments entail a redistribution of income.

VIII. External Debt
  A. No Crowding Out. (Figure 12.5)
        1. External financing allows us to get more public-sector goods without cutting
           back on private-sector production.
        2. As long as foreigners are willing to hold U.S. bonds, external financing has no
           real cost.
  B. Repayment
        1. Foreigners may not be willing to hold bonds forever.
        2. External debt must be paid with exports of real goods and services.

IX.   Deficit and Debt Limits
  A. Deficit Ceilings
        1. The only way to stop the growth of the national debt is to eliminate the budget
            deficit that created it.
        2. Definition: Deficit ceilings - An explicit, legislated limitation on the size
                            of the budget deficit.
        3. The Balanced Budget and Emergency Deficit Control Act of 1985 (Gramm-
            Rudman-Hollings Act) was the first explicit attempt to force the federal budget
            into balance.
                 It set a lower ceiling on each year‘s deficit until budget balance was
                 Called for automatic cutbacks in spending if Congress failed to keep the
                     budget below the ceiling.
                 Required Congress to pare the deficit from over $200 billion in FY1985 to

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                    zero (balanced) by 1991.
                   Congress refused to cut spending and raise taxes enough to meet the
                    targets, and the Supreme Court declared the ―automatic‖ mechanisms

X. The Economy Tomorrow: “Dipping into Social Security”
  A. “Saving Social Security”
        1. Since 1985, the Trust Fund ahs collected more than it paid out.
        2. Between 2002 and 2014 the Fund will acquire another $2 trillion.
  B. Aging Baby Boomers
        1. Baby boomers, now in their peak earning years are approaching retirement age.
        2. By 2030 there will be only 2 workers for every retiree.
  C. Social Security Deficits
        1. To finance baby boomer retirement, Congress will have to raise future taxes or
            make cuts in other programs.
        2. If GDP growth slows, it will tougher to fund Social Security benefits.

  1. Who paid for the Revolutionary War? Did the deficit financing initiated by the
     Continental Congress pass the cost of the war on to future generations?
        Citizens and taxpayers in the new country obviously paid most of the war's costs.
        There were loans from France and Spain. These loans were a form of external debt.
        To the extent these external debts were paid by taxpayers and resulted in losses
        through exports, the cost of the war was passed on to the future.
  2. In what ways do future generations benefit from this generation's deficit spending? Cite
     three examples.
         The point here is that we will have more public goods and services in the future as a
         result of present borrowing. Some examples to consider are the "investments" in
         the infrastructure by the U.S. Government (e.g., the highway system, water-
         treatment facilities. and park land), housing of the poor, and aid to developing
         countries. All these provide future benefits-some of which are as intangible as

  3. What is considered "too much" debt or "too large" a deficit? Are you able to provide any
     guidelines for deficit or debt ceilings?
        Whenever the burden of financing and refinancing generates undesirable
        reallocations of resources away from the private sector, there should be some
        limitations on the growth of the debt. It may be useful to pose the following extreme
        case. Suppose the debt were 20 times the GDP of the economy and the interest rate
        were 5 percent. Then the total GDP would be needed to service the debt. The
        government would take all income and redistribute it to the bondholders. Some
        possible guidelines for deficit or debt ceilings would include:
         The burden does not significantly affect work incentives and entrepreneurship.
         The burden of external debt does not significantly affect internal consumption.
         The burden of the debt does not affect the stability of the government but
            contributes to the stability of the economy.

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4. If deficit spending "crowds out" some private investment, could future generations be
   worse off? If external financing eliminates crowding out, are future generations thereby
        Future generations could be worse off if crowding out results in government
            spending which has less of a positive impact on long-range growth than the
            private spending it crowds out.
        External financing will not protect future generations. Eventually a return
            must be paid unless external groups have an insatiable appetite for American
5. If tax cuts crowd out government spending, is the economy worse off? (See In the News)
        The answer depends in part on the current state of the macroeconomy. If there are
        underused resources, then the federal government may not be able to use fiscal
        policy to restore full employment. Also, the answer depends on how one views
        government spending. Conservatives who believe that private spending is more
        efficient than government spending may not worry if government spending is
        “crowded out.” Liberals may respond that public spending sometimes can be more
        efficient or more necessary than private spending.
6. A constitutional amendment has been proposed that would require Congress to balance
   the budget each year. Is it possible to balance the budget every year? Is it desirable?
   Yes, it is technically possible to have a balanced budget every year. This case is
   demonstrated by state governments each year. The more important questions is
   whether this is desirable.
        PRO (There should be a balanced budget):
         When debt is out of control, it can undermine the economy and government. It
            might be worth pointing out that Germany after World War I was crushed with
            the debt from the Versailles treaty
         Incurring obligations to repay debt in the future transfers the costs of our
            current consumption to future generations. They will find their standard of
            living lessened by having to repay our loans, particularly if the debt is held
        CON (There should not be a balanced budget):
         There is a loss of flexibility in the use of fiscal policy; in fact, fiscal policy will
            exacerbate swings of the economy, forcing restraint in times of depression and
            stimulus in boom periods.
         There is a loss of control through monetary policy-which is put into place
            through the sale and purchase of government securities.
         There are fewer choices for savers looking for places to hold their wealth.
         The government becomes more shortsighted and difficult to manage. It has less
            ability to plan and to perform in its infrastructure, education, and other long-
            run functions; the cyclical nature of the economy will be a source of continual
            surprise that prevents effective planning.
7. What should the government do with a budget surplus?
     Of course, there are many „correct‟ answers to this question, but some possible
     answers are: Pay off some of the accumulated debt, spend more on needed social
     programs, spend more on education, lower taxes. The answer to this question
     depends on whether we as a nation are satisfied with the current mix of
     government provision of goods and services vs. private provision of goods and

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8. By how much did defense spending increase in 1940 to 1944? What was crowded out?
      Defense spending increased from $45 billion to $882 billion (stated in chain-
      weighted dollars) resulting in crowding out things like non-essential business
      investment and consumer goods. For example, during World War II, sugar, rubber
      and nylons were rationed and nearly impossible to obtain.

9. How long would it take to pay off the national debt? How would the economy be
       The answer to this question depends on how much we want to pay on the national
       debt each year. Historical evidence suggests that we will never pay off the debt. As
       noted in the chapter, however, paying off the national debt primarily involves a
       redistribution of income from taxpayers to bond holders. To the extent that this is
       an internal transfer of income, the economy will be essentially unaffected by paying
       off the national debt, although the distribution of income will change. To the
       smaller extent that bonds are held outside the U.S., there will be less goods and
       services available for domestic consumption, ceteris paribus, as foreign holders of
       debt purchase U.S. goods and services with their new cash. It is, of course, possible
       that the dollars will not return to the U.S. but rather will circulate elsewhere in the
       global economy. In such a case, there will be little or no effect internally due to the
       repayment of the national debt.

1o. Which of the following option do you favor for resolving future Social Security deficits?
    What are the (dis)advantages of each option?
     Cutting Social Security benefits
     Raising payroll Taxes
     Cutting non Social Security programs
     Raising income taxes

   The answers to this question will depend upon each student‘s viewpoint. All the options
   are hard choices.
    Cutting Social Security benefits will certainly help resolve deficits, however,
       taxpayers usually believe there is a social contract with social security. In other
       words, when they paid their social security taxes, they perceived a certain level of
       benefits would be available. Based on this information, taxpayers made investment
       and retirement decisions. To change this social contract would not only be
       considered inequitable by many, it could cause significant financial problems for
       those who are currently on social security or for those who will be participating in
       the program in the relatively near future.
    Raising payroll taxes is also a method of resolving the deficit, however, doing so
       would result in reduced AD as consumers incomes decline. This could exacerbate
       the problem of insufficient revenues for the social security system. Also payroll taxes
       are regressive.
    Cutting non Social Security programs is also another solution, however, doing so is
       essentially robbing Peter to pay Paul. The question becomes which government
       spending program is most important. In addition, cutting any program has the
       contractionary effect discussed above.
    Raising income taxes causes the same problems listed above for raising payroll taxes
       except that income taxes are progressive.

                         Chapter 12 – Deficits, Surpluses, and Debt - Page                208
                                                                                  1.a.Tax revenue
                                                                                  b. government
                                                                                  c. budget deficit
                                                                                  2. Four times
                                                                                  3. Japan
4. a. Revenue rises by $56 billion; spending falls by $4 billion.                 4.a.deficit falls
                                                                                  by $60 billion
b. Revenues rise by $84 billion; spending rises by $70 billion                    b. deficit
                                                                                  decreases by
                                                                                  $14 billion

                                                                                  5a. fiscal
                                                                                  restraint of $96
.                                                                                 b. fiscal
                                                                                  stimulus of
                                                                                  $252 billion

6. The problem shows how interest rates have become an increasingly
important part of the budget balance picture.
(a) Deficit = spending - taxes = $10 billion - $8 billion = $2 billion            6a. $2 billion
(b) $2 billion of bonds are needed to finance this deficit.                       b. $2 billion
(c) Annual interest on new bonds = $2 billion x 0.1 = $0.2 billion.               c. $0.2 billion

                                                                                  d. i. $2.2 billion
                                                                                  ii. $2.2 billion
                                                                                  iii. $0.22
                    Year 3                Year 4                  Year 5
    Deficit         2.42                  2.662                   2.9282
    New debt        6.62                  9.282                   12.2102
    Debt service    0.662                 0.9282                  1.2102

f. 0.2/2.2 = 9.1%; 0.42/2.42 = 17.4%; 0.662/2.662 = 24.9%;
0.9282/2.9282 = 31.7% .

g.The cumulative debt above rises relative to the government
expenditure of $10 billion.

7.a.Between 1931 and 1933, the structural deficit decreased from $4.5             7a.$6.5 billion
billion to a $2 billion surplus, a $6.5 billion level of fiscal restraint.

                              Chapter 12 – Deficits, Surpluses, and Debt - Page                        209
b. If the MPC was 0.80, the spending multiplier is 5. Given a $6.5               b. $32.5 billion
billion fiscal restraint, the AD would have been ultimately reduced by
$6.5 billion x 5 = $32.5 billion.

8. a.If there is no external financing available, then the opportunity cost      8a. h1-h2
of increasing government spending from g1 to g2 is a decrease in private-
sector output from h1 to h2.
b. If there is complete external financing available, then in the short-         b. no
run, there is no opportunity cost. However, at some point in the future,         opportunity
the external financing must be repaid and there will be an opportunity           cost




         1996     1998    2000     2002       2004

The two measures move differently because of the recession that
occurred in 2001.

                             Chapter 12 – Deficits, Surpluses, and Debt - Page                      210

In-class Debate
A Balanced Budget Amendment?

The text describes (on page 290) a proposed amendment to the U.S. Constitution that would
require a balancing the federal budget every year. Should the U.S. pass such a requirement?

1) What are two strong arguments against requiring a balanced Federal budget every year?

2) What are two strong arguments in favor of requiring a balanced Federal budget? (For each
argument you make, you may qualify your support. That is, you may add words to the proposal
to balance the federal budget every year in order to make it acceptable to you.)

Teaching note

Student answers could consider:

1) a) Balancing the budget could prevent giving stimulus when the economy needed it.
   b) Balancing the budget every year could prevent fiscal restraint when the economy needed it.

2) a) It would avoid excessive federal spending by restricting Congressional action. hands.
 b) The amendment could be changed to balance the budget over the business cycle or to
    allow for deficits for certain expenditures or in certain situations.

Extending the Debate
What will future US Federal deficits (or surpluses) look like?

The Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) both
provide estimates of economic variables for future years. Find their estimates at: (CBO) (OMB)

Do these estimates make sense? Why do they differ?

For background see:

Debate Project

Is Social Security Going Broke?

                            Chapter 12 – Deficits, Surpluses, and Debt - Page                 211
Over the next few decades, retiring baby boomers will increase outflows in the social security
system. Will there be sufficient funds to keep social security going—and should it be kept
going? The issue has become highly politicized, often obscuring facts about the system and
limits to what we know about future economic data.

Key questions:

      Will there be sufficient funds available to maintain benefits when baby boomers retire?
      When will this potential problem occur?
      Can the problem be solved with minor changes in taxes or benefits?
      Do we know enough to make accurate forecasts far in the future?
      Should private retirements funds replace social security?

For background on the debate from relatively non-partisan groups see:

Social Security Administration
Its 2001 Report:

Twentieth Foundation The Social Security Network


For the position that social security is in crisis that cannot be readily fixed, or that it should be
replaced by a private retirement system se:

Concord Coalition

Cato Institute

Citizens for a Sound Economy

For the position that social security is not going ―broke,‖ or that it can be easily fixed see:

Economic Policy Institute ―Facts at a glance‖

Center for Economic and Policy Research

2030 Action

                              Chapter 12 – Deficits, Surpluses, and Debt - Page                    212
PRINT MEDIA EXERCISE                                                   Name:_________________
Chapter 12                                                             Section:__________________
Deficits, Surpluses, and Debt                                          Grade:___________________

Find an article that illustrates a change in discretionary fiscal policy. Use the article you have
found to fulfill the following instructions and questions:

1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page.
   Make sure there is room at the bottom of the article to write the answers to the questions.

2. Does the change in fiscal policy involve government purchases, income transfers, or taxes
   (government receipts)? Below the article write which one of the three is involved.

3. Underline the one sentence that refers to the change in fiscal policy.

4. The change in fiscal policy should be classified as a change in a leakage or an injection.
    Write below the article whether the change in fiscal policy involves an injection or a
    Write below the article whether there is more or less of the injection or leakage.

5. What is the impact of the change in fiscal policy, ceteris paribus, on the deficit? Write below
   the article the most appropriate of the following possible responses: "a greater deficit," "a
   greater surplus," "a smaller deficit," or "a smaller surplus."

6. Use an arrow to indicate in the article at least one of the decision makers who is responsible
   for the change in the fiscal policy.

7. Does the article mention the implication of the fiscal policy change on the deficit or debt?
   Below the article write "mentions" if it does mention or "not mention" if it does not mention
   the implication.

8. In the remaining space below your article, indicate the source (name of newspaper or
   magazine), title (newspaper headline or magazine article title), date, and page for the article
   you have chosen. Use this format:
   Source: ____________________ Date: ______________ Page: _____________
   Title: ___________________________________________________________
   If this information also appears in the article itself, circle each item.

9. Neatness counts.

                             Chapter 12 – Deficits, Surpluses, and Debt - Page                   213
Professor's Note
Learning Objective for Media Exercise

To enable students to see how policies reported in the media--even if they do not refer to a
deficit or the debt--nevertheless affect this crucial public policy issue.

Suggestions for Correcting Media Exercise

1. Compare the passage that is underlined with the description below the article of which
   element of fiscal policy is being used (government purchases, income transfers, or taxes).
2. Compare the passage that is underlined with the description below the article of whether an
   injection or a leakage is involved. Students should be able to identify the change in a leakage
   or an injection properly.
3. The indication below the article of whether a greater or smaller deficit or surplus results
   should also be consistent with the underlined passage.
4. The assignment is about discretionary fiscal policy, not necessarily about higher deficits or
   debt reported in the press, which may reflect cyclical elements of the economy. A decision
   can be made about whether to grade students on this issue.

Likely Student Mistakes and Lecture Opportunities

1. The students may still fail to understand leakages and injections. Mistakes on this may give
   one more chance to emphasize this issue.
2. The exercise may also complement a discussion on the circular flow.
3. This exercise can be done simultaneously with the assignment of the previous chapter--with
   extra credit for the students who find one article that will serve for both assignments. Then
   the students will produce articles that illustrate the multiplying effects of fiscal policy.
4. Several articles that students use will not be about discretionary fiscal policy, but about
   uncontrollables. This assignment provides an opportunity to emphasize this particular
5. Many of the students will find articles that say nothing about deficits, surpluses, or the debt.
   This is an opportunity to show them the importance of recognizing the deficit/surplus/debt
   implications of government action, regardless of whether the media report them.

   Baker, Dean and Mark Weisbrot, Social Security: The Phony Crisis. University of Chicago
          Press, 1999. Accessible discussion of the social security system and the political
          dimensions of the ‗crisis.‘

   Blejer, Mario I., and Adrienne Cheasty: "The Measurement of Fiscal Deficits: Analytical and
           Methodological Issues‖, Journal of Economic Literature, December 1991, pp. 1644-
           1678. Provides a sophisticated, international perspective on the problems of fiscal
           management and measurement.

                             Chapter 12 – Deficits, Surpluses, and Debt - Page                  214