Questions for Review
1. What is unusual about U.S. fiscal policy since 1980 is that government debt increased
sharply during a period of peace and prosperity. Over the course of U.S. history, the
2. Many economists project increasing budget deficits and government debt over the next
several decades because of changes in the age profile of the population. Life expectancy
3. Standard measures of the budget deficit are imperfect measures of fiscal policy for at
least four reasons. First, they do not correct for the effects of inflation. The measured
deficit should equal the change in the government’s real debt, not the change in the
4. Public saving is the difference between taxes and government purchases, so a debt-
financed tax cut reduces public saving by the full amount that taxes fall. The tax cut
5. According to the Ricardian view, a debt-financed tax cut does not stimulate consump-
tion because it does not raise permanent income—forward-looking consumers under-
stand that government borrowing today means higher taxes in the future. Because the
tax cut does not change consumption, households save the extra disposable income to
pay for the future tax liability that the tax cut implies: private saving increases by the
full amount of the tax cut. This increase in private saving exactly offsets the decrease
in public saving associated with the tax cut. Therefore, the tax cut has no effect on
national saving.
6. Which view of government debt you hold depends on how you think consumers behave.
If you hold the traditional view, then you believe that a debt-financed tax cut stimu-
lates consumer spending and lowers national saving. You might believe this for several
reasons. First, consumers may be shortsighted or irrational, so that they think their
CHAPTER 16 Government Debt
7. A budget deficit might be good policy for the following reasons. First, it can help stabi-
lize the economy if output is below full employment. Second, it can allow the country to
8. The level of government debt might affect the government’s incentives regarding money
creation because the government debt is specified in nominal terms. A higher price
level reduces the real value of the government’s debt. Hence, a high level of debt might
encourage the government to print money in order to raise the price level and reduce
the real value of its debt.
Problems and Applications
1. The budget deficit is defined as government purchases minus government revenues.
Selling the Liberty Bell to Taco Bell would raise revenue for the U.S. government and,
hence, reduce the deficit. A smaller budget deficit would lead the government to borrow
less, and as a result the measured national debt would fall.
2. Here is one possible letter:
Dear Senator:
In my previous letter, I assumed that a tax cut financed by government borrowing
would stimulate consumer spending. Many economists make this assumption because
it seems sensible that if people had more current income, then they would consume
more. As a result of this increase in consumption, national saving would fall.
Ricardian economists argue that the seemingly sensible assumption that I made is
172 Answers to Textbook Questions and Problems
If national saving did not change, then as pointed out by the prominent economist
you heard from yesterday, the budget deficit would not have the effects I listed. In par-
ticular, output, employment, foreign debt, and interest rates would be unaffected in
both the short run and the long run. The tax cut would have no effect on economic well-
being.
There are several reasons the Ricardian argument may fail. First, consumers
3. a. We will assume that the life-cycle model of Chapter 16 holds and that people want
to keep consumption as smooth as possible. This implies that the effect on con-
sumption of a temporary change in income will be spread out over a person’s
entire remaining life. We will also assume for simplicity that the interest rate is
zero.
Consider a simple example. Let Tbe the amount of the one-time, temporary
tax levied on the young, and let Bbe the amount of the one-time benefit paid to
the old, where B= T. If a typical elderly person has 10 years left to live, then the
temporary benefit increases the present consumption of the elderly by B/10. If a
typical worker has 30 years left to live, then the increase in taxes decreases their
present consumption by T/30. Aggregate consumption changes by an amount
4. A rule requiring a cyclically adjusted balanced budget has the potential to overcome,
at least partially, the first two objections to a balanced-budget rule that were raised
in this chapter. First, this rule allows the government to run countercyclical fiscal
policy in order to stabilize the economy. That is, the government can run deficits dur-
ing recessions, when taxes automatically fall and expenditures automatically rise.
These automatic stabilizers affect the deficit but not the cyclically adjusted deficit.
Second, this rule allows the government to smooth tax rates across years when
income is especially low or high—it is not necessary to raise tax rates in recessions or
Chapter 16 Government Debt and Budget Deficits 173
Chapter 16 Government Debt 174
5. The Congressional Budget Office (www.cbo.gov) regularly provides budget forecasts.
One excellent CBO publication that summarizes these forecasts is the “The Budget and
Economic Outlook.” For example, in the March 2009 update of this publication, the
CBO projected that the debt held by the public would rise from 41 percent of GDP at
the end of 2008 to a peak of 62 percent by the end of 2011 and then decline to 56 per-
every year since 2003, federal spending on these health programs will be much greater
than projected.
Third, the CBO assumes that the taxes in the future will be whatever legislation
currently says they will be (i.e., the CBO does not take a stand on what changes legis-
lators might pass in the future).
Fourth, the CBO makes educated guesses about future potential economic growth,
now projected at 2.3 percent over the next decade, and other economic indicators. As
discussed in the January 2009 issue of the “Budget and Economic Outlook,” the CBO
justifies these assumptions by noting “CBO’s baseline projections are not intended to be
a forecast of future budgetary outcomes; rather, they serve as a neutral benchmark