Economics 504 (2024)

Chapter 14: Problems

3. Is it possible for budget deficits and surpluses to stabilize the economy? On the basis of your response, evaluate the argument for an annually balanced federal budget.

Budget deficits and surpluses can help to stabilize the economy. If the economy enters a recession taxes will fall as income and employment fall. At the same time, government spending will increase as people are given unemployment compensation and other transfers such as welfare payments. Such automatic changes in revenue and expenditures work to increase the deficit. At the same time, they also work to mitigate the decrease in disposable income that households are experiencing. This maintains consumption at a higher level than would otherwise be the case. As discussed in Chapter 11, this helps to maintain the level of aggregate demand and thereby soften the effects of recession.

If the economy is in an expansion and experiencing inflation, a budget surplus works to stabilize the economy. In this instance taxes increase in response to the increase in employment and income. At the same time, government expenditures fall as fewer individuals receive unemployment compensation and other transfer payments. These changes work to lower the level of consumption and hence the level of aggregate demand. Thus, the surplus works to stabilize the economy during inflationary periods.

On the above grounds, it is possible to argue that an annually balanced budget may actually work to destabilize the economy. In particular, such a'requirement may work to worsen recessions and inflations. In the case of recession, we have already seen that revenue falls while expenditures rise thereby creating a deficit. In order to balance the budget, government must raise more revenue (by increasing taxes) and cut expenditures. Both of these actions will lower disposable income. As a result, consumption and aggregate demand will fall. As aggregate demand falls, the recession worsens.

In the case of inflation, we find that revenue rises automatically while expenditures fall. It is possible that such changes would create a surplus. In order to eliminate the surplus, government must lower revenue (by cutting taxes) and increase expenditures. Both actions would work to increase disposable income. This increase in disposable income will then work to increase consumption and hence aggregate demand. As aggregate demand rises, the price level will increase further thereby worsening inflation. Hence, if one is concerned with stabilizing the economy, an annually balanced federal budget would be undesirable.

6. Explain why it is undesirable for the federal government to run a deficit during times of full employment.

If the government rum a deficit during times of full employment it can lead to inflation. Suppose the economy is currently at full employment and government increases expenditures. Suppose this results in a deficit that is financed through the issuance of bonds. The increase in government expenditures will result in an increase in aggregate demand and a higher price level. (Note this increase in aggregate demand will be less than in the case of the issuance of money due to the offsetting effect of the fall in investment on aggregate demand) Because the economy is already at full employment, there will be no increase in output. Further, the increase in borrowing by the government is likely to lead to a relatively large increase in the demand for loanable funds. As discussed previously, this will lead to a relatively large rise in the rate of interest. As a result, investment will fall, the capital growth rate will fall, productivity will lag, and living standards will be lowered. Further, there will be negative effects on both the export sector and the import competing sector of the economy.

If the deficit is financed through the issuance of money there will be relatively little effect on the interest rate. However, the expansionary effect of the increase in government expenditures will be compounded by the expansionary effect of the increase in the money supply. As a result there will be a relatively large increase in aggregate demand. Because the economy is already at full employment there will be no increase in output. Instead, the increase in aggregate demand will be reflected in a relatively large increase in the price level.

13. Do you favor running government surpluses in order to reduce the national debt? Defend your answer.

There are several reasons why running surpluses is not a desirable way to eliminate the debt. First, we have seen that at times it may be desirable to run a deficit in order to help stabilize the economy. If annual surpluses were required, the possibility of using fiscal policy to stabilize the economy during times or recession would be eliminated. In fact, it is possible that this practice would make the recession more severe. Second, it is sometimes desirable to borrow in order to increase the flow of income or services in the future. For example, it may be desirable for government to invest in a transportation system that will yield services far into the future. Any time a project will yield a flow of services or benefits in the future that are sufficient to repay the loan, it is desirable for government to borrow in order to undertake the project. On these grounds, it would be better to simply reduce or eliminate the budget deficit so that the debt grows more slowly than to run annual surpluses to reduce the debt. With deficit reduction and with economic growth, the debt as a percentage of GDP would decline and become less of a problem over time.