- Study Guide (Course-wide Content)
A. The Economic Consequences of the Government Debt
- Budgets are systems used by governments and organizations to plan and control expenditures and revenues. Budgets are in surplus (or deficit) when the government has revenues greater (or less) than its expenditures. Macroeconomic policy depends upon fiscal policy, which comprises the overall stance of spending and taxes.
- Economists separate the actual budget into its structural and cyclical components. The structural budget calculates how much the government would collect and spend if the economy were operating at potential output. The cyclical budget accounts for the impact of the business cycle on tax revenues, expenditures, and the deficit. To assess fiscal policy, we should pay close attention to the structural deficit; changes in the cyclical deficit are a result of changes in the economy, while structural deficits are a cause of changes in the economy.
- The government debt represents the accumulated borrowings from the public. It is the sum of past deficits. A useful measure of the size of the debt is the debt-GDP ratio, which for the United States has tended to rise during wartime and fall during peacetime.
- In understanding the impact of government deficits and debt, it is crucial to distinguish between the short run and the long run. Review the box on page 638 and make sure you understand why a larger deficit can increase output in the short run while decreasing output in the long run.
- To the degree that we borrow from abroad for consumption and pledge posterity to pay back the interest and principal on such external debt, our descendants will indeed find themselves sacrificing consumption to service this debt. If we leave future generations an internal debt but no change in capital stock, there are various internal effects. The process of taxing Peter to pay Paula, or taxing Paula to pay Paula, can involve various microeconomic distortions of productivity and efficiency but should not be confused with owing money to another country.
- Economic growth may slow if the public debt displaces capital. This syndrome occurs when people substitute public debt for capital or private assets, thereby reducing the economy's private capital stock. In the long run, a larger government debt may slow the growth of potential output and consumption because of the costs of servicing an external debt, the inefficiencies that arise from taxing to pay the interest on the debt, and the diminished capital accumulation that comes from capital displacement.
- Classical economists relied upon Say's Law of Markets, which holds that "supply creates its own demand." In modern language, the classical approach means that flexible wages and prices quickly remove any excess supply or demand and thereby reestablish full employment. In a classical system, macroeconomic policy has no role to play in stabilizing the real economy, although it will still affect the path of prices.
- New classical macroeconomics holds that expectations are rational, prices and wages are flexible, and unemployment is largely voluntary. The policy-ineffectiveness theorem holds that predictable government policies cannot affect real output and unemployment. The theory of the real business cycle points to supply-side technological disturbances and to labor market shifts as the clues to business-cycle fluctuations.
- What is our appraisal of the contribution of the new classical approach to short-run macroeconomics? The new classical approach properly insists that the economy is populated by forward-looking consumers and investors. These economic actors react to and often anticipate policy and can thereby change economic behavior. This lesson is particularly important in financial markets, where reactions and anticipations often have dramatic effects.
- Nations face two considerations in setting monetary and fiscal policies: the appropriate level of aggregate demand and the best monetary-fiscal mix. The mix of fiscal and monetary policies helps determine the composition of GDP. A high-investment strategy would call for a budget surplus along with low real interest rates.
- Should governments follow fixed rules or discretion? The answer involves both positive economics and normative values. Conservatives often espouse rules, while liberals often advocate active fine-tuning to attain economic goals. More basic is the question of whether active and discretionary policies stabilize or destabilize the economy. Economists often stress the need for credible policies, whether credibility is generated by rigid rules or by wise leadership. A recent trend among countries is inflation targeting for monetary policy, which is a flexible rule-based system that sets a medium-term inflation target while allowing short-run flexibility when economic shocks make attaining a rigid inflation target too costly.
- Remember the dictum: "Productivity isn't everything, but in the long run it is almost everything." A country's ability to improve its living standards over time depends almost entirely on its ability to improve the technologies and capital used by the workforce.
- Promoting economic growth entails advancing technology. The major role of government is to ensure free markets, protect strong intellectual property rights, promote vigorous competition, and support basic science and technology.