Budget Deficits and Burden of the Debt Federal Government Outlays Federal Government Receipts Federal Deficit =  3,600 2,775 = 825 Defense 635 Human Resources 2,420 Interest on Debt 220 Social Security 815 Medicare 500 Income Security 535 Health 360 Other 210

Long Run Issue: The Federal Deficit and the National Debt Federal Government Outlays Federal Government Receipts Federal Deficit =  3,600 2,775 = 825 Individual Income Taxes 1,315 Corporate Income Taxes 275 Social Insurance Taxes 950 Other Taxes 235

Federal Deficit and the Federal (National) Debt Green region: 1998-2001

Should This Be Worrisome? Total Federal Total Federal Federal Deficit = Government  Government Outlays Receipts Question: When a deficit exists, how does the Federal government make up the shortfall? That is, when the government spends more than it takes in, how does it make up the shortfall? Answer: It borrows. Question: How does the government borrow? Answer: The U.S. Treasury issues bonds. Question: What does the national debt represent? Answer: The total of all government bonds (IOUs) that “others” own; these IOUs must be repaid.

Federal (National) Debt: December 2013 Burden of the Debt: What is “bad” about deficits and debt? “When the government runs a deficit, we are placing a burden upon future generations of Americans who will have to repay the accumulated debt.” External borrowing: Federal government borrows from non-U.S. citizens.   Federal (National) Debt: December 2013 Country (billions of dollars) China, Mainland 1270.0 Japan 1182.5 Belgium 256.8 Caribbean Banking Centers 295.3 Oil Exporters 238.3 Brazil 245.4 United Kingdom 163.6 Taiwan 182.2 Switzerland 176.7 Hong Kong 155.8 All Externally Held Debt 5,793.1 All Debt 11,281.2 Family analogy Question: Will external borrowing be a burden when the IOUs are repaid? Answer: Yes

Internal borrowing: Federal government borrows from U.S. citizens. Question: Will internal borrowing be a burden when the IOUs are repaid? Family analogy At first glance it appears that the answer should be no. The family analogy suggests that one American loses another one gains. The family analogy breaks down when we apply it to the U.S. as a whole, however. To explain why the family analogy breaks down, we return to our aggregate demand/aggregate supply model.

Review: The Aggregate Supply Curves LRAS  (%) AS Question: How many final goods and services would be produced if the inflation rate () were _______ percent, given that all other factors relevant to supply remained the same? AS The aggregate supply (AS) curve intersects the long run aggregate supply (LRAS) at the expected inflation rate (E). E The aggregate supply (AS) curve is upward sloping Potential GDP (GDPP): Equals (Actual) GDP when the actual inflation rate () turns out to equal the expected inflation rate (E). G&S GDPP The long run aggregate supply (LRAS) is a place mark for potential GDP (GDPP). Aggregate Supply (AS) Curve and Changes in Expected Inflation When the expected inflation rate (E) increases the aggregate supply (AS) curve shifts up. When the expected inflation rate (E) decreases the aggregate supply (AS) curve shifts down. Adaptive Expectations While we cannot determine precisely what the expected inflation rate (E) equals, it seems reasonable to believe that it depends on the actual inflation rate () in the recent past.

In our simulations, potential GDP (GDPP) equals 2,000. Scenario 1: Stable Start Benchmark Infl Rate Period GDP  (%) 0 2000 2.0 1 2000 2.0 2 2000 2.0 . 6 2000 2.0 7 2000 2.0 Exp Infl Rate E (%) 2.0 2.0 2.0 Macro Lab 7.1a: AS Dynamics   (%) Adaptive Expectations: The expected inflation rate depends on the inflation rate in the recent past. LRAS 2.8 AS0, 1,…, 7 2.4 Potential GDP (GDPP): Equals (Actual) GDP when the actual inflation rate () turns out to equal the expected inflation rate (E). 2.0 1.6 In our simulations, potential GDP (GDPP) equals 2,000. AD 1.2 GDP 1,800 1,900 2,000 2,100 2,200

Over time, GDP moves to 2,000, potential GDP. Scenario 2 Potential Infl Rate Exp Infl Rate Period GDP GDP  (%) E (%) GDP > Potential GDP  Actual Infl Rate () greater than Expected Infl Rate (E) 0 2,160 2,000 1.4 1 2,064 2,000 1.7 2 2,026 2,000 1.9 . 7 2,000 2,000 2.0 8 2,000 2,000 2.0 1.4 1.7  Expected Infl Rate (E) increases 2.0  (%) LRAS  AS curve shifts up Adaptive Expectations: The expected inflation rate depends on the inflation rate in the recent past. AS and LRAS intersect at the expected inflation rate.  GDP decreases  Macro Lab 8.2: AS Dynamics AS8 AS2 AS1 Next focus on period 2. 2.0 1.7 AS0 Next focus on period 1. 1.4 First focus on period 0. AD Potential GDP (GDPP) equals 2,000 Over time, GDP moves to 2,000, potential GDP. 2,000 2,064 2,160 GDP

Over time, GDP moves to 2,000, potential GDP. Potential Infl Rate Exp Infl Rate Period GDP GDP  (%)  (%) Scenario 3 GDP < Potential GDP  Actual Infl Rate () less than Expected Infl Rate (E) First focus on period 0. 0 1,840 2,000 2.6 1 1,936 2,000 2.3 2 1,974 2,000 2.1 . 7 2,000 2,000 2.0 8 2,000 2,000 2.0 2.6 2.3 Next focus on period 1.  Expected Infl rate (E) decreases Now focus on period 2. 2.0  (%)  AS curve shifts down LRAS AS0 AS1  GDP increases AS2 AS8 2.6 AS and LRAS intersect at the expected inflation rate. 2.3 2.0 Adaptive Expectations: The expected inflation rate depends on the inflation rate in the recent past.  Macro Lab 8.3: AS Dynamics AD Over time, GDP moves to 2,000, potential GDP. Potential GDP (GDPP) equals 2,000 1,840 1,936 2,000 GDP

Summary of AS Dynamics: Over time, GDP moves to potential GDP. GDP < Potential GDP GDP > Potential GDP Adaptive Expectations: The expected inflation rate (E) depends on the actual inflation rate () in the recent past.  Actual Infl Rate less than Expected Infl Rate  Actual Infl Rate greater than Expected Infl Rate  AS curve shifts down  AS curve shifts up AS and LRAS Curves: The AS and LRAS intersect at the expected inflation rate.  GDP increases  GDP decreases Long Run: The process continues until  (%) LRAS  (%) LRAS AS0 AS1 Actual Inflation Rate () equals Expected Inflation Rate (E) AS1 and GDP equals Potential GDP (GDPP) AS0 AD AD GDPP GDP GDPP GDP

Summary of AS Dynamics: Over time, GDP moves to potential GDP. Question: Why does actual GDP ever deviate from potential GDP?