THE ECONOMIC EFFECTS OF PUBLIC SECTOR BORROWING Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

12-2 Deficits and Debt The core critique of fiscal stimulus focuses on the budget consequences of government pump- priming –How do deficits arise? –What harm, if any, do deficits cause? –Who will pay off the accumulated national debt?

12-3 Budget Effects of Fiscal Policy Keynesian theory highlights the potential of fiscal policy to solve macro problems –Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes Use of the budget to stabilize the economy implies that federal expenditures and receipts won’t always be equal

12-4 Budget Surpluses and Deficits Deficit spending: The use of borrowed funds to finance government expenditures that exceed tax revenues Budget deficit: Amount by which government spending exceeds government revenue in a given time period

12-5 Budget Surpluses and Deficits If the government spends less than its tax revenues, a budget surplus is created Budget surplus: An excess of government revenues over government expenditures in a given time period

12-6 Keynesian View Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy The goal of macro policy is not to balance the budget but to balance the economy at full- employment

12-7 Economic Effects of Deficits Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing Crowding out reminds us that there is an opportunity cost to government spending Government borrowing to finance deficits puts upward pressure on interest rates

12-8 Public-sector output Private-sector output Crowding Out Increase in government spending... Crowds out private spending b c a g2g2 g1g1 h2h2 h1h1

12-9 Economic Effects of Surpluses Four potential uses for a budget surplus: –Spend it on goods and services –Cut taxes –Increase income transfers –Pay off old debt (“save it”) The economic effects are the mirror image of those for deficits

12-10 Crowding In Crowding in: An increase in private-sector borrowing (and spending) caused by decreased government borrowing When the government reduces borrowing, it takes pressure off market interest rates As interest rates drop, consumers will be more willing and able to purchase big-ticket items

12-11 Crowding Out Hypothesis Real Source (direct) crowding out Financial (indirect) crowding out –Disincentive-to work –Disincentive-to-invest Higher interest rates Inflation