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

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

3. Federal Deficit and the Federal (National) Debt
Green region:

4. 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.

5. 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

6. 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.

7. 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.

8. In our simulations, potential GDP (GDPP) equals 2,000.
Scenario 1: Stable Start Benchmark
Infl Rate Period GDP  (%) .
Exp Infl Rate
E (%)
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

9. 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,
1 2,064 2,
2 2,026 2, .
7 2,000 2,
8 2,000 2,
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

10. 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,
1 1,936 2,
2 1,974 2, .
7 2,000 2,
8 2,000 2,
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

11. 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

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