Deck 14: The Federal Debt and Deficit Crisis: The Limits of Fiscal Policy

Question 1

What is meant by the notion of "twin deficits"?

Answer 1

The notion of "twin deficits" refers to a situation in which a country is experiencing both a fiscal deficit and a current account deficit simultaneously. Let's break down these two components to understand the concept better:

1. Fiscal Deficit: This occurs when a government's total expenditures exceed the revenue that it generates, excluding money from borrowings. In other words, it's the gap between what the government spends and what it earns, which is not covered by income from taxes and other receipts. A fiscal deficit is often funded by government borrowing, which can lead to an increase in public debt.

2. Current Account Deficit: This is a measurement of a country's trade where the value of the goods and services it imports exceeds the value of the products it exports. The current account includes net income, such as interest and dividends, and transfers, like foreign aid, in addition to the trade balance. A current account deficit indicates that a country is importing more than it is exporting, which can be a sign of economic imbalance.

When a country has both a fiscal deficit and a current account deficit, it is said to have twin deficits. The twin deficits hypothesis suggests that there is a relationship between these two deficits. For example, a fiscal deficit can lead to a current account deficit by increasing domestic consumption, which may increase imports. Additionally, if a government finances its fiscal deficit by borrowing from foreign lenders, this can also contribute to a current account deficit.

The twin deficits are often seen as a warning sign for potential economic problems. They may indicate that a country is living beyond its means, spending more on imports and government programs than it can afford. This can lead to a buildup of debt and can make a country vulnerable to external shocks, such as changes in global interest rates or investor sentiment.

Policymakers may address twin deficits by implementing fiscal consolidation measures to reduce the fiscal deficit, such as cutting government spending or increasing taxes. They may also try to improve the current account balance by promoting exports, reducing imports, or allowing the currency to depreciate to make exports more competitive.

It's important to note that having twin deficits is not always a sign of poor economic health, as they can sometimes be a result of strategic economic policies or temporary economic conditions. However, sustained twin deficits may require careful monitoring and policy adjustments to ensure long-term economic stability.

Question 2

Distinguish between the federal budget deficit and the federal debt.

Answer 2

The federal budget deficit and the federal debt are related but distinct concepts that pertain to the financial operations of the United States government.

**Federal Budget Deficit:**
The federal budget deficit occurs when the government's expenditures exceed its revenues within a given fiscal year. In other words, it is the amount by which the government's spending is greater than the income it receives, primarily through taxes and other fees. The deficit is a flow variable, meaning it is measured over a specific period of time (usually a year). When the government runs a deficit, it must borrow money to cover the gap between its spending and revenue, which it does by issuing government securities like Treasury bonds, notes, and bills.

**Federal Debt:**
The federal debt, also known as the national debt or public debt, is the total amount of money that the government owes to its creditors. It is the accumulation of all past deficits, minus any surpluses the government may have run in previous years. The debt is a stock variable, which means it is measured at a specific point in time. It represents the cumulative borrowing by the government to cover all its past budget deficits. The debt increases when the government runs a deficit and can decrease if the government runs a surplus (though this is less common).

In summary, the federal budget deficit is the yearly difference between government spending and revenue, while the federal debt is the total amount of money owed by the government as a result of borrowing to cover these deficits over time. The deficit contributes to the debt, and managing both is a significant aspect of fiscal policy and economic management.

Question 3

Why has popular and economic thinking become skeptical of the use of deficit spending to improve the economy?

Answer 3

Popular and economic thinking has become skeptical of the use of deficit spending to improve the economy for several reasons. One of the main concerns is that deficit spending can lead to an increase in national debt, which can have long-term negative effects on the economy. As the national debt grows, the government may need to allocate more funds towards paying off interest on the debt, which can limit the amount of money available for other important government programs and services.

Additionally, there is a concern that deficit spending may lead to inflation, as the increased government spending can drive up demand for goods and services, leading to higher prices. This can erode the purchasing power of consumers and reduce the overall standard of living.

Furthermore, there is a belief that deficit spending can lead to a crowding out effect, where government borrowing can compete with private investment for available funds, potentially leading to higher interest rates and reduced investment in the private sector.

Overall, these concerns have led to a more cautious approach towards deficit spending as a means of improving the economy, with a greater emphasis on finding alternative methods such as monetary policy or structural reforms to stimulate economic growth.

Question 4

List and explain the different means by which the federal budget deficit might be reduced.

Question 5

What are the detrimental effects of regularly running budget deficits and accumulating debt? Is burden shifting important in this regard? Why or why not?

Question 6

Use diagrams to illustrate how the crowding-out effect could raise interest rates and reduce investment spending.

Question 7

Define the following terms and explain their respective practicality for federal budget management.
a. annually balanced budget
b. cyclically balanced budget
c. functional finance

Question 8

Fiscal policy refers to the use of government taxation and spending to promote full employment and economic stability.

Question 9

During recessions, automatic stabilizers tend to cause a budget surplus.

Question 10

Federal tax revenues fall during recessions.

Question 11

Fiscal drag may result from the presence of automatic stabilizers when the economy is expanding towards full employment.

Question 12

Which of the following represent proposal for budget reform:

A) line-item veto
B) balanced budget amendment
C) permitting a federal government capital budget
D) shifting responsibility for certain programs to the stste and local levels of government
E) all of the above

Question 13

Keynesian economic theory focuses upon aggregate supply management in order to achieve full employment.

Question 14

An annually balanced budget policy requires that the federal budget be in balance on a year-to-year basis.

Question 15

A cyclically balanced budget calls for deficits during recessions and surpluses during periods of prosperity.

Question 16

Increasing aggregate demand in the vertical range of the aggregate supply curve will raise the price level and real output.

Question 17

The 16th Amendment to the Constitution ensures that the federal government may declare bankruptcy if it spends too much.

Question 18

The crowding-out effect occurs when government deficit financing raises interest rates and lowers private investment spending.

Question 19

The federal budget deficit may worsen the trade deficit.

Question 20

The Gramm-Rudman-Hollings Act successfully lowered federal budget deficits to zero.

Question 21

The adoption of capital budgeting could reduce the size of annual federal budget deficits by separating capital outlays from operating outlays.

Question 22

The intent of the Reagan Administration with the tax reductions of 1981 was to stimulate aggregate supply more than aggregate demand.

Question 23

A structural deficit arises when the economy sinks into recession.

Question 24

There has been a significant increase in the per capita debt burden since the 1980s.

Question 25

The Employment Act of 1946 provided a definitive and precise economic and legal obligation for the federal government to stabilize the economy.

Question 26

Deficit spending can cause inflation.

Question 27

Privatization is a suggested means of deficit reduction that would involve converting private businesses to public ownership.

Question 28

A Constitutional amendment to balance the budget annually is in place.

Question 29

The American Recovery and Reinvestment Act was intended to be contractionary fiscal policy.

Question 30

From 2002-2008 the federal government has routinely run structural deficits.

Question 31

The proposed "Balanced Budget Veto" would give the president line-item veto power only in years following a deficit.

Question 32

Placing primary emphasis upon the use of the federal budget to stabilize the economy is the practice of:

A) functional finance
B) crowding-out
C) cyclically balanced budget
D) annually balance budget
E) capital budgeting

Question 33

The deficit reduction schedule of the Gramm-Rudman-Hollings Act of 1985 was rendered irrelevant by:

A) the new presidential power of line-item veto
B) the Tax Reform Act of 1986
C) the collapse of Communism in the Soviet Union in 1991
D) the Deficit Reduction Act of 1990

Question 34

Which of the following statements is true?

A) About half the federal debt held by the public is foreign owned.
B) We owe the federal debt to ourselves.
C) The Social Security trust fund holds most of the federal debt.
D) Federal debt as a percentage of GDP has been continuously falling since 2001.

Question 35

Answer the next two questions based upon the following diagram.


-If the government borrows to finance the deficit:

A) the demand for money will shift from D₂ to D₁
B) investment spending will increase from i₁ to i₂
C) the interest rate will fall from i₁ to i₂
D) the demand for money will shift from D₁ to D₂

Question 36

Answer the next two questions based upon the following diagram.


-If government deficits do raise the interest rate, the extent of the crowding out effect is:

A) the decrease in interest rates from i₂ to i₁
B) the decrease in investment spending from I₁ to I₂
C) the amount of investment from 0 to I₁
D) the S curve

Question 37

Federal debt per capita is:

A) rising
B) falling
C) constant
D) about $12 trillion

Question 38

If tax reductions produced a supply-side effect:

A) aggregate demand would shift upward
B) aggregate supply would shift upward
C) real output would fall
D) aggregate supply would shift downward

Question 39

Answer the next six questions on the basis of the following diagram.


-If aggregate demand moves from AD₁ to AD₂:

A) the price level rises
B) full employment results
C) real output increases
D) taxes must have been raised and government spending reduced

Question 40

Answer the next six questions on the basis of the following diagram.


-A shift in aggregate demand from AD₃ to AD₄:

A) may have been caused by countercyclical policy directed at bringing about full employment
B) a tax increase and cuts in government spending
C) higher interest rates
D) will make the price level fall

Question 41

Answer the next six questions on the basis of the following diagram.


-A rise in aggregate demand from AD₄ to AD₅ will:

A) increase real output
B) increase the price level, only
C) decrease the price level, only
D) increase both real output and the price level

Question 42

Answer the next six questions on the basis of the following diagram.


-When the aggregate demand shifts from AD₂ to AD₃:

A) full employment is achieved
B) the budget will balance
C) the economy moves toward recession
D) real output and the price level increase

Question 43

Answer the next six questions on the basis of the following diagram.


-To counter inflation, policymakers might reduce aggregate demand from AD₅ to AD₄ by:

A) incomes policies
B) tax increases
C) reductions in government spending
D) all of the above

Question 44

Answer the next six questions on the basis of the following diagram.


-The diagram indicates that:

A) policymakers can increase real output by raising aggregate demand without encountering inflation
B) policymakers will have to make tradeoffs with regard to the price level and full employment
C) full employment can never be achieved
D) policymakers should strive for AD₁

Question 45

Which of the following schools of thought emphasizes aggregate demand management over aggregate supply management?

A) Reaganomics
B) Supply-side economics
C) Blind-side economics
D) Keynesian economics
E) Obamacare

Question 46

Which of the following items are concerns about the public debt?

A) The debt burden may be shifted to future generations
B) The government has borrowed heavily from the Social Security system
C) It can worsen the trade deficit
D) All of the above

Question 47

The notion of "twin deficits" refers to:

A) the federal budget deficit causing a larger trade deficit
B) both the federal government and the general public being heavily indebted
C) having neither a bird in the hand nor one in the bush
D) the coming crisis of the Social Security system and Medicare simultaneously

Question 48

Fiscal policy in 2008 and 2009 can accurately be described as:

A) reckless
B) neutral
C) focused exclusively on balancing the budget
D) expansionary in an effort to counter the recession
E) making the government the employer of first resort