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recessionary gap. If the fiscal authorities wish to restore GDP to its original level, they must
Monetary and Fiscal
shift the aggregate demand curve back to its original position, Policy
D0D0, as indicated by the blue arrow. To do so, they must either
raise spending or cut taxes, thereby opening up a budget deficit.
Potential GDP
Thus, the tightening of monetary policy changes the appropriate
fiscal policy from a balanced budget to a deficit, because both
monetary and fiscal policies affect aggregate demand. D0 Effect of
By the same token, a given target for aggregate demand im-
plies that any change in fiscal policy will alter the appropriate
monetary policy. For example, we can reinterpret Figure 1 as in-
Price Level

dicating the effects of increasing the budget deficit by raising
government spending or cutting taxes (the blue arrow). Then, A Effect of
fiscal policy
if the Fed wants real GDP to remain at Y1, it must raise interest B
rates enough to restore the aggregate demand curve to D1D1.
It is precisely the preferred mix of policy”a smaller budget
deficit balanced by easier money”that the U.S. government D0
managed to engineer with great success in the 1990s. Congress
raised taxes and cut spending, which reduced aggregate D1
demand. But the Federal Reserve pursued a sufficiently ex- Y1 Y0
pansionary policy to return this “lost” aggregate demand to Real GDP
the economy by keeping interest rates low.
So we should not expect a balanced budget to be the norm.
How, then, can we tell whether any particular deficit is too large or too small? From the
discussion so far, it would appear that the answer depends on the strength of private-
sector aggregate demand and the stance of monetary policy. But those are not the only

One implication of what we have just said is that various combinations of fiscal and
monetary policy can lead to the same level of aggregate demand, and hence to the same
real GDP and price level, in the short run. For example, the government could reduce

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Part 3
302 Fiscal and Monetary Policy

aggregate demand by raising taxes, but the Fed could make up for it by cutting interest
rates. Or the reverse could happen: The government could cut taxes while the
Fed raises interest rates, leaving aggregate demand unchanged. The long-run conse-
quences of these alternative mixes of monetary and fiscal policy may be quite different,
In previous chapters, we learned that more expansionary fiscal policy (tax cuts or
higher government spending) and tighter money should produce higher real interest rates
and therefore lower investment. Thus, such a policy mix should shift the composition of
total expenditure, C 1 I 1 G 1 (X 2 IM), toward more G, more C (from tax cuts), and less
I.1 The expected result is less capital formation, and therefore slower growth of potential
GDP. As we shall see shortly, it was precisely that policy mix”large tax cuts and very
tight money”that the U.S. government inadvertently chose in the early 1980s and, to a
lesser extent, in the years 2004“2006.
But the opposite policy mix”tighter budgets and looser monetary policy”should
produce the opposite outcomes: lower real interest rates, more investment, and hence
faster growth of potential GDP. That was the direction U.S. macroeconomic policy took
in the 1990s”with excellent results. Lowering the budget deficit and then turning it
into a surplus, economists believe, was an effective way to increase the investment
share of GDP, which soared from 12 percent in 1992 to 17 percent in 2000. The general
point is
The composition of aggregate demand is a major determinant of the rate of economic
growth. If a larger fraction of GDP is devoted to investment, the nation™s capital stock
will grow faster and the aggregate supply schedule will shift more quickly to the right,
accelerating growth.
International data likewise show a positive relationship between growth and the share
of GDP invested. Figure 2 displays, for a set of 24 countries on four continents, both in-
vestment as a share of GDP and growth in per-capita output over two decades (the 1970s
and 1980s). Countries with higher investment rates clearly experienced higher growth, on

F I GU R E 2 SOURCE: Economic Report of the President (Washington, D.C.: U.S. Government Printing Office;
Average Annual Growth Rate of per Capita Real GDP,

Growth and
Investment in 24 Japan
3 Finland
Canada Spain Austria

U.K. France
Denmark Netherlands Australia
U.S. Sweden
New Zealand

0 18 20 22 24 26 28 30 32
1995), p. 28.

Average Investment as Percent of GDP,

Assume for the moment that net exports, X 2 IM, are fixed. We will deal with the consequences of fiscal and

monetary policy on exports and imports in Chapter 19.

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Chapter 15 303
Budget Deficits in the Short and Long Run

So it appears that when we ask whether the budget should be in balance, in deficit, or
in surplus, we have posed a good but complicated question. Before attempting to answer
it, we need to get some facts straight.

First, some critical terminology. People frequently confuse two terms that have differ-
ent meanings: budget deficits and the national debt. We must learn to distinguish between
the two.
The budget deficit is the amount by which the government™s expenditures exceed its The budget deficit is the
amount by which the gov-
receipts during some specified period of time, usually a year. If, instead, receipts exceed
ernment™s expenditures
expenditures, we have a budget surplus. For example, during fiscal year 2007, the federal
exceed its receipts during a
government raised $2.568 trillion in revenue and spent $2.730 trillion, resulting in a deficit
specified period of time,
of $162 billion.2 usually a year. If receipts
The national debt, also called the public debt, is the total value of the government™s in- exceed expenditures, it is
debtedness at a moment in time. Thus, for example, the U.S. national debt at the end of called a budget surplus
fiscal year 2007 was almost $9 trillion. instead.
These two concepts”deficit and debt”are closely related because the government
The national debt is the
accumulates debt by running deficits or reduces its debt by running surpluses. The rela- federal government™s total
tionship between the debt and the deficit or surplus can be explained by a simple anal- indebtedness at a moment
ogy. As you run water into a bathtub (“run a deficit”), the accumulated volume of in time. It is the result of
water in the tub (“the debt”) rises. Alternatively, if you let water out of the tub (“run a previous budget deficits.
surplus”), the level of the water (“the debt”) falls. Analogously, budget deficits raise
the national debt, whereas budget surpluses lower it. But, of course, getting rid of the
deficit (shutting off the flow of water) does not eliminate the accumulated debt (drain
the tub).

Some Facts about the National Debt
Now that we have made this distinction, let us look at the size and nature of the accumu-
lated public debt and then at the annual budget deficit. How large a public debt do we
have? How did we get it? Who owes it? Is it growing or shrinking?
To begin with the simplest question, the public debt is enormous. At the end of 2007, it
amounted to nearly $30,000 for every man, woman, and child in America. But just under
half of this outstanding debt was held by agencies of the U.S. government”in other
words, one branch of the government owed it to another. If we deduct this portion, the net
national debt was about $5 trillion, or approximately $16,500 per person.
Furthermore, when we compare the debt with the gross domestic product”the
volume of goods and services our economy produces in a year”it does not seem so
large after all. With a GDP approaching $14 trillion in late 2007, the net debt was only
about 35 percent of the nation™s yearly income. By contrast, many families who own
homes owe several years™ worth of income to the banks that granted them mortgages.
Many U.S. corporations also owe their bondholders much more than 35 percent of a
year™s sales.
But before these analogies make you feel too comfortable, we should point out that
simple analogies between public and private debt are almost always misleading. For one
thing, individuals do not live forever. But the federal government does”or at least we
hope so”which increases its capacity to carry debt.
On the other hand, a family with a large mortgage debt also owns a home whose value
presumably exceeds the mortgage. And a solvent business firm has assets (factories, ma-
chinery, inventories, and so forth) that far exceed its outstanding debt in value. Is the same

Reminder: The fiscal year of the U.S. government ends on September 30. Thus, fiscal year 2007 ran from Octo-

ber 1, 2006, to September 30, 2007.

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Part 3
304 Fiscal and Monetary Policy

thing true of the U.S. government? No one knows for sure. How much is the White House
worth? Or the national parks? And what about military bases, both here and abroad? Be-
cause these government assets are not sold on markets, no one really knows their true
value. But some people think the value of the government™s assets may be almost as large
as the value of its debt.
Figure 3 charts the path of the net national debt from 1915 to 2007, expressing each
year™s net debt as a fraction of that year™s nominal GDP. Looking at the debt relative to
GDP is important for two reasons. First, we must remember that everything grows in a
growing economy. Given that private debt has expanded greatly since 1915, it would be
surprising indeed if the public debt had not grown as well. In fact, federal debt grew more
slowly than did either private debt or GDP for most of the period since World War II. The
years from 1980 to about 1994 stand out as an aberration in Figure 3, with the debt-to-GDP
ratio climbing sharply.
Second, the debt is measured in dollars and, as long as there is any inflation, the
amount of purchasing power that each dollar represents declines each year. Dividing the
debt by nominal GDP, as is done in Figure 3, adjusts for both real growth and inflation,
and so puts the debt numbers in better perspective.
Figure 3 shows us how and when the U.S. government acquired all this debt. Notice
the sharp increases in the ratio of debt to GDP during World War I, the Great Depression,
and especially World War II. Thereafter, you see an unmistakable downward trend until
the recession of 1974“1975. In 1945, the national debt was the equivalent of about a year™s
worth of GDP. By 1974, this figure had been whittled down to just two months™ worth.
Thus, until the 1980s, the U.S. government had acquired most of its debt either to
finance wars or during recessions. As we will see later, the cause of the debt is quite ger-
mane to the question of whether the debt is a burden. So it is important to remember that
Until about 1983, almost all of the U.S. national debt stemmed from financing wars and
from the losses of tax revenues that accompany recessions.
But then things changed. From the early 1980s until 1993, the national debt grew faster
than nominal GDP, reversing the pattern that had prevailed since 1945. This growth spurt
happened with no wars and only one recession. By 1993, the debt exceeded five months™
GDP”nearly triple its value in 1974. This development alarmed many economists and
public figures.

F I GU R E 3
The U.S. National Debt Relative to GDP, 1915“2007
SOURCE: Constructed by the authors from data in Historical Statistics of the United States



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