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Macroeconomic effects of government debt

Abstract The purpose of this paper is two-fold. This paper surveys the literature on the macroeconomic effects of government debt. It begins by discussing the impact of federal government debt on aggregate economic activity such as lower output and income, increased demand for output in the short run, inflation and reduced economic growth. The paper then presents the recommended policies that can be implemented by governments to reduce their debts such as the contraction fiscal policy. Statement of the problem The relationship between budget deficits or public debt and real economic activity has sparked a tremendous debate.

Federal government deficits negatively affects the aggregate economic activity in several ways for example government deficits causes lower output and income levels since a growing portion of savings would go towards purchases of government debt, rather than investments in productive capital goods such as factories and computers, leading to lower output and incomes than would otherwise occur. A high debt level may result in inflation if currency devaluation is viewed as a solution to debt reduction.

Debt levels may also affect economic growth rates. Economists Kenneth Oregon and Carmen Reinhardt reported in 2010 that among he 20 advanced countries studied, average annual GAP growth was

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3-4% when debt was relatively moderate or low (I. E. Under 60% of GAP), but it dips to Just 1. 6% when debt was high (I. E. , above 90% of GAP. Another effect of government debt is to alter the political process that determines fiscal policy. Some economists have argued that the possibility of government borrowing reduces the discipline of the budget process.

A country with a large debt is likely to face high interest rates, and the monetary authority may be pressured to try to reduce those rates through expansionary policy. This strategy may reduce interest rates in the short run, but in the long run will leave real interest rates roughly unchanged and inflation and nominal interest rates higher. Another effect of government debt is the deadweight loss of the taxes needed to service that debt. The debt-service payments themselves are not a cost to a society as a whole, but, leaving aside any payments to foreigners, merely a transfer among members of the society.

Introduction An important economic issue facing policymakers during the last two decades of the twentieth century has been the effects of government debt. The reason is a simple one, the debt of the U. S. Federal government rose from 26 percent of GAP in 1980 to 50 percent of GAP in 1997. Many European countries exhibited a similar pattern macroeconomic effects of government debt By phenylalanine only during wars or depressions. Recently, however, policymakers have had no ready excuse. This episode raises a classic question: How does government debt affect the economy?

That is the question that we take up in this paper. Increased Demand for Output in the short run High government debt may lead to an increase in the demand of output in the short run. Suppose that the government creates a budget deficit by holding spending constant and reducing tax revenue. This policy raises households’ current disposable income and, perhaps, their lifetime wealth as well. Conventional analysis presumes that the increases in income and wealth boost household spending on consumption goods and, thus, the aggregate demand for goods and services.

According to conventional analysis, the economy is Keynesian in the short run, so the increase in aggregate demand raises national income. That is, because of sticky wages, sticky prices, or temporary misconceptions, shifts in aggregate demand affect he utilization of the economy’s factors of production. ( Elmsford and Manama, 1998) Inflation Nevertheless, successive Chairmen of the Federal Reserve Board of America have warned of the possible link between the budget deficit and inflation. A high debt level may result in inflation if currency devaluation is viewed as a solution to debt reduction.

If wages are rising due to inflation, fixed amounts of debt can be paid off more easily using cheaper dollars. This helps the debtor but hurts the debt holder, who receives less value in return for their loan. A variety of factors are placing increasing pressure on the value of the U. S. Dollar, increasing the risk of devaluation or inflation and encouraging challenges to dollar’s role as the world’s reserve currency. The U. S. Federal Reserve has significantly expanded the money supply in the wake of the supreme mortgage crisis.

This increases the risk of inflation once economic growth resumes at historical rates (Woodward, 1995). Ben Brenan stated in January 2013: “We have increased the monetary base, which is the amount of reserves that banks hold with the Fed. There are some people who think that is going to be inflationary. Paul Blocker told Congress in 1985 that “the actual and prospective size of the edged deficit heightens skepticism about our ability to control the money supply and contain inflation” (p. 10).

Alan Greenshank said in 1995 that he expected that “a substantial reduction in the long-term prospective deficit of the United States will significantly lower very long-term inflation expectations as well in other countries” (p. 141). In extreme cases, a country with a large debt may have difficulty financing an ongoing through seignior. If the fiscal authority can force the monetary authority to finance ongoing deficits with seignior, then, as Sergeant and Wallace (1981) argue, inflation is ultimately a fiscal phenomenon rather than a monetary one.

This modernization of the debt is the classic explanation for hyperinflation. For example, staggering budget deficits as a share of national income were the root cause of hyperinflation in sass Germany and sass Bolivia Decrease in economic growth Debt levels may also affect economic growth rates. Economists Kenneth Oregon and Carmen Reinhardt reported in 2010 that among the 20 advanced countries studied, average annual GAP growth was

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3-4% when debt was relatively moderate or low (that is under 60% of GAP), but it dips to Just 1. % when debt was high (I. E. Above 90% of GAP). Economists continue to debate about the level of debt relative to GAP that signals a “red line” or dangerous level, or if any such level exists. In January 2010, Economists Kenneth Oregon and Carmen Reinhardt stated that gross debt which is the debt held by the public plus intergovernmental debt) exceeding 90% of GAP might be an indicative danger level. A February 2013 paper from four economists concluded that, “Countries with debt above 80 percent of GAP and persistent current-account [trade] deficits are vulnerable to a rapid fiscal deterioration.

However, other economists disagreed with their results, indicating that the relationship between higher national debt levels and higher interest rates did not hold for countries that could print their own currency. The statistical relationship between a higher trade deficit and higher interest rates was stronger for several troubled Euro zone countries, indicating significant private borrowing from foreign countries (required to fund a trade deficit) may be a bigger factor than government debt in predicting interest rates.

Fed Chair Ben Brenan stated in April 2010 that “Neither experience nor economic theory clearly indicates he threshold at which government debt begins to endanger prosperity and economic stability. But given the significant costs and risks associated with a rapidly rising federal debt, our nation should soon put in place a credible plan for reducing deficits to sustainable levels over time. High interest rates A country with a large debt is likely to face high interest rates, and the monetary authority may be pressured to try to reduce those rates through expansionary policy.

This strategy may reduce interest rates in the short run, but in the long run will leave real interest rates roughly unchanged and inflation and nominal interest rates Geiger. Despite rising debt levels, interest costs have remained at approximately 2008 levels (around $450 billion in total) due to lower interest rates paid to Treasury debt holders in the U. S. However, should interest rates return to historical averages, the interest cost would increase dramatically. Historian IANAL Ferguson described the risk that foreign investors would demand higher interest rates as the U. S. Debt levels increase over time in a November 2009 interview.

Another effect of government debt is the deadweight loss of the taxes needed to service that debt. The debt-service payments themselves are not a cost to a society as a whole, but leaving aside any payments to foreigners, merely a transfer among members of the society. Yet effecting that transfer in a world without lump-sum taxes will create some distortion of individual behavior that generates a deadweight loss. Thus, a policy of reducing taxes and running a budget deficit means smaller deadweight losses as the debt is being accumulated but larger deadweight losses when the debt is being serviced with higher taxes.

Lower output and incomes Government debt also results in lower output and incomes. This is because a growing portion of savings would go towards purchases of government debt, rather than investments in productive capital goods such as factories and computers, leading to lower output and incomes than would otherwise occur. Reduced domestic investment over a period of time will result in a smaller domestic capital stock, which in turn implies lower output and income. With less capital available, the marginal product of capital will be higher, raising the interest rate and the return earned by each unit of capital.

At the same time, labor productivity would be lower, thereby educing the average real wage and total labor income. Reduced net foreign investment over a period of time means that domestic residents will own less capital abroad (or that foreign residents will own more domestic capital). In either case, the capital income of domestic residents will fall. Moreover, the decline in net foreign investment must be matched by a decline in net exports, which constitutes an increase in the trade deficit of goods and services.

As this connection between the budget deficit and the trade deficit became better known in the United States during the sass, it led to the popular term “twin deficits. Pushing the trade balance into deficit generally requires an appreciation of the currency, which makes domestically-produced goods relatively more expensive than foreign produced goods. Changes the political process that determines fiscal policy An additional effect of government debt is to alter the political process that determines fiscal policy. Some economists have argued that the possibility of government borrowing reduces the discipline of the budget process.

When additional government spending does not need to be matched by additional tax revenue, policymakers and the public will generally worry less about whether the additional spending is appropriate. This argument dates back at least to Weeklies Wagner (1977), and Fieldstone (1995) among others. Weeklies claimed that if the benefit of some type of government spending exceeded its cost, it should be possible to finance that spending in a way that would receive unanimous support from the voters. He concluded that the government should only undertake a course of spending and taxes that did receive nearly unanimous approval.

In the case of deficit finance, Weeklies was concerned that “the interests [of future taxpayers] are not represented at all or are represented inadequately in the tax-approving assembly” (p. 106). Engrave noted that when budget balance is altered for stabilization purposes, “the function of taxes as an index of opportunity cost [of government spending] is impaired” (p. 522). Buchanan and Wagner asserted that a balanced-budget rule “will have the effect of bringing the real costs of public outlays to the awareness of decision makers; it will tend to dispel the illusory ‘something for nothing’ aspects of fiscal choice” (p. 78). And Fieldstone wrote that “only the ‘hard budget constraint’ of having to balance the budget” can force politicians to Judge whether spending “benefits really Justify its costs” (p. 05). It is also possible that the existence of government debt reduces the fiscal flexibility of the government. If moderate levels of debt have only small negative effects, but larger debts are perceived to be quite costly, then a country with a moderate debt will be constrained from responding to calls for greater spending or lower taxes.

This constraint on future policymakers is, in fact, one of the explanations sometimes given for why governments choose to accumulate large debts. The economy becomes more vulnerable to a crisis of international confidence. Another way in which government debt could affect the economy is by making it ore vulnerable to a crisis of international confidence. The Economist (4/1195) noted that international investors have worried about high debt levels “since King Edward Ill of England defaulted on his debt to Italian bankers in 1335” (p. 59).

During the early sass, the large U. S. Budget deficit induced a significant inflow of foreign capital and greatly increased the value of the dollar. Marries (1985) argued that foreign investors would soon lose confidence in dollar-denominated assets, and the ensuing capital flight would sharply depreciate the dollar and produce severe macroeconomic robbers in the United States and other countries similar cases. As Grumman (1991) described, the dollar did indeed fall sharply in value in the late sass, but the predicted “hard landing” for the U. S. Economy did not result.

Grumman emphasized, however, that currency crises of this sort have occurred in countries with higher debt-output ratios, particularly when much of that debt is held by foreigners, as in many Latin American countries in the sass. More effect of government debt is the danger of diminished political independence or international leadership. As with the danger of a hard landing, this problem is ore likely to arise when government borrowing is large relative to private saving and when the country experiences a large capital inflow from abroad. Friedman (1988) asserted: “World power and influence have historically accrued to creditor countries.

It is not coincidental that America emerged as a world power simultaneously with our transition from a debtor nation to a creditor supplying investment capital to the rest of the world” (p. 13). Recommend policies that can be implemented by the government Contraction fiscal policy can be used by the government to reduce the federal government debt. This is accomplished by decreasing aggregate expenditures and aggregate demand through a decrease in government spending (both government purchases and transfer payments) or an increase in taxes.

Contraction fiscal policy leads to a smaller government budget deficit or a larger budget surplus. In general, contraction fiscal policy works through the two sides of the government’s fiscal budget which includes spending and taxes. However, it’s often useful to separate these two sides into three specific tools namely government purchases, taxes, and transfer payments. Government Purchases One of the three fiscal policy tools available to the government sector is government purchases. Government purchases are expenditures by the government sector, especially those by the federal government, on final goods or services.

It is that portion of gross domestic product purchased by governments. These purchases are used to buy everything from aircraft carriers to paper clips, from office furniture to highway construction, from traffic lights to teacher salaries. The actual purchases are typically undertaken by individual government agencies. Highway construction, for example, is undertaken with funds appropriated to the Department of Transportation. Aircraft carriers are financed with funds appropriated to the Department of Defense. Contraction fiscal policy involves a decrease in the funds appropriated to these assorted agencies.

The agencies then reduce their purchases which decrease aggregate production, income, and thereby reducing the government debt. Canada faced a nearly double-digit budget deficit in the sass. By instituting deep budget cuts (20% or more within four years), the nation reduced its budget deficit to zero within three years and cut its public debt by one-third within five years. The country did this without raising taxes. In theory, others countries could emulate this example. Taxes The second of three fiscal policy tools is taxes, primarily personal income taxes levied by the federal government, but other taxes are also used.

Taxes are the involuntary generate the revenue needed to provide public goods and to undertake other government functions. Personal income taxes are more specifically the taxes collected on the income received by members of the household sector. Contraction fiscal policy involves either an increase of the income tax rates or a one-time surcharge. The increase in taxes provides the household sector with less exposable income that can be used for consumption expenditures, which then reduces aggregate production and employment and leads to further decreases in income, thus reducing government debt.

The government can use the proceeds from taxpayers to finance deficits as opposed to borrowing which would result in a problem of ongoing debts. While tax changes tend to be administratively easier to implement than government purchases, they are less political palatable to political leaders and voters who prefer lower taxes to higher taxes. Higher taxes have been used as part of contraction fiscal policy, but sparingly in most countries. Transfer Payments The third fiscal policy tool is transfer payments.

Transfer payments are payments made by the government sector to the household sector with no expectations of productive activity in return. The three common transfer payments are Social Security benefits to the elderly and disable, unemployment compensation to the unemployed, and welfare to the poor. Like the income tax system, transfer payments rely on a payment schedule based on qualifying characteristics of the recipients which include age, employment status, income, etc. Those who meet the criteria then receive payments.

Contraction fiscal policy involves either a decrease in payment schedule for one or more of the transfer systems or perhaps some sort of across-the- board reduction in payments to all who qualify. That is, the unemployment compensation might be decreased by 5 percent or all Social Security recipients might receive a reduction of $100 in their monthly check. The decrease in transfer payments reduces the disposable income available to the household sector, which then forces a reduction in consumption expenditures, leading to less aggregate production and employment and subsequently a decrease in government debt.

This is because the government will have fewer obligations that need to be financed hence there will be no need to borrow more money thereby reducing government deficit. Conclusion This essay has touched on some of the major issues in the debates over the effects of Government debt on the aggregate economic activity and it has been observed that federal government debt is very harmful to the aggregate economic activity for example by diminishing economic growth. However the contraction fiscal policy can be implemented by the government in order to reduce federal government debt.

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