1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-1 National Debt and Economic Growth See: DeLong/Olney: Macroeconomics; McGraw-Hill; 2006; Chapter 14, section 14.3

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-2 Questions What are the reasons that we should worry about a rising national debt? What are the reasons that we shouldn’t worry too much about a rising national debt?

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-3 Debt & Deficits The national debt (D) is the amount of money that the government owes those from whom it has borrowed –when government spending < tax revenues, the difference is the government surplus (-d) the national debt falls by d –when government spending > tax collections, the difference is the government deficit (d) the national debt rises by d

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-4 Measuring the Budget Balance The government budget balance reported in the news is generally the unified cash balance –the difference between the money the government actually spends in a year and the money it takes in –unifies all of the government’s accounts and trust funds –doesn’t take account of changes in the value of government-owned assets or future liabilities

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-5 Inflation A good measure of the deficit should be a measure of whether the government is spending more in the way of resources than it is taking in –we should correct the officially-reported cash budget balance for inflation –the real deficit (d r ) is related to the cash deficit (d c ) by

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-6 Liabilities & Generational Accounting The correct way to count the government’s debt is to look at all of its promises to pay money out in the future –this system is called generational accounting it would examine the lifetime impact of taxes and spending programs on individuals born in specific years and would come up with a balance that could be used for long-term planning

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-7 The Equilibrium Debt-to-GDP Ratio Fiscal policy is sustainable if the debt- to-GDP ratio (D/Y) is heading for a steady state –D and Y must be growing at the same proportional rate Y grows at a proportional rate equal to the sum of the annual rate of growth of the labor force (n) and the annual rate of growth of labor efficiency (g)

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-8 The Equilibrium Debt-to-GDP Ratio The debt next year will be equal to Since tax revenues and spending grow with real GDP, it makes sense to focus on the deficit as a share of GDP

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-9 The Equilibrium Debt-to-GDP Ratio The proportional growth rate of the debt is

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-10 The Equilibrium Debt-to-GDP Ratio The debt-to-GDP ratio will be stable when the proportional growth rates of the debt and GDP are equal

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-11 The Equilibrium Debt-to-GDP Ratio Example –growth rate of labor force (n) = 2% –growth rate of output/worker (g) = 1% –inflation rate () = 5% –if the current debt-to-GDP ratio<1/2, the debt-to-GDP ratio will rise –if the current debt-to-GDP ratio>1/2, the debt-to-GDP ratio will fall

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-12 Sustainability The higher the debt-to-GDP ratio, the riskier an investment financiers judge the debt of a country to be –if the government changes hands, the new government must decide whether to honor the debt issued by previous governments –the government can lower the real value of its debt by increasing the rate of inflation

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-13 Sustainability A deficit is sustainable only if the associated steady-state debt-to-GDP ratio is low enough that investors judge the debt safe enough to be willing to hold it If a government has too much debt to be considered safe, the interest rates it must pay will rise dramatically –the government will then be faced with a larger deficit (because of interest costs)

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-14 The U.S. Debt-to-GDP Ratio The typical pattern the U.S. has followed is one of sharp spikes in the debt-to-GDP ratio during wartime, followed by the paying-off of the debt during peacetime –the greatest peaks in the debt-to-GDP ratio occurred after the Civil War, World War I, and World War II –the debt-to-GDP ratio also rose during the Great Depression and the Reagan and Bush presidencies (both)

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-15 Figure 14.7 - U.S. Debt-to-GDP Ratio Since the Revolutionary War

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-16 Figure 14.8 - Federal Revenues and Expenditures as Shares of National Product since the Civil War

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-17 Deficits and Long-Run Economic Growth If the deficits continue for long, they will affect the economy’s capital intensity A lower balanced growth capital- output ratio implies a lower level of output per worker for any given level of the efficiency of labor

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-18 Debt Service, Taxation, and Real GDP A higher deficit also implies a higher debt, which means that the government owes more in the way of interest payments to bondholders –over time, the increase in interest payments will require tax increases –these tax increases may discourage entrepreneurship and economic activity

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 14-19 Deficits and long-run growth Persistent deficits  a rising national debt  threaten to diminish national savings, reduce the level of output per worker along the economy’s balanced growth path, and retard economic growth