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 contractionary 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 Rogoff and Carmen Reinhart reported in 2010 that among the 20 advanced countries studied, average annual GDP growth was 3–4% when debt was relatively moderate or low (i.e. under 60% of GDP), but it dips to just 1.6% when debt was high (i.e., above 90% of GDP. 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.
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 GDP in 1980 to 50 percent of GDP in 1997. Many European countries exhibited a similar pattern during this period. In the past, such large increases in government debt occurred 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 misperceptions, shifts in aggregate demand affect the utilization of the economy's factors of production. ( Elmendorf and Mankiw, 1998)
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 ...