CHAPTER

16

Government Debt

Questions for Review
1. What is unusual about U.S. fiscal policy since 1980 is that government debt increased sharply during a period of peace and prosperity. Over the course of U.S. history, the indebtedness of the federal government relative to GDP has varied substantially. Historically, the debt–GDP ratio generally increases sharply during major wars and falls slowly during peacetime. The 1980s and 1990s are the only instance in U.S. history of a large increase in the debt–GDP ratio during peacetime. 2. Many economists project increasing budget deficits and government debt over the next several decades because of changes in the age profile of the population. Life expectancy has steadily increased, and birth rates have fallen. As a result, the elderly are becoming a larger share of the population. As more people become eligible for “entitlements” of Social Security and Medicare, government spending will rise automatically over time. Without changes in tax and expenditure policies, government debt will also rise sharply.

3. Standard measures of the budget deficit are imperfect measures of fiscal policy for at least four reasons. First, they do not correct for the effects of inflation. The measured deficit should equal the change in the government’s real debt, not the change in the nominal debt. Second, such measures do not offset changes in government liabilities with changes in government assets. To measure the government’s overall indebtedness, we should subtract government assets from government debt. Hence, the budget deficit should be measured as the change in debt minus the change in assets. Third, standard measures omit some liabilities altogether, such as the pensions of government workers and accumulated future Social Security benefits. Fourth, they do not correct for the effects of the business cycle.

4. Public saving is the difference between taxes and government purchases, so a debtfinanced tax cut reduces public saving by the full amount that taxes fall. The tax cut also increases disposable income. According to the traditional view, since the marginal propensity to consume is between zero and one, both consumption and private saving increase. Because consumption rises, private saving increases by less than the amount of the tax cut. National saving is the sum of public and private saving; because public saving falls by more than private saving increases, national saving falls. 5. According to the Ricardian view, a debt-financed tax cut does not stimulate consumption because it does not raise permanent income—forward-looking consumers understand that government borrowing today means higher taxes in the future. Because the tax cut does not change consumption, households save the extra disposable income to pay for the future tax liability that the tax cut implies: private saving increases by the full amount of the tax cut. This increase in private saving exactly offsets the de...

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