10.2: Understanding Fiscal Policy and Deficits
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- 287984
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)Governments use demand-side policy (like changes in taxation and spending) to manage macroeconomic outcomes. When governments spend more than they collect in tax revenue during a fiscal year, they run a budget deficit. If they spend less than they collect, they run a budget surplus. These budget outcomes have implications for the broader economy and national debt.
Differences between Deficits and Debt
The difference between deficits and debt can be best understood by distinguishing between flow and stock variables in economics.
A budget deficit is a flow variable. It measures the difference between government spending and government revenue over a specific period (usually one year). When the government spends more than it collects in taxes and other revenues during that year, it runs a deficit. If revenues exceed spending, the government runs a surplus. Since deficits and surpluses describe changes over time, they are flows.
In contrast, the national debt is a stock variable. It represents the total amount of money the government owes at a given point in time. The national debt accumulates over years of budget deficits (and is reduced by surpluses). It is a cumulative measure of all past borrowing that has not yet been repaid.
Think of the deficit as a faucet and the debt as a bucket. The deficit is the flow of water (how much new borrowing is added each year). The debt is the level of water in the bucket, the total amount the government owes at a point in time. The more the faucet runs, the fuller the bucket gets. See figure 2.
Figure 2
In summary: the deficit is the yearly shortfall (a flow), and the debt is the running total of all deficits minus surpluses (a stock).
A fiscal stimulus, such as tax cuts or increased government spending, is often used during recessions to boost aggregate demand and guide the economy back toward full-employment GDP. However, such stimulus policies often increase the budget deficit, requiring the government to borrow money and add to the national debt.
Budget Deficit or Surplus* = Government Spending – Tax Revenues
* When government spending is less than tax revenues, the result is a budget deficit. When government spending is greater than tax revenues it results in a budget surplus.
How the Federal Government Borrow Money
The federal government borrows money by selling U.S. Treasury securities to investors in financial markets. These securities allow the government to raise funds to cover budget deficits and finance ongoing operations. When you buy a Treasury security, you are lending money to the government, and in return, the government agrees to pay you interest and return the principal at a later date. What sets these securities apart is their maturity - that is, how long it takes before the government pays back the borrowed funds.
The main types of Treasury securities are:
Treasury Bills (T-Bills)
- Maturity: Short-term (a few days to 1 year)
- Interest: Sold at a discount and do not pay interest directly. Instead, you earn the difference between the purchase price and the face value at maturity.
- Example: You buy a $1,000 T-bill for $980. When it matures in 6 months, the government pays you $1,000.
Treasury Notes
- Maturity: Medium-term (2 to 10 years)
- Interest: Pay a fixed interest rate (called a coupon) every six months until maturity.
- Example: A 5-year Treasury note with a 3% coupon pays $15 every six months on a $1,000 investment and returns $1,000 at the end of five years.
Treasury Bonds
- Maturity: Long-term (20 or 30 years)
- Interest: Like notes, bonds pay semiannual interest and return the principal at maturity.
- Example: A 30-year bond with a 4% coupon pays $20 every six months on a $1,000 bond, plus the $1,000 principal at maturity.
Together, these instruments make up the national debt held by the public. See figure 3.
Figure 3 (Source: JEC)
Investors range from individuals and pension funds to foreign governments and the Federal Reserve. The variety of maturities allows the government to borrow flexibly - using short-term borrowing to manage liquidity needs and long-term bonds to lock in funding at fixed interest rates.
This mix also gives investors choices depending on their preferences for risk, return, and time commitment, making Treasury securities a cornerstone of global financial markets.