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ps11ans - ECON 205: PRINCIPLES OF MACROECONOMICS FALL 2008...

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ECON 205: PRINCIPLES OF MACROECONOMICS FALL 2008 MARK MOORE PROBLEM SET 11: SOLUTIONS 1. The actual budget may be in a deficit because the economy is below full employment, in which case T (tax revenues minus transfers) will be lower than it would be at full employment. (Do you know why?) If the economy were at full employment, it is possible that the same government policies could produce a surplus. 2. If the Fed raises interest rates, output will tend to fall (because investment is adversely affected and the AD curve shifts left). The fall in output tends to reduce T. In addition, the rise in interest rates will lead to an increase in interest payments on government debt. For both these reasons, the deficit will rise. To offset the effects of the Fed policy on the AD curve, the government would have to increase G or reduce T. Either of these actions would increase the deficit further. 5. An identifiable cost of expansionary fiscal policy is that it tends to increase the interest rate and therefore reduce investment. (It is true that expansionary fiscal policy tends to increase output, which is good for investment, but the output effect is temporary. Over time, output tends to return to its potential level.) Less investment means less capital accumulation, so potential GDP for future generations is lower than it would be otherwise. As far as the debt burden, almost half of the U.S. national debt is owed to U.S. citizens, so the interest burden is paid from one set of citizens (all taxpayers) to another (holders of Treasury bonds). On the other hand, more than half of U.S. debt is owned by foreigners, so debt service and any principal repayment to these bondholders does amount to a payment from the United States to the rest of the world. Since the United States is able to borrow in dollars, in principle it need never default, because it can create dollars. If its creditors do not wish to continue lending, the Treasury can use tax revenues to pay off bondholders (thereby increasing the deficit, since less revenue is available to pay for G), then sell new bonds (directly or indirectly)
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ps11ans - ECON 205: PRINCIPLES OF MACROECONOMICS FALL 2008...

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