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Fiscal Policy

Government Deficits and Debt

Expansionary fiscal policy has a major effect on government deficits and debt, which, in turn, have serious implications for the wider economy as a whole.

Recall that the federal budget is taxes minus government spending. A deficit in the government's budget arises when it spends more money than it receives in revenues (taxes). Each year the government runs a deficit. The deficit is added to the national debt, the total value of all outstanding Treasury bills, notes, and bonds that the federal government owes investors. Conversely, a budget surplus arises when revenue is greater than expenditure. Government revenues are directly impacted by increases or decreases in the tax rate, so the fiscal policy has a major impact on whether the government runs a surplus or deficit and whether the national debt is growing or shrinking. Because expansionary fiscal policy can create a situation in which expenditures are greater than revenues, it is also sometimes known as deficit spending. In times of severe economic downturn, deficit spending is accepted as a good way to stimulate the economy. In the short run, expansionary fiscal policy is necessary, as there is an increased need for government programs and a need for government spending, which creates jobs. Also, tax cuts combined with increased spending will stimulate the economy. But, if revenues from taxation are down, the government must borrow. This leads to deficit spending. However, an expansionary fiscal policy must be enacted with the understanding that once the economy is growing again, measures will be enacted to reduce the deficit and cut the debt accrued because of these policies.

The national debt itself affects the state of the deficit because the interest on the debt is paid out of the government budget. A higher national debt means higher interest payments and higher government expenditures. If not directly addressed, debt and deficit comprise a cycle that is hard to reverse.
Historically, the United States has accumulated debt during major conflicts and paid it off in the years following. That trend ended after World War II. Some economists worry about the trend of increasing debt during peacetime.
To control the deficit and national debt, a period of contractionary policies (policies that reduce aggregate demand and debt levels) should follow a period of an expansionary policy. However, a contractionary policy is often politically unviable. Political pressures contribute to maintaining deficit spending because the government can continue to fund itself by issuing bonds and Treasury notes. A Treasury bond is a government bond issued by the U.S. Treasury. Purchasing a bond amounts to loaning the federal government money, to which they pay back with tax revenues when the bond matures (this is when the loan amount is to be repaid). Increased interest rates dampen aggregate demand, which can send the economy into a recession. Eventually, perpetuating the deficit spending ends up re-creating the circumstances it was meant to fix.

A large national debt can have several serious negative impacts on the wider economy. It causes a rise in interest rates. Furthermore, it can cause the value of the currency to depreciate, which, in turn, diminishes the value of the Treasury bonds the government relies on to fund its operations. This bond depreciation occurs for two reasons. First, bonds devalue along the same lines as currency does because their value is measured in dollars. Second, bond prices are inversely related to interest rates; that is, higher interest rates correspond to lower bond prices. High national debt levels raise interest rates. Thus, as interest rates increase, the value of the Treasury bonds go down.