[MUSIC] Let's turn now to our discussion of the various economic problems created by chronic budget deficits and a growing government debt. To begin this discussion, we have to first recognize that the kind of problems the deficit and debt may cause is in large part determined by how the deficit is financed. In this regard, there are three major ways the government can finance a deficit, raising taxes, borrowing money or printing money. Best way to draw this distinction is again by example. Suppose then that the budget is initially in balance and that the government undertakes an expansionary fiscal policy to close a recessionary gap. Suppose further that this expansionary policy involves a net increase of government expenditures of $25 billion. How shall these expenditures be financed? The raise taxes option is interesting because at first glance you might ask yourself, how can the economy expand if taxes and expenditures are going up by the same amount? It's a good question. And the answer lies in the dynamics of the marginal propensity to consume that we discussed in a previous lesson. Think about it this way, if government raises taxes by $25 billion, to cover the increase in government expenditures and the marginal propensity to consume is say, 0.8, consumption will only fall by $20 billion or (0.8*$25 billion). This means that even after the tax hike, the net increase in aggregate expenditures is still $5 billion. Now, given that the marginal propensity to consume is 0.8, we also know from a previous lesson that the multiplier will be 5. So, if you multiply this $5 billion increase in aggregate expenditures by our multiplier of 5, you get a total economic expansion of $25 billion, which perhaps curiously is exactly equal to the original outlay government expenditures. Macroeconomists refer to this phenomenon as the balanced budget multiplier. This multiplier has a value of one because when you simultaneously increase government expenditures and increase taxes by the same amount, you get an economic expansion exactly equal to the increase in government expenditures. While the balanced budget multiplier approach to financing a deficit may sound like a great way to conduct expansionary fiscal policy without increasing the budget deficit. This macroeconomic technique is however rarely used, reason is that, raising taxes is politically unpopular. Unfavorable politics of raising taxes typically means that the government has to resort to one of two other means to finance the deficit. Borrowing money or printing money, both of which create their own problems. With the borrow money option, the US Treasury sells IOUs in the form of bonds or treasury bills directly to the private capital markets and uses the proceeds of the sales to finance the deficit. Note that in this case, the Federal Reserve is out of the loop. Note also that the US Treasury is competing directly in the capital markets with private corporations, which may also be seeking to sell bonds and stocks in order to raise capital to invest in new plan equipment. In order to compete for these scarce investment dollars, the treasury typically must raise the interest rate it is offering in order to attract enough funds. This is because in the borrow money option, running the deficit is largely a Zero Sum Game. The money used to finance the deficit is money that would otherwise have been borrowed and spent by corporations and businesses on private investment. In this case, deficit spending by the government is said to crowd out private investment. As we learned in lecture six, crowding out is the offsetting effect on private expenditures caused by the government's sale of bonds to finance expansionary fiscal policy. This crowding out effect which is one of the most important concepts in macroeconomics is illustrated by these two figures. The left hand figure, an increase in investment demand by the government shifts the investment demand curve from Id1 to Id2. This raises the interest rate and reduces private investment as it made clear by the left hand figure. Note that in this figure if the economy starts at point A and moves to point B crowding out will be equal to H1 minus H2. But if the economy starts at point C in a recession and moves to point B, crowding out need not occur. The broader point here is that crowding out applies only the structural deficits. The cyclical deficits rises because of a recession, the logic of crowding out simply does not apply. Why? Because a recession causes a decline in the demand for money and leads to lower interest rates. And the Federal Reserve tends to loosen monetary policy in a recession. This point is important because it underscores the observation that there is no automatic link between deficits and investment. Now, here's a pretty hard question. Can you use the Keynesian model to more fully illustrate how the crowding out effect might reduce the actual effectiveness of fiscal policy? In this Keynesian model, the initial equilibrium is at Y, where the aggregate expenditure curve, AE crosses the aggregate production curve, AP. However, expansionary fiscal policy shifts the aggregate expenditure curve up to AE1, this leads to a new equilibrium of Y1. However, because the government has had to borrow money from the private capital markets to finance these expenditures, interest rates rise. This reduces investment and the resulting contractionary effect shifts the aggregate expenditure curve back down from AE1 to AE2. And the final equilibrium at Y2, the net economic expansion equals Y2 minus Y. At the same time, the partial crowding out of private investment may be measured by Y1 minus Y2. This on the basis of this kind of analysis that critics have discretionary Keynesian fiscal policy have argued that it is a very weak policy tool. In fact, monetarists tend to take the view that crowding out is almost complete, so that fiscal policy is completely ineffective. Keynesians, on the other hand, typically argue that crowding out is minimal. At least in theory, it's possible to avoid crowding out altogether with the print money option. With this option, the Federal Reserve is said to accommodate the Treasury's expansionary fiscal policy. In particular, the Fed simply buys the Treasury securities itself rather than letting this securities be sold in the open capital markets. To pay for these deficit financing Treasury securities, the Federal Reserves simply prints new money. The problem with this option, of course, is that the increase in the money supply can cause inflation, undesirable result in and of itself. Moreover, if such inflation drives interest rates up and private investment down, as it is likely to do, the end result of the print money option may be a crowding out effect as well.
