Unit 5 · Topic 5.4

Government Deficits and the National Debt

A budget deficit is one year's excess of government outlays over tax revenue; a surplus is the reverse.

Practice 1: Principles and ModelsPractice 2: Interpretation

Part 1 · Hook

Why this matters

A news report says the government's deficit fell this year, and in the same breath that the national debt hit a record. Both can be true. A deficit is one year's gap between what a government pays out and what it collects; the debt is the total it owes from every year so far. Shrinking a deficit still adds to the debt, just more slowly.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. Which is an example of contractionary fiscal policy?

  1. Raising income taxes
  2. Cutting income taxes
  3. Raising government spending
  4. Lowering the policy rate
Show the answer

Higher taxes lower disposable income and consumption, shifting AD left.

  • Correct: Raising income taxes:
  • Cutting income taxes:
  • Raising government spending:
  • Lowering the policy rate:

2. How do automatic stabilizers act in a recession?

  1. Tax revenue falls and transfer payments rise with no new law
  2. Tax rates rise automatically to balance the budget
  3. The central bank lowers its policy rate
  4. Government spending falls automatically
Show the answer

Progressive taxes collect less and benefits such as unemployment compensation pay out more as incomes fall.

  • Correct: Tax revenue falls and transfer payments rise with no new law:
  • Tax rates rise automatically to balance the budget:
  • The central bank lowers its policy rate:
  • Government spending falls automatically:

Part 4 · See it

See it first

Bars of an invented national debt: 1,100, 1,170, 1,150 and 1,290 billion dollars after deficits of 100 and 70, a surplus of 20, and a deficit of 140.
Each deficit adds to the debt; a surplus subtracts (invented numbers). LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. Outlays exceed tax revenue in a yearthe government runs a budget deficit
  2. The government runs a deficitit borrows the difference by selling bonds
  3. It sells bondsthe national debt rises by the amount of the deficit
  4. A recession lowers revenue and raises transfersthe deficit widens even with no new law

Part 6 · Key ideas

Key ideas

  • Budget balance = tax revenue - outlays. Negative is a deficit, positive a surplus, zero a balanced budget. Outlays include spending, transfer payments and interest on the debt.
  • The national debt is the total owed: past deficits minus past surpluses. A deficit is a flow over one year; the debt is a stock at a point in time.
  • A smaller deficit still raises the debt. Only a surplus lowers it.
  • Expansionary fiscal policy and recessions (through automatic stabilizers) widen deficits; contractionary policy and expansions shrink them.

Part 7 · Misconception

A common mistake

The wrong idea: When the deficit falls, the national debt falls.

What actually happens: The debt falls only when the government runs a surplus. A smaller deficit means the debt grows more slowly, because the government is still borrowing.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

1. What is a government's budget deficit?

  1. The total amount the government owes from past borrowing
  2. The amount by which its outlays exceed its tax revenue in one year
  3. The amount by which imports exceed exports in one year
  4. The amount by which the government's tax revenue exceeds its outlays in one year
Show the answer

Deficit = outlays - tax revenue, measured over one year. The debt is the running total.

  • The total amount the government owes from past borrowing: That is the national debt, a stock built up from past deficits.
  • Correct: The amount by which its outlays exceed its tax revenue in one year: Right: a deficit is a yearly flow, outlays (spending, transfers and interest) minus revenue.
  • The amount by which imports exceed exports in one year: That is a trade gap between a country and the rest of the world, not the government budget.
  • The amount by which the government's tax revenue exceeds its outlays in one year: Revenue above outlays is a budget surplus.

Data

The budget of Brenna (invented), billions of dollars

Brenna, an invented country, owed 1,200 billion dollars at the start of Year 1. Outlays include spending, transfer payments and interest on the debt.
YearTax revenueGovernment outlays
1760850
2800860
3880850
4790920

2. What is Brenna's budget balance in Year 2, in billions of dollars? Use a negative number for a deficit.

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Budget balance == revenue −- outlays =800−860=−60= 800 - 860 = -60: a deficit of 60 billion dollars.

  • Answer: -60

3. How much does Brenna owe at the end of Year 3, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Deficits of 90 and 60 add to the debt and the surplus of 30 reduces it: 1,200+90+60−301{,}200 + 90 + 60 - 30=1,320= 1{,}320 billion dollars.

  • Answer: 1320

4. In which year did Brenna's national debt fall?

  1. Year 2
  2. Year 4
  3. Year 3
  4. Year 1
Show the answer

The debt falls only in a year with a surplus.

  • Year 2: The deficit was smaller than in Year 1, but a smaller deficit still adds to the debt.
  • Year 4: Year 4 has the largest deficit, 130, so the debt rose the most.
  • Correct: Year 3: Right: revenue (880) exceeded outlays (850), a surplus of 30 that pays down the debt.
  • Year 1: Outlays exceeded revenue by 90, so the debt rose.

Scenario

A headline in Tarvia (invented country)

Last year the government of Tarvia, an invented country, ran a budget deficit of 80 billion dollars. This year its deficit is 50 billion dollars. A news headline reads: "Tarvia cuts its debt."

5. How does Tarvia's government pay for its 50 billion dollar deficit?

  1. It borrows, by selling government bonds
  2. It raises the reserve requirement for banks
  3. It cuts transfer payments by 50 billion dollars
  4. It records the deficit as an export to other countries
Show the answer

Deficits are financed by borrowing; the bonds sold are the debt.

  • Correct: It borrows, by selling government bonds: Right: a government covers a deficit by borrowing from households, firms, banks and foreign lenders.
  • It raises the reserve requirement for banks: A reserve requirement is a central bank tool; it does not raise money for the government budget.
  • It cuts transfer payments by 50 billion dollars: That would shrink the deficit, but it is a policy choice, not how an existing deficit is paid for.
  • It records the deficit as an export to other countries: A budget deficit is about the government's own revenue and outlays.

6. Which statement correctly compares a budget deficit with the national debt?

  1. A deficit is a flow over one year; the debt is a stock, the total owed at a point in time
  2. A deficit is the total owed; the debt is the amount borrowed this year
  3. A deficit is owed to foreigners; the debt is owed to citizens
  4. A deficit is measured in percent; the debt in dollars
Show the answer

Deficit or surplus: one year's budget gap (a flow). Debt: the accumulated total (a stock).

  • Correct: A deficit is a flow over one year; the debt is a stock, the total owed at a point in time: Right: each year's deficit flows into the debt, like water into a tub.
  • A deficit is the total owed; the debt is the amount borrowed this year: That reverses the two terms.
  • A deficit is owed to foreigners; the debt is owed to citizens: Both deficits and debt can be financed at home or abroad; that is not the difference.
  • A deficit is measured in percent; the debt in dollars: Both can be measured in dollars or as a percent of GDP.

Part 9 · Summary

Summary

A budget deficit is one year's excess of government outlays over tax revenue; a surplus is the reverse. The government borrows to cover a deficit, so the national debt, a stock, rises by each deficit and falls only with a surplus. Expansionary fiscal policy and recessions widen deficits, contractionary policy and expansions narrow them, and interest on the debt is itself part of outlays.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic