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Lesson summary: Deficits and debts

In this lesson summary review and remind yourself of the key terms and graphs related to deficits and debts.


We've learned that expansionary fiscal policy, such as decreasing taxes or increasing government spending, can be a powerful tool to fix a recession. But just like you, if a government’s spending exceeds its income, it has to borrow the difference.
When a government's expenditures on goods, services, or transfer payments exceed their tax revenue, the government has run a budget deficit. Governments borrow money to pay for budget deficits, and whenever a government borrows money, this adds to its national debt.

Key terms

Key termDefinition
balanced budgetwhen a government's spending on goods, services, and transfer payments equals its tax revenues
budget deficitwhen a government spends more on goods, services, and transfer payments than it collects in tax revenues; budget deficits add to the national debt
budget surpluswhen a government spends less on goods, services, and transfer payments than it collects in tax revenues; budget surpluses can be used to pay down the national debt
national debtthe accumulated amount of money that a government owes to its creditors as the result of running budget deficits
transfer payments (aka implicit liabilities)payments by the government that are not in return for goods and services; for example, when the government of Hamsterville pays a grandmother a retirement pension, they are transferring money to her, rather than buying goods and services from her.

Key takeaways

Deficits occur when government spending and transfer payments exceed tax revenues

If a person finds that they are spending more money than they have, they will either need to sell off some of their belongings or borrow money. The government faces the same problem. The money that the government has to spend is the money it collects in the form of taxes; if that isn't enough to cover its spending, the government has run a deficit and will have to borrow money.
What does the government spend money on? Governments spend money on goods and services, such as computers for government employees and payments to government contractors. Additionally, governments frequently have legal obligations to make payments to individuals, such as social security retirement payments in the United States.

When a government borrows money, its debt increases

Whenever a government runs a budget deficit, it adds to its long-term debt. For example, suppose the government of Kashyyyk has a $200 million budget deficit one year, so it borrows money to pay for its budget deficit. The next year the government runs another deficit, this time of $100 million. Now the government has accumulated a debt of at least $300 million.

Government debt reduces the ability of a government to spend in the future

Notice that we said that the government has accumulated a debt of at least $300 million in the last example. If you are asking yourself, "but doesn't $200 million plus $100 million equal $300 million exactly?", then you are forgetting an important aspect of debt: interest.
Just like anyone else borrowing money, governments have to pay back both the amount of a loan and interest on that amount. For example, if Kashyyyk's loans accrue 10% interest each year, then at the end of the first year it now owes:
Debt at the end of the year=Amount of loan+amount of interest=$200 million×($200 million×10%)=$200 million×$20 million=$220 million
So, if the government doesn't pay down any part of the amount borrowed in the first year or the interest, the total accumulated debt when it runs a deficit the second year is $320 million.
Debts must be repaid. That means that if the government of Kashyyyk wants to repay that debt, it will have to stop running deficits and start running surpluses. A government will have to begin to reallocate spending away from goods, services, or transfer payments and toward paying down its debt.

There is a close relationship between the budget balance and the business cycle

Governments tend to run deficits during recessions and surpluses during expansions. Recall that automatic stabilizers tend to kick in when there are changes in output, which means that during recessions, government spending on things like transfer payments tends to increase at the same time that tax revenues decrease.

Key equations

Public savings is calculated as:
Savings by government=Tax revenueGovernment spendingTransfer payments
For example, if a country takes in $700 in tax revenue, spends $600 on goods and services and $200 in transfer payments:
Savings by government=Tax revenueGovernment spendingTransfer payments=$700$600$200=$100
Note that the savings here are negative. National savings can be positive, which would mean the government has money that it could loan out. However, negative national savings means that the government is borrowing money.

Common misperceptions

  • New learners sometimes get the terms "deficit" and "debt" confused. Deficit describes a one-time shortage (for example, in an annual budget), while debt describes a shortage that has accumulated over time, e.g. from multiple annual deficits
  • Many people assume that deficits are "bad," but an economist would remind those people that we tend to stick to positive analysis rather than normative analysis. A deficit might be the result of an event such as a recession which gets paid off the next time an economy experiences a boom (and a budget surplus as a result of that boom). However, running many deficits leads to debt, and debts must be repaid. That means that eventually paying a debt will limit what a government can spend in the future.

Questions for review

  • Suppose a government has a deficit in 2016 of $100 million and there is $600 million in national debt that it accrued before 2016. If the interest paid on debt is 10%, how much of a budget surplus will be necessary for 2017 to keep the debt from getting any larger? SHOW YOUR WORK.
  • If a government has a budget deficit, what are its options to return to a balanced budget?

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