Explain the three subjectsbelow using economic terminology, economic logic, and economic reasoning

The Stimulative Effect of Bigger Deficits

In the short run, increasing the federal budget deficit has a stimulative effect on the economy. A bigger deficit could occur if the government boosted spending without raising taxes by the same amount, or if it cut taxes without a matching cut in spending. In either case, more money would stay in the pockets of U.S. consumers, and the government would have to borrow more.

For example, in 2001 President George W. Bush proposed a sharp tax cut, which Congress passed. Three things happened as a result. First, the federal budget went from $128 billion in surplus in 2001 to $158 billion in deficit in 2002. Second, the disposable income of U.S. consumersthat is, the income they had left after taxes were taken outrose in 2002, even though employment was weak and the economy was sluggish. Third, consumer spending continued to rise as well.

These three facts are related. In general, an increase or decrease in the budget deficit serves as a rough-and-ready measure of the amount of fiscal stimulus applied to the economy. In this case, the total fiscal stimulus was roughly equal to $286 billion ($128 billion plus $158 billion, or the size of the swing from surplus to deficit).

An increasing budget deficit pushes up interest rates and crowds out private investment, all other things being equal.

Of course, the 2002 stimulus was dwarfed by the Great Recession, when the budget deficit went from $459 billion in 2008 to a staggering $1,413 billion in 2009. This was an enormous stimulus to the economy.

During a recession, the budget deficit generally increases because tax revenues weaken while expenditures rise. That increase in the deficit is known as anautomatic stabilizerbecause the widening budget deficit pumps stimulus into the economy without the need for the government to change tax rates.

Crowding Out

However, government borrowing does have negative effects on the rest of the economy. When the budget deficit rises, the increased borrowing pushes the demand schedule for loans to the right, as we see inFigure 11.7. That, in turn, pushes the interest rate up fromrtor.

Figure 11.7 The Impact of Government Borrowing on Interest Rates

As the government borrows more money, it pushes up demand for loans and raises the interest rate. That, in turn, discourages private borrowing.

The law of demand tells us that if something is more expensive, the market will buy less of it. So when the government's increased borrowing makes capital more expensive, business will be able to afford less investment in equipment and structures, and consumers can spend less on consumer durables such as homes and cars.

This phenomenon is known ascrowding out. In effect, the government competes with the private sector for capital and elbows the private sector out of the way. Crowding out is bad in the short run because it lessens the stimulative effect of a bigger budget deficit. The fiscal stimulus may generate jobs and income, but it is accompanied by a reduction in private investment. Crowding out is also bad because with less capital investment, businesses are less productive. Over the long run, that means economic growth will be slower.

The damage done by crowding out is not as apparent as the pain of taxation. You can see how much the government is taking from you in taxes just by looking at your paycheck or tax returns. It's much harder to see how much government borrowing has raised the interest rate.

The Impact of Budget Deficits in the Long Run

No discussion of the budget deficit would be complete without a mention of its long-term impact. As of 2018, the federal budget deficit had grown to 3.9 percent of GDP, from 2.4 percent in 2015. Out of that total, almost half the deficit comes from interest payments on federal debt. In other words, the federal government is borrowing in part to pay interest on existing debt.

Going forward, the Congressional Budget Office projects that the deficit will steadily rise as a share of GDP. Part of that is due to increased obligations to care for an aging population. But the CBO also projects that the federal government will get stuck in a self-feeding cycle, where it has to keep borrowing more money to pay interest on its debtbut the more money it borrows, the more interest it has to pay in the future.

This is definitely not a desirable outcome. Therefore, it is necessary to get the long-term budget deficit under control, which means doing something about controlling the cost of Medicare, Medicaid, and Social Security.

Putting It All Together

As we have seen, there are a lot of things going on simultaneously in fiscal policy. Congress and the president can raise or lower government spending. They can raise or lower taxes. Then the combination of these two decisions can lead to a bigger or smaller budget deficit, which changes the amount of borrowing.

All the fiscal policy actions put together can affect employment, output, inflation, and interest rates. It's useful to see all the impacts in one place.Table 11.3summarizes the positive and negative impacts of the different actions the federal government can take. For example, lowering taxes can create jobs, boost GDP, and provide incentives for work and investmentbut it can also widen the budget deficit and pump up interest rates.

Fiscal Policy Action	How It Can Help	How It Can Hurt
Increase government spending.	Can create jobs and boost GDP, and perhaps do something useful with the spendingfor example, build new bridges and highways.	Can boost inflation and widen the budget deficit, leading to higher interest rates and lower private investment.
Lower taxes.	Can create jobs and boost GDP, and provide incentives for work and investment.	Can boost inflation and widen the budget deficit, leading to higher interest rates and lower private investment.
Accept wider budget deficit.	Can create jobs and boost GDP. Other impacts depend on the particular combination of spending and tax changes.	Can lead to higher interest rates and lower private investment. Over the long run, can lower productivity and GDP growth.