Debating Deficits
Subject Federal Budget
Topic Taxes, Spending, and Deficits
Key Words Budget Deficit, Budget Surplus, GDP
News Story

President Bush submitted his $2.13 trillion budget, which will result in budget deficits replacing what had been forecasts of a surplus in fiscal years 2003 through 2005. War-related expenditures and the need for increased domestic security to prevent terrorist attacks are accepted reasons for increased spending. What is being debated is whether the increased spending should come at the expense of other programs or by incurring a deficit. In particular, there is a controversy as to whether budget deficits and rising debt harm the economy by pushing up long-term interest rates.

Democrats, among others, argue that deficit spending means increased borrowing that raises interest rates. According to this view, the federal government competes with potential investors for scarce savings and therefore, money lent to the government is not available to finance business expansion and new capital equipment. Economic growth is curtailed when investment is reduced and, as a result of rising interest rates, consumers must pay higher mortgage costs, car and college loans, and credit card payments. Democrats claim that the current deficit and forecasted shortfalls are the result of last-year's tax cut and increased military spending.

Republicans believe that last-year's tax cut was needed to stimulate the economy and spending for that purpose should be the highest priority. When the economy weakens, tax revenues decrease and some programs, like unemployment compensation and food stamps, must increase. It is the economy that drives the budget and as the economy improves, so will the budget picture. Republicans favor balanced budgets and look to downsizing government programs and increased competition from the private sector to restore fiscal austerity.

Alan Greenspan, chairman of the Federal Reserve and a Republican, has made a number of statements recently that support the Democrats' contention. Mr. Greenspan said that the worsening fiscal outlook has had an effect on raising long-term interest rates. On the other hand, the most widely cited research on the impact of deficits on interest rates found that "the interest rate effects of typical changes in government debt are quite small."

(Updated March 20, 2002)

1. Draw an aggregate demand/aggregate supply diagram and illustrate an economy initially at equilibrium with a recessionary gap. Carefully label the equilibrium level of real GDP and the aggregate price level. Illustrate the impact of an increase in government spending on equilibrium values of real GDP and prices.
2. If the government were to run a deficit, how is the deficit typically financed?
3. Now draw an investment demand and supply of savings function illustrating the equilibrium interest rate and the volume of savings/investment. What is the impact on the savings supply schedule of a federal budget deficit? What is the impact on interest rates and the volume of savings/investment?
4. What is the impact of higher interest rates on investment demand? Consumption? Real GDP?
Source Richard W. Stevenson, "On Tax Cuts And Deficits, A Battle of Believers," The New York Times, February 10, 2002.

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