The Government Budget

Review Questions

1. What are the major components of Federal government spending? How has each behaved over the last thirty years?


Transfer payments have increased (from about 6% to 12% of GDP), defense spending has decreased (from more than 8% to less than 3.5% of GDP), real interest outlays have increased (from less than 0.5% to about 2% of GDP), and other expenditures have decreased (from about 3.5% to less than 2% of GDP).


2. Compare the behavior of Federal government spending and revenues over the last thirty years.


Revenues have varied between 18% and 20% of GDP,  and this ratio has not displayed any long-run trend.   Expenditures are about 19% of GDP, about the same as thirty years ago, but this ratio has shown more variation.  Expenditures exceeded 22% of GDP for a few years in the mid-1980s.


3. What is the major difference between the real and conventional measures of the government budget deficit? How large is this difference?


The real deficit recognizes revenue from money creation (reducing the deficit by about $25 billion) and uses real rather than nominal interest expense (reducing the deficit by about $80 billion, depending on the inflation rate). [See the relevant overhead for details of calculations.]


4. What is the primary budget deficit, and why is it a relevant number?


The primary deficit is government purchases plus transfer payments less tax receipts.  Thus, it ignores interest outlays altogether.  It is relevant because governments cannot run primary deficits forever, so it puts an an easily calculated upper limit on the size of the sustainable deficit.  Governments that persistently run primary deficits will eventually either default on their debt or resort to excessive money growth as a source of revenue, which will lead to inflation.


5. Can the government run conventionally-measured budget deficits forever?


Yes, as long as the debt does not forever grow faster than GDP.
6. What are the economic effects of government budget deficits according to the traditional view?


Higher consumption and lower saving, leading to higher interest rates and lower investment in a closed economy (or, as will be seen in the next module, to a stronger currency and a smaller current account balance in an open economy).


7. What are the economic effects of government budget deficits according to the Ricardian view? No change in consumption or any other important variable.


8. What accounts for the difference between the predictions of the conventional and Ricardian views? The difference in consumption behavior.


9. Why is an unfunded social security system like government debt? The government promises to make future payments financed by taxes on future workers.


10. What determines the rate of return on worker contributions to funded and unfunded social security systems? The rate of return in an unfunded system is the rate of growth of aggregate wages, which is roughly equal to the rate of growth of GDP.  The rate of return in a funded system is the net rate of return on capital, which is higher than than the GDP growth rate in most if not all countries.

Show review questions without answers