Budget Deficits, National Debt and Interest Rates

A previous video lesson (Introduction to Bond Markets and Interest Rate Determination), it was explained that under some circumstances, persistent government budget deficits and growing national debt can drive up interest rates as investors’ demand for the nation’s bonds decreases while supply increases, driving up the government’s borrowing costs.

In this lesson we will examine the circumstances under which this “crowding-out effect” will NOT occur, by looking at data on budgets balances, interest rates and savings rates for the United States between 2000 and 2011.


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Introduction to Bond Markets and Interest Rate Determination

One of the least understood topics among introductory Econ students is how bond markets work. This video lesson introduces the bond market, and explains how the demand for a government’s debt is an important determination of the borrowing costs faced by that government. We will answer some important questions about bond markets, such as, “What’s the relationship between bond prices and bond yields?” and “How could budget deficits and debt affect interest rates?”

In the next video we’ll examine circumstances under which large budget deficits and national debt may NOT drive up a government’s borrowing costs.

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The Relationships between Budget Deficits, Surplus and National Debt

In this lesson we distinguish between the different situations a government’s budget may be in and explain how the level of national debt is determined by past years’ budget balances.

We will examine several case studies within Europe and outline the circumstances under which government debt is considered to be a burden and when it is not, according to the terms outline in the European Union’s Stability and Growth Pact

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Automatic Stabilizers in Fiscal Policy

Fiscal policy takes two distinct forms: that which requires legislation to enact, and that which kicks in automatically when there is a change in the level of income in a country.

This lesson distinguishes between discretionary fiscal policy and automatic stabilizers in fiscal policy, and examines the mitigating effect of automatic fiscal policy in an AD/AS diagram.

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Different Tax Systems’ Effects on Income Distribution (part 1)

There are two things in life that are guaranteed: Death and… taxes. But how a tax affects individuals and society depends on the tax system in place in a particular country. Three tax systems exist, often alongside one another, in different countries and to varying degrees. These are:

  • Progressive income taxes
  • Proportional income taxes
  • Regressive Consumption taxes

This video will outline the different effects of the three tax systems on three hypothetical individuals earning different levels of income.

Part one shows how to calculate the amount of tax paid and the average tax rates under a progressive marginal income tax system and a proportional tax system.

Part 2 will calculate the amount of tax paid and the average tax rates on three individuals under a consumption tax system and explore the impact of the three different tax systems on a nation’s income distribution using a Lorenz curve.

In the second part of this lesson we will calculate the impact of consumption taxes on the amount of tax paid and the average tax rate of three hypothetical individuals. We will then compare the three tax systems (progressive marginal income taxes, proportional income taxes and consumption taxes) on a country’s income distribution using a Lorenz curve.

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Evaluating the Effectiveness of Monetary Policy During Recessions

Monetary Policy is often employed during recessions to try and stimulate aggregate demand by reducing interest rates in the banking system. The effectiveness of these policies, however, depends on just how responsive the private sector is to decreases in the interest rate initiated by the central bank.

During mild recessions, when Investment demand is still relatively strong and businesses will respond to lower interest rates by demanding more funds for capital investments, expansionary monetary policy can be relatively effective at stimulating aggregate demand and moving the economy back towards its full employment level of output. However, if a country is in a deep recession, then investment demand will be weak and businesses will be relatively unresponsive to lower interest rates, as low confidence and the expectation of future deflation creates a strong incentive to save, rather than invest.

This lesson will use the money market diagram and the investment demand curve in the loanable funds market to evaluate the effectiveness of monetary policy during recessions. Based on this evaluation, we can better understand the circumstances under which expansionary fiscal policy may be justified, despite its effect on deficits and debt.

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Introduction to Supply-side Policies

This lesson will introduce some of the market-oriented and interventionist supply-side macroeconomic policies a government may implement to promote the accomplishment of objectives such as full employment, economic growth and price level stability.
Supply side policies contrast with demand-side fiscal and monetary policies, which are aimed at stimulating or contracting the level of spending in an economy. Supply-side policies, on the other hand, are meant to stimulate production among the nation’s firms by either reducing the costs faced by firms through deregulation and labor market reforms or by improving the productivity of the human and physical capital available to producers. If successful, supply-side policies will stimulate job creation and economic growth, allowing output and employment to increase while maintaining a stable price level in the economy.

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The Business Cycle – Illustrating the Economy’s Booms and Busts

The business cycle model is one often referred to in the media, which likes to use terms like “boom’ and ‘bust’. It is a model that can communicate several important pieces of information about a nation’s economy. Basically, the business cycles is a graph which shows the level of real GDP over time. The vertical axis shows the level of GDP, and horizontal axis time.

A typical nation’s business cycle will most likely look like a wave, showing how GDP rises and falls over time. Assuming the country is achieving economic growth over the long-run, business cycle’s ‘line of best fit’ or ‘trend line’ will slop upwards, indicating that over the span of years or decades, a nation’s economy will produce more output. But over shorter periods of time, output may fluctuate, as the economy experiences those ‘booms and busts’ the media are so fond of.

There are four fundamental phases in any nation’s business cycle:

  • Expansion: Also known as the recovery phase, when the nation’s output is rising at a rate faster than the long-run trend.
  • Peak: This is the end of a period of expansion, when output begins to decline
  • Contraction: Also known as the recession phase, when the nation’s output is falling over time.
  • Trough: This is the end of a period of recession, when output begins to recover (the economy enters an expansion phase again).

This video lesson will explore the four phases of a nation’s business cycles and explain how the goal of macroeconomic policies is to ‘smooth out’ the fluctuations in the business cycle, and thereby reduce the amount of uncertainty faced by a nation’s households and firms regarding the future level of economic activity.

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Updated: Real versus Nominal GDP and the GDP Deflator

A nation’s GDP measure’s the value of its output of goods and services in a particular period of time. Gross Domestic Product is expressed in dollar terms, which means that if the price of goods and services rise, a country’s nominal GDP figure will increase. The problem with this is that an increase in the nominal (numerical) value of a country’s output can increase when price levels rise, even if the actual level of output remains the same.

For this reason, it is important to adjust a nation’s nominal GDP for any changes in the price level that occur between two periods of time. Once nominal GDP is adjusted for inflation or deflation, we arrive at real GDP, which is a much more accurate measurement of the actual level of output in a nation, adjusting for any changes in prices.

This lesson will define nominal and real GDP and use a numerical example to illustrate why measuring nominal GDP produces a false impression of the actual level of output a nation is producing from one year to the next. We will then use a simple formula to determine the GDP deflator, the price index that allows us to adjust nominal GDP to arrive at real GDP.

To order practice activities on this and other lessons from the Econ Classroom, click here.

For student revision guides and teacher PowerPoints, click here.

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