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.


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.

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

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.

Fiscal Policy – another interpretation of the Crowding-out Effect

In our first lesson on the crowding-out effect we examined the impact that deficit-financed government spending may have on the demand for private loanable funds in the economy. A government’s need to borrow to pay for a fiscal policy drives up private interest rates and could, therefore, crowd-out private investment and consumption, making the fiscal policy less effective at stimulating economic activity.

In this lesson we’ll examine another interpretation of the crowding-out effect, which says the supply of funds available in the private sector will decrease when a government deficit spends, due to the fact that government must offer higher interest rates on its debt, making saving in the private banking system less attractive to households. The supply of loanable funds will therefore decrease, driving up private interest rates and reducing the quantity of investment and consumption among households. The end result is the same: government spending is “crowded-out” by a decline in private spending, rendering the fiscal policy less effective than desired.


Once you’ve watched this video, learn more about the crowding-out effect by reading one of the following blog posts and responding to the discussion questions included:

Fiscal Policy – the Crowding-out Effect

Previous lessons on fiscal policy have explored the multiplier effects resulting from increases in government spending and decreases in taxes. This video will examine the possibility that expansionary fiscal policy, when financed by a budget deficit, will actually result in less private sector spending, i.e. “crowding-out” of the private sector. When governments borrow to pay for a stimulus, this drives up borrowing costs for households and firms, reducing the amount of consumption and investment. The crowding-out effect reduces the effectiveness of expansionary policies aimed at increasing the total demand for a nation’s output.

Once you’ve watched this video, learn more about the crowding-out effect by reading one of the following blog posts and responding to the discussion questions included:


Fiscal Policy – the Tax Multiplier

This is part two of the lessons on the multiplier effects of fiscal policy. The first lesson explained how the Keynesian Spending Multiplier could be found using the marginal propensities to consume and save. Watch that video here before watching the one below.

This lesson illustrates how a tax cut of a particular amount will ultimately affect aggregate demand in the economy and therefore total output. Tax cuts are an indirect injection into the macro-economy, meaning that they put money into the pockets of households, but who then get to decide how much of it to spend on goods and services. For this reason, the tax multiplier is generally thought to be smaller than the spending multiplier. What does this mean for fiscal policy-makers? When considering the possible expansionary effects of a particular tax cut or government spending package, it should be acknowledged that tax cuts, may not provide the level of stimulus as government spending, since some of a tax cut will be saved rather than spent.


Fiscal Policy – the Government Spending Multiplier

This video will introduce and explain the effect of an expansionary fiscal policy on aggregate demand, specifically an increase in government spending. When government spending increases, household incomes rise and therefore consumption increases, further adding to the expansionary effect on Aggregate Demand. If we know the marginal propensity to consume among a nation’s households, we can calculate the size of the spending multiplier, and thereby determine how much of a stimulus would be needed to increase AD by a particular desired amount.

Once you’ve watched the video, read and respond to the discussion questions for one of the following blog posts:

Introduction to Fiscal Policy – Expansionary vs. Contractionary Policies

This video lesson will introduce the use of fiscal policies by a government aimed at expanding or contracting the level of economic activity in the nation. Changing the amount of government spanding and taxation can influence several macroeconomic variables, such as employment, price levels and the level of output.

When should a government alter the level of taxes and spending it engages in? This lesson will introduce two circumstances under which fiscal policy may be used to promote the achievement of various macroeconomics objectives.