Order Code RL31235
The Economics of the Federal Budget Deficit
Updated January 25, 2008
Brian W. Cashell
Specialist in Macroeconomic Policy
Government and Finance Division

The Economics of the Federal Budget Deficit
Summary
The Congressional Budget Office (CBO) estimates that the federal budget
deficit for FY2007 was $161 billion, a decline from the $248 billion deficit recorded
in FY2006. The CBO expects the deficit for FY2008 to be $407 billion.
Over fairly short periods of time, say three or four years, fiscal policy can affect
the rate of economic growth by adding to, or subtracting from, aggregate demand.
For a time, the effect on the economy may even be larger than the initial change in
the budget. These effects, however, tend eventually to diminish because of either
higher interest rates or rising prices. Estimates of the multiplier effect on the
economy of a change in fiscal policy vary, but most of them suggest that it reaches
a peak somewhere between one and one-and-a-half times size of the change in the
budget. In most economic models, that peak effect is realized within one or two
years of the initial change in policy.
One measure economists use to assess fiscal policy is the structural, or
standardized-employment, budget. This measure estimates, at a given time, what
outlays, receipts, and the surplus or deficit would be if the economy were at full
employment. Although the actual budget was in surplus beginning in 1998, the
standardized measure first registered a balanced budget in 1999. Between 1992 and
2000, the actual budget surplus increased from -4.7% (a deficit of 4.7%) to 2.4% of
gross domestic product (GDP), a shift of 7.1 percentage points. During the same
period, the standardized measure rose from -2.9% to 1.1% of GDP. That suggests
that a little more than half of the shift was the result of changes in policy, and a little
less than half was attributable to the economic expansion. Between 2000 and 2007,
the actual surplus fell from 2.4% to -1.2% of GDP, whereas the standardized measure
fell from 1.1% to -1.2% of GDP.
In the long run, economic growth is determined primarily by three factors:
growth in the labor force, the rate of technological advance, and the amount of capital
available to the workforce. Of the three, the last one may be the most susceptible to
the influence of policymakers. The larger the capital stock is, the more productive
the labor force tends to be. Although it is possible for fiscal policy to have an effect
on the rate of technological progress in the way public money is spent, it probably
has a much larger effect on growth through its influence on the size of the domestic
stock of capital and the amount of capital available for each worker in the labor force.

Contents
Recent Budget History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Deficit or Surplus, What Difference Does it Make? . . . . . . . . . . . . . . . . . . . . . . . 3
Fiscal Policy in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Limits on Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Standardized Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Fiscal Policy in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Net Capital Inflows Reflect Net Imports . . . . . . . . . . . . . . . . . . . . . . . . 8
Reducing the Federal Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
List of Figures
Figure 1. Outlays, Receipts, and the Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Figure 2. Actual and Standardized Budget Surplus . . . . . . . . . . . . . . . . . . . . . . . . 6
Figure 3. Sources of Saving by Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Figure 4. Federal Debt Held by the Public as a Percentage of GDP . . . . . . . . . . 11

The Economics of the
Federal Budget Deficit
The Congressional Budget Office (CBO) estimates that the federal budget
deficit for FY2007 was $161 billion, a decline from the $248 billion deficit recorded
in FY2006. The CBO expects the deficit for FY2008 to be $407 billion.1
During the second half of the 1990s, deficit reduction was an important
objective in the setting of overall budget policy. Between 1992 and 1998, a
combination of budget policy and a booming economy entirely eliminated the deficit.
But after four successive years of surpluses, outlays again exceeded revenues in 2002
and the budget has been in deficit since then.
Strictly speaking, economics generally has little to say regarding whether a
budget deficit is a good thing or not. Whether the budget is in deficit or surplus, and
whether the budget deficit is growing or shrinking, have consequences for the
performance of the economy, both in the short and long run. At the same time, the
performance of the economy can have substantial effects on the budget as well.
Recent Budget History
The share of income that is saved is simply a reflection of relative preferences
for current and future consumption. From an economic standpoint, there is no
optimal rate of saving. Nonetheless, raising the national rate of saving has long been
a goal of policymakers.
Most economists, however, believe the capacity of public policy to influence
private saving behavior is limited. The one certain way to raise the national saving
rate through public policy is to increase the public sector saving rate, and that is what
happened in the 1990s. The national saving rate rose after 1995 because increases
in public saving more than offset falling private saving.
In recent history, budget surpluses have been rare, and a succession of surpluses
rarer still.2 In every year between FY1969 and FY1998, the federal budget was in
deficit; that is, outlays exceeded receipts. Beginning in 1929 and until 1969, the
budget was in surplus for a total of nine years, and during that time was never in
surplus for more than three years in a row.
1 Congressional Budget Office, The Budget and Economic Outlook: An Update, Sept. 2008.
2 Unless otherwise specified, in this report surpluses and deficits (negative surpluses) reflect
both on- and off-budget receipts and outlays. That is, they are from the unified budget.


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Figure 1 presents figures for federal budget outlays, receipts, and the surplus
beginning in 1977. Rather than showing dollar amounts, each of the three series is
expressed as a percentage of gross domestic product (GDP). Showing the figures in
this way focuses attention on the size of the budget aggregates relative to the
economy as a whole.
Figure 1. Outlays, Receipts, and the Surplus
Source: Congressional Budget Office.
An economic downturn began in mid-1981 and ended in late 1982 contributing
to a drop in the surplus, to -6.0% of GDP in 1983. Since then, with a brief reversal
attributable to an economic contraction in 1990 and 1991, the surplus increased
steadily until 2000. In 2001, the surplus fell from 2.4% of GDP the previous year to
1.3% of GDP. In 2002, there was a negative surplus (a budget deficit) of -1.5%
(1.5%) of GDP and by 2004 it had reached -3.6% of GDP. Since 2004, the surplus
(deficit) has risen (fallen) each year.

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Deficit or Surplus, What Difference Does it Make?
The federal budget and the economy are closely interrelated. The strength or
weakness of the overall economy affects the levels of outlays and receipts
substantially. The budget also has significant effects on the economy, both in terms
of how fast the economy grows, and also in terms of the overall allocation of
resources.
Fiscal Policy in the Short Run
Over fairly short periods of time, say three or four years, fiscal policy can affect
the rate of economic growth by adding to, or subtracting from, aggregate demand.
Consider, for example, a one-time increase in total federal spending, with no
matching rise in tax receipts. Each additional dollar of government spending
becomes income for those who satisfy the initial increase in demand for public goods
and services. In turn some of that increase in income will be spent, raising the
income of those who satisfy a second wave of increased demand for goods and
services. Theoretically, this process continues with each successive increment to
income getting smaller and smaller as some is saved and some is spent.
Because of the initial increase in spending and the additional spending that is
subsequently stimulated, the economy grows somewhat faster than it otherwise
would have. For a time, the size of the economy may even increase by more than the
initial increase in government spending. Government spending is thus said to have
a ‘multiplier effect.’ There can also be a multiplier effect in the case of a spending
cut, although the effect is in the opposite direction. If the government reduces
spending, that can cut the incomes of those who otherwise would have provided
goods and services to the government. If it does, they must either reduce their
spending or their saving. To the extent that they cut spending, it adds to the decline
in output initiated by the cut in public spending.
The government may also be able to influence the rate of economic growth in
the short run via tax cuts or increases. Just as an increase in public sector spending
temporarily increases some incomes, so a tax cut increases the amount of income
taxpayers have at their disposal. Some of that increase in after tax income is likely
to be spent, and so tax cuts may have a multiplier effect just as changes in
government spending do. A tax increase reduces disposable income, and so
contributes to a slowdown in private sector spending.
Limits on Fiscal Policy. That is not the end of the story, however. In the
view of most economists, the government cannot permanently increase the size of the
economy just by increasing spending, or cutting taxes. As is often the case in
economics, other things do not remain equal. An increase in spending, or a tax cut,
increases the deficit and so increases the public sector’s demand for credit. Increased
credit demand tends to raise interest rates. Higher interest rates, in turn, discourage
borrowing in the rest of the economy for those activities that depend on credit,
especially housing and consumer durable goods.

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Higher interest rates also tend to make dollar-denominated financial assets more
attractive to overseas investors. To buy those assets, however, foreigners must first
buy dollars. This increased demand for dollars pushes the foreign exchange value of
the dollar above what it otherwise would have been. The ‘stronger’ dollar makes
imported goods cheaper, and makes goods and services produced in the United States
more expensive abroad. The change in prices tends to increase demand for U.S.
imports and reduce demand abroad for U.S. exports, raising the trade, or current
account, deficit. Thus, some of the stimulus is, in a sense, exported.
Fiscal policy may also affect prices. An increase in aggregate demand,
stimulated by an increase in spending or a cut in taxes, can be satisfied in one of two
ways; either an increase in real production, or an increase in the general price level.3
If the economy is already operating at full employment, and the capital stock is
operating at or near full capacity, then it is more likely that any increase in demand
will be met by higher prices than by increased production of goods and services. In
a fully employed economy, an increase in government spending would yield a much
larger increase in nominal than it would in real GDP.
In a slack economy, with high unemployment and idle resources, a stimulative
fiscal policy would be less likely, at least initially, to push up prices. Instead, any
increase in demand could be met by increased employment and capacity utilization
rates. In an economy with excess capacity, a stimulative fiscal policy would tend to
increase the production of goods and services more than it would prices, and any
increases in real and nominal GDP would tend to be of similar size.
Given a sufficient fiscal policy boost, a slack economy would tend gradually to
converge to full employment. As the economy approaches full employment of both
labor and capital, additional increases in aggregate demand would be more likely to
be satisfied by higher prices than by increased real output.
Whether because of higher interest rates or rising prices, any effects of an
increase in government spending, or a tax cut, on the rate of economic growth tend
to diminish over time. Estimates of the multiplier effect of a change in fiscal policy
vary, but most of them suggest that it reaches a peak value of somewhere between
one and one-and-a-half times the original stimulus. In most economic models, that
peak effect is realized within one or two years of the initial change in policy. In other
words, for every dollar increase in federal spending, the economy, within a year or
two, will be larger than it otherwise would have been by somewhere between a dollar
and a dollar-and-a-half.
Not all changes in spending and taxes, however, reflect changes in fiscal policy.
Just as the budget can have an effect on short-run economic growth, the rate of
economic growth can also have an effect on the budget. Faster economic growth
tends to raise revenues above, and reduce outlays below, what they otherwise would
have been. Faster growth means more people are working, which raises taxable
incomes, which in concert with progressive tax rates increases tax receipts. Faster
economic growth, along with higher incomes and employment, tends to reduce
3 In the short run, to which this discussion is limited, supply is more or less fixed.

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outlays, especially for spending on unemployment insurance and various income
support programs.
What this means is that it may be difficult to examine the ups and downs in the
budget, and in the deficit in particular, and discern whether those changes reflect the
fluctuations of the economy, or are due to deliberate changes in budget policy.
The Standardized Budget. One measure economists use to assess fiscal
policy is the structural, or standardized-employment, budget. This measure
estimates, at a given time, what outlays, receipts, and the surplus or deficit would be
if the economy were at full employment. It is a way of separating changes in the
budget totals that are due to changes in overall economic conditions from those
changes that are the result of deliberate changes in tax and spending policy. Changes
in the standardized-employment surplus reflect changes in policy and are not affected
by variations in underlying economic conditions. For example, if the economy is less
than fully employed, then the standardized measure of outlays is less than actual
outlays, standardized receipts are higher than actual receipts, and the standardized
budget deficit would be smaller than the actual deficit.
Economists track the standardized-employment surplus as a percentage of
potential GDP to assess if fiscal policy is stimulative or contractionary. As the
economy grows, outlays and receipts tend to rise as well. Comparing the budget to
GDP filters out changes due to variations in the overall size of the economy.
Potential GDP is an estimate of what the total value of production of goods and
services would be if labor and capital resources were fully employed. Using potential
GDP as a base for comparison avoids the problem of cyclical factors masking
changes in fiscal policy. A decrease in the standardized budget deficit relative to
potential GDP would be considered indicative of a contractionary fiscal policy.
Similarly, an increase in the standardized budget deficit as a percentage of potential
GDP would be indicative of a stimulative fiscal policy.
The CBO regularly publishes estimates of the standardized budget.4 Figure 2
compares the standardized budget surplus (deficits are simply negative surpluses)
with the actual surplus since 1977, both as a percentage of GDP.5
4 Congressional Budget Office, The Cyclically Adjusted and Standardized Budget Measures:
An Update
, August 2007.
5 It should be noted that these data incorporate other adjustments in addition to the one
related to the business cycle. These adjustments removed, for example, the effects of
outlays for deposit insurance, receipts from auctions of the electromagnetic spectrum, and
foreign contributions related to Operation Desert Storm — all of which are considered to
be one-time events or otherwise unrelated to discretionary policy.


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Figure 2. Actual and Standardized Budget Surplus
Source: Congressional Budget Office.
For the most part, the two series exhibit the same behavior over time. Since
1977, however, the two have moved in opposite directions on numerous occasions,
indicating that either the surplus rose at a time that fiscal policy was actually
expansionary or that it fell at a time when fiscal policy was actually contractionary.
Most of the time, the actual budget surplus has been smaller than the standardized
measure, suggesting that, at least by CBO’s calculations, the economy has, more
often than not, been less than fully employed.
Between 1997 and 2001, the actual surplus was larger than the standardized
measure. Although the actual budget was in surplus between 1998 and 2001, the
standardized measure first registered a balanced budget in 1999. Between 1992 and
2000, the actual budget surplus increased from -4.7% to 2.4% of GDP, a shift of 7.1
percentage points. Over the same period, the standardized measure rose from -2.9%
to 1.1% of GDP. That suggests that a little more than half of the shift during that
period was the result of changes in policy, and a little less than half was attributable
to improving economic conditions.
Between 1992 and 2000, fiscal policy, as measured by changes in the
standardized budget surplus, was contractionary. In every year between 1992 and
2000, the standardized surplus grew relative to GDP. Between 1992 and 2000, the
average increase per year in the surplus was 0.5% of GDP. The average annual rate
of increase in real GDP over the same period was 3.7%. Although fiscal policy was
contractionary, other factors contributing to economic growth more than
compensated. Between 2000 and 2003, the standardized surplus fell, suggesting that

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fiscal policy was expansionary. Since 2003, it has risen slightly in each year,
indicating a modest contractionary effect.
Fiscal Policy in the Long Run
A constant deficit or surplus, by itself, is believed to have little if any effect on
the short run rate of economic growth. It is changes in the surplus that matter for
short run growth. However, whether the budget is in surplus or not does have
consequences for the composition of economic output, and that can have an effect on
growth in the long run.
In the long run, economic growth is determined primarily by three factors:
growth in the labor force, the rate of technological advance, and the amount of capital
available to the workforce. Of the three, the last one may be the most susceptible to
the influence of policymakers. The larger the capital stock, the more productive the
labor force tends to be.
Although it may be possible for fiscal policy to have an effect on the rate of
technological progress in the way public money is spent, it probably has a much
larger effect on growth through its influence on the size of the domestic stock of
capital and the amount of capital available to each worker in the labor force. How
this comes about can be illustrated by a brief introduction to economic accounting.
The total value of national output can be measured in two ways. Either the total
value of the goods and services produced can be added up, or the total value of the
incomes resulting from that production can be counted. These two accounts, at least
in the abstract, add up to the same total.
The measure of total output based on the value of production is typically
subdivided into several categories of demand. Specifically, it is calculated as the sum
of consumption spending (C), investment (I), government spending (G) and the
difference between exports (X) and imports (M):
GDP = C + I + G + (X - M).
The alternative measure of total output is the sum of the various uses to which
income is allocated. On this side of the economic accounting ledger the value of
national output is expressed as the sum of consumption (C), private sector saving
(S)6, and tax payments (T):
GDP = C + S + T.
6 For the purposes of this explanation, State and local government saving is included in
public saving. Most of the variations in the public sector saving rate, however, are
attributable to the federal government.

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Combining the two equations, and simplifying gives:
I = S + (T - G) + (M - X).
That is, total investment spending is equal to the sum of private saving (S), the
government budget surplus (T - G, which, if it is negative, is a deficit), and the
difference between imports and exports of goods and services (M - X). The last
equation is an identity. In other words, investment is by definition equal to the sum
of private saving, the budget surplus, and net capital inflows from abroad. Other
things being equal, a reduction in public sector saving means less investment and
slower growth in the capital stock.
Net Capital Inflows Reflect Net Imports. Along with international flows
of goods and services, financial capital flows back and forth between countries. If
the value of imports exceeds the value of exports, then other things (i.e., investment,
saving and the budget surplus) being equal, capital inflows will exceed capital
outflows; otherwise there would be no way of paying for the excess of imports over
exports.
Among other things, an increase in either private or public sector saving may
have an effect on the amount of foreign financial capital flowing into the United
States. One reason that might happen would be that an increase in domestic saving
would tend to push interest rates down in the United States. That would make
domestic financial assets less attractive to foreign investors and make foreign
financial assets more attractive to U.S. investors. Thus, changes in domestic saving
and net foreign investment could offset one another.
Figure 3 shows each of the three sources of investment funds over the past eight
years, each one expressed as a percent of GDP. Private saving includes the saving
of households and businesses. Public saving here reflects federal, state, and local
governments.
In 1996, the public sector contribution to national saving was small — less than
1% of GDP. By 2000, public sector saving had risen to 4.4% of GDP, but has since
fallen, and in 2007 accounted for about 0.5% of GDP. Between 1996 and 2007,
private sector saving fell from 15.8% of GDP to about 13%. Net inflows of foreign
capital rose from 1.3% of GDP in 1996 to over 5% in 2007. Total funds available
for investment in the United States, from all sources rose from 17.8% of GDP in
1996 to 22.1% in 2000, before falling below 20% in 2007.7
Saving from domestic sources, public and private, rose from 16.5% in 1996 to
18.3% in 1998, but has since fallen below 14% in 2007. At the same time, because
of rising inflows of foreign capital, the claims of foreign investors to income from
the domestic capital stock were increasing. In the 1980s, large inflows of foreign
capital were typically associated with large federal budget deficits. These deficits
7 Even though the federal budget was not in surplus until 1998, the public sector saving rate
was positive beginning in 1996 because of the surpluses of state and local governments.


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added to domestic credit demands and pushed up interest rates. More recently, other
factors may also have been at work.
Figure 3. Sources of Saving by Sector
Source: Department of Commerce, Bureau of Economic Analysis.
Two reasons have been suggested for the increased foreign capital inflows at a
time when public sector surpluses were rising. One is that because the domestic
economy is doing so well — in particular, productivity growth seems to have
accelerated — there has been a surge in profitable investment opportunities. The
other is that even in the absence of an increased yield on U.S. assets, foreign capital
may have flowed here because of a perception of increased risk in countries where
the capital might otherwise have been invested. In this case, the United States serves
as a ‘safe haven’ for foreign capital. The economy will likely be more productive in
the future than it would have been in the absence of any increase investment, but of
that increase in output will have to be paid out to foreign investors as either rents,
interest, or dividends.
The increase in investment spending of the 1990s was made possible by both
the increase in national saving and an increase in foreign capital coming into the
country. After 2000, there was a decline in saving from domestic sources, due
primarily to a drop in public saving. Capital inflows from abroad did not offset the
decline, and so total funds available for investment, measured as a share of GDP, fell.

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Reducing the Federal Debt
Perhaps the most obvious effect of the federal government budget surpluses of
the 1990s was a decline in the amount of federal debt. From an economic
perspective, however, the measure of debt that matters more is not the absolute level
in dollar terms, but rather the debt relative to total output, or GDP. From this
perspective, the debt began to fall in 1993.
Many economists believe that a steadily growing federal debt is not by itself a
cause for concern. As long as the federal debt grows faster than GDP, however,
interest payments on that debt will constitute an ever-increasing share of total federal
spending and of GDP. If investors should come to expect that the debt would grow
faster then GDP indefinitely, and that the debt-to-GDP ratio would continue to rise,
they might eventually become unwilling to buy new issues of federal debt. In that
case, the Federal Reserve might be the only buyer and that would likely lead to an
accelerating rate of inflation.
In the long run, the relationship between the growth rate of the federal debt and
the overall rate of economic growth is critical to financial stability. Perpetual debt
growth in excess of the rate of economic growth is an inherently unstable situation.
It is likely that investors would become unwilling to buy federal debt issues long
before all of GDP was accounted for by the interest payment on the federal debt,
because of growing doubts about the government’s ability to raise sufficient revenue
to pay just the interest on that debt.8
Whether the debt-to-GDP ratio is on such an explosive path depends on the rate
of interest and the rate of growth of GDP. Consider the case where the budget is in
balance except for the interest payment on the debt. That is, the budget deficit is
equal to the interest payment. In this example, the debt would grow each year by an
amount equal to the interest cost of financing the debt; thus the growth rate of the
debt would equal the interest rate. If the interest rate on the federal debt remained
above the economic growth rate, then the debt would grow faster than GDP and the
ratio of debt to national output would rise. The converse is also true; as long as the
interest rate on the debt remains below the growth rate of GDP, then the ratio of debt
to income will fall.9
8 Should the federal government be unable to find private sector buyers for its securities
there would be two possible outcomes. First, the federal government would simply be
unable to meet all of its obligations. Second, and the more likely of the two, rather than
allow the federal government to default, the Federal Reserve would buy those securities.
Although the Federal Reserve is independent and under no legal obligation to ensure the sale
of government securities, it might well step in to avert default. Should it come to that, the
threat would not be one of government insolvency, but rather of inflation.
9 Inflation can cause both the interest rate and the growth rate of GDP to rise. Interest rates
usually reflect investors’ inflation expectations, but a substantial rise in the price level that
was unexpected by holders of existing debt would raise nominal GDP, but not the level of
outstanding debt, and the debt-GDP ratio would fall.


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Thus even with a budget deficit, the ratio of debt to national income can fall.
For the United States, the recent peak level of the federal debt relative to GDP was
reached in 1993 at 49.4%, when the budget deficit was $255 billion. In 1994, even
though the deficit was still over $200 billion, the debt fell relative to GDP. By 2001,
federal debt had fallen to a low of 33.0% of GDP. In 2002, the ratio of debt to GDP
began to rise for the first time in eight years, and continued rising through 2005,
when it stood at 37.4%. Since then, debt as a percent of GDP has fallen. In 2007 it
was 36.8% Figure 4 shows the level of the debt-to-GDP ratio since 1977.
Figure 4. Federal Debt Held by the Public as a Percentage of GDP
Source: Congressional Budget Office.
During the period shown in Figure 4, the budget was in deficit most of the time.
Clearly, variations in the ratio of debt to GDP do not depend solely on whether the
budget is in surplus or deficit. As long as the budget is in deficit, however, the ratio
cannot fall to zero. For the sake of long term economic stability, what matters most
is that the ratio is not perpetually rising.10
10 The possibility that eventually all of the federal debt held by the public would be paid off
raises a number of interesting questions. For example, the Federal Reserve manages the size
of the money stock by buying and selling Treasury securities in its open-market operations.
In the absence of a market for federal government debt, the Federal Reserve might have to
(continued...)

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Conclusion
Economics, generally speaking, is neutral with respect to whether one saving
rate is better than another. Ultimately, it is an expression of the public’s relative
preference for present versus future consumption. For the time being, however, the
public sector can also have important effects on the pool of savings.
Whether it is better to have a budget surplus or a deficit, the budget has clear-cut
consequences for the economy. In the short run, whether the budget is in surplus,
makes little difference to economic performance. In the short run, it is changes in the
surplus or deficit that can affect the rate of economic growth. A reduction in the
deficit would tend to be contractionary, while an increase in the deficit would tend
to be stimulative. Those effects, however, are likely to be short lived.
In the long run, a shift from a budget surplus to a deficit represents a reduction
to national saving. Less saving means a shift from future to present consumption.
Consuming more now means less investment now, a lower level of output of goods
and services in the future, and thus, less to consume in the future than otherwise
would have been the case. To the extent that investment is financed by importing
capital from abroad, some of that higher output will be paid to foreigners.
Even with a budget deficit, the outstanding federal debt may still fall, relative
to GDP, but that depends on the size of the deficit, and of the interest payment on the
outstanding debt. A rising debt-to-GDP ratio eventually poses the risk of
accelerating inflation.
10 (...continued)
buy and sell private sector assets to conduct monetary policy. The absence of federal
government debt could also affect the banking sector. Banks hold Treasury securities
among other assets and the fact that they are considered to be riskless assets reduces the
overall risk associated with banks’ portfolios. If risk-free assets are unavailable, adjustments
to these portfolios might be necessary to avoid increasing portfolio risk.