Macroeconomic Issues Related to the Federal Deficit and the National Debt

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Table of Contents

Introduction
Effects of deficits on short-run output
Effects of deficit on Unemployment
Effects of deficit on inflation
Works Cited

Introduction

The US economy has been rated the largest economy in the world. In 2011, its nominal gross domestic product was stipulated to be worth $15 trillion. This figure was approximated to be a quarter of the nominal gross domestic product globally. Currently, the government of the United States is working on expanding the opportunities for economic growth, an initiative expected to take two years.

It takes into account the challenges faced by recent fiscal budget, aiming at reducing government spending and elimination of loopholes. In addition, it aims at reducing unnecessary spending by few wealthier Americans and giant corporations.

Although the Senate Budget is working on improving the situation, the Americans are losing hope with their government. However, the Senate is proposing for a strategic plan of laying down a strong economic foundation, which would see job creation, replacement of sequestration, and tackling of debt and deficits responsibly.

According to Congressional Budget Office (CBO ) (1), the economy will grow at a slow pace due to the current changes in the budget. However, as projected by the CBO (3), the rate of unemployment will still stand at 7 percent through out this year. If this does not improve in 2014, then it will be longest period that labor force will be in crisis in the past seven decades.

A nation is termed to be economically stable if it is capable of sustaining its people in all aspects of growth ranging from employment, capital investments and provision of basic amenities.

The US economy has maintained a stable, overall growth rate, high research levels and investments as well as moderate rates of unemployment (Mitchell 1). Economic growth is termed as the wealth increase of a nation’s economy. This is achieved through capitalization growth and overall nation’s production. In addition, this can be affected by the government economic policies and expenditure.

In the last few decades, the world has been experiencing a credit crunch. This has resulted to financial crisis, forcing various reserve banks and governments interventions with an aim of curbing the economic turmoil. Credit crunch refers to a state where interest rates are high resulting to a constrain lending to the customers and businesses because of limited availability of cash. Credit crunch over a period follows a recession, which may stifle the economic growth.

This happens because of a reduced capital liquidity, which in turn limits the chances of borrowing especially from the productive sector. Inability to borrow reduces the expansion chances leading to business stagnation. In extreme cases, it can lead to bankruptcies and close of businesses. This eventually results to detrimental effects on the economy and increases the rate of unemployment. Through this, people lose their homes, assets and financial institutions collapse, prompting central bank and government to intervene for a solution.

As noted by the CBO(4), current laws governing the federal spending and taxes do not change but it is estimated that in 2013, there will be a shrink in budget deficit to about $850 billion which is equivalent to 5.3 percent Gross Domestic Product. It is also postulated that deficits will have a downward move in the few years ahead and in 2015; the GDP will have fallen to 2.4 percent.

Although deficits are expected to have an upward trend in a decade’s time, there are worries of maintaining the ever-rising health costs of the aging population, increase in federal financial support to the health insurance and increasing interests on the federal debts (Mitchell 1). This is an indication of the federal debt remaining at a relative high rate in comparison with the economy size of the coming years. Such debts impacts the economy negatively as increase in interest rates raises the interest of payments on the government spending. In addition, government-borrowing causes a reduction in savings hence contributes to a decline in total income and capital stock.

As observed by the CBO (p.2&3), US economic growth is expected to show a slow move in 2013 and probably show a steady upward trend in the years to come. The current law represents monetary policies, which according to experts; is expected to be lower than the maximum level in the next four years.

In the fourth quarter of financial year 2012, the GDP was below its potential level, which was 6 percent. As economy is expected to adjust in 2013, rapid growth is projected because of underlying factors of economy. According to CBO (4), a 3.4 percent growth is expected to be realized in 2014 and this will be followed by a 3.6 percent average in the next four years.

This means that effects of financial and housing crisis will fade as construction of more housing units will be realized. This will encourage an increase in the prices of stocks and credit availability. In turn, this will see a faster growth cycle in business investments, employment, consumer spending and income.

Effects of deficit on interest rates on Government debt and on bank loans

There is also a question of effects of federal budget deficits on federal debts and their interest rates. The effect is dependent on the upward trend of the interest rates. However, some economists such as Friedman feel that there is a significant effect on interest rates because of government borrowing (Hubbart, 4).

This can only be explained through a theoretical framework in describing the effects of interest rates because of government borrowing. Interest rate affects the level of the capital stock, which is the federal debt level (Broun 1).

What is affected by the federal budget deficit, which is equivalent to government debt level, is the change in the rate of interest. Empirically, this may sometimes differ significantly depending on whether debt or deficit is used. In an empirical work point of view, the difference in specifications implies that the deficit is reverted on interest rate levels (Seater 1).

The government can achieve economic intervention through realigning fiscal policies. The US Government is focusing to achieve this in the next decade through changing the taxation level and government spending. This influences aggregate demand and the economic activity.

Reduced inflation rate and stimulated economic growth will be realized from such an effort. On the other hand, reserve banks will achieve this through adjusting the monitory policies in favor of businesses. In the recent years, real estates and banking sectors have been strongly affected by the fluctuating interest rates.

The Federal Reserve Bank has made efforts to reduce the interest rates through changing reserve banks requirements, money supply manipulation in the open market and changing the rate on loans to banks. The federal bank may opt to raise the interest rate in case of inflation in an effort to improve the economic growth (Hubbart 25).

There are other aspects, which determine the rate of interest in the credit market. For instance, in a stable economy, the fiscal authority purchases federal debt aiming at expansion of the money supply. This tries to maintain prices at a constant level. As observed in the studies, federal debt held by lending institutions such as central banks do not swarm out capital formulation in the private sector.

For instance, over the last decades, the federal debt detained in the hands of the public as GDP percentage kept on fluctuating from a high note of 60 percent to a low value of about 25 percent in 1970s. The federal debt increased between 1980 and 1990 to about 50 percent GDP. However, this declined thereafter to less than 40 percent GDP but in 2007 to 2009, this rose sharply to 60 percent and above. This is a period when US economy experienced a financial crisis.

Empirically, studies on the federal debt and rates of interest ignore purchase of federal debt by the central bank (Hubbart, 18). Both domestic and foreign investors were seen to retain monetary gains that the public surrendered to the federal government. In a bid to conduct fiscal policy, the Federal and the US fiscal authorities held securities as assets.

Currently, the Federal Reserve holds treasury securities amounting to 11 percent (Krugman 125). According to economists, an economy that is on recovery, the Federal Reserve must possess treasury securities that would see expansion of money supply as well as prevention of deflation (Mitchell 1).

Effects of deficits on short-run output

Deficit reduction tends to generate a minor negative impact on the GDP particularly on the short run. This happens if the economy is strong and if minimal constrains on the monetary policy were felt in the ability to handle economic headwinds. Through reducing the short-term interest rates, the Federal Reserve seeks to eliminate the tightened fiscal policy.

The Federal Reserve may opt to reduce the interest to low near zero in case the outputs are below the potential levels. This means that the Federal Reserve may not be in a position to lower the short-term interest any more in order to eliminate the negative effects of the short-run on the GDP. This is concerning the reduction of spending and tax increase (Thomas 1).

In case the output approaches economy’s potential for a given period, the Federal Reserve develop measures to increase the short-term interest rates slightly above the zero mark. When this happens, the fiscal tightening may have no or smaller effect on GDP and unemployment.

Reduction in deficit is seen to have a little effect on the short-run output. Deficits on short run output have an effect of ending recession but this depends on the government spending on the money borrowed. However, failure of government borrowing means a shortfall in productive investments. In such a case, short-run out puts are not a means to go by. Following an economic downturn, jobs are lost and the rate of spending decreases. Use of short run out put deficits stimulates people’s spending hence increasing tax receipts (Elmendorf 1).

For instance, deficits have affected the economy of the US in that this has affected the employment sector. In the recent years, US economy has provided employment opportunities. However, the federal deficit is at inflation since the extensive federal spending, which is higher than its revenue adds more pressure to the US economy. In addition, investments such as housing have also been retarded.

Effects of deficit on Unemployment

As observed by Krugman (4), the US economy has been affected by the federal government deficit, which touches on key pillars of the economy such as employment. Since the era of Great Depression, America has been hard hit by the high rates unemployment, which is seen to demoralize workers (Krugman 5).

The most worrying thing is that when one loses his/her job, he/she loses the health insurance as well. As the rates of unemployment increases, household spending is also affected in that families cannot make savings or pay their bills, which in the end leads to loss of property.

In macroeconomic terms, long-term unemployment is contributed by poor policy formulation, which is beyond anyone’s control. The long term effects of losing a job in America is that it becomes hard to find another one and one becomes unemployable. Surprisingly, the rate of unemployment among the youth is higher that that of the older generation.

This means that the American workforce will be in crisis in the near future since the older generation lacks skills and knowledge required by the modern economy. In addition, Krugman(6) noted that there has been a fall in wages to those in full time employment since most of the Americans have no choice but take menial jobs, which do not match with their qualifications.

High rates of unemployment have affected families in that most of the youths between twenty-four and thirty-four years of age are still in their parent’s hands since their opportunities to live on their own are diminished.

The federal government expenditure has an overall effect on the Gross Domestic Product (GDP). This is the overall performance of the economy in terms of goods and services generated in a certain period. Government income contributes to wages, taxes and profits realized in a fiscal year. Research conducted by (CBO p.4) indicates that GDP will probably maintain a maximum level, which is sustainable in the coming decade.

Between the years 2013 and 2019, the real GDP will have an upward trend of about 2.25 percent yearly (Krugman 35). This growth is however slower than what it experienced some years back. Furthermore, there will be a slow growth in labor force, as baby boomers will be retiring. In addition, the rate of unemployment will decrease to about 5.2 percent by the year 2023.

Rates of interest and inflation will however remain steady through out this period. In this year alone, revenues are expected to have an upward trend due to increase in taxes and income from individuals to a level of about of about 12 percent. This will be due to the increase in income on investments and taxes, which will affect the highest taxpayers through income taxation (CBO 4).

Over the past few years, the US has recorded deviations in rates of unemployment. This was due to changes in cost of labor as well as the political situation. The US rate of economic growth was seen to increase in 2006 by 3.5 percent and in the subsequent year, the rate of unemployment decreased.

Since then, the US has created more jobs, estimated to be 850, 000 jobs. However, productivity in the labor market makes the private firms give a boost to their sales volume, and profitability ratio thus forcing the government charge them high taxes in a bid to finance its projects.

This is seen to affect salaries and wages of most workers. The US administration is working on policies to stabilize the growth of its economy through lowering of taxes to multinational companies. This could see such corporations in a position to increase salaries and wages of the workers (Krugman 10)

Effects of deficit on inflation

Whenever the government borrows money from the public, the outstanding debts magnitude is equivalent to its net borrowing. Government deficit is the additional borrowing to the outstanding debt (Blogvesting 1). The deficit records as negative upon the fall of the outstanding debt. This is also known as a surplus.

The government owes debts mostly in terms of bonds. Long-term borrowing by the government will mean a long-term bond, which will in turn take a long-term payment from the time the bond was issued to the time the principal amount will be paid back.

This may have an effect on the economy, as the whole process will see the rate of government spending slow down hence calling for adjustments. Government outstanding debt is adjusted through inflation. A bond value is the price of a dollar in the market, which in turn affects the price of a commodity in the market.

The rate of inflation increases because of faster monetary growth base than the amount of commodities in the market. Boosting consumption rate through deficit spending may result in inflation due to an increase in monetary base while the amount of commodities in the economy remains unchanged. The Obama government is in the process of laying down infrastructure that would see an improvement in production to counter inflation and boost consumption.

This is a long-term strategic plan, which will realize employment of large number of the work force in the next decades. It is expected that this will aid in economy recovery by boosting of domestic production as well as reduction in imports. Money printing by Fed should also be increased for the government to purchase treasuries in the market to limit interest rate effects. This will focus more on how the money is spent rather than focusing on the amount of spending on stimulus (Blogvesting 1).

With the rising inflation, consumers are shying away from spending, and their spending habits have changed with time. Companies are trying hard to retain and identify new customers. This is through the provision of discounted prices to different products and services. The methods to identify such consumers include “those” who buy “what”, the quantity and “how often”.

This information will enable the business to identify its potential customers who will continue buying its products despite the slow down in the economy. Such consumers do purchase, but they are a bit cautious with what they buy hence they buy basic goods and keep off any luxurious products.

On conclusion, deficit spending can be either way, bad or good for the economy. This call for an immediate action especially on the effect the deficit has on employment and inflation. What the US government is supposed to do is to pay attention on the most effective mechanisms to spend on the stimulus money. This is especially on the current projects that will see decreased levels of unemployment, inflation and interest rates on money borrowed. If the federal deficit is utilized correctly, such effects will decline over the stipulated years.

The federal government should come up with a strategy that will make people spend more in the US through rising of import fees. Since businesses are producing products in the overseas countries, the cost of production becomes minimal.

Hence, imports are sold at a lower cost that products produced within the US. Through an increase in importation fees, this would encourage businesses to operate and invest heavily in the US thus creating employment. Another strategy is to lower taxation, which will encourage investors to operate in the US. This would result to workers being offered better salaries. In addition, products and services will be affordable to the people hence reduction in the rate of inflation.