AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/5/5-4)
Unit 5 · Topic 5.4
5.4 Government Deficits and the National Debt
A budget deficit is one year's gap when the government spends more than it collects in taxes, and the national debt is the total it owes from all its past borrowing. Every deficit adds to the debt. The government must pay interest on that debt, and those payments grow as the debt grows; money spent on interest can't be used for anything else.
Key terms
- budget deficit
- budget surplus
- national debt
- transfer payments
- interest on the debt
Deficit, surplus and balanced budget
Each year, compare what the government takes in with what it pays out.
Government purchases are spending on goods and services, such as roads and military equipment. Transfer payments are money paid out without buying anything in return, such as Social Security and unemployment benefits. Both count when you calculate the deficit, even though only purchases count in GDP (2.1).
- Budget balance = tax revenue − (government purchases + transfer payments).
- Budget deficit: spending plus transfers is greater than tax revenue, so the balance is negative.
- Budget surplus: tax revenue is greater than spending plus transfers, so the balance is positive.
- Balanced budget: the two are equal.
Deficits are flows; the debt is a stock
A deficit is measured over one year, like water flowing into a bathtub. The national debt is the total the government owes at a point in time, like the water already in the tub.
To cover a deficit, the government borrows, mostly by selling bonds, and that borrowing adds to the debt. So the debt keeps growing as long as there is any deficit, even a shrinking one; a smaller deficit just means the debt grows more slowly. Only a surplus lets the government pay some of the debt down.
Why deficits change over the business cycle
In a recession, tax revenue falls as incomes fall, and transfer payments such as unemployment benefits rise. These automatic stabilizers (3.9) widen the deficit without any new law. Expansionary fiscal policy, such as new spending or tax cuts, widens it further. In a boom, tax revenue rises and transfer payments fall, so the deficit tends to shrink.
The burden of the debt
The government must pay interest on everything it owes, and those interest payments are part of its spending. A larger debt or higher interest rates mean bigger interest payments. If those payments are covered by more borrowing, the debt grows faster still.
Economists and policymakers disagree about how much debt is too much, and about whether to reduce deficits with spending changes or tax changes. On the exam, describe what the models predict, not which side is right. The models point to these costs:
- Opportunity cost: every dollar spent on interest is a dollar that can't go to other uses, such as schools or tax cuts.
- Crowding out: heavy government borrowing can raise real interest rates and reduce private investment (5.5).
- Who holds the debt: interest paid to domestic bondholders stays in the country; interest paid to foreign bondholders flows abroad.
- Future budgets: borrowing now may mean higher taxes or less spending later to cover the interest.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Deficit and debt over three years
A government starts Year 1 owing $500 billion. In Year 1 it collects $300 billion in taxes, buys $280 billion of goods and services and pays $60 billion in transfer payments. Year 2 has a $60 billion deficit, and Year 3 has a $20 billion surplus that goes toward the debt. (a) What's the Year 1 budget balance? (b) What's the national debt at the end of Year 3?
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- Step 1: (a) Budget balance = taxes − (purchases + transfers) = 300 − (280 + 60) = 300 − 340 = −$40 billion: a $40 billion deficit.
- Step 2: (b) End of Year 1: 500 + 40 = $540 billion.
- Step 3: End of Year 2: 540 + 60 = $600 billion.
- Step 4: End of Year 3: the surplus pays down debt, so 600 − 20 = $580 billion.
Answer: (a) A $40 billion deficit. (b) $580 billion.
- Example 2Calculator allowed
The cost of interest
Continuing the example, suppose the government pays an average interest rate of 3% on its $580 billion debt. How much interest does it owe each year, and what's the opportunity cost?
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- Step 1: Interest = $580 billion × 0.03 = $17.4 billion a year.
- Step 2: That $17.4 billion is part of government spending, but it doesn't buy any new goods or services.
- Step 3: The opportunity cost is whatever else that money could have paid for, such as more public spending or lower taxes.
Answer: $17.4 billion a year, money that can't be used for other spending or tax cuts.
- Example 3
Deficit falls, debt rises (classic trap)
News reports say the federal deficit fell from $90 billion last year to $50 billion this year. A student concludes that the national debt fell. Is the student right?
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- Step 1: A deficit of $50 billion means the government still spent $50 billion more than it took in, and it borrowed to cover the gap.
- Step 2: That borrowing adds $50 billion to the debt.
- Step 3: The debt grew more slowly than last year (by $50 billion instead of $90 billion), but it still grew. It falls only when the government runs a surplus.
Answer: No. The debt rose by $50 billion; it just grew more slowly than the year before.
Common mistakes
- Using 'deficit' and 'debt' as if they meant the same thing. The deficit is one year's shortfall; the debt is the total owed from all past borrowing.
- Leaving transfer payments out of the deficit. They're part of government outlays even though they aren't counted in GDP.
- Thinking a falling deficit means a falling debt. The debt falls only when the government runs a surplus.
On the exam
- Multiple-choice questions may ask you to compute a deficit or surplus from tax and spending numbers, or to say how a deficit or surplus changes the national debt.
- When asked about the burden of the debt, name a specific cost: interest payments, the opportunity cost of those payments, or crowding out of private investment.
Connected topics
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Check yourself
4 questions on 5.4 Government Deficits and the National Debt. Pick an answer to see if you got it, and why.
| Year | Tax revenue (billions of dollars) | Government spending, including transfer payments (billions of dollars) |
|---|---|---|
| 1 | 400 | 450 |
| 2 | 420 | 480 |
| 3 | 470 | 460 |
| 4 | 480 | 520 |
Hypothetical data. Country D's national debt was $1,000 billion at the start of Year 1. Assume all deficits are financed by borrowing and any surplus is used to repay debt.
In which year or years did Country D run a budget surplus?
What was Country D's national debt at the end of Year 4?
What happened to Country D's national debt during Year 3?
Which of the following correctly distinguishes a budget deficit from the national debt?
0 of 4 answered