Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on economic growth. As always, my key terms are in red, and examples are in green.
In this tutorial, we'll talk about how the government finances expansionary fiscal policy. You'll understand that expansionary fiscal policy in the short run can actually result in a negative impact on our GDP growth in the long run due to the deficits that it creates.
So fiscal policy is typically policy set by a central government authority, where spending by the government is adjusted to stabilize economic activity. We know that the government actually has two tools, spending and taxation, and so fiscal policy looks at these at the policies in these two areas. They can then use these two tools to stabilize our economy's movement through business cycles.
So we have short- and long-term issues here in this tutorial. In the short term, we know that our goals of fiscal policy are full employment and price stability, so managing the unemployment rate and making sure that prices aren't out of control. And so the government then uses taxation and spending to stabilize our economy when either unemployment or inflation rises.
But in the long term, a third fiscal policy goal is economic growth over time. We want to make sure that over time our economy is producing more and becoming more efficient and productive over the years and over the decades. So economic growth is the measure of the change in real GDP over periods of time. It's the percent change in value of the sum of goods and services produced in a country's natural borders over a specified time interval.
So kind of the big idea here that I want to get across to you in this tutorial is that our short-term fiscal policy decisions can end up impacting our long-term ability to achieve economic growth because of that short-term fiscal policy impact on our national debt.
So without increasing taxes, our government has to borrow money by selling treasury securities to finance the increased government spending any time we need to stimulate the economy. Remember, we don't want to increase taxes to pay for those things usually, because to increase taxes takes money away from people, when in fact we're trying to get people spending again to get us out of a recession. So what they end up having to do is take on debt.
So to increase demand and stimulate the economy in the short term, the government has to spend more money than they collect in tax revenue. And so when expenditures are greater than tax revenue, that's known as a deficit. Deficits are shortages that result from spending in excess of revenue. So when the government then borrows money to finance the expansionary policy needed, in the future they have two options. They can repay with tax revenue, so they can kind of crank up taxes once the economy has rebounded, or they can take on new debt to repay the old debt.
Let's talk about the first option for a second. What if the government chooses tax revenue in the future to repay? So the point of taking on the deficit was to stimulate or grow the economy by increasing demand and increasing employment. In the long term, though, if we just need to enact contractionary policy to repay our debts by increasing taxes, that will eventually have a negative effect on real GDP. We learned about contractionary policy in a different tutorial. Contractionary policies decrease demand and tend to increase the unemployment rate.
So what about option two? So option two is, we take on new debts to pay the old debt. And when that's the option chosen, when new debt is chosen, we say the debt is being rolled over. At the very least, what we have to do is we have to pay interest to service our debt.
So here's a big, long definition for you for interest. Interest, we know, is the cost of money. Nominal interest is the prevailing rate. Real interest rates reflect that prevailing rate adjusted for inflation, so the real rate of-- the real interest rate is the nominal rate minus the inflation rate. Interest is also a return on investment, where return varies based on the risk profile of the investment, time horizon, or opportunity cost of a comparable risk-free investment and inflation expectations.
OK. So the government does not get to borrow money for free, unfortunately. They have to pay bondholders interest, and they have to make these payments periodically. So here's one thing that we need to compare the difference between. First of all, if they are borrowing money by selling treasury securities to Americans, so if the bondholders end up being Americans, then the government ends up having to pay interest to Americans, to its own people, and this payment is in US dollars. The money then would stay in the US economy, and the impact on our real GDP wouldn't be huge, because taxes collected from Americans are what's being used to pay interest to other Americans who then make purchases. So, you know, there's a minimal impact here.
But if the bondholders are foreigners, then the government ends up paying interest to people in other nations. The money is then leaving the United States economy, and taxes being collected from Americans are being used to pay interest to foreigners, and our real GDP can fall then, hampering our economic growth, which we said is our long-term goal. This can also impact our exchange rate, which is the subject of a different tutorial. And foreign exchange, remember, is the amount of a foreign currency attained by exchanging a specified amount of domestic currency. So the big idea of how it can impact our foreign exchange is that if we're repaying foreigners, our exchange rate can actually fall because the demand for our currency can actually end up falling. But stay tuned to that tutorial to understand how the intricacies of that actually work.
So in this tutorial, we talked about how the government has to finance expansionary fiscal policy by issuing debt. The government then pays interest to borrow money, and either pays the interest with tax revenue or by rolling it over. These deficits taken on in order to expand the economy in the short run can actually have a negative impact on our GDP growth in the long run.
Thanks so much for listening. Have a great day.
Terms to Know
Typically policy set by a central government authority, whereby spending by the government is adjusted to stabilize economic activity.
Shortages that result from spending in excess of revenue.
Measure of the change in real GDP over periods of time; percent change in value of the sum of goods and services produced in a country’s natural borders over a specified time interval.
The cost of money; Nominal interest is the prevailing rate; real interest reflects the prevailing rate adjusted for inflation (real = nominal rate minus the inflation rate); Return on investment where return varies based on the risk profile of the investment, time horizon, opportunity cost of a comparable risk-free investment and inflation expectations.
The amount of a foreign currency obtained by exchanging a specified amount of domestic currency.