Source: Image of Supply and Demand for U.S. Debt created by Kate Eskra
Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on funding fiscal policy. As always, my key terms are in red and my examples are in green.
In this tutorial, we'll talk about how the government finances expansionary fiscal policy. And you'll see how the process of selling Treasury bonds, notes, and bills works.
So first of all, there are two tools of fiscal policy, government spending and taxation. Fiscal policy looks at the policies in these two areas then. So the government can use these two tools of spending and taxation to stabilize our economy's movement through business cycles, making sure that recessions aren't too severe and expansions aren't too rapid.
Expansionary policy is either monetary or fiscal policy that is enacted to stimulate economic growth, as measured by the GDP growth rate. In this tutorial, we're really focusing on the fiscal policy side of it. So this is used when the economy is slowing and we need to expand it or get people spending money again.
Contractionary policy is the opposite. It's either monetary or fiscal policy that is enacted to slow economic growth, actually. And this is again as measured by the GDP growth rate. So this is actually when the major concern becomes inflation. It's when we need to slow down spending and cool down prices.
So in terms of the government spending as their first tool of fiscal policy, we know that the government spends money in many ways. And this is just a few of them. I wrote down things like national defense, education, and health care, welfare programs, and infrastructure. But obviously you know the government spends more money than on just these programs.
So the key idea with the spending side of it is that if the government wants to try to stimulate the economy and use expansionary policy, they can spend more money in any of these areas in order to create jobs and give people more money to spend. Remember, we calculate economic activity by calculating GDP. And this is the expenditure approach.
The expenditure approach calculates GDP by adding up everything that is being spent in the economy. Consumers are spending money. Businesses are investing in capital. That's the letter I. And government is purchasing things too.
So the hope here is that if consumers and businesses are kind of shying away from making purchases because the economy's a little bit slow, the government can kick things off. The government can increase their spending. And the hope is that this will encourage greater consumer and business spending as well.
Unfortunately, if they end up increasing taxes to pay for the increased government spending, then that's going to be counterproductive, because if they're trying to get people to spend more money, if they just increase taxes, then that takes money away from people. So that can be very counterproductive.
So how do they do it? Well, without increasing taxes the government then has to borrow money to finance the increased spending needed to stimulate the economy. And how they do it is by selling Treasury securities and taking on debt.
So this process works in this way. I'm just going to run through an example for you. If the government wants to fund a $1 billion program without raising taxes, the US Treasury basically has to sell IOUs, which then they'll have to repay later.
What the IOU is is it's in the form of a Treasury bond, bill, or note. And they'll have to sell $1 billion worth of these. So let's just say that the Treasury sells a one-year Treasury bill with a face value of $1,000. That is not necessarily how much the buyer is going to pay. It's just that face value says that in one year, the government will owe the bondholder $1,000.
What they pay determines the rate of return on the bond. So if the buyer paid $950, that's the price of the bond. Then the government is basically paying $50 to borrow $1,000, right? So if they're paying $50, that's the return on the bond to the investor. It's a 5% interest rate or yield, because we take the $50 return divided by the $1,000 face value.
So if the price that buyers are willing to pay falls, then that interest rate is going to rise. You'll see this on a graph at the end of my tutorial. Because if the buyers are only willing to pay let's say $900, then there would be a greater return. It would be $100 on the $1,000 investment.
And that's what this idea of return or yield means. It's the return on an investment. It's a combination of the interest rate on the face value of the bond and the difference in purchase price and the price to the time held for a bond.
So maturity is the idea of when debt needs to be repaid. So it's the time when the bond, bill, or note has reached its face value and payment is due then. And as soon as the bond, bill, or note has reached maturity, the government either has to repay using tax revenue or new debt. So in a lot of situations, new debt is chosen. And that's when we say we're just rolling over our debt, taking on new debt to repay old debt.
And here's a little chart for you. Really, the only difference between a bond, a note, and a bill is the length of time. So a bond is long term. It can be up to 30 years. Notes are what I kind of describe as medium term, up to 10 years. And bills are the short term, up to one year.
So this graph can look a little bit confusing at first. But here's the bond price. So this is not the face value, but the price that bondholders are paying.
I used the example for you of a $1,000 face value bond. This price of $950 was that first example I used for you. So that's what the investor is paying.
The interest rate that they were receiving on that was the $50 was their return on the $1,000 face value of the bond. So it was 5%. Notice that as the bond price falls-- so now if bondholders were paying $9000 on that $1,000 bond, their interest rate is now 10%, because they're getting a $100 return on it. If the price fell further to $850, the rate is rising to 15%, because their return is $150 on the $1,000 bond.
So it's interesting, because as the bond price is going up, the interest rate is actually rising. I'm sorry. As the bond price is going up, the interest rate is falling. So they're the inverse of one another. And as the bond price is going down, that's where our interest rate is rising.
So if we wanted to keep our demand a downward-sloping demand curve, it's downward-sloping because there's an inverse relationship between the quantity demanded and the price of the bond. If we wanted just to map interest rates here, we would actually have an upward-sloping demand curve. But I thought that looked more confusing, because we're used to seeing demand as having an inverse relationship between two things.
But just note the relationship here between the bond price and the interest rate and how those are inverse of one another. So as the price that bondholders pay is rising, like I said, their return or interest rate declines. As the price they're paying falls, their return or interest rate is going up.
So you would think that as our government as an example is continually issuing more and more and more debt, that's increasing the supply of bonds out there. You would think that the overall impact of that would be rising interest rates, because as we're moving more and more to the right, that's an increase of supply of bonds. That would result in an increase in interest rates.
However, we've noticed that apparently because the demand for bonds has continued to increase, that's been good for us. And that has offset this effect. So it's kind of an interesting example to look at.
That's where I put this pink curve here would be an increase in demand for our bonds. Now keep in mind if at some point we experience a drop in demand for our bonds, then it could become more difficult for us to borrow money. And interest rates would rise.
So in this tutorial, we looked at how the government has to finance expansionary fiscal policy by issuing debt. You saw a little bit of how this debt issuance works through the selling of Treasury bonds, notes, and bills. And then the government pays interest to borrow money, and either pays the interest with tax revenue or by rolling it over and taking on more debt.
Thanks so much for listening. Have a great day.
Either monetary or fiscal policy that is enacted to slow economic growth (as measured by the GDP growth rate).
Either monetary or fiscal policy that is enacted to stimulate economic growth (as measured by the GDP growth rate).
The return on an investment; a combination of the interest rate on the face value of the bond and the difference in purchase price and price to the time held for a bond.