Impact of the Federal Deficit

Principles of Macroeconomics course. Prior understanding of fiscal and monetary policy is required. Note that some textbooks cover the federal deficit after discussion of fiscal policy, but before monetary policy is described. This activity works best if students understand both fiscal and monetary policy.

Overview

Using a fable about "King Big Debt" teams examine four possible outcomes of deficit spending: monetizing the debt; external debt; crowding out; and Keynesian crowding in. Students learn the impact of these outcomes on the economy (inflation; economic growth; employment) Teams must select which outcome most closely resembles the impact of the current U.S. federal deficit. Students must use data on the current U.S. economy to make this decision.

Expected Student Learning Outcomes

Students will be able to identify the economic results of a Federal deficit under differing initial conditions.
Students will be able to use data about the current economy to evaluate the impact of the federal deficit.

Information Given to Students

Fable start (Acrobat (PDF) 77kB Aug15 12)

Fable endings (Acrobat (PDF) 63kB Aug15 12)

Which ending most closely corresponds the U.S. economy today?

A) Keynesian (also called crowding in)

B) Crowding out

C) External debt

D) Monetizing the debt
Debt choices (Microsoft Word 2007 (.docx) 12kB Feb11 18)

Before teams make the specific choice of A, B, C or D it may be helpful to make certain that they understand the economics behind each ending. After reading out loud the introduction to the fable, ask teams to identify which ending goes with A, B, C or D (without considering which is currently occurring.) In addition, a prior Application Exercise could be to ask each team to identify which ending is the worst for a country (B, C or D are all arguably bad endings.)

Finally, when all students understand the economics behind the fable endings, ask them the team question: Which ending most closely corresponds the U.S. economy today?

Answers will depend on the current state of the U.S. economy. And, it is possible that strong arguments can be made for more than one of the endings.

• External debt: Much of the U.S. federal debt is held outside the U.S. However, there may be little evidence that this has caused resources to move out of the U.S. Unlike debt in other countries, U.S. debt is paid back in the U.S.'s own currency. So there is less pressure to sell resources to obtain a different currency (often for other countries, the U.S. dollar). Also when foreign debt comes due, much of it simply is turned back into new U.S. debt because the U.S. is considered a safe investment venue.
• Crowding out: Evidence for crowding out would be rising interest rates and declining private domestic investment.
• Keynesian/crowding in : Evidence would be strong economic growth without large increases in inflation.
• Monetizing the debt: Evidence would be a surge in inflation.

A straight-forward assessment of individual accountability is to ask each student to write a essay using current U.S. economic data to argue that one or more of the endings is occurring.

A variation would be to ask what economic data would be needed to demonstrate that each ending has occurred.

Or, fictional data for a future year, say high inflation or strong economic growth, is presented and students are asked which ending is most compatible with this data.

For data on U.S. domestic private investment, inflation, economic growth and foreign ownership of debt see FRED