Share
Explore BrainMass

federal deficit

To reduce the federal deficit, the government would have to cut back on government purchase, transfer payments, and/or increase taxes. How does the federal deficit affect GDP and the multiplier? Would an attempt to reduce the budget deficit not increase it? Does today's deficit not create tomorrow's surplus?

Solution Preview

How does the federal deficit affect GDP and the multiplier?
The Key "Multiplier" Relationship Between Money Growth and Economic Growth. In a growing economy, "New Money" created by the banking system plays a dual role:
1. New Money SUPPLIES the additional Money STOCK to meet the economy's growing DEMAND for money-inventory to service the growing FLOW of GDP spending. The amount of M1 stock needed to service the policy-desired rate (level) of GDP spending is equal to the current trend value of the MDR multiplied by the corresponding flow of GDP spending.

2. New Money is the chief financer of GDP growth -- by providing additional ("exogenous"-- not out of previous income) purchasing power for those who initially borrow the new money from money-creating (checkable-deposit) banks. Moreover, as that initial new money is re-spent again and again in its circulation around the economy, the initial spending is multiplied many fold. This Money Multiplier effect is limited only because, as the economy grows, new money becomes successively "locked into" the MDR-required level of individual money inventories
To the extent that the MDR remains constant, the precise amount of this multiplier is equal to the MDR reciprocal. Thus, the present U.S. MDR of about 14% has a multiplier of about 7 -- i.e., each dollar of new money finances about 7 dollars of additional GDP. However, any change in the trend value of the MDR growth rate tends to have an equal and opposite effect on the GDP growth rate -- and on the amount of money stock needed to service the policy-desired rate of GDP growth.
Would an attempt to reduce the budget deficit not increase it?
An attempt to reduce budget deficit will not increase it. Those concerned about large deficits usually argue as follows: deficits let current generations off the hook for paying the government's bills. Therefore, current generations consume more. This reduces the amount Americans save and invest. A reduced rate of investment means less capital per worker and, therefore, lower productivity growth. When capital is scarce, its rate of return rises, causing interest rates to increase. Higher U.S. interest rates attract foreign investment to the United States and imply larger trade deficits, because increased foreign investment must increase the trade deficit.
Yet, there is very little correlation between budget deficits and interest rates, saving and investment rates, or productivity growth rates. Some economists, led by Robert Barro of Harvard, claim that the absence of a ...

Solution Summary

How does the federal deficit affect GDP and the multiplier?

$2.19