Question

How does United States large public debt affect it's economy? please explain using macroeconomic models. Explain what happens because of the large debt and what happens if you try to reduce debt (by increasing t or reducing g). I know the bbasic IS/LM model, where the IS would move down and would like a more detailed answer for this.

Answer 1

In 2009, the recession in the US economy was mitigated by increase in govt spending which had an effect of ANNUAL BUDGET DEFICIT & INCREASING PUBLIC DEBT (option b). The reason behind the answer is economically explained below.

Recession is a part of the business cycle in the economy when there is a decline in productivity, industrial investments and activity leading to fall in GDP and employment. Recession is highly damaging and destructive to an economy. It creats an widespread unemployment or job loss which affects the households the most. Rising unemployment rates leads to fall in purchasing power of the economy leading to fall in demand(consumers purchases fall), which affects the productive capacity of the economy, gdp falls and thus investments. Business goes bankrupt.

During recession, same as in 2009 Great Depression, the Government to mitigate rising unemployment tries to stimulate the economy by increasing public expenditure/ govt spending in new projects, investments and infrastructure which boosts employment. The govt may also cut taxes to increase the disposable income of the households to increase their puschasing power and boosts consumption demand of the economy.

This huge spending on the part of the govt creates a budget deficit when govt expenditue exceeds its income because the taxes are reduced which reduces govt income and expenditure is increased through investments and govt projects.

This govt deficit is met through govt borrowings such as market loans, issuing treasury bills and securities to the public. this increases the public debt of the govt.