Question

1. List the 5 potential problems associated with the national debt.

2. What effect will an expansionary fiscal policy have on interest rates and the exchange rate?  

3. What are the three schools of thought on fiscal policy?

4. "The level of real GDP does not change when the government decreases government spending and taxes by the same amount." Evaluate this statement.

5. What are the problems associated with a cyclically balanced budget fiscal policy?  

Answer 1

1. The problems resulting from growing national debt are as follows:

A) High interest on debt : Due to high government borrowing, the revenues received by the government go more into paying interest on debt financed from abroad.

B) Higher future taxes : As a result of government borrowing abroad, the burden on debt financed spending by the government can lead to the burden shifting to the citizens in the form of higher taxes in the future for repayment of debt and it's interest payments.

C) High interest rates : With less belief on the government being able to repay the bonds issued, holders demand higher higher bond yields. This upward push in bond yields has a spillover on nominal interest rates in the economy, with interest rates also being pushed to higher limits.

D) Increase in capital flight : With news of high government borrowing reaching abroad, foreign investors are likely to lose trust in the economy with rising debts. Therefore, the capital inflows are likely to decline and outflows likely to increase.

E) Reduction in domestic savings and investment : As a result of citizens losing faith in returns that the domestic investments can generate, given the increasing national debt, there is a likelihood of investments moving abroad in search of better returns and stronger currencies.

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