Question

Suppose a government has no debt and a balanced budget. Suddenly it decides to spend $4 trillion while raising only $3 trillion worth of taxes.

(a) What will be the government’s deficit? _________

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(b) If the government finances the deficit by issuing bonds, what amount of bonds will it issue? _________

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(c) At a 4 percent rate of interest, how much interest will the government pay each year? _________

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(d) Add the interest payment to the government’s $4 trillion expenditures for the next year, and assume that tax revenues remain at $3 trillion. In the second year, compute the

(i) Deficit. _________

(ii) Amount of new debt (bonds) issued. _________

(iii) Total debt at end of year. _________

(iv) Debt service requirement. _________

Answer 1

(a) Spending by government = $4 trillion

Tax collected by government = $3 trillion

Calculate government deficit –

The government’s deficit will be $1 trillion.

(b) The deficit of government will be $1 trillion. If government wants to finance this deficit by issuing bonds then it have to issue bonds equivalent to the amount of deficit.

Thus, government will issue $1 trillion worth of bonds.

(c) Amount of bonds issued = $1 trillion

Rate of interest = 4% or 0.04

Calculate amount of interest –

The government will pay $0.04 trillion as interest each year.

(d)

(i) Government expenditure = $4 trillion

Interest payment = $0.04 trillion

Total spending = $4 trillion + $0.04 trillion = $4.04 trillion

Tax collected = $3 trillion

Calculate government deficit –

The government’s deficit will be $1.04 trillion.

(ii) The deficit in current year is $1.04 trillion. If government wants to finance this deficit by issuing bonds then it have to issue bonds equivalent to the amount of deficit.

Thus, government will have to issue $1.04 trillion worth of new bonds.

Thus, amount of new debt (bonds) issued is $1.04 trillion.

(iii) Calculate Total debt at the end of year –

Debt of previous year = $1 trillion

Debt of current year = $1.04 trillion

Thus, the total debt at the end of year is $2.04 trillion.

(iv) Calculate debt service requirement –

Amount of total debt = $2.04 trillion

Rate of interest = 4% or 0.04

Calculate amount of interest –

The government will require $0.081 trillion for debt servicing.