Question

Suppose the economy is in a slump and the current public debt is quite large. Explain the trade - off of short - run versus long - run objectives that policy makers face when deciding whether or not to engage in deficit spending.

Answer 1

When the economy is at a recession, generally the government will engage in an expansionary fiscal policy which means that it will either increase government spending or decrease taxes to boost private spending and investment.

Whichever alternative the government chooses, it will generally result in a budget deficit resulting from spending more money than what it collects. This means that the government must issue more debt that will increase future spending in interest payments.

Most economists belief that even though government deficits generate future problems, they can be offset if the economy starts to grow and the government's revenue grows at higher rates. The problem is that economics is not an exact science and the negative effects of budget deficits can last several years. E.g. when Bill Clinton left the presidency, the government had a surplus, but then George W. Bush started to increase spending and the government deficit and national have constantly kept growing ever since and almost 20 years have passed.

Answer 2

If the economy is in recession or depression, according to keynes the government has to spend more to stimulate demand in the short-run goal might be to increase expansionary fiscal policy: increase spending, cut taxes to stimulate the economy. Though, in the long-term this could result in much greater public debt because the government would be have borrowed a lot to finance their deficit budgeting .