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Short-Term GDP and National Debt: Keynes' Theory

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  • 0:05 Paying Down Debt vs.…
  • 3:10 Keynesian Economics
  • 4:47 Budget Speak
  • 6:50 When to Balance the Budget
  • 10:34 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Discover the tension fiscal authorities face between the two equally rewarding goals of reducing the national debt and maintaining a growing economy in the short term. This lesson explains the tension from the Keynesian point of view.

Competing Goals of Paying Down Debt vs. Growing the Economy

We're taking a short trip to Econoworld, where the widget factory has produced over a million widgets just this year that have been shipped all over the universe. Jerry just lost his job because the widget factory's sales are way down. In fact, all the companies throughout the economy have lower sales. As a result, millions of people are out of work. The only thing Jerry knows how to do is make widgets. He tries to find another job, but no one's hiring.

President Arnold and the government leaders know that getting the economy going again is the only way that Jerry gets his job back. Besides that, every day that Jerry isn't working is a day when Jerry is making his own widgets and stacking them outside the White House of Econoworld. So far, Jerry has stacked 5,481 widgets, enough to completely block the view of any tourist on a double-decker tour bus who may be excited about seeing the White House but who now must listen to a very unusual explanation from a tour guide as to why there are over 5,000 widgets stacked outside the office of the most important government leader in all of Econoworld.

Now President Arnold really does like Jerry, even if Jerry is frustrated right now. As we'll see in a little while, there are some important decisions being made that could improve Jerry's situation and the situation of many, many others as well.

So let's talk about an important decision that's about to be made by policymakers. Econoworld has a budget deficit of $300 billion and a national debt of $15 gazillion and counting. Sitting on top of President Arnold's desk right now is a plan to pay down the national debt. He knows that keeping the finances in order is an important goal if Econoworld is going to continue to prosper for many generations. What we want to answer in this lesson is: when is the most appropriate time for the government to implement this plan?

Economist John Maynard Keynes (first on the left)
John Maynard Keynes

When it comes to fiscal policy, some economists recognize that not all economic goals are equally important in the short term. The goal of paying off the national debt, which begins with balancing the national budget, is an important long-term goal that often defers to the more important goal of achieving economic growth in the short term.

John Maynard Keynes was a famous economist who, through his personal and professional observations of the Great Depression, challenged the classical economic thinking of the time that economies will simply fix themselves if they are just left alone long enough. The longer and longer that people suffered through the Depression, the more open the world was to his economic viewpoint, which has become known as 'Keynesian.'

A Keynesian economist believes that the government should be active, not passive, and step in during extreme situations to help smooth out the economy's cycles of growth. What you'll find in economics is that, when it comes to most long-term issues that arise, a Keynesian is not willing to sacrifice the short-term growth of the economy in order to reach a long-term goal - a viewpoint that goes right back to Keynes' observation of what happened during the Great Depression. This Keynesian viewpoint is something you'll clearly see in the rest of this lesson.

Let's first take a look at the terms that policymakers use to describe budgets. Then we'll talk about the most appropriate time for them to tackle the important budget issues of balancing the budget and paying down the debt.

Budget Speak

Econoworld currently has a budget deficit. A budget deficit of the nation is when the federal government spends more than the revenues it receives from taxes. For example, when the government receives $1.8 trillion in revenue and spends $1.9 trillion for goods and services, there is a budget deficit of exactly $100 billion.

On the other hand, a budget surplus is when it spends less than the revenues it receives. Government spending in Econoworld of $500 billion during a year when revenues are $800 billion - that would mean that there would be a $300 billion budget surplus.

Now there's the term of the national debt. What's that all about? The national debt, on the other hand, is the cumulative total of all the previous budget deficits of a nation. Whenever there's a budget deficit, this shortfall gets added to the national debt, while every budget surplus pays down the national debt. For example, if the government of Econoworld receives $1.8 trillion in revenues and spends $1.9 trillion for goods and services, that means the national debt will increase by $100 billion.

Now that you understand the terms that policymakers use and how they're connected, let's answer the key question I posed at the beginning of this lesson: when is the most appropriate time to balance the budget and pay down the debt?

When is the Best Time to Balance the Budget?

Increasing government spending increases economic output.
Aggregate Demand Formula

Keynesian economists recognize that there are appropriate times to attempt to balance the budget and appropriate times to increase the deficit. Economist John Maynard Keynes rejected the idea that the government needed a balanced budget. He argued that the appropriate fiscal policy to deal with budgets was dependent on economic conditions. He believed that fiscal policy needs to act in the short run because 'In the long run, we are all dead.' Therefore, the Keynesian view is that the government should shift its budget toward a deficit during a recession.

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