House Republican Leader John Boehner of Ohio asks When will

House Republican Leader John Boehner of Ohio asks: When will the White House tackle these jaw-dropping deficits that pile more and more debt on future generations while it massively increase federal spending? Source: USA Today, September 11, 2009 Explain the effects of the federal deficit and the mounting debt on the U.S. economic growth.

Solution

High federal deficit and debt results in short run economic growth but slows down long run growth.

In the short run, high federal deficit, that is caused by high level of government spending, increases aggregate demand, output and income which leads to higher growth. However, to finance this deficit, government resorts to borrowing, which raises market interest rate. Higher interest rate lowers investment demand in medium run, which decreases aggregate demand, therefore crowding out the increase in aggregate demand caused by government spending.

In the long run, by Ricardian equivalence, the government has to cover the deficit and debt-financing by raising taxes. Therefore, while current generation gains from high federal deficit and debt, the future generation is harmed since high taxation levels lower consumption and investment demand, decreasing aggregate demand and economic growth in the long run.