Question

Suppose a government has no debt and a balanced budget. Suddenly it decides to spend $5 trillion while raising only $4.5 trillion worth of taxes.
Instructions:
a. What will be the government's deficit?
b. If the government finances the deficit by issuing bonds, what amount of bonds will it issue?
c. At a 4 percent rate of interest, how much interest will the government pay each year?
d. Add the interest payment to the government $5 trillion expenditures for the next year, and assume that tax revenues remain at $4.5 trillion. In the second year, compute the
(i) Deficit: $____billion.
(ii) Amount of new debt (bonds) issued to finance the deficit in the second year: $____billion.
(iii) Total debt at the end of the second year: $___billion.
(iv) Debt service requirement: $____billion

Answer 1

Answer:

a. The government's deficit is $0.5 trillion or $500 billion.

b. The amount of bonds issued = $0.5 trillion or $500 billion.

c. At a 4 percent rate of interest, the interest the government will pay each year = $20 billion.

d. i) Deficit: $__520__billion.

(ii) Amount of new debt (bonds) issued to finance the deficit in the second year: $_520___billion.

(iii) Total debt at the end of the second year: $_1,020__billion.

(iv) Debt service requirement: $__40.8__billion

Explanation:

a) Data and Calculations:

Government spending = $5 trillion

Income from taxes = $4.5 trillion

Deficit = $0.5 trillion

Bonds issued = $0.5 trillion

Interest rate = 4%

Annual interest expense = $20 billion ($0.5 trillion * 4%)

Expenditure next year = $5 trillion

Interest payment =          $0.02 trillion

Total governmental spending = $5.02 trillion

Tax revenue =                               4.50 trillion

Deficit =                                        $0.52 trillion