Assignment for Chapter Two It is well known that the federal government is operating with a "large" deficit and

accumulating a large debt. First I would like you to explain the loanable funds theory, which states "that the market interest rate is determined by the factors that control the supply and demand for loanable funds." Right now the Federal Debt is over 16 trillion dollars. Why has interest rates stayed low even though the Federal Government continues to borrow more and more? Should there not be a crowding out effect caused by this level of Federal Debt? Do not forget to discuss the fact that government demand for funds is interest-inelastic. Finally this following article tells us about the magnitude of the Federal Governments Debt and the risk it brings with it. Should we be concerned with the fiscal cliff or applaud the direction of spending and taxing it brings with it?

Debt-to-GNP ratio at height unseen since WWII with no easy fix ahead
By George Bennett Palm Beach Post Staff Writer The last time the federal government was this deep in debt, it took the defeat of Hitler and the atomic bombing of Japan to climb out. The trillion-dollar deficits and growing debt that frame the current fiscal cliff debate in Washington represent a level of government borrowing and indebtedness not seen since World War II and its immediate aftermath. The national debt in 1945 topped $251 billion. That figure wouldnt quite cover the governments annual interest payments these days, but it represented 112.7 percent of the nations economic output at the time. Today, the $11.5 trillion in federal debt held by the public is about 73 percent of U.S. gross domestic product. The debt-to-GDP ratio is one commonly used indicator of a nations economic health and fiscal discipline, with a lower ratio generally viewed as something to aim for. Gross domestic product is the market value of all the goods and services produced within a nations borders in a year. Government debt as a percentage of GDP is a tool that can be used by international lenders to, among other things, rate the creditworthiness of a nation. In Greece, considered the modern poster nation for debt crises, government debt was about 165 percent of GDP in 2011. While U.S. government debt held by the public exceeded 100 percent of GDP in 1945, the end of World War II brought a decrease in government spending and an explosion of economic growth that quickly reduced the national debt compared to the economy as a whole. Theres no similar scenario in sight today. If tax policies and spending commitments remain largely as they are now, the nonpartisan Congressional Budget Office estimates that the federal government will pile up another $10 trillion in debt over the next decade. The amount of debt held by the public would approach 90 percent of GDP in 2022. If Congress and the White House allow automatic spending cuts and across-the-board tax increases to take effect on Jan. 1 and then leave those changes in place for the next 10 years the dreaded fiscal cliff scenario the national debt will still increase, but only by $2.2 trillion over 10 years, according to the CBO. As a share of gross domestic product, debt held by the public would decrease to 58.5 percent of GDP in 2022 if the government leaps off the fiscal cliff.

Total U.S. debt now exceeds $16.3 trillion, which is larger than the nations $15.8 trillion gross domestic product. But economists and think-tankers generally agree the more relevant debt figure is the $11.5 trillion in debt held by the public through Treasury securities that are purchased by investors other than the federal government investors that can include foreign governments. The remaining $4.8 trillion in debt is held by the Social Security Trust Fund and other federal accounts. The federal government spent $258 billion last year just to cover interest payments on its debt. The U.S. government has carried debt throughout its history, except for a brief period in 1835 when the government paid off all its obligations. Debt increased dramatically during the Civil War, World War I and the Great Depression but never came close to 50 percent of gross domestic product until World War II, when it spiked from 43.3 percent of GDP in 1941 to the 112.7 percent figure in 1945. The national debt decreased steadily over the next three decades, bottoming out at less than 25 percent of GDP in 1974. Since the Great Recession began in late 2007, the combination of the sluggish economy, depressed tax collections and increased federal spending largely to stimulate the economy has increased debt as a percentage of GDP from 36.3 percent to 72.6 percent. There doesnt appear to be wide agreement on what constitutes a healthy ratio of debt to GDP but the current level and its upward trend make many observers uneasy. Federal debt cannot grow faster than the nations output indefinitely and prolonged increases in debt relative to GDP can cause significant long-term damage to both the governments finances and the broader economy, the CBO says in a recent report on deficit-reduction choices. I dont know that theres an optimal level, says Patrick Louis Knudsen of the conservative Heritage Foundation. But if were rising above 70 percent and its still growing, thats taking a risk. We are in a sense playing with matches when we are at that level and especially when we are at that level and rising. Richard Kogan of the left-leaning Center on Budget and Policy Priorities says theres no evidence, such as rising interest rates, to suggest debt at 73 percent of GDP is a problem. But, Kogan adds, Everybody I know would like it to be lower. He says, The debt ratio cannot rise forever. If it did, that would shrink the amount of national saving available for private investment, ultimately impairing productivity growth and, in turn, living standards. Kogan recently authored a plan to reduce the deficit by $2 trillion over 10 years, primarily through tax increases, to prevent debt from rising above 73 percent of GDP. Kogan also says the government should try to keep annual deficits at about 2.5 percent of GDP. For the 40 years between 1968 and 2007, federal spending averaged 20.6 percent of GDP while revenues averaged 18.2 percent an average annual deficit of 2.4 percent of GDP. From 2008 to 2012, a period that includes the effects of the Great Recession, federal spending has averaged 23.4 percent of GDP and revenues have averaged 15.8 percent an average deficit of 7.4 percent. The gap between what the government spends and what it takes in is expected to widen as Baby Boomers age and draw more Social Security and Medicare benefits. Kogan says entitlement programs for seniors should be preserved with revenue increases to pay for them. My policy judgment is that Medicare and Medicaid and Social Security are good programs and worth paying for, so that if you handled their natural increases because of demographics and health care cost growth by raising revenues, that would be fair, Kogan said. The Heritage Foundation favors scaling back spending for these programs and not raising taxes. Under a Heritage plan released last year, the retirement age for Social Security and Medicare would eventually be raised to 68 and benefits would be reduced for individual retirees with incomes above $55,000 and eliminated for individuals with incomes above $110,000. Whatever course Congress and the White House end up choosing, the Congressional Budget Office says the public and politicians cannot expect to continue with budgetary business as usual. In sum, a wide gap exists between the future cost of the services that the public has become accustomed to receiving from the federal government especially in the form of benefits for older people and the tax revenues

that the public has been sending to the government to pay for those services, the CBO report says. It adds: Because the federal budget is on an unsustainable path under current policies, those policies will need to be changed in significant ways. [Link]