Question

In which of the following cases does the size of the government’s debt and deficit indicate potential problems for the economy? Explain your answer.

a) The government’s debt is relatively low, but the government is running a large budget deficit as it builds a high-speed rail system to connect the major cities of the nation.

b) The government’s debt is relatively high due to a recently ended deficit-financed war, but the government is now running only a small budget deficit.

c) The government’s debt is relatively low, but the government is running a budget deficit to finance the interest payments on the debt.

Answer 1

Option C.

• In the third scenario, the size of the government's dept and deficit would indicate a potential problem for an economy.
• This is because, the government is running a budget deficit even when it it's debt is relatively low due to which it is not able to finance the interest payments on the debt.
• This shows that the real GDP would fall very low and would not Increase for a long time. This will cause the economy to move into a severe recession for a very long time.

In (a), even if the government is running a large budget deficit, the government will be able to overcome severe economic problems after building the high speed rail system as it can earn revenues from it.

In (b), even if this scenario is a cause of concern after the war ends it faces only a small deficit. After few more years it can still earn higher surplus.