Question

A government starts off with a total debt of \(\$ 3.5\) billion. In year one, the government runs a deficit of \(\$ 400\) million. In year two, the government runs a deficit of \(\$ 1\) billion. In year three, the government runs a surplus of \(\$ 200\) million. What is the total debt of the government at the end of year three?

Short answer

The total government debt at the end of year three is \(\$4.7\) billion.

Step-by-step solution

- Identify the initial debt, deficits, and surpluses

The initial debt is \(\$3.5\) billion. The deficits and surpluses are as follows: - Year 1: Deficit of \(\$400\) million - Year 2: Deficit of \(\$1\) billion - Year 3: Surplus of \(\$200\) million It is critical to note that the deficit of Year 1 is in millions while the initial debt and the deficit of Year 2 are in billions.

- Convert all values to the same unit

To add or subtract the values, we need to convert all of them to the same unit, either billions or millions. In this case, we'll convert them to millions: - Initial debt: \(\$3.5\) billion = \(\$3500\) million - Year 1 Deficit: \(\$400\) million (no conversion needed) - Year 2 Deficit: \(\$1\) billion = \(\$1000\) million - Year 3 Surplus: \(\$200\) million (no conversion needed)

- Calculate the total debt after each year

To find the total debt at the end of year three, first, we'll calculate the total debt after each year: - End of Year 1: Initial debt + Year 1 Deficit = \(\$3500\) million + \(\$400\) million = \(\$3900\) million - End of Year 2: Year 1 Total debt + Year 2 Deficit = \(\$3900\) million + \(\$1000\) million = \(\$4900\) million - End of Year 3: Year 2 Total debt - Year 3 Surplus = \(\$4900\) million - \(\$200\) million = \(\$4700\) million

- Present the final answer

The total government debt at the end of year three is: \(\$4700\) million, which can be converted back to billions as \(\$4.7\) billion.

Key concepts

Fiscal Policy

Fiscal policy is a crucial tool used by governments to manage the economy by adjusting both its spending levels and tax rates. It's how the government influences economic activity, particularly in terms of aggregate demand, employment, and inflation.

Fiscal policy plays a pivotal role in balancing the economic cycle through either expansionary or contractionary measures. An expansionary fiscal policy involves increasing government spending or decreasing taxes to stimulate economic growth. On the other hand, a contractionary fiscal policy aims to reduce inflation and may involve reducing government spending or increasing taxes.

In our exercise scenario, the government's decision to run deficits in the first two years and a surplus in the third year reflects its fiscal policy choices aimed at managing the level of economic activity.

Budget Surplus

A budget surplus occurs when a government's revenues exceed its expenditures during a fiscal period. This is the opposite of a budget deficit, which happens when spending surpasses revenue. Having a budget surplus suggests that a government has extra funds at its disposal, which can be used to pay down existing debt, invest in social programs, or save for future uncertainties.

A surplus could arise from increased tax revenues due to economic growth or from spending cuts. In the given exercise, we see that the government achieved a budget surplus in the third year, which positively contributed by reducing the cumulative debt.

National Debt

National debt, also known as public debt, is the total amount of money that a country's government has borrowed and not yet repaid. It usually arises from accumulating budget deficits when a government spends more money than it receives in revenue.

Debt can be held domestically or owed to foreign creditors and is often considered an indicator of a country's financial health. It's critical to keep an eye on the national debt as it can impact the country's economic stability, interest rates, and even the value of its currency. In our exercise, we see the national debt increasing in year one and two due to budget deficits and then marginally decreasing in year three as a result of the budget surplus.

Government Budget

A government budget is a financial statement presenting its expected revenues and expenditures for a financial year. The budget is a plan for how the government intends to manage its resources, which includes income from taxes and other sources, and expenses on public services, defense, infrastructure, and debt interest.

There are several outcomes for a budget depending on whether revenue is equal to, less than, or greater than expenditures, leading to a balanced budget, budget deficit, and budget surplus respectively. The government in our exercise has made decisions over the three years that reflect a combination of these budget outcomes, demonstrating how fiscal policy can influence the overall economic picture.