We begin with the government budget constraint as it operates in a single year. This budget constraint can be seen in terms of the flows into and from the government sector in the circular flow, as shown in Figure 14.1 “The Government Sector in the Circular Flow” (which explicitly shows that taxes come from households and firms). Later we discuss a second government budget constraint that links spending and revenues over longer periods of time. Figure 14.1 The Government Sector in the Circular Flow
The inflows into the government sector come from taxes and borrowing from the financial sector. The outflows comprise government purchases and government transfers. You might be wondering how it is possible for the government to have outlays that exceed its revenues. The answer is given by the government budget constraint. The government budget constraint says that the deficit, which is the difference between outlays and revenues, must be financed by borrowing. If outlays exceed revenues in a given year, then the government must somehow make up the difference. It does so by borrowing from the public. In this sense, the government is no different from a household. Each of us can, like the government, spend more than we earn. When we do, we must either borrow from someone or draw on our savings from the past. The government borrows by issuing government debt. This debt can take several forms. The government has many types of obligations, ranging from short-term Treasury Bills to longer-term bonds. For our analysis, we do not need to distinguish among these different assets.
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The Single-Year Government Budget Constraint
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