1. Positive – stimulate economic growth through

a. multiplier effect – government spending turns

b. ease social problems – government spending resources on crucial social issues might release social tensions, stabilize political situation (for example, COVID subsidies). Mention at least one of them for 10 points.

2. Negative – hinder economic growth

a. (over-heating) an initial positive stimulus might over-heat the economy and result in higher levels of inflation. (Please note that while issuing government bonds has a contractionary effect on the money supply, it is important to take into account what the government does with the raised money, i.e. use the funds to increase government spending).

b. (level) higher share of government income devoted to servicing debt, hence, less money left for other programs, including public funding of education, medical care, research.

c. (volatility) makes country more vulnerable to economic shocks: a fall in GDP and collected taxes makes it harder to keep a balanced budget and leads to either more borrowing or cuts in critical social care programs; an increase in the interest rates leads to a higher cost of servicing debt, which then makes it harder to balance the budget.

d. (uncertainty) since the country might find it harder to balance budget in the future, there is more policy uncertainty. I.e. it is not clear today if the government will chose to issue more debt and/or increase taxes, by how much and when. An increase in policy uncertainty leads to a reduction in investment and slows down economic growth.

e. (social justice) an increase in the taxes necessary to repay the debt will likely be disproportionally more borne by future generations, hence, it creates a social tension. Older generation today benefit from an increase in spending and stimulus of economy, but it is future and younger generations that will have to bear the costs of such an expansion.

5 pts for discussing each of the mentioned issues up to 20 points. (i.e. should mention 4 out of 5 to get full credit).

Comments: First of all, having government debt does not automatically mean that the government will have to raise taxes to repay it or will default on it or will have to borrow more to repay it. Think of it in the context of a business cycle – during downturns the government is in deficit and borrows money to finance its expenditures, but in upturns its revenues are higher than expenses and it uses funds to repay debt. However, the higher the level of debt, the more concerns investors might have in the government's ability to deliver on its promises.

Many of contestants answered that the government will print money to finance its deficit. This is a rather strong assumption, which goes outside of the scope of the question for the following reasons.

"Printing money" is a process of the Fed (central bank) purchasing government bonds (treasuries), which was not specified that it would happen in the problem. When government finances its deficit, it issues bonds (treasuries), that are sold in auctions (i.e. through markets), and Fed might buy them or not, depending on its policy. The question was cast in the framework of US and Europe, so by default we assume that other investors (domestic or foreign) are buying the bonds, some of the bonds might be purchased by the Fed, but assumption that all of them or almost all of them every time there is a budget deficit is too much of a stretch. (Such an assumption might be more plausible for a developing country with a compromised central bank that finds itself unable to find investors willing to buy its bonds, i.e. already in crisis). Government bonds are purchased by banks, financial institutions such as insurance companies and mutual and pension funds, and individual investors, among others.

Therefore, in US and in Europe, a central bank buying some of the government bonds is one possible scenario, that might happen or might not. Importantly, in both US and in Europe, central banks are independent bodies, they are not directly controlled by the government. And while it might be the case that some politicians in Italy or Greece, hypothetically, would have liked the ECB to buy all of their bonds, they can hardly expect ECB to simply follow their will. Therefore, the concern that the first and foremost effect of budget deficit in US and Europe is "printing money" is incorrect.

There were many comments on inefficiencies in government spending. It is important to remember that they are not unique to situations with budget deficit and therefore, are not of first-order importance in this question. Some answers talked about repayment of the loans as necessarily meaning something bad/negative for the economy. This is not the case, since repayment of the loan merely represents the second part of the transaction that transfers some funds from future periods to the present, i.e. a natural part of debt contract. Therefore, such repayments can not be analyzed in isolation and only together with the use of these borrowed funds today. A few answers commented on the effect of budget deficit on the current account. This effect depends on the currency in which the debt is issued. Please note that the question was cast in the context of US and Europe, so it is expected that contestants assumed that the bonds were issued in domestic currency, as is the case in US and Europe. Hence, when the government issues bonds (and if the lending market can not absorb it and there is an upward pressure on interest rates), it creates an inflow of funds to the country and appreciation of the domestic currency (uncovered interest parity). This discussion was not expected in the answers, as it is beyond the scope of this question.