Answers:

1. When countries run budget deficits, they typically pay for them by borrowing money. When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out.

2. Ricardian equivalence: This is the idea that consumers anticipate the future so if they receive a tax cut financed by government borrowing they anticipate future taxes will rise. Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged.

Similarly, higher government spending, financed by borrowing, will imply lower spending in the future. If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases. This implies that during budget deficits when the governments issues more bonds or reduces taxes will not impact the interest rates since the individual consumer will save more for more taxes to be paid in future to the government.

3. The distinction between internal and external debt is important only in the sense that the currency in which the debt is contracted is the main variable. Local currency is easier for local banks and governments to control than foreign currency. Internal debt is debt owed to locally owned banks in the local currency is “internal” debt, while when a country borrows from bankers abroad, the debt is considered “external.”

4. As discussed above, the use of debt financing by a national government increases the wealth of the current generations as due to the fact when individuals buy government interest-bearing debt, they are making a voluntary decision to give up the current use of resources for a larger future income (larger by the amount of interest they receive on their now larger asset holdings). Since this is a voluntary decision, no burden is imposed on the purchaser (i.e., the generation present when the debt is contracted). In fact, since the purchase would not have been made had a superior alternative been available, the purchaser is actually better off than had an alternative use been made of that income. However, subsequent generations of taxpayers must surrender to the bond holders the wherewithal for debt service. And this necessity is forced on them. In this sense, it is the future generations who will bear the burden of an internally held debt and the burden is the taxes they must pay for debt service. This is not a voluntary decision, but one forced on them by the decisions of an earlier generation. The only way to offset is that given by Barro who says “Crowding out would not occur and the burden would not be shifted forward to future generations if the current generation would only save an additional amount of resources to match the increased demand for resources represented by the additional government expenditures that are financed by issuing interest-bearing debt. Barro has an ingenious argument for why such behavior could be forthcoming. Suppose, he says, that individuals live forever and that they have as a goal the maximization of consumption over time. To attain this goal, they have to be concerned about the private capital stock for it is an important determinate of income and income governs consumption. As in the standard macroeconomic model, the saving behavior of the public governs the resources available for capital goods purposes”.