AQA A-level Economics: Budget balance, national debt and deficits (7136) – Revision Notes

These notes condense the budget balance and national debt points of AQA A-level Economics (7136), specification version 1.3, section 4.2.5.1 (3.2.5.1 on the AQA website). For full explanations and longer worked examples, read the study guide. Test yourself on the practice questions. Course pages: AQA A-level Economics hub, checklist and free diagnostics. Related: aggregate demand and supply. All figures are invented and illustrative.

Definitions

Term	Meaning
Budget balance	Revenue minus spending over a period (a flow)
Budget deficit	Spending greater than revenue; the gap is borrowed
Budget surplus	Revenue exceeds spending, leaving funds to repay debt
National debt	Everything the government owes on one date (a stock)
Primary balance	Revenue minus spending excluding interest
Cyclical deficit or surplus	The part caused by the economic cycle, which reverses as output returns to potential
Structural deficit or surplus	The part that remains with output at potential
Crowding out	Government borrowing raising interest rates and reducing private investment
OBR	Independent body producing forecasts and assessing the public finances

Key relationships

Relationship	Rule
Balance	Revenue minus total spending
Total spending	Non-interest spending plus interest
Interest	Debt multiplied by average interest rate
Closing debt	Opening debt plus deficit (or minus surplus)
Deficit ratio	Deficit divided by GDP
Debt ratio	Debt divided by GDP
Cyclical part	(Tax change + benefit change per unit of gap) x output gap
Structural part	Total deficit minus cyclical part
Multiplier	1 divided by (saving + tax + import rates)
Interest burden	Interest payments divided by revenue

Method in steps

To split a deficit into cyclical and structural parts

1. Find the output gap: potential output minus actual output.
2. Find the net automatic effect per unit of gap (lost tax plus extra benefits).
3. Multiply the two: the result is the cyclical deficit.
4. Take that away from the whole deficit: what is left is the structural deficit.
5. State what it means: policy must deal with the structural part; the cyclical part should fade as output recovers.

To judge a debt

1. State debt/GDP and whether it is rising.
2. Compare the interest rate with nominal GDP growth.
3. Find interest as a share of revenue.
4. Say who holds it and in which currency.
5. Say what it financed.
6. Conclude: a judgement tied to those points, not just “high” or “low”.

Worked reminders

Surplus and debt (Country P, illustrative year). Revenue is 540, spending 500, opening debt 800, GDP 1,500.

Surplus      = 540 - 500 = 40    (40 / 1,500 = 2.7% of GDP)
Closing debt = 800 - 40 = 760
Debt ratio   = 800 / 1,500 = 53.3% before
After 3% nominal growth: GDP = 1,545, ratio = 760 / 1,545 = 49.2%

A surplus lowered the debt, and growth lowered the ratio further.

Cyclical split (Country Q, illustrative). Deficit 45, output gap 50, net automatic effect 0.30 per unit.

Cyclical   = 0.30 x 50 = 15
Structural = 45 - 15 = 30

Rebalancing by a spending cut (multiplier 2.5, induced tax rate 0.2). Withdrawals are 1 / 2.5 = 0.4. A cut of 10 reduces income by 25 and tax revenue by 0.2 x 25 = 5. The deficit falls by 10 - 5 = 5, half the cut.

Holding the debt ratio steady (Country R, illustrative). Debt is 600, GDP 800 (a ratio of 75.0%), interest 6%, nominal growth 2%, and the primary balance is zero.

Interest     = 0.06 x 600 = 36, so closing debt = 636
GDP          = 800 x 1.02 = 816
Debt ratio   = 636 / 816 = 77.9%   (up from 75.0%)
To hold 75%  : debt may reach 0.75 x 816 = 612, so borrowing can be only 12
Primary surplus needed = 36 - 12 = 24   (3.0% of GDP)

When the interest rate is above nominal growth, the ratio climbs even with a balanced primary budget, and the government needs a primary surplus to stop it.

Chains of reasoning to learn

Deficit in a recession. Output falls below potential, so tax receipts fall and benefit spending rises. The deficit widens by itself, which supports household incomes and spending. Consequence: AD falls by less than it would otherwise. Evaluation: this is the cyclical part and should fade in recovery, so cutting hard now would deepen the slump.

Persistent deficit near full capacity. Extra demand meets limited spare capacity, so prices rise more than output. Government borrowing competes with firms for funds, interest rates rise and investment is crowded out. Consequence: slower growth in potential output. Evaluation: much depends on whether the borrowing financed investment that raises supply.

Rebalancing by cuts. Lower spending reduces AD, income and tax receipts, so the deficit falls by less than the cut. Consequence: slower growth and higher unemployment in the short run. Evaluation: lasting gains need a credible plan, spare capacity elsewhere, or lower interest rates to offset the fall in demand.

Consequences at a glance

Effect	Deficit	Surplus
AD and growth	Raises AD; helpful with spare capacity	Lowers AD; helpful when overheating
Unemployment	Lowers cyclical unemployment	Raises it if output weakens
Inflation	Pressure near full capacity	Eases pressure
Current account	Higher AD pulls in imports	Lower AD reduces imports
Interest rates	Crowding out risk	Debt repayment may lower rates
Supply side	Investment can raise LRAS	Room for investment later
Future	Interest payments, tax burden	Lower debt, room to respond to shocks

Must-know distinctions

• Deficit (flow) against debt (stock): a deficit adds to the debt.
• Cyclical against structural: the cycle against the built-in gap.
• Headline against primary balance: with and without interest.
• Debt level against debt ratio: the ratio can fall while debt grows.
• Automatic stabilisers against discretionary policy: no decision against a decision.
• Borrowing for investment against borrowing for current spending.
• Cutting spending against raising taxes: different multipliers and different groups affected.

The OBR in brief

Created in 2010, independent of ministers. Roles: economic and fiscal forecasts for Budget announcements; assessing performance against fiscal targets; long-term sustainability; fiscal risks; scrutinising tax and welfare costings. It informs and judges; it does not set policy. Strength: outside forecasts are less open to political optimism, so targets are more credible. Weakness: forecasts are uncertain and get revised.

Evaluation toolkit

For any claim about a deficit, surplus, debt or rebalancing measure, test it against:

• the size of the output gap and the state of the cycle
• whether the balance is cyclical or structural
• the multiplier and the type of spending or tax involved
• the interest rate against growth
• the time frame: short run against long run
• who gains and who loses
• what the borrowing financed

Quick self-test

1. Revenue is 300 and total spending 345. State the balance.
2. GDP is 1,500. Express that balance as a percentage of GDP.
3. Opening debt is 600. Find the closing debt.
4. The output gap is 50 and each unit of gap changes the balance by 0.30. Find the cyclical and structural deficits when the total deficit is 45.
5. Interest is 24 and revenue is 300. Find interest as a share of revenue.
6. Saving, tax and import rates are 0.1, 0.2 and 0.2. Find the multiplier.
7. After 3% nominal growth, GDP is 1,545. Find the closing debt ratio for question 3, and compare it with the opening ratio.
8. Total spending of 345 includes interest of 24. Find the primary balance.
9. Why does a cut in spending reduce the deficit by less than the cut?
10. Why can a country with a high debt ratio have a lower risk than one with a low ratio?
11. Name two roles of the OBR.
12. Give one reason a surplus in a recession could be harmful.

Answers

1. Deficit of 45 (300 - 345 = -45).
2. 45 / 1,500 = 3.0%.
3. 600 + 45 = 645.
4. Cyclical 0.30 x 50 = 15; structural 45 - 15 = 30.
5. 24 / 300 = 8.0%.
6. 1 / (0.1 + 0.2 + 0.2) = 1 / 0.5 = 2.
7. 645 / 1,545 = 41.7%, up from 600 / 1,500 = 40.0%: the deficit outpaced growth.
8. Primary balance = 300 - (345 - 24) = 300 - 321 = -21, a primary deficit of 21.
9. Lower spending reduces income through the multiplier, so tax receipts fall and benefit spending can rise, offsetting part of the saving.
10. Debt risk depends on the interest rate against growth, who holds the debt, its currency and its maturity, not on the ratio alone.
11. Any two: forecasting, assessing performance against fiscal targets, long-term sustainability, fiscal risks, scrutinising policy costings.
12. A surplus removes demand, so it can deepen the downturn, raise unemployment and reduce tax revenue.

Where marks are usually lost

• Using “deficit” and “debt” as if they meant the same thing.
• Quoting a debt figure with no comparison to GDP, interest rates or growth.
• Assuming a deficit is always a problem, with no reference to the cycle or purpose of the borrowing.
• Treating the multiplier as a fixed number for every policy, or ignoring the tax recouped.
• Listing consequences with no chain of reasoning from cause to macroeconomic effect.
• Evaluation that says “it depends” without saying on what.
• Claiming austerity always works or never works, rather than linking it to the state of the economy.
• Calling the OBR a lawmaker or a source of tax policy.
• Ignoring the time frame: short-run effects on demand against long-run effects on supply.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, published by AQA. These notes follow the A-level content in section 4.2.5.1.