Now that we have defined budget deficits, budget surpluses, and the government debt, it is time to examine what determines these economic variables. The budget deficit reflects two forces: the stance of fiscal policy and the state of the economy. Fiscal policy refers to the choice by the government of (1) its levels of spending on goods and services, (2) its transfers to households, and (3) the tax rates it sets on households and firms. Most countries have different levels of government, so some tax and spending decisions are made for the whole country, whereas others are made locally. In principle, we can include all levels of government in our discussion. This means that, in the United States, “government” can refer to the totality of local government, state government, and the federal government. In practice, though, it is the decisions of the federal government that have the main impact on the overall fiscal policy of the country. The same is true in other countries—local government decisions are not usually very important for the overall stance of fiscal policy. Tools of Fiscal Policy There are two aspects of fiscal policy: government spending and tax/transfer policy. These fiscal policy choices determine the deficit.  Government Spending Over long periods of time, government spending increases as an economy gets richer. Over shorter periods of time, however, the level of government spending is not closely influenced by the overall level of economic activity. For this reason, we typically suppose that government spending is an exogenous variable that is determined “outside” our framework of analysis.
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