The Congressional Budget Office (CBO) estimates that the federal budget deficit for FY2009 was $1,414 billion, triple the $459 billion deficit recorded in FY2008. CBO expects the deficit for FY2010 to be $1,349 billion. CBO estimates that, in FY2009, the American Recovery and Reinvestment Act (ARRA) resulted in additional outlays of $112 billion and a drop in revenues of $88 billion, which raised the budget deficit $200 billion above what it otherwise would have been. The budget deficit in FY2009 was, in dollar terms, unprecedented. Compared to the overall economy, the $1.4 trillion budget deficit equaled 9.9% of gross domestic product (GDP). In 1943, the budget deficit reached 30.3% of GDP. Since 1946 and before now, the largest the budget deficit had been, relative to the overall economy, was 6% of GDP in 1983. As recently as FY2001, the budget registered a surplus. Between 1992 and 1998, a combination of budget policy and a booming economy entirely eliminated the deficit. But after four successive years of surpluses, outlays again exceeded revenues in 2002 and the budget has been in deficit since then. In an economic downturn, deficit reduction is usually not an immediate consideration. The economy is expected to begin to recover in 2010, but deficits are likely to remain high for some time both because of continued countercyclical fiscal policy and because reducing the deficit as soon as the economy begins to recover could have an undesired contractionary effect. In the longer run, however, continued deficits at current levels could ultimately reduce the long-run rate of economic growth. Although both the severity of the current downturn and the size of the projected deficits surpass what most policymakers have experienced, experience remains a guide to policy. Economists are not necessarily changing their views about the economic effects of budget deficits even though those views may have been established in less trying times. This report examines the economics the budget deficit. The share of income that is saved depends in part on relative preferences for current and future consumption. From an economic standpoint, there is no optimal rate of saving. Nonetheless, raising the national rate of saving is an oft-stated goal of policymakers. Most economists, however, believe the capacity of public policy to influence private saving behavior is limited. The one certain way to raise the national saving rate through public policy is to increase the public sector saving rate, and that is what happened in the 1990s. The national saving rate rose after 1995 because increases in public saving more than offset falling private saving. In recent history, budget surpluses have been rare, and a succession of surpluses rarer still. In every year between FY1969 and FY1998, the federal budget was in deficit; that is, outlays exceeded receipts. Beginning in 1929 and until 1969, the budget was in surplus for a total of nine years, and during that time was never in surplus for more than three years in a row. Figure 1 presents figures for federal budget outlays, receipts, and the surplus beginning in 1979. Rather than showing dollar amounts, each of the three series is expressed as a percentage of GDP. Showing the figures in this way focuses attention on the size of the budget aggregates relative to the economy as a whole. An economic downturn began in mid-1981 and ended in late 1982, and the budget deficit grew to 6.0% of GDP in 1983. Since then, with a brief reversal attributable to an economic contraction in 1990 and 1991, the deficit shrank and turned into a surplus which increased steadily until 2000. In 2001, the surplus fell from 2.4% of GDP the previous year to 1.3% of GDP. In 2002, there was a budget deficit of 1.5% of GDP and by 2004 it had reached 3.5% of GDP. The U.S. economic expansion came to an end in December 2007 and in 2008 the deficit increased to 3.2% of GDP. For 2009, the deficit reached 9.9% of GDP, is projected by CBO to stay above 9% of GDP for 2010. The federal budget and the economy are closely interrelated. The strength or weakness of the overall economy substantially affects the levels of outlays and receipts. The budget also has significant effects on the economy, both in terms of how fast the economy grows, and also in terms of the overall allocation of resources. Over fairly short periods of time, say three or four years, fiscal policy can affect the rate of economic growth by adding to, or subtracting from, aggregate demand. Consider, for example, a one-time increase in total federal spending, with no matching rise in tax receipts. Each additional dollar of government spending becomes income for those who satisfy the initial increase in demand for public goods and services. In turn some of that increase in income will be spent, raising the income of those who satisfy a second wave of increased demand for goods and services. Theoretically, this process continues with each successive increment to income getting smaller and smaller as some is saved and some is spent. Because of the initial increase in spending and the additional spending that is subsequently stimulated, the economy grows somewhat faster than it otherwise would have. For a time, the size of the economy may even increase by more than the initial increase in government spending. Government spending is thus said to have a 'multiplier effect.' There can also be a multiplier effect in the case of a spending cut, although the effect is in the opposite direction. If the government reduces spending, that can cut the incomes of those who otherwise would have provided goods and services to the government. If it does, they must either reduce their spending or their saving. To the extent that they cut spending, it adds to the decline in output initiated by the cut in public spending. The government may also be able to influence the rate of economic growth in the short run via tax cuts or increases. Just as an increase in public sector spending temporarily increases some incomes, so a tax cut increases the amount of income taxpayers have at their disposal. Some of that increase in after tax income is likely to be spent, and so tax cuts may have a multiplier effect just as changes in government spending do. A tax increase reduces disposable income, and so contributes to a slowdown in private sector spending. Given current economic conditions, with rising unemployment and idle resources, a stimulative fiscal policy is more likely to support growth than raise either interest rates or inflation. Given a sufficient fiscal policy boost, other things being equal, a slack economy will tend gradually to converge to full employment. As the economy approaches full employment of both labor and capital, additional increases in aggregate demand would be more likely to be satisfied by higher prices than by increased real output. For the moment it is not much of a concern, but in the view of most economists, the government cannot permanently increase the size of the economy by forever increasing spending, or cutting taxes. As is often the case in economics, other things do not remain equal. An increase in spending, or a tax cut, increases the deficit and so increases the public sector's demand for credit. Increased credit demand tends to raise interest rates. Higher interest rates, in turn, discourage borrowing in the rest of the economy for those activities that depend on credit, especially housing and consumer durable goods. Higher interest rates also tend to make dollar-denominated financial assets more attractive to overseas investors. To buy those assets, however, foreigners must first buy dollars. This increased demand for dollars pushes the foreign exchange value of the dollar above what it otherwise would have been. The 'stronger' dollar makes imported goods cheaper, and makes goods and services produced in the United States more expensive abroad. The change in prices tends to increase demand for U.S. imports and moderate U.S. exports, raising the trade, or current account, deficit. Thus, some of the stimulus is, in a sense, exported. Fiscal policy may also affect prices. An increase in aggregate demand, stimulated by an increase in spending or a cut in taxes, can be satisfied in one of two ways; either an increase in real production, or an increase in the general price level. If the economy is already operating at full employment, and the capital stock is operating at or near full capacity, then it is more likely that any increase in demand will be met by higher prices than by increased production of goods and services. In a fully employed economy, an increase in government spending would yield a much larger increase in nominal than it would in real GDP. Whether because of higher interest rates or rising prices, any effects of an increase in government spending, or a tax cut, on the rate of economic growth tend to diminish as the economy approaches full employment. In a fully employed economy, an increase in government spending is more likely to result in a change in the composition of output than to raise its level. Estimates of the multiplier effect of a change in fiscal policy vary, but most of them suggest that it reaches a peak value of somewhere between one and one-and-a-half times the original stimulus. In most economic models, that peak effect is realized within one or two years of the initial change in policy. In other words, for every dollar increase in federal spending, the economy, within a year or two, will be larger than it otherwise would have been by somewhere between a dollar and a dollar-and-a-half. Not all changes in spending and taxes, however, reflect changes in fiscal policy. Just as the budget can have an effect on short-run economic growth, the rate of economic growth can also have an effect on the budget. Faster economic growth tends to raise revenues above, and reduce outlays below, what they otherwise would have been. Faster growth means more people are working, which raises taxable incomes, which in concert with progressive tax rates increases tax receipts.