Deficit Spending

Deficit Spending

Deficit spending is a government’s spending exceeding the revenue it collects. Deficit spending can be used to finance wars, social programs and more. The opposite of deficit spending is budget surpluses or balanced budgets where revenues equal expenditures. Governments typically run budget surpluses during economic growth because more tax revenues and less demand for social services such as unemployment benefits are coming in. Deficit spending is a strategy that governments use to create demand within the economy (Bodea and Higashijima, 2017). It does this by injecting more money into the economy than it takes out. This extra money, in theory, will allow companies to expand production and hire more employees, which allows consumers to spend more money and pay down debt. Deficit spending is often used during economic recessions or depressions because it helps jump-start a sluggish economy. This paper seeks to describe the advantages, disadvantages, and effects of deficit spending on a nation’s economy.

Advantages

• It is useful in controlling inflation in the economy.
• It helps in achieving full employment and economic growth.
• It helps promote exports and reduce imports with the help of the devaluation of the currency.
• It helps remove income and wealth inequality by increasing aggregate demand for goods and services, thereby helping to redistribute income and wealth more evenly.
• It provides a cushion against adverse changes in business cycles; it can be used for counteracting a recession or depression during business cycle troughs.

The government can use deficit spending to encourage economic growth and reduce unemployment by putting more money into the economy. Deficit spending can also be used to finance wars and other expensive activities. However, the downside of deficit spending is that governments have to borrow money to pay for the extra spending, which eventually has to be paid back with interest.

Disadvantages

• When the government runs a deficit, a large debt burden must borrow more money from the public and foreign countries to pay for its expenses. If a country runs too many deficits, it could lead to the large national debt, resulting in high-interest payments, high taxes, inflation, or even bankruptcy.
• Crowding out - If the government borrows too much money from banks, there will not be enough left over for businesses or consumers to borrow. This can slow economic growth since businesses won’t expand or hire new workers unless they can get loans from banks.
• Increased borrowing will force governments to pay higher interest on their debt obligations, which means less money available for public services in the future (Pettifor, 2019).
• A final disadvantage is that deficit spending can lead to a trade imbalance, causing foreign governments to reduce their holdings of U.S. investments, driving down demand for U.S.-based assets and increasing costs for U.S.-based companies selling goods overseas.

Effects of Government Borrowing

One impact is the crowding effect. The crowding-out effect occurs when the federal government borrows to finance its spending, increasing interest rates. This increases the cost of capital for firms and consumers, decreasing private investment in the economy, with less investment, less employment and less output. The crowding-out effect can be particularly pronounced in a weak economy with high unemployment rates and low economic growth. Instead of addressing these problems by boosting demand through increased spending, the government pursues austerity policies, cutting spending and borrowing. The result is less spending overall in the economy and continued stagnation or recession. There are several ways this process works. For example, when the government borrows money directly from consumers by issuing savings bonds or Treasury bonds, it draws that money away from private investment and other uses (Bodea and Higashijima, 2017). If interest rates are higher than inflation rates, investors will choose to hold onto their money instead of spending or investing it. This reduces demand and increases unemployment. Another effect is that federal debt can be inflationary. The Federal Reserve controls the monetary supply through adjusting interest rates. If the Fed buys government debt for them to raise the supply of cash, it may also increase inflation if there are insufficient goods relative to the existing supply.

Conclusion

This paper has explained the advantages, disadvantages, and effects of deficit spending on a nation’s economy. Deficit spending is where a government spends more money than it receives as revenue, resulting in a shortfall. It does this by issuing debt, which allows the government to balance its overall expenditure and the total revenue made. Proponents of deficit spending argue that it can be beneficial in an economic recession or downturn because it can help increase the money supply in circulation and compensate for reduced private investment by giving people more money to spend or invest themselves. Opponents say significant drawbacks include rising interest rates and rising private businesses crowded out of credit markets by increased government borrowing. The biggest argument against deficit spending is that it doesn’t help long-term growth because it leads to a larger national debt. Once you add up all the government’s deficits over the years, you have a very large amount of money that is in debt through interest payments or taxation.

References

Bodea, C., & Higashijima, M. (2017). Central bank independence and fiscal policy: Can the central bank restrain deficit spending?. British Journal of Political Science, 47(1), 47-70.

Javed, S. A. (2019). Limitless Deficit Financing for Economic Prosperity: Where They Got the Keynes’s Deficit Spending Wrong?. Journal of King Abdulaziz University: Islamic Economics, 32(1).

Pettifor, A. (2019). ‘Deficit Financing’or ‘Deficit-Reduction Financing?’Debates in Contemporary Economics: Origins, Confusions and Clarity. Journal of King Abdulaziz University: Islamic Economics, 32(1).