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Deficit spending occurs when a shortage of financial resources in the federal budget arises. In the modern economic environment, the economies of many countries are associated with chronic budget deficits, i.e. exceeding budget spending over national incomes. Many economists correlate budget deficits with adverse impacts on economic development – the stimulation of inflation processes, the creation of barriers to economic growth, and negative social outcomes. However, a budget deficit is not necessarily an extremely negative phenomenon, and it is argued that budget deficits can provoke the revival of national economic activity.
Money creation is considered a traditional method of budget balancing. The emissive method of covering budget deficits implies the increase in monetary volumes, i.e., the government issues extra money, which is used to cover excess expenditures. The major advantage of this method is the growth of money supply that is interrelated with the increase in the aggregate demand and production output (Van Lear, 2002).
The increased money supply determines the decrease in interest rate growth at the money market, and it stimulates investments and growth of aggregate expenditure and output. However, it is always interrelated with inflation. To avoid adverse effects of emission, the supporters of the Keynesian perspective suggest the implementation of deficit spending as an effective method for the distribution of tax burdens in time and the consequent facilitation of debt reimbursement.
Nowadays, the necessity for the use of deficit spending for the fulfillment of social needs is defined by many factors. Adherence to active social policy, an increase in defensive potentialities, international activities, etc. require continuous investments. At the same time, budget income is constrained by taxation limits. Thus, the use of deficit spending methods associated with the increase in domestic debt may help to achieve immediate loosening of contradictions between the growing social demands and limited national resources.
Contrary to money emission, budget-balancing through issuing and selling securities to the population can be regarded as a non-inflationary method since it is not associated with the growth of monetary supply. The use of public securities sales is strategically more acceptable for the government than taxation increases, as the increase in taxes may lead to public discontent. Debt financing may stimulate economic growth. By increasing expenditures through loans, the government produces a demand for investment and consumer goods. At the same time, the positive multiplier effect stimulates the activities in other sectors and increases employment rates (Couch, 2010).
Every debt should be paid out. The population will not purchase government securities if they do not bring profit, i.e., in case the government does not pay interest. The larger governmental debt is (the greater number of public securities is issued), the bigger sums are required for debt service (Couch, 2010). But the interest payments for public securities constitute a large portion of government budget expenditures.
Thus, increased interest rates can lead to the growth of budget deficits. The vicious circle arises – government issues securities with financing the deficit, but the consequent increase in interest rates provokes greater deficits. Eventually, the implementation of money emission can be required to cover the growing debt and prevent the development of payment balance deficits. Thus, in the long run, the sale of public securities and governmental loans may lead to inflation.
One of the major disadvantages of deficit spending is a crowding-out effect, which is associated with the extrusion of private investments. The crowding-out effect implies that the increase in the number of governmental debenture stocks at the securities market requires spending a portion of household savings for the purchase of government securities that supports deficit spending, i.e., it is used to fulfill non-production objectives. It provokes a decline in the purchase of private firms’ securities, which is interrelated with production expansion and economic growth (Leclaire, 2008). As a result, while the government issues state securities, it reduces the financial resources of private entities and their investments.
The literature review reveals that while the government finances deficit through the increase of internal loans, it builds a financial pyramid, i.e., refinances deficit through repaying past debts by borrowing resources in the present. However, a new debt should be paid in the future as well, and the debt repayment includes the sum of debt itself, as well as the relevant interests. Based on this, when the government uses deficit spending as the only method of deficit financing, the moment when the deficit will become so large (i.e., the excess number of government bonds will be issued, and debt service expenditures will be substantial) that it’s financing through debt increase will not be possible, money emission will be needed.
In this case, the volume of emission will be much higher than when it is implemented gradually and in small portions. As a result, an outbreak of inflation may arise. Thus, to avoid high inflation, it can be suggested not to refuse the use of emission method completely, but to implement it in combination with the sales of public securities.
Couch, K. (2010). Deficit Spending and The Debt. Journal of Policy Analysis and Management,29(4), 875-876. Web.
Leclaire, J. (2008). U.S. Deficit Control and Private-Sector Wealth. Journal of Post Keynesian Economics, 31(1), 139-149. Web.
Van Lear, W. (2002). A Political Economic Commentary on Government Finance and Monetary Policy. Journal of Economic Issues, 36(1), 183-185. Web.