Question

a. Explain four (4) ways of financing budget deficits

b. Discuss four (4) macroeconomic problems associated with high budgetary deficits

Answer 1

a) Government can finance budget deficits by following methods

1) Increase in the tax rate:Revenue collected from taxation is the primary source of revenue for the government. Thus government finance its budget deficit by increasing the tax rate.

2) Decrease in the government spending : The government can postpone or reduce its spending in order to reduce its budget deficit.

3) Borrowing : Government can borrow funds to reduce its budget deficit. It can take loan from Central bank or directly from public at a certain interest rate. Government can also borrow from other countries or international institutions like IMF to support its budget deficit.

4) Disinvestment: Government can sell the stake of government securities to raise funds for its budget deficit.

b) Problems associated with high budgetary deficits are following :

1) High budget deficit calls for debt monetisation ie printing of currency by the central bank to help reduce budget deficit of government. But this can result in high inflation(Hyperinflation).

2) A favourable Debt to GDP ratio (Should be 60%) indicates an economy can easily pay its debt. In the case of high budget deficit, debt to GDP ratio is also quite high, indicating that government can default on its loan. Thur further loan extending is barred.

3) High debt to GDP ratio leads credit rating agency to downgrade the government bonds which makes government bonds risky. Thus government unable to borrow further. FDI and FPI also reduces due to high risk.

4) Overall economic shrink and poses high risk of collapsing of the economy.