Question

How will a growing budget deficit affect the economy? Your answer should discuss interest rates, private investment, and aggregate expenditure.

8.5.2

Answer 1

Economic effects of a budget deficit

Increase in public sector debt

The government will have to borrow from the private sector. In the UK, the Debt Management Office (DMO) sells bonds and gilts to the private sector. The public sector debt is the total amount of debt owed by the government.

Higher debt interest payments

When the government borrows, it offers to pay an interest payment to those who buy the bonds. The interest rate attracts investors to lend the government money.

Increased aggregate demand (AD)

A budget deficit implies lower taxes and increased Government spending (G), this will increase AD and this may cause higher real GDP and inflation. For example, in 2009, the US lowered VAT in an effort to boost consumer spending, hit by the great recession.

Fund public sector investment

A government may run a budget deficit to finance infrastructure investment. This could include building new roads, railways, more housing and improved telecommunications. This public sector investment can help increase long-run productive capacity and enable a higher rate of economic growth. If growth does improve, then the borrowing can pay for itself. For example, many public sector investment projects can have a rate of return higher than the cost of borrowing

Future – higher taxes and lower spending

In the future, the government may have to increase taxes or cut spending in order to reduce the deficit. After 2010, the coalition government implemented a period of austerity. This involved cutting public sector spending; in particular, areas such as local government, public sector pay saw cuts in government spending – affecting public services and public pay.

Increased interest rates/bond yields

If the government borrows more, this can cause interest rates to increase. This is because they will need to increase interest rates in order to attract investors to buy the extra debt. In 2012, countries in the Eurozone saw a rise in bond yields because there was a lack of confidence in Eurozone economies and the ability to finance the deficit.

Crowding Out

Increased government borrowing may cause a decrease in the size of the private sector. The government borrow by selling bonds to the private sector. Therefore, if the private sector (banks/private individuals) buy government bonds, they have less money to invest in private sector projects. If there is crowding out, government borrowing will not cause higher aggregate demand