Question

What is the difference between a nominal deficit and the real deficit? How can inflation wipe out the burden of the national debt? Who bears the cost of eliminating debt with inflation? Explain in a short paragraph.

Answer 1

Nominal deficit can be defined as the difference between actual expenditures and actual receipts. On the other hand, Real deficit is the nominal deficit adjusted for inflation. The following formula clearly differentiates between the two:

Real Deficit (R) = Nominal Deficit(D) – (inflation × total debt)

Inflation can be helpful in wiping out the burden of the national debt. Inflation makes the value of the home currency used to payoff the debt worth less in real terms than when it was borrowed. But the cost of a fall in the value of a currency falls on government security holders. They are paid back the principal amount that they lent to the government when they bought the bond plus the interest. But if they are not compensated for the decline in the value of each unit of currency they receive as repayment , they lose, due to inflation. The bondholders' loss is the government's gain. Consequently, bondholders pay back the part of the debt with their lost purchasing power.