Problems of Budget Deficits

A budget deficit occurs when Government spending is greater than tax revenues. For political reasons a budget deficit often occurs. Politicians never gain votes by raising taxes and cutting spending. With many major World economies facing a large budget deficit. It is worth considering the main economic disadvantages of Government borrowing.

Increased Borrowing

The govt will have to borrow from the private sector, in the UK the government does this by asking the Bank of England to sell bonds and gilts to the private sector.

Higher debt interest payments

Selling bonds will increase the national debt, this is currently £300 billion. The annual interest payments is approximately £23 billion, this has a high opportunity cost because it requires future generations to pay higher taxes.

Increased AD

A budget deficit implies lower taxes and increased G, this will increase AD and this may cause higher Real GDP and inflation.

Higher Taxes and lower spending

In the future the govt may have to increase taxes or cut spending in order to reduce the deficit. This may cause reduced incentives to work

Increased Interest rates

If the govt sells more bonds this is likely to 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.

If govt interest rates increase this will push up other interest rates as well.

Crowding Out

Increased govt borrowing may cause a decrease in the size of the private sector (see fiscal policy)

Inflation

In extreme circumstances the govt may increase the money supply to pay the debt, however this is unlikely to occur in the UK

If the govt sells short term gilts to the banking sector then there wil be an increase in the money supply, this is because banks see gilts as near money therefore they can maintain there lending to customers. However they will also be increasing the money supply by lending to the govt.

note the effect of a budget deficit depends to some extent on the cause. For example in a recession a budget deficit may be necessary to get the economy out of recession. If the government is borrowing to invest in infrastructure and education this can benefit the economy in the long term.

Source by Richard Pettinger

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