How Do You Use Math In The Real World Essay Problems of Budget Deficits

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Problems of Budget Deficits

A budget deficit occurs when public spending is greater than tax revenue. For political reasons, a budget deficit often occurs. Politicians never win votes by raising taxes and cutting spending. With many major world economies facing large budget deficits. It is worth considering the main economic disadvantages of public borrowing.

Increase in indebtedness

The government will need 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

The bond sale will increase the national debt, currently £300 billion. Annual interest payments are approximately £23 billion, this has a high opportunity cost because it requires future generations to pay higher taxes.

AD increase

A budget deficit implies lower taxes and an increase in G, this will increase DA and this can lead to higher real GDP and inflation.

More taxes and less spending

In the future, the government may have to raise taxes or cut spending to reduce the deficit. This can lead to reduced incentives to work

Increase in interest rates

If the government sells more bonds, interest rates are likely to rise. This is because they will have to raise interest rates to attract investors to buy the additional debt.

If government interest rates rise, so will other interest rates.

Displacement

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

inflation

In extreme circumstances, the government can increase the money supply to pay off the debt, but this is unlikely to happen in the UK.

If the government sells gilts short-term to the banking sector, there will be an increase in the money supply, because the banks see that gilts are close to money, so they can keep them for loans to customers. However, they will also increase the money supply by lending to the government.

Note that 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 pull the economy out of recession. If the government borrows to invest in infrastructure and education, this can benefit the economy in the long run.

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