government deficit financing

Government Deficit Financing (Cambridge A‑Level Economics 9708)

1. Macro‑Economic Objectives Linked to Deficit Financing

• Price stability – model: AD/AS. A right‑ward shift of AD raises the price level (inflation) if the economy is near full capacity.
• Full employment – model: AD/AS and the Phillips curve. In a recession, a right‑ward AD shift raises output and reduces cyclical unemployment, moving the economy down the short‑run Phillips curve.
• Economic growth – model: AD/AS (short‑run) and potential output (long‑run). Deficit‑financed investment can raise the LRAS curve, increasing real GDP per capita.
• External balance – model: current‑account = savings – investment. Higher domestic demand can widen the current‑account deficit; foreign borrowing can affect the balance of payments.
• Equitable distribution of income – model: distributional impact of fiscal policy. Progressive spending (e.g., welfare, education) can reduce poverty and inequality.

Deficit financing can help achieve the first three objectives in the short run, but it may create trade‑offs (inflation, crowding‑out, external deficits). Recognising these trade‑offs is a core part of the syllabus.

2. Fiscal‑Policy Foundations

2.1 Key Definitions

Term	Definition
Budget balance (fiscal balance)	Difference between total government revenue (T) and total government expenditure (G) in a year.
Primary deficit	G – T (excludes interest payments on existing debt).
Overall (total) deficit	G – T + iB, where iB is interest on the existing stock of debt B.
National debt (stock of debt)	Cumulative total of past deficits – the outstanding government bonds and loans.
Debt‑to‑GDP ratio	Debt ÷ Nominal GDP (expressed as a %). Indicates the sustainability of the debt burden.
Fiscal sustainability	Occurs when the growth rate of nominal GDP (g) exceeds the average interest rate on the debt (r), i.e. g > r, or when a primary surplus can be generated.

2.2 The Budget Identity

The flow of fiscal operations can be written as:

\[ G + iB = T + \Delta B \]

Re‑arranging gives the overall‑deficit equation shown above. The primary deficit isolates the effect of current‑year spending and taxation, ignoring the debt‑service cost.

2.3 AD/AS View of an Expansionary Deficit

• Deficit‑financed government spending (or tax cuts) raises aggregate demand → AD shifts right.
• Short‑run: if the economy is below full capacity, output rises and unemployment falls; price level rises only modestly.
• Long‑run: if the economy reaches potential output, the AD shift mainly raises the price level (inflation).

2.4 Worked Example – Debt‑to‑GDP Ratio

Suppose at the end of 2023:

• Outstanding public debt = £850 bn
• Nominal GDP = £2 500 bn

Debt‑to‑GDP ratio = \(\frac{£850\text{ bn}}{£2 500\text{ bn}} = 0.34 = 34\%\).

If the government runs a primary deficit of £30 bn and the interest rate on debt is 3 %:

• Interest cost = 0.03 × £850 bn = £25.5 bn
• Overall deficit = £30 bn + £25.5 bn = £55.5 bn
• New debt stock = £850 bn + £55.5 bn = £905.5 bn
• Assume nominal GDP grows by 4 % → new GDP = £2 500 bn × 1.04 = £2 600 bn
• New debt‑to‑GDP ratio = \(\frac{£905.5}{£2 600} ≈ 34.8\%\).

The ratio rises only slightly because GDP growth outpaces the increase in debt, illustrating a sustainable path (g = 4 % > r = 3 %).

3. Why Governments Run Deficits

• Counter‑cyclical stimulus – boost AD during a recession (Keynesian policy).
• Financing long‑term productive investment – infrastructure, education, R&D that raise potential output.
• Smoothing tax burdens – spread the cost of volatile revenue (e.g., commodity price shocks) over time.
• Emergency spending – natural disasters, wars, pandemics.
• Political considerations – election cycles can generate temporary deficits (political‑business cycle).

Each motive must be weighed against the five macro‑policy objectives (section 1).

4. Main Methods of Deficit Financing

Method	Typical Instruments	Source of Funds	Key Advantages	Key Disadvantages / Risks
Borrowing from the domestic public	Government bonds, Treasury bills	Households, firms, banks (private sector)	Does not create new money; preserves central‑bank independence.	May raise domestic interest rates → crowding‑out; limits future borrowing capacity.
Borrowing from the central bank (Monetisation)	Direct purchase of bonds, quantitative easing (QE)	Central bank creates high‑powered money.	Immediate financing; can keep interest rates low.	Risk of inflation or “fiscal dominance” if used excessively.
Foreign borrowing	External bonds, loans from multilateral institutions, sovereign‑credit lines	Foreign investors, foreign governments, IMF, World Bank.	Access to larger capital pools; may lower borrowing cost when domestic rates are high.	Exchange‑rate risk; future debt‑service in foreign currency; possible impact on external balance.

5. Central‑Bank Financing (Monetisation) in Detail

1. The Treasury issues a government bond for the required amount.
2. The central bank buys the bond on the open market, paying with newly created reserves (high‑powered money).
3. Commercial banks receive the reserves, which can be multiplied through the fractional‑reserve system.

The money multiplier links the monetary base (high‑powered money) to the broader money supply (M):

\[ m = \frac{1}{c + r} \]

• c = cash‑hold ratio (currency held by the public relative to deposits).
• r = reserve‑to‑deposit ratio required by the central bank.

Example: If c = 0.2 and r = 0.1, then m = 1/(0.2+0.1) = 3.33. A £10 bn bond purchase could ultimately increase the money supply by about £33 bn, assuming banks lend out the full multiplier.

6. Interaction with Monetary Policy

• Interest‑rate targeting – The central bank may raise the policy rate to offset inflationary pressure from monetisation, shifting the LM curve leftward.
• Quantitative easing (QE) – Large‑scale bond purchases are a form of deficit financing that also aims to lower long‑term yields.
• IS‑LM analysis – Deficit spending shifts IS right; a simultaneous monetary expansion shifts LM right. The net effect on output and interest rates depends on the relative magnitude of the two shifts.
• AD‑AS framework – In the short run, increased AD raises output and the price level; in the long run, if the economy is at full capacity, the primary effect is higher prices (inflation).

7. Effects on the Money Supply and the Real Economy

Financing Method	Immediate Impact on Money Supply	Typical Short‑run Effect on Interest Rate & Output	Long‑run Considerations
Domestic public bond issuance	Neutral – funds move from savers to the Treasury.	Potential rise in real interest rates (crowding‑out) → lower private investment; AD may rise modestly.	Higher debt‑service costs; risk of fiscal unsustainability if deficits persist.
Central‑bank purchase (Monetisation)	Expansionary – reserves rise, money supply expands via multiplier.	Lower interest rates; AD shifts right → higher output and price level.	Inflation risk if output is near full capacity; possible “fiscal dominance”.
Foreign borrowing	Depends on exchange‑rate regime; domestic money supply rises if proceeds are spent locally.	Can support output without raising domestic rates; may appreciate the currency under a fixed regime.	Future repayment in foreign currency; exchange‑rate volatility; impact on external balance.

8. Crowding‑Out vs. Crowding‑In

• Crowding‑out – Government borrowing shifts the demand for loanable funds leftward, raising the real interest rate (r) and reducing private investment. In IS‑LM terms, IS shifts right while LM shifts left.
• Crowding‑in – If the deficit finances productive infrastructure, human‑capital or R&D, the marginal productivity of private capital rises. This can shift the investment (or loanable‑funds supply) curve rightward, lowering the effective cost of borrowing and stimulating private investment.

In exam answers, evaluate both possibilities and link them to the type of spending (consumption vs. investment) and the state of the economy (recession vs. full‑employment).

9. Fiscal Theory of the Price Level (FTPL)

The FTPL states that the price level is determined by the present value of future primary surpluses relative to the existing stock of debt:

\[ P = \frac{M}{\displaystyle\sum_{t=1}^{\infty}\frac{(G_t - T_t)}{(1+r)^t}} \]

Implication for A‑Level: even with a constant monetary base, a credible lack of future primary surpluses can raise inflation expectations, causing the price level to rise.

10. Policy Mix & Evaluation

10.1 The Policy Mix

• Fiscal policy – deficit financing, tax changes, public‑sector investment.
• Monetary policy – interest‑rate setting, open‑market operations, QE.
• Supply‑side measures – infrastructure, education, deregulation, tax incentives.

Effective coordination matters: an expansionary fiscal stance combined with an accommodative monetary stance can maximise the boost to AD, whereas a tight monetary stance may neutralise the fiscal stimulus.

10.2 Evaluation Criteria (What Examiners Look For)

Criterion	What to Assess
Effectiveness	Magnitude of impact on output, unemployment and inflation.
Efficiency	Cost‑benefit of the financing method (interest cost, inflation risk).
Equity	Distributional effects of the spending and of the future debt burden.
Timing	Speed of implementation versus the lag in the economy.
Sustainability	Debt‑to‑GDP trajectory, need for future primary surpluses, fiscal rules.
Risk of Government Failure	Political‑business cycle, fiscal dominance, rent‑seeking, corruption.

10.3 Government Failure in Deficit Financing

• Politically motivated deficits that are not linked to macro‑economic goals.
• Misallocation of borrowed funds (e.g., wasteful current‑consumption projects).
• Failure to plan credible future surpluses → loss of confidence and higher inflation expectations.

11. Policy Implications & Coordination

• Adopt a clear fiscal rule (e.g., debt‑to‑GDP ceiling, structural‑balance target) to guard against unsustainable borrowing.
• Central banks should retain operational independence but monitor the composition of government debt to detect “fiscal dominance”.
• In a low‑inflation environment, moderate monetisation (QE) can support recovery; near full capacity it should be avoided.
• Supply‑side deficit financing (infrastructure, education) can generate crowding‑in and improve long‑run growth, helping to bring the debt ratio down.

12. Suggested Diagrams for Exam Answers

• IS‑LM diagram showing the combined effect of a fiscal expansion (rightward IS) and a central‑bank purchase (rightward LM).
• Loanable‑funds market illustrating crowding‑out (demand shift) and crowding‑in (supply shift).
• AD‑AS diagram with a rightward AD shift caused by deficit‑financed spending – short‑run output rise, long‑run price‑level rise.
• Debt‑to‑GDP trajectory chart comparing a sustainable path (g > r) with an unsustainable path (r > g).

13. Summary Checklist for Exam Answers

1. State whether the deficit is primary or overall and show the relevant budget identity.
2. Identify the financing method and describe its immediate effect on the monetary base.
3. Analyse the short‑run impact on interest rates, investment, output and inflation (use IS‑LM, AD‑AS or loanable‑funds diagrams where appropriate).
4. Discuss long‑run sustainability: debt‑to‑GDP trend, need for primary surpluses, and possible inflationary pressures.
5. Evaluate the policy using the criteria of effectiveness, efficiency, equity, timing, sustainability and risk of government failure.
6. Conclude with a recommendation on whether the chosen financing method is appropriate given the current macro‑economic context.