A government deficit happens when the money the government spends in a year is greater than the money it collects through taxes and other revenues. Think of it like a family that spends more on groceries, rent, and entertainment than it earns from its job. The family has to borrow money from a bank or other family members to cover the shortfall. The same idea applies to a country’s budget.
Governments sell bonds to investors (individuals, banks, pension funds). In return, the government promises to pay back the principal plus interest at a future date. This is like a student borrowing money from a friend to buy a laptop, promising to pay back with a small extra as a thank‑you.
Governments can also borrow from foreign governments, international organisations (e.g., IMF), or foreign banks. This is similar to a student borrowing from a scholarship fund abroad.
Sometimes the central bank buys government bonds directly, effectively creating new money. This is like a friend giving you cash on the spot, but it can lead to inflation if overused.
| Bond Type | Typical Maturity | Risk Level | Interest Rate |
|---|---|---|---|
| Treasury Bills | < 1 year | Low | 0–2% |
| Government Bonds | 1–10 years | Low–Medium | 2–5% |
| Eurobonds | 5–30 years | Medium–High | 3–7% |
When the central bank purchases government bonds, it injects new money into the economy. The basic money‑supply identity is:
\$M = C + D\$
where M is the money supply, C is cash, and D is deposits. If the central bank keeps buying bonds, D rises, increasing M and potentially causing inflation if the growth outpaces real output.
Key Points to Remember:
Exam Question Tip: Use diagrams where possible (e.g., the money‑supply identity) and relate the discussion to real‑world events like the 2008 financial crisis or recent stimulus packages.