Background
John Maynard Keynes is referred as to one founder of the present-day macroeconomics theory. He analyses the relationship between the government’s spending habits to the government’s income in the form of taxes (Wernicke, 2018). Deficit spending refers to a situation where the government expenditure rates are more than the government’s revenues during a fiscal period. For instance, the government can take a loan while utilizing its spending power to create demand in the economy.
Deficit spending works by following the fiscal policy and other economic realities. During a recession or when fostering future economic growth, the government intentionally runs deficits to stimulate the economy (Wernicke, 2018). The shortages are created by reducing the current surplus, importing goods and services more than exports, and raising the existing debt load. This, in turn, spurs the productivity of the country’s economy and increases the local industries’ competitiveness globally.
Advantages of Deficit Spending
Deficit spending is effective in stimulating the economic growth of the economy. The government will have adequate funds at its disposal to improve infrastructure and create more job opportunities for the existing large labour force (Schirm, 2019). Economic stability and growth will attract investors into the country who will set up various businesses that will serve as employment opportunities and also increase the revenue earned by the government. Deficit funding is, therefore, an easy source of funding for the government.
By Increasing the debt load, the government will have more liabilities and interest to pay back. Due to these interests, the government will be mandated to be more responsible in its spending. Therefore, the government is careful when making decisions on investing, budgeting and allocating resources (Schirm, 2019). The spending and government projects will always be prioritized based on their importance. Deficit spending can also be considered an emergency fund in cases of disasters. Deficit spending, therefore, serves as a protection service for the country. For instance, if the government is faced with a disaster or war while in recession, deficit spending can be used to bail the bills of controlling the disaster.
Disadvantages of Deficit Spending
Though deficit spending intends to stimulate the economy, it can lead to economic deterioration in some cases. Poor financial performance is because the government may be forced to prioritize paying off the debts and interests of various funding bodies rather than focusing on growth (Irwin, 2019). In cases of emergencies, the government will lack enough resources to resolve the problem. The government will be forced to borrow to meet its expenditures in some cases, resulting in a vicious cycle. Also, in the efforts to accumulate enough funds, the government will hike taxation rates, reduce necessary public services and raise the prices of commodities. This will result in inflation of the economy and lower living standards.
If the government officials fail to manage the resources efficiently, the country’s debt will increase, resulting in further recession. This will reduce resources used in infrastructure and development. Investors will be discouraged from establishing their businesses in the country (Irwin, 2019). Deficit spending can put the country’s national sovereignty at risk. This is so because the financing institutions will significantly influence the government decisions on the country’s governance. Nations and financial institutions that loan money to another nation in times of recession will always tend to make demands before approving the release of the funds. For example, they will demand the government to auction its assets to pay off the loan. The government may be forced to change the spending laws and policies of the country to meet the loaner requirements.
Crowding out effect
The crowding-out effect refers to an economic theory that states that a rise in the public sector spending will cause a reduction or eliminate the private sector spending. The spending dampens the initial surge of total spending investment (Strupat & Klohn, 2018). The government adopts an expansion policy that raises its spending to stimulate economic activity. The approach leads to increased interest rates that affect the investment decisions of the private sector. Increased rates make investment expensive, and it makes it challenging to access debts because the opportunity cost of borrowing funds rises, making investments cost-prohibitive.
Crowding out is associated with three reasons, including economics, social welfare and infrastructure. When the economy is above capacity, the government meets competition from the private sector, unlike when it is weak. Suppose the economy is weak, the spending of both the government and the personal sector increases (Strupat & Klohn, 2018). Spending on aggregate demand leads to increased tax on the private sector, causing a reduction of consumers and private firms’ discretionary income. Also, crowding out increases the government’s borrowing rates from the private sector. To pay off what it has borrowed, it sells its bonds to the private sector. This causes the government to crowd out private investment within the private sector.
Effects of Deficit Spending on Short-term and Long-term Economic Growth
The effects deficit spending has on the economy are dependent on how well the resources are managed. In the short-term economic growth, it is helpful as it provides easy access to funds that can promote economic growth and create a conducive environment for investment. However, deficit spending will tend to hinder long-term economic growth. This is so because, with time, the interest of the loans taken by the government will rise (Gómez-Puig & Sosvilla-Rivero, 2018). At such times the government will prioritize paying off the debts and interests at the expense of economic growth.
References
Gómez-Puig, M., & Sosvilla-Rivero, S. (2018). Public debt and economic growth: Further evidence for the Euro area. Acta Oeconomica, 68(2), 209-229. Web.
Irwin, N. (2019). How America learned to stop worrying and love deficits and debt. New York Times.
Schirm, S. A. (2019). Domestic politics and the societal approach. In The Palgrave Handbook of Contemporary International Political Economy (pp. 103-117). Palgrave Macmillan, London. Web.
Strupat, C., & Klohn, F. (2018). Crowding out of solidarity? Public health insurance versus informal transfer networks in Ghana. World Development, 104, 212-221. Web.
Wernicke, I. H. (2018). The” Mystery” of banking, money supply and deficit spending from a European perspective. Journal of Economic Development, Management, IT, Finance & Marketing, 10(1).