What Part Does Interest Play In Deficit Spending?

What Part Does Interest Play In Deficit Spending

There are instances where the government spends much more than the revenue it generates. These instances result in a deficit in the budget of the government. Thus, a deficit occurs when expenses exceed revenue. The term, deficit, does not only apply to the government. It also applies to individuals and organizations.

The question is: what part does interest play in deficit spending?

In looking at what deficit spending entails, one might want to ask, what part does interest play in deficit spending? Interest plays a pivotal role in the circumstances that surround deficit spending. When the government runs into deficit spending, it usually issues bonds as an avenue to generate revenue. These bonds come with an interest rate that is payable to those buying the bonds. Thus, when the interest rate is low, it becomes easy for the government to service the debt, but where it is high, the cost of maintaining the debt is also high.

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What Is Deficit Spending?

The word deficit means a state of surplus. Thus, the government experiences a state of deficit spending when it spends more than it has budgeted for a particular year. It could also be a situation where the liabilities of the government exceed its assets.

It does not mean that the government consciously and deliberately decides to run into deficit spending. However, it is a phenomenon that society must check because, with these bonds, the government keeps accumulating interest, which in the long run, leads the government into more debt. The result is that it destroys the financial and economic stability of the country.

How Does Deficit Spending Work?

Most times, deficit spending is a policy that the government introduces when it faces severe economic challenges such as a recession. Thus, deficit spending helps the government to tackle issues like unemployment in the society. It is because by using the fiscal policy of deficit spending, the government can create more jobs for its citizens.

Deficit spending arises when the expenditure of the government is much more than the revenue it is generating. In such circumstances, there must have been a reduction in its revenue. It could also have engaged in more expenditure that did not match up to the revenue generated.

A Look At The Revenue Of The United States

When we take a look at the revenue of the government of the United States of America, we discover that about 46% of the government’s revenue comes from income taxes alone. Thus, the government generates more revenue from income taxes than from other sources.

After the income taxes, the next primary source of income for the American government is the social insurance taxes, which make up about 35% of the revenue. The other sources of government revenue are corporate taxes that generate up to 10%, while excise duties and the other taxes make the remaining 9%

How The Government Spends?

The expenses of the government are in two categories. The first is the mandatory expenditure, while the other is the discretionary expenditure. Mandatory expenditure consists of the expenditures that reflect in the budget for the year. Discretionary expenditure, on the other hand, does not reflect in the budget. When they arise at any time, a particular bill has to go through the approval process, even without the President’s veto power.

The government’s budget also includes on-budget and off-budget expenditures. Off-budget expenditures refer to those elements of the government’s budget that derives funding from the government. It does not follow through the normal process for passing the budget because they have a separate source of funding. With off-budget expenditure, there could be a deficit or surplus depending on the amount of revenue that the funding source generates.

On-budget expenditure depends on the revenue that passes under the authority of Congress. Thus, the amount of money spent on on-budget expenditure depends on the amount fixed by Congress.

Keynesian School Of Thought On Deficit Spending

The British Economist that goes by the name of Maynard Keynes proposed a school of thought on deficit spending. He wrote a book called The General Theory of Employment, where he supported the idea of fiscal policy using an academic and intellectual approach.

According to him, deficit spending will help the government to tackle the issue of unemployment in the society. In turn, the economy will boom, which will help the government to be able to repay the money borrowed to fund its deficit spending.

Although there were a lot of arguments about the school of thought, which he developed in support of deficit spending, he went ahead to say that in cases where there was the threat of inflation, the government could always impose higher taxes to balance the economy.

Thus, deficit spending remains a fiscal policy which the government can resort to whenever it seeks to resolve the problem of unemployment in the society. When the government does this, the economy improves, thereby yielding more revenue. The optimized revenue can now go towards repaying the outstanding deficit.

What Role Does Interest Rate Play?

When engaging in deficit spending, the government issues bonds as a way to generate money for its deficit spending. The adverse effect of this policy is that the government accrues interest rates on these bonds that it issues. The interest rate is the extra charge that the government has to pay for the bonds as it is only borrowing money to cushion the effect of deficit spending.

When the government issues these treasury bonds, it can sell it at different times until the end of the debt contract. The government can sell a bond for a shorter period or for as long as thirty years. So any country or organization that buys this bond furnishes the government to finance the loan.

As a result, the government needs to regularly pay interest on the bonds to fulfill its obligations under the debt contract. It is in these circumstances that interest rate comes into the picture. The government has the responsibility to keep paying interest on the bonds.

Thus, when we talk about the government engaging in servicing the debt, we are referring to both the interest rate and the principal payments. When the cost of maintaining the debt becomes too high, it will have an overbearing effect on the budget. As a result, interest rates are vital in the running cost of a deficit.

When the interest rate is low, repaying the debt will be cheaper and the burden lighter for the government. However, when the interest rate is high, repaying it might be heavier on the government.

At the maturation of the bond, the government repays the actual amount of the bond. When the government is not able to generate enough revenue to repay the debt, it rolls over, and it might have to issue new bonds to pay the ones that are expiring.

Is Deficit Spending Avoidable?

When a country is going through a major financial and economic crisis, deficit spending might seem unavoidable. It is because, in such circumstances, the expenditure tends to be higher than the revenue that the government is generating. However, it is entirely appropriate to have spending bills that will help the country to manage such situations better.

In the interim, the government can adjust its budget by reducing its expenditures. When it does this, it means that there would be some level of unemployment dues to the reduction of the government’s expenditure. However, people pay charges for unemployment insurance and would expect that at such times, they get it when they need it. But due to the prolonged recession, the duration that the government has to keep paying unemployment insurance keeps stretching.

However, increasing taxes does not seem advisable going by the ideologies of Maynard Keynes. It is because it will have the effect of reducing the purchasing power of the people, in a time when the economy needs it most.

The circle of running surpluses during an economic boom, and running deficits during a recession is what we refer to as the countercyclical strategy. The government’s deficit spending aligns with an increase in the long haul interest rate. In a similar vein, an increase in interest rate will, without a doubt, increase the future budget deficit, covering household investment and reducing the future degree of yield.

High-interest rate raises the expense of borrowing, and this can resist growth, either in the private or public sector, as interest rises. Indeed, even the banks will charge more for business loans.

Conclusion

Policymakers tend to face difficult decisions when dealing with the deficit and debt-related issues. It is what brings the question, what part does interest play in deficit spendingto mind. Reducing the deficit spending of the government will require that it imposes programs that will affect the current GDP, economic recovery. Fortunately, debts and deficit spending problems are both manageable and solvable, as long as policymakers would go on a long term voyage in their legislation and, at the same time, be willing to compromise.

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