Governments have a responsibility to balance between their country’s expenditure and revenue by formulating and enacting monetary and fiscal policies. Moreover, governments should ensure that they balance between the application of the monetary and fiscal policies to stimulate economic growth. This assertion arises from the view that the implemented economic policies influence the components of a country’s GDP. One of the balancing acts entails developing and implementing effective national budgets (Baumol & Blinder, 2012).
Nevertheless, governments usually encounter budget deficits that arise if the expenditures are higher than the revenue receipts during a particular fiscal year. Budget deficits tend to increase a country’s national debt, which entails the total government indebtedness (Baumol & Blinder, 2012). This aspect shows the existence of a strong correlation between national debt and budget deficit.
Budget deficits do not occur in the less developed economies but also in the developed countries. In 2009, the Obama administration budget was projected to triple the deficit and add almost $ 6.5 trillion to the national debt. Different economists have evaluated the concept of deficit spending over the years. This aspect has led to the emergence of varied perspectives regarding its appropriateness in an economy.
Some economists are of the opinion that deficit spending does not have minimal effect on the rate of output and employment. On the contrary, deficit spending primarily leads to improvement in output distribution. This paper evaluates the effect of deficit spending in and to the economy based on the Keynesian, classical, new Keynesian, new classical and monetarist theories. The analysis is undertaken based on the policy move by the US government to increase the budget deficit and the national debt.
The Keynesian economists opine that the purpose of deficit spending is to foster economic growth and full employment. The projected $ 6.5 trillion increase in the US national debt would have both positive and negative effect on the country’s economy according to the Keynesian theory.
The projected increase in deficit spending in the US through borrowing was necessitated by the need for the government to move out of the 2008 economic recession. Subsequently, the increase in government spending was in the form of stimulus packages to the different economic sectors.
According to the Keynesian theory, deficit spending stimulates economic growth. The Keynesian economists argue that it is possible for a government to stimulate full employment during economic recession by adopting deficit spending. Welch (2012) posits, “Even if the government has to borrow to increase spending, the deficit could be justified because eventually higher employment rates would increase tax revenue” (p. 112).
The rationale behind deficit spending is that it culminates in significant improvement in growth in demand, the creation of new jobs, and the stimulation of production. The creation of new jobs increases the consumers’ disposable income and hence their purchasing power. The increase in consumption constitutes one of the critical components of a country’s Gross Domestic Product (Holt & Pressman, 2005). Thus, the Keynesian perspective holds that deficit spending is characterized by an inherent multiplier effect.
Keynesians are of the opinion that during the economic recession, investors in the private sector tend to reduce their investment in productive assets hence leading to a decline in their output. The decline arises from the reduction in consumer demand (Odekon, 2015).
However, the adoption of fiscal stimulus such as through an increase in government spending tends to trigger upward economic performance. Thus, the private sector perceives the likelihood of an increase in consumer demand and spending and hence the chances of attaining high economic profits.
In addition to the above aspects, an increase in deficit spending has a significant effect on a country’s trade deficit. An increase in deficit spending increases the rate of interest. However, its effect on the trade deficit depends on whether a country has either adopted an open or a closed economic system. In an open economy such as the US, an increase in trade deficit tends to increase the exchange rate.
Odekon (2015) affirms, “Deficit spending puts upward pressure on the f additional tax to cater domestic interest rate, which leads to inflows of financial capital and an appreciation of the exchange rate” (p. 83). The increase in the rate of exchange makes a country’s export expensive. Consequently, the reduction in the volume of exports tends to depress the country’s current account and hence its economic growth.
The new Keynesian economists have largely emphasized on the impact of government spending on private consumption. Private consumption is critical in stimulating a country’s economic growth. The new Keynesian economists further underscore the existence of a negative relationship between government spending and consumption. The economists emphasize that deficit spending has a negative effect on wealth generation.
Coenen and Straub (2005) corroborate that the “negative wealth effect is amplified by the fact that all households are forward-looking and in a position to smooth consumption by trading in physical and or financial assets” (p. 4). Due to the increased deficit spending, households are forced to work hard but their consumption is reduced significantly. The new Keynesian economists postulate that an increase in the level of consumption can only arise if the country is characterized by an accommodative monetary policy.
Moreover, new-Keynesian economists emphasize that deficit spending fosters imperfect competition. Coenen and Straub (2005) affirm that imperfect competition “generates an aggregate demand externality according to which an increase in output leads to a rise in profit and income” (p. 3). The increase in income and profit levels aid in offsetting the adverse effect of deficit spending on wealth creation. Due to the sticky prices, the demand for labor to facilitate the production process increases considerably compared to labor supply.
The classical theory
Unlike the Keynesian economists, classical economists further argue that increase in government borrowing leads to a considerable increase in the rate of interest. Skousen (2014) asserts that the increase in interest rate arises from the competition between the private sector and the government in borrowing money. Consequently, the private sector experiences an increase in the cost of borrowing because of increase in the lenders skepticism on the government’s ability to repay.
Therefore, the increase in government spending by relying on borrowing is likely to crowd investment in the country’s private sector. The crowding out effect arises from the fact that the government consumes the money meant for stimulating economic growth in the private sector.
Adam Smith is one of the renowned classical economists who have emphasized on the crowding out effect associated with the increase in deficit spending. Consequently, the expansion in consumer spending arising from the increase in government borrowing is likely to stifle the country’s economic growth hence destroying some capital (Romano, 2007).
Classical economists further argue that deficit spending has a negative impact on a country’s political climate. Skousen (2014) posits that deficit spending leads to the creation of political indiscipline regarding public spending. The political class tends to increase their spending on out-of-control government spending. Moreover, classical economists argue that deficit spending tend to promote the establishment of big governments or welfare states that are costly to sustain.
For example, the public might be required to pay an additional tax to cater for the ‘big government’ spending. This occurrence is well illustrated by Reagan, who affirms that the political class use deficit spending to support social programs that are impossible to fund using the tax revenue (Skousen, 2014).
Deficit spending promotes inequitable distribution of wealth in an economy. Skousen (2014) affirms that deficit spending “redistributes wealth from taxpayers [middle class] to the rich [bondholders]” (p. 543). Therefore, to borrow from the ‘rich class’ successfully, the government might be required to pay the lenders a higher rate of interest. The high rate of interest rate fixed on the government bond tends to stimulate an increase in other rates of interest hence affecting the level of investment and spending.
Additionally, the prevalence of deficit spending in the country might lead to the development of a negative perception amongst the public. For example, the public might perceive the likelihood of the government being unable to pay its debts. Consequently, the chances of the public avoiding lending to the government in the form of bonds might be increased.
According to monetarist economists, deficit spending tends to increase the rate of inflation in a country. This assertion arises from the view that the government borrows for consumption purposes rather than producing extra goods.
The increase in the rate of consumption by the government through deficit spending leads to an increase in the money circulating within the economy. The quantity theory of money postulates that an increase in money supply tends to increase the price of commodities. Consequently, the purchasing power of the households is adversely affected.
Deficit spending by the government culminates into a significant increment in the price of various resources necessary to stimulate production. Consequently, the increase in production cost is transferred to the final consumer through high product prices.
According to Lux (2008), “every dollar of deficit spending by the government costs a $ 0.0274 rise in resource prices, which means that a 100 billion dollar deficit will produce a 2.74 billion dollar increase in resource prices” (p. 47). Therefore, the projected enactment on the US budget is likely to have a significant reduction in the country’s production.
New classical model
The new classical economists have emphasized on the foundations of classical economists. New classical economists are of the opinion that deficit spending does not stimulate household consumption and aggregate demand. On the contrary, they argue that the classical economists did not take into account the impact of deficit spending on future tax liability.
Deficit spending culminates in higher future tax and interest rates to ensure that debts are serviced (Gwartney, Stroup, Sobel, & Macpherson, 2015). Moreover, the future generations might be burdened by the requirement to pay high taxes to finance the high national debt. Furthermore, the government’s future budgets might be affected because of the inability to increase the tax rate to cater for additional national debt.
The new classical economists are of the view that debt “financing simply substitute’s higher future taxes for the current low taxes and simply affects the timing of taxes but not their magnitude” (Gwartney et al., 2015, p. 91).
Changing the timing within which taxes are collected does not have an effect on the households’ wealth. If consumers expect a $100 billion increase in national debt will lead to an increase in high future taxes, the taxpayers are likely to sustain their consumption spending and increase their saving to cater for the increment in taxes. Given that consumers maintain their level of consumption, the overall aggregate demand of a country remains constant.
Equally, the increase in the level of savings amongst the consumers increases the government capacity to access debt finance. Consequently, the real rate of interest remains unchanged. In summary, the new classical economists argue that larger budget deficit and national debt does not have a multiplier effect as proposed by the Keynesian economists. On the contrary, aggregate demand, real interest rates, output, and the level of employment remain unchanged.
Governments have an obligation to promote a country’s economic growth by enacting effective monetary and fiscal policies. One of the fiscal policies that a government can adopt entails deficit spending. Economists have developed varied perspectives on deficit spending. The Keynesian economists affirm that deficit spending is effective in promoting a country’s economic growth. In their opinion, deficit spending can be beneficial to an economy if it is used to a source of fund for different economic stimulus packages.
Such deficit spending has a multiplier effect on an economy. For example, deficit spending on the different economic sectors fosters the creation of new jobs and hence the consumers’ purchasing power. This aspect increases the level of consumption hence contributing to improvement in the national output. On the contrary, new Keynesian economists affirm that imposition of deficit spending policy affects the creation of wealth by the private sector.
The classical economists fault the application of deficit spending. These economists argue that deficit spending culminates to an increase in the rate of interest due to the competition of the available savings between the private sector and the government. The subsequent effect of an increase in the rate of interest is the reduction in the level of investment in the private sector. Deficit spending further promotes inequity in the distribution of wealth in addition to the creation of big governments that are expensive to maintain.
The new classical economists affirm that consumers may be forced to pay high taxes and interest rates to finance the high national debt. Conversely, the monetarist economists are of the view that deficit spending increases the rate of inflation. This aspect reverses the gains of the increase in the level of consumption.
From the analysis, it is imperative for the US government to understand the long-term implication of deficit spending policy on the economy before its implementation. This approach will aid in making an optimal decision on whether to rely on deficit spending to address the likelihood of the country experiencing a bloated national debt. Such a debt could affect the country’s future budget in addition to stifling the country’s economic growth.
Coenen, G., & Straub, R. (2005). Does government spending crowd in private consumption? Theory and empirical evidence for the Euro area. New York, NY: International Monetary Fund.
Baumol, W., & Blinder, A. (2012). Macroeconomics; principles and policy. Mason, OH: Cengage.
Gwartney, J., Stroup, R., Sobel, R., & Macpherson, D. (2015). Macroeconomics; private and public choice. Stamford, CT: Cengage Learning.
Holt, R., & Pressman, S. (2005). A new guide to post-Keynesian economics. New York, NY: Routledge.
Lux, L. (2008). In search of the perfect economic matrix. Chicago, IL: iUniverse.
Odekon, M. (2015). Boom and busts; an encyclopedia of economic history from the first stock market crash. New York, NY: Routledge.
Romano, F. (2007). Clinton and Blair; the political economy of the third way. Upper Saddle River, NJ: Routledge.
Skousen, M. (2014). Economic logic. Washington, DC: Capital Press.
Welch, S. (2012). Understanding American government. Boston, MA: Wadsworth.