Economic Effects of a Budget Deficit

  • Increased borrowing

The govt will have to borrow from the private sector, it does this by asking the Bank of England to sell bonds and gilts to the private sector.

  • Higher debt interest payments

Selling bonds will increase the national debt, this is currently £300 billion. The annual interest payments is approximately £23 billion, this has a high opportunity cost because it requires future generations to pay higher taxes.

  • Increased AD

A budget deficit implies lower taxes and increased G, this will increase AD and this may cause higher Real GDP and inflation.

  • Higher Taxes and lower spending

In the future the govt may have to increase taxes or cut spending in order to reduce the deficit. This may cause reduced incentives to work

  • Increased Interest rates

If the govt sells more bonds this is likely to cause interest rates to increase. This is because they will need to increase interest rates in order to attract investors to buy the extra debt.
If govt interest rates increase this will push up other interest rates as well.

  • Crowding Out

Increased govt borrowing may cause a decrease in the size of the private sector (see fiscal policy)

  • Inflation:
    • In extreme circumstances the govt may increase the money supply to pay the debt, however this is unlikely to occur in the UK
    • If the govt sells short term gilts to the banking sector then there will be an increase in the money supply, this is because banks see gilts as near money therefore they can maintain there lending to customers.

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