INDEX: 11310917

COURSE : ELEMENTS OF MACROECONOMICS

PROGRAM : B. Sc. BUSINESS ADMINISTRATION
ASSIGNMENT 2: EXPLAIN HOW DOMESTIC BUDGET DEFICIT FINANCING
INCREASES MONEY SUPPLY IN THE ECONOMY.

Budget deficit is the annual shortfall between government spending and tax revenue. The deficit is the
annual amount the government need to borrow. The deficit is primirily funded by selling the
government bonds(gifts) to the private sector.

The domestic Budget deficit financing increases money supply in the economy in many ways thus;
Higher debt interest payment: when the government borrows, it offers to pay an interest payment to
those who buy the bonds. The interest rate attracts investors to lend the government money. In 2009-
2010, the cost of debt interest payments on UK government debt was £30bn. By 2010-2011, this
interest cost had increased to £45bn.
Increased aggregate demand (AD); A budget deficit implies lower taxes and increased government
spending this will increase Aggregate demand and this may cause higher real GDP and inflation. For
example, in 2009, the UK lowered VAT in an effort to boost consumer spending, hit by the great
recession.
Fund public sector Investment; A government may run a budget deficit to finance infrastructure
investment. This could include building new roads, railways and improved telecommunications. This
public sector investment projects can have a rate of return higher than the cost of borrowing.
Inflation; in extreme circumstances, the money supply to pay the debt, and this will lead to inflation.
This has occurred in the countries such as Germany (1920s) and Zimbabwe (2000s). However,
Inflation from a budget deficit is rare in developed countries.
If government sells short term gilts to the banking sector then there will be an increase in money
supply, this is because banks see gilts as near money, therefore, they can maintain there lending to
consumers.
The national money supply is the amount available for consumers to spend in the economy. In the
United States, the circulation of money is managed by the Federal Reserve Bank. An increase in money
supply causes interest rates to drop and makes more money available for customers to borrow from
banks.
An increase in paper money reduces the value of the U.S dollar, but increases the money banks can
lend to consumers. When banks have more money to loan, they reduce the interest rates consumers pay
for loans, which typically increases consumer spending because money is easier to borrow. The
government will request money supply when the economy begin to slow to spur additional spending by
consumers and build confidence in the economy.
Successfully managing the global economy requires effective monetary policies. An increase in the
money supply is only one of many options available to government policy makers. They can also
modify tax rates, adapt foreign trade restrictions, modify bank reserve requirements and change the
federal interest rate.
If an increase in money supply is too drastic, It can lead to deflation in the economy because the value
of the country's currency can drop when compared to that of their countries.
Money demand would like to increase because there are more transactions to finance Budget deficit,
whether due to higher spending or low tax collection, in either form has to be financed through
borrowing. Therefore, money supply must increase with budget deficit.