Government Budget Deficits
A government’s budget deficit is tax revenues minus spending. Government gets money from either taxation or borrowing. If tax revenues are equal to expenditures, it has a balanced budget. A budget deficit happens when expenditures exceed tax revenues. A budget surplus happens when tax revenues exceed expenditures. Governments borrow by selling bonds. Both types of fiscal policy, monetary and fiscal, often increase government deficits. Large sustained budget deficits may lead to inflation.
An interest rate is the price you pay to borrow money. What determines the level of interest rates? One factor is the demand for money. Interest rates are the price of money. People may want to borrow money if they are planning to purchase a house or a car. If the demand for money increases because people want to borrow more money, interest rates rise. In the law of supply and demand, when demand increases, prices rise. High interest rates discourage people from borrowing money and encourage other people who have money to invest their money into interest-bearing securities instead of just holding on to their cash. Another factor that influences interest rates is monetary and fiscal policies of governments. People’s expectations and their level of uncertainty will also affect interest rates. In uncertain economic times, people may postpone borrowing money for large purchases. At the same time, financial institutions will not be as willing to lend money. Another factor that affects interest rates is worldwide economic conditions.
Inflation is a period of rising prices. Not all prices may rise, but if on average they are rising, there is inflation. Since your money buys less goods and services in the future than it does today, quite often you will find dollar amounts “adjusted for inflation”. There are two types of causes of inflation:
1. If there is too much demand and too little supply, prices rise. This is called demand-pull inflation. This can happen when consumers spend more and save less or when governments cut taxes.
2. Cost-push inflation occurs when the raw material costs of business rise, such as a sharp increase in oil prices, manufacturers usually push those increases along to the wholesalers who in turn push those costs along to the consumer in the form. An increase in oil costs can also affect shipping costs which affects anything that needs to be shipped.
Nominal and Real Rates
Nominal interest rates are the normal interest rates that are stipulated as the return. These are the rates that we are familiar with. Real interest rates take into accont inflation by measuring the returns based on the value of goods or services you actually lend and the value of these returned. For example, if a widget costs $200 today and is expected to cost $210 one year from now, the expected rate of inflation is five percent. A lender of money may be willing to lend $200 for one year and expect to get $218 back one year from now. That’s nine percent more. The nominal interest rate is 9% but the real interest rate is only 4%. The Fisher equation states that the nominal interest rate is the real interest rate plus the expected rate of inflation. In a period of inflation where the inflation rate is expected to increase further, we can expect that lenders will increase their nominal interest rates.
A bond is a financial asset for which you pay a certain amount of money now in exchange for the promise to receive a payment or payments of money in the future. There are two types of payments: face value payments and coupon payments. The face value payment is printed on the bond certificate and is paid on the date the bond expires. The coupon payments are often made twice per year until the bond expires. Bonds don’t guarantee a rate of return. They only promise to make the payments. The rate of return depends on the price you paid for the bond and when the bond expires. If a bond promises to pay $1000 one year from now and you paid $950 for it, the rate of return is about five and one quarter percent. Higher bond prices mean lower interest rates. Lower bond prices mean higher interest rates.
Quantity Theory of Money
Prices and the value of money are inversely related, meaning that when the value of money goes up, prices go down, and vice versa. The demand for money tends to grow slowly over time because growing economies produce more goods and services and consumers demand more money with which to buy the available goods and services. The quantity theory of money states that the overall level of prices in the economy is proportional to the quantity of money circulating in the economy. If you triple the money supply, prices will eventually adjust to be three times higher than they were. If the supply of money increases faster than the demand for money, inflation results.
Hyperinflation is a situation of rapidly rising prices. Currency loses its value. Normally inflation is reported and analyzed on an annual basis, but in times of hyperinflation, it is often reported monthly. Hyperinflation is damaging to a country’s economy. Hyperinflation destroys the incentive to save money because its losing its value each day. One problem with that is if nobody saves any money businesses can’t borrow any money for new investments. Another problem is that even if there was some money available to borrow, who would want to lend it not knowing its future value? When the loan is repaid, the lender runs the risk of being worse off from a purchasing power point of view.
In 1971 in the United States, President Nixon took the United States off the gold standard and put it on the fiat system. In the fiat system, paper currency isn’t backed by anything. Fiat in Latin means “let it be”. With this system, there is nothing that can prevent a government from printing as much money as it wants to pay off its debts.
Monetary policy is the manipulation of the money supply and interest rates by governments. Monetary policy uses an increase in the money supply to lower interest rates. Lower interest rates make borrowing money easier to pay back, causing many consumers to spend more and many firms to invest more. This spending and investing stimulates the economy.
Fiscal policy concerns itself with how governments tax and spend. Fiscal policy refers to either an increase in government purchases of goods and services or a decrease in taxes to stimulate the economy. The government purchases increase economic activity directly, while the tax reductions are designed to increase household spending by leaving household spending by leaving households more after-tax dollars.
Paying For Increased Government Spending
There are only three ways to pay for government spending:
(1) The government “prints more money”
(2) The government raises taxes
(3) The government borrows money
Privatization is the incidence or process of transferring ownership of businesses or other organizations from the public sector (government) to the private sector (business). In a broader sense, privatization refers to transfer of any government function to the private sector including governmental functions like revenue collection and law enforcement.
“Neoliberalism” is a label referring to a set of economic policies including removing state economic apparatus and industry regulation, reducing the influence of unions, cutting back on government funded welfare programs and privatizing essential services. It’s proponents sometimes claim a heritage in economic liberalism or classical liberalism, however many policies attributed to neoliberalism conflict with the ideas of classical economic scholars, and the claim is often disputed. Neoliberalism supports free markets, free trade, and decentralized decision-making. Proponents of neoliberalism often claim that “higher economic freedom” correlates with higher living standards, self-reported happiness, and peace, a claim which is disputed by many economists, historians and social commentators.