Chapter 17: Problem 1

When governments run budget deficits, how do they make up the differences between tax revenue and spending?

Short Answer

Expert verified

Governments cover budget deficits through borrowing, printing money, and increasing taxes or cutting spending. They typically issue debt securities like treasury bills, notes, and bonds to borrow money from domestic or foreign sources. Printing more money increases the money supply, potentially causing inflation. Increasing tax revenue or cutting spending are also used, but these may be politically unpopular depending on the impact on citizens. The chosen method depends on the country's economic situation and political factors.

Step by step solution

Understand budget deficits

A budget deficit occurs when a government's spending in a given period exceeds its tax revenue. This means that the government needs to find other ways to generate funds to cover its expenses.

Identify methods to cover budget deficits

Governments typically use three main methods to cover their budget deficits: borrowing, printing money, and increasing taxes or cutting spending.

Explain borrowing

One of the most common ways for governments to cover budget deficits is to borrow money from domestic or foreign sources. To do this, governments issue debt securities such as treasury bills, notes, and bonds. These securities are bought by investors, banks, and other financial institutions, effectively lending money to the government. The government then uses this borrowed money to cover the difference between its spending and tax revenue.

Explain printing money

In some cases, governments might choose to print more money to make up for the budget deficit. This is sometimes referred to as "monetizing the debt." When a government prints more money, it increases the money supply, which can lead to inflation if not managed carefully. This method is usually less preferable due to the potential negative impacts on the economy and the value of the currency.

Discuss increasing taxes or cutting spending

Another way for governments to address budget deficits is to either increase tax revenue or cut spending. Raising taxes can be a politically unpopular choice, as it directly impacts taxpayers. However, if done effectively, it can generate additional revenue for the government. On the other hand, cutting spending can also be controversial if it involves reducing funding for programs or services that citizens depend on. In some cases, a combination of tax increases and spending cuts may be implemented to reduce the budget deficit. In conclusion, governments typically use a combination of borrowing, printing money, and adjusting tax rates and spending to cover budget deficits. The specific approach taken will depend on the country's economic circumstances and political considerations.