What is the common method of financing budget deficit? Solution A budget deficit

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A budget deficit occurs when government expenditure (G) is greater than revenue (T) (G>T). There are three main ways the government can finance a deficit. Firstly, the government can borrow funds from the other sectors of the economy. This involves the selling of new Commonwealth Government Securities (CGS) such as treasury bonds through a tender system. This is the preferred government method of raising funds, as it does not add to net foreign debt, because the government is not borrowing from overseas. However, there is a disadvantage to this form of debt financing. When the Federal Government sells CGS it competes with the private sector for domestic savings, creating what is referred to as a “crowding out effect”. A shortage of funds in the domestic market can result and domestic investors may need to borrow funds from overseas. Government borrowing has then, effectively “crowded out” private investment. Private investment may be postponed as interest rates and the cost of credit rise. Rising domestic interest rates will also impact upon other areas of the economy. For example, higher interest rates encourage overseas investment, increasing capital inflow and causing an appreciation in the value of the Australian dollar. An appreciation in the value of the Australian dollar can cause problems with the current account, as exports become more expensive for overseas buyers and imports cheaper for domestic consumers The second possible method of financing a deficit is for the Commonwealth Government to sell CGS to the Reserve Bank. This form of borrowing from the Reserve Bank basically means that the government prints money to finance the deficit. The Government has not used this method of deficit financing since the deregulation of the Australian financial market in 1982. This is because it is highly inflationary: when the government spends the money, there is an increase in the money supply; if the economy is near full employment, demand inflation occurs rapidly, as there is too much money chasing a limited supply of goods. The third possible method used to finance a budget deficit is for the government to borrow funds from international financial markets. The government has not borrowed from overseas since the late 1980s to finance the deficit. When using this method, the Reserve Bank sells new CGS to overseas buyers, and receives foreign funds that are converted into Australian dollars. This method of financing the deficit adds to foreign debt when interest is paid on the securities (net income component of the balance of payments). The government may decide to borrow funds from overseas to reduce the crowding out effect. Under a floating exchange rate such borrowing has no effect on the domestic money supply. However, exchange rates and domestic interest rates can be affected; further, it adds directly to foreign debt. The selling of government assets is an alternative method to borrowing that the government can also use to fund a budget deficit. The sale of assets can create a headline budget surplus and reduce the crowding out effect typically caused by the sale of government bonds. The sale of the Commonwealth Bank and Telstra are examples. This form of financing a budget deficit is, however, not sustainable as it can only be used on a ‘one off’ basis. It can also reduce the net worth of the government over time when these assets are a source of revenue eg. Dividends earned from Telstra.

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