Budget Deficit and Interest Rate

Recently I came across a problem which questioned how a country can increase budget deficit (through Gov. Spending) without increasing the interest rate. It asked its readers to solve it using IS-LM model and figure out two ways of achieving it. Surely a pertinent question in today’s scenario when central banks have pumped in lot of liquidity in the market but are afraid of hiking/rising interest rates so as to keep the recovery on a smooth track.

Well, I would try not to use any model and still explain you the ways in which it can be achieved. But let’s first understand why increase in Gov. Spending (without proportional increase in Gov. Earning) leads to the rise in interest rate.

Ok so before we go on to understand money supply let’s first understand what is money. Just as “light” exhibits properties of both wave as well as particle, similarly money exhibits two basic properties of “mode of exchange” as well as a “commodity”. There is a limited supply of money in an economy and interest rate is the cost of obtaining/purchasing the money. You might draw some parallel with cost of capital which takes into account the interest rate at which capital is borrowed. Money, just like any other commodity experiences forces of supply and demand. In very simplified terms, when the central bank prints new currency notes, supply of money in the economy increases. Similarly, when say businesses try to borrow from domestic market, demand for money/capital increases. There are many more similar cases. We can imagine it as a central pool of fund and businesses, governments, individuals, all draw funds from this pool. Businesses need capital to expand, invest, etc government needs loan when they can’t meet their expenses through their earnings and individuals needs a share of the pool too to say buy houses, for education, investment, etc. When the overall demand on this pool of fund increases, just like any other commodity, the price of money goes up or cost of capital goes up or the interest that you pay to obtain the money goes up. When the government runs a budget deficit, they need to get the money from somewhere to meet its expenses. This money again comes from the limited fund available in the pool thus increasing the demand to borrow from the pool. This is what happens in a free market economy where government doesn’t artificially try to fix interest rates. The supply and demand of money determines the interest rate.

In countries like India which doesn’t follow free market economy in its purest form, a similar thing happens but with an intervention from central bank. An increasing budget deficit resulting from increased government spending is soon followed by increased money supply in the market and thus increased inflation. Then the central bank intervenes with string of measures including hike in the interest rate to increase the cost of money and also increase of CRR to soak up the extra money pumped in earlier to boost the market. But either way increasing budget deficit results in increasing interest rates.

Now how can hike in interest rate be avoided while still taking care of the budget deficit? Thus we are talking of a scenario when the increasing demand due to increased gov. borrowing doesn’t increase the cost of money.

Well one simple way is to increase the supply of money to match the demand. Central bank can print more money to finance the deficit. The challenge faced in this path is printing fresh money increase inflationary pressure and after a while governments need to alter the interest rate, CRR, etc as explained above which for example, Indian government does too often.

Well, what is the other way of getting the money for the government without adding pressure on the local pool of funds? Of course in a global economy when you don’t want to borrow from local savings, borrow from the savings of rest of the world. So the government borrows from abroad. The challenges faced are

1.      1. Upward pressure on the local currency thus hampering exports.

2.      2. Exchange rate risks which has the potential of repeating the East Asian crisis of the 90s.

Thus, managing budget deficit while avoiding interest rate hike is possible but the solutions come with caveats attached. Clearly none of the solutions can sustain prolonged period of deficit. Well, perhaps that is the reason why budget deficits need much more cautious approach. This becomes increasingly paramount when governments need expansionary fiscal policy to fight recession. The process of recovery through gov. spending especially becomes tough when you see economies entering recession with an already high budget deficit. This is what happened to Greece in the recent crisis and they were not left with any room to manoeuvre their fiscal policy as they already had huge external debt being used to finance their budget deficit.

This is really a hot topic of discussion today and I would love to see your comments.