March 23, 2012 Leave a comment
During severe economic recessions, increasing money supply through monetary policy (cut down interest rate) has failed to stimulate growth and reduce unemployment level. There is one last resort that the government can do to revive the economy, by running budget deficit.
The concept of budget deficit is to spend more than the taxes that have been collected. This is like an individual spend more on credit card than his/her personal income. To get that extra money to spend, government will have to issue more bonds.
Central bank will massively create new money to buy government bond, this process is known as Quantitative Easing (US). In a way the central bank is printing more money that will be used to buy government bond. Also, other countries can also fund the government by buying more of those bonds.
In running budget deficit, government will increase their spending to do more projects, such as public infrastructure upgrade; building new roads and freeways; expand rail network; public healthcare upgrade; build more schools and etc. All this activities and projects will encourage investment from companies, employment level will also start going up. And ultimately spur the economy into growth.
Risk of deficit
In case you are wondering, yes the central bank can print money at will. However, massive printing of money will depreciate the value of the currency and create high inflation. If the central bank fails to manage it, high inflation will damage the economy.
Running deficit might force the government to raise tax in future. Nobody likes tax increase. This will increase public dislikes against the government.
Unrealized Loss From Other Foreign Bond Holders
By having massive money supply, it will greatly depreciate the value of the currency. If foreign countries bond holders were to sell back those bonds or wait until maturity, they might suffer losses the moment they convert the money back to their own currency.
Undercut Private Investment
In the bond market, companies will have to compete with the government in selling bonds. Companies, to make their bonds more attractive to investors, will have to drive up the interest rate of those bonds. In the end, companies might find that it is not worth to sell those bonds with such high interest.
As a result, companies will not have enough funding, and started cutting down on investment on new projects.