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What is the relation between deficit spending and interest rates?

Please explain
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Comments

  • edited July 26

    Both are inversely proportional.

    Take the example of USA post 2008 crisis. Their economy was facing recession and needed a push therefore they started their new monetary policy of quantitative easing.

    Here low interest rates were set by the Fed. This allowed the US govt, industries and individuals to borrow at cheap rates so that some kind of stimulus could be provided to the economy. It was hoped that this deficit finance(cheap money) would ultimately fuel increased aggregate demand, consumption, investment, output and growth.

    Now 9 years down the line since the global economy is back on track, the federal reserve is increasing interest rates again so that inflation is kept under control.

    Hope it helps
  • edited July 26
    Did you try searching on google and wiki? Just suggesting cause when you first explore yourself you will get better idea about such topics.

    Anyway, see the relation is simple. Deficit spending is done by the government in various situations, mostly when it needs to spend more than it earns from its revenue sources. (It is not very good practice if it is unsustainable, or it is being used to finance committed/revenue expenditure. Cause simply you wouldn't survive if you keep spending more than you are earning.)

    So how government gets its money to finance its fiscal deficit? One option is borrowing from the market. (By issuing government bonds etc.) So when government becomes major player in borrowing, it crowds out other private players (who are more efficient in capital investment). This heavy intervention of government creates scarcity of liquidity/resources in the economy and when something is scarce its value rises. Thus value of money/loan rises for all players.

    Thus deficit spending gives rise to higher interest rate. And other negative consequence if spending is on farzi non productive schemes etc.

    Edit: Adding some pointers to explore
    https://en.wikipedia.org/wiki/Deficit_spending#Crowding_out
    http://www.investopedia.com/terms/c/crowdingouteffect.asp
  • Thanks. My doubt was from this article, http://blog.forumias.com/inflation-and-its-impact-on-indian-economy/ .

    I couldn't understand this statement, "High deficit spending is not compatible with lower interest rates."
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  • edited July 26

    Thanks. My doubt was from this article, http://blog.forumias.com/inflation-and-its-impact-on-indian-economy/ .

    I couldn't understand this statement, "High deficit spending is not compatible with lower interest rates."

    Yeah.. Either you control interest rate or inflation, in case of high deficit financing. You cant control both.
    Hope now you get the link between these three variables i.e. Deficit financing, interest rate, and inflation.
    ( cause deficit financing can also be achieved by prinitng money, which might control interest rate but will surely lead to inflationary pressure)
  • edited July 26
    Think of govt too as an individual. Anyone spending beyond capacity creates excess demand. With supply being constant, it is bound to create inflation. Excessive inflation necessitates higher interest rates to control the excess spending capacity, thus
    reducing demand, thus reducing inflation. Hence deficit spending incompatible with lower interest rates.
    As per my understanding.
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