From Raj Nallari  and Breda Griffith's lecture notes.
If a government’s expenditure is greater than its various forms of revenue and grants, the government is said to be running a budget deficit. The standard theory of fiscal deficits states that if a government cuts taxes and runs a budget deficit, then the private sector including households respond to the increase in disposable income partly with higher desired private savings and partly with higher consumer demand, depending upon each household’s marginal propensity to consume. Since desired private savings rise by only a fraction of the budget deficit, desired national savings (private and public savings) would decline. National savings must equal domestic investment in a closed economy without inflow of foreign savings. As such, a decline in national savings would lower national savings, increase real interest rates and reduce investment demand, and raise desired private saving. This is the crowding out of investment in the short term.
An accumulation of budget deficits leads to the build-up of public debt. Unless the government’s budget deficit is covered by private savings minus investment, there will be a current account deficit with the rest of the world in an open economy context. The country will be forced to increase its net foreign debts to cover the amount of the deficit. If government cannot finance the deficit by borrowing, there will be pressure on the currency to finance the deficit through depreciation. This leads to inflation thus reducing purchasing power which can have serious political consequences. Depreciation also increases the burden of foreign debt.
Financing public deficits
While several options for financing public deficits exist, some may not be available or appropriate in a particular context.
Issuing or selling debt titles or securing domestic bank loans – This essentially means that government is borrowing from the local public; it is appealing since costs are being deferred into the future while the government ensures its autonomy from abroad. In addition, there is no inflation risk in the short run. However, selling debt titles competes for private savings at home since bonds present an alternative method of savings to the more traditional ones employed. Furthermore money is channeled away from investment and raises interest rates.
Borrowing from abroad – In most low income countries, development banks such as the World Bank, the Asian Development Bank and the African Development Bank, and bilateral donors are the only available lenders since the country does not enjoy the credit rating required to borrow on the open international capital markets. While this method defers costs into the future without crowding out domestic investment or causing inflation, risks are heightened if repayment is in foreign currency. This approach also makes the country dependent on foreign lenders allowing them to set conditionalities for access to any money borrowed.
Asset sales – Privatization through which government property is transferred to the private sector through sales is another option for “financing” public deficits. Privatization’s appeal lies in the fact that the government does not have to make plans for repayment since assets are being exchanged for revenue. However this is an unsustainable option since assets can only be sold once.
Printing Money – While this method has short term benefits, being the availability of ready cash, the pernicious consequences last much longer making this a last resort for most governments. Printing money leads to less money or credit being available to the private sector, which increases interest rates and subsequently reduces investment. Alternatively, more money may be available overall, but this is a harbinger for inflation, which distorts prices leading to a loss in the value of nest egg savings.
Next week: Fiscal Policy and its Impacts