Deficit Spending

Article byPeter Johnson
Reviewed byDheeraj Vaidya, CFA, FRM

What is Deficit Spending?

Deficit spending refers to the technique by which an entity spends more than its revenue during a specific period. The term is often associated with the government’s fiscal policies to energize the economy by increasing spending.

During a recession, the government spends more to increase ordinary people’s money supply and purchasing power. To offset such deficits, the government usually issues securities. When government expenditure is greater than the revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more, it contributes to what is known as a expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more. The budgetary deficit could be the sum of the deficit from revenue and capital account. ” url=”https://www.wallstreetmojo.com/budget-deficit/”]budget deficit[/wsm-tooltip]. Continuous deficit spending by year results in national debt.

Key Takeaways

  • Deficit spending’s definition explains it as spending more than what is available as income. The term is typically associated with government spending but can also be applied to other entities.
  • During economic downturns, Keynesian economics calls for higher levels of government expenditure to revive the economy, whereas fiscal conservatism advocates for lower levels of government spending.
  • During the Great Depression, President Roosevelt implemented the new deal entailing various initiatives reflecting the higher level of spending and saving the economy from collapsing.
  • A continual budget deficit will lead a country into national debt.

Deficit Spending Explanation

Deficit Spending

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Deficit spending is considered necessary during economic downturns because the government spending exceeding its revenue during a recession will result in a multiplier effect, ultimately leading to economic upliftment. For instance, government spending or purchases can increase business profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more and market size. That, in turn, escalates income and personal consumption expenditure. It subsequently increases the demand for goods and services, private investment, employment opportunities, and GDPGDPGDP or gross domestic product refers to the sum of the total monetary value of all finished goods and services produced within the border limits of any country. GDP determines the economic health of a nation. GDP = C + I + G + NXread more.

The budget deficit scenario was primarily associated with funding a war. However, it is mainly used to support citizens and promote economic growth Economic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more when needed. Government can implement spending above revenue in different ways like a cut on tax receipts, increasing expenditures on existing government programs, or new programs. Sometimes automatic stabilizers/deficits are enough to replace the need for deficit spending.

This ideology of government effort to cause economic development aligns with Keynesian economicsKeynesian EconomicsKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression.read more promoting deficit during recession and surplus during the economic boom. Opponents of Keynesianism encourage government adherence to a balanced budget. In addition, opponents argue that overspending will harm the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more through increased interest rates and associated reductions in investment.

The prolonged effect associated with overspending may contribute to inflation and national debt. Therefore, the government should attain a budget surplus promptly to reduce the public debt and associated services like interest payments. To generate a budget surplusBudget SurplusA budget surplus occurs when the government's earnings through tax revenues is more than its spending in the current quarter or year. A government surplus is a positive sign in an economy because it demonstrates the government's earning power.read more, the government would need to cut down on spending, and in most cases, that would mean cutting a government program.

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Deficit Spending Example

Here is a simple deficit spending example that we can witness in everyday life:

The monthly income of Mr. A is $5,000 after taxes, and the total expense per month is $4,000, inclusive of rent, insurance, utilities, groceries, and other miscellaneous costs. Therefore, he can save or spend the remaining $1,000 attributable to discretionary incomeDiscretionary IncomeDiscretionary income refers to the portion of gross income available after paying taxes, obligate payments like rent, and other essentials like food. It capacitates people to enjoy luxuries of life and has a positive influence in improving the quality of life.read more. For example, in the current month, assume Mr. A bought a car worth $16,000 using his savings of $7,000, current month discretionary income of $1,000, and loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more of $8,000.

Monthly income: $5,000

Monthly expense: $4,000

Discretionary income: $1,000 ($5,000-$4,000)

Funds utilized for the purchase of the car: $7,000 savings+ $1,000 discretionary income of current month $8,000 loan.

That points to a scenario of spending more than revenue because Mr. A obtained part of the amount by borrowing funds, contributing to debt.

Deficit Spending in the Great Depression of the U.S.

The objective of fiscal policies until the great depression focused on maintaining a balanced budget. Then, the roaring twenties, referring to a period of economic prosperity from 1920 to 1929, began to slow down, leading to a recession that turned into the great depression, which started in 1929 and continued till the end of World War II.

President Franklin D. Roosevelt implemented policies to revive the economy and banking system during the great depression. It included various banking acts, stalling the use of the gold standard, creating national banking holidays, and other techniques attributed to the fiscal policies. In addition, Roosevelt introduced the “new deal,” which represented the framework outlining various programs, policies, and projects to support the economy. These programs embracing deficit spending were intended to increase business output, create jobs, price improvisation, wage enhancement, and increase the government’s role in the economy.

The spending programs and employment opportunities associated with World War II helped reverse the economy and decrease unemployment. In addition, the new deal and other spending programs introduced during the Great Depression changed the way many people think about federal deficit spending and its impact on the economy.

Frequently Asked Questions (FAQs)

What is deficit spending, and how does it work?

Deficit spending’s meaning implies that it occurs when the spending in quantitative terms exceeds the income earned during a specific period like the fiscal year. The money utilized for it usually comes from debt, which increases the interest or debt obligations of the government. Soon the government may increase tax rates to cover up the interest expenses.

Why does the government use deficit spending?

Governments intentionally use it as a fiscal policy to revive the economy stuck in a recession or depression. As a result, government spending increases the money stock and people’s purchasing power. As a result, it will increase the demand for goods and services and subsequent GDP growth.

What are the advantages of deficit spending?

Many economists believe that the government’s overspending will benefit the economy by ending the recession and boosting the economy. The government’s plan to boost government expenditure stimulates business production, revenue, and GDP growth. It frequently focuses on increasing labor demand while gradually increasing demand for products and services.

This article is a guide to Deficit Spending. Here, we discuss the deficit spending definition, an example, the Great Depression of the U.S. and its causes. You may also have a look at the following articles to learn more: –