Fiscal Policy: Budget Balances & National Debt (AQA A Level Economics)

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Written by: Lorraine

Reviewed by: Steve Vorster

The Budget Balance & National Debt

The Government Budget (Fiscal policy) is presented each year as a balanced budget, a budget deficit, or a budget surplus
- A balanced budget means that government revenue = government expenditure
- A budget deficit means that government revenue < government expenditure
- A budget surplus means that government revenue > government expenditure
A budget deficit has to be financed through public sector borrowing
- This borrowing gets added to the national debt (the cumulative total of past government borrowing which has to be repaid with interest)
- Keynesian economists believe that the government should ‘run a budget deficit’ to finance spending and stimulate economic growth
  - However, this increasing debt puts a greater burden on the population that will have to repay it in the future

Cyclical & Structural Budget Deficits & Surpluses

A cyclical budget deficit or surplus is related to the economic cycle and aggregate demand
- During a boom, there is an improvement in the government budget as tax revenues rise and expenditure falls, decreasing the deficit
- During a recession, there is an increase in government expenditure, leading to a greater budget deficit
  - A cyclical deficit could then be corrected when the economy recovers again through the impact of automatic stabilisers
A structural budget focuses on the long-term underlying fiscal position of the government, independent of the effects of the business cycle
- It aims to assess whether government revenues are sufficient to cover ongoing expenditures over the long term, without considering temporary fluctuations in economic activity
- Structural budget analysis often involves evaluating the sustainability of government policies and the need for fiscal adjustments to ensure long-term fiscal stability
- For example, an increase in an ageing population will require the government to spend more on pensions and healthcare
  - If this expenditure is greater than revenue, it is added to national debt and is called a structural budget deficit
  - Correcting a structural budget deficit resulting from excessive borrowing is challenging
  - Governments need to increase taxes and cut public spending (austerity measures) which can negatively impact economic growth and employment

Consequences of Budget Deficits & Surpluses

Consequences of a Budget Deficit

Many countries continue to run a budget deficit year after year
- A deficit must be financed through borrowing from somewhere
  - Borrowing from outside the country (external borrowing) may cause political vulnerabilities
  - Singapore only borrows from its own citizens (internal borrowing), which reduces the risk of external pressure on their policies

Diagram: Consequences of a Budget Deficit

Running a budget deficit enables a government to spend more than it receives

Explaining the Consequences

Consequences of a Deficit	Explanation
National debt increases	National debt rises as the government spends more than it takes in. This money has to be paid back with interest There is a burden on future generations, as they are left with large interest payments on the debt This creates an opportunity cost as future governments may have to cut spending on services, in order to repay the debt
Inflationary pressures	A deficit can cause the economy to overheat, as governments spend more money (injects more than it withdraws) This causes demand pull inflation, as there is more money in circulation
Economic shocks	The economy is more vulnerable to economic shocks If there is no surplus set aside in the event of a shock (e.g. Covid), then the ability to respond is limited
Economic growth	If the borrowing is to be spent as increased government spending, the economy may benefit in the short to medium term However, more borrowing may cause inflation, which can lead to a rise in interest rates to curb that inflationary pressure Higher interest rates will discourage investment by firms and also cause the nation's currency to appreciate, meaning that its exports are less price competitive In the longer term, fewer investments and exports, together with higher interest payments on the debt, may cause AD to fall and lead to lower levels of economic growth

Consequences of a Budget Surplus

A budget surplus can be used to reduce general government debt and reduce future costs of servicing the debt
- A surplus can be set aside for future economic shocks e.g. the Covid 19 crisis
However, a surplus may mean that the government withdraws (higher taxes) more money than it injects (less spending)
- A surplus may then reduce economic growth and also reduce pressure on prices levels leading to disinflation or even deflation

The Significance of the Size of the National Debt

A budget deficit has to be financed through public sector borrowing
This borrowing gets added to the national debt
- The size of the UK’s national debt increased significantly during the Covid pandemic

Debt to GDP Ratio

A Debt to GDP ratio measures the size of a country’s debt in relation to size of the country’s economy
- A high Debt to GDP ratio creates vulnerabilities

The Significance of Large National Debt

Implication	Explanation
Cost	A growing national debt results in higher annual cost of repaying national debt plus paying interest The increase will prompt the government to raise taxes for future taxpayers Increasing the burden on future generations
Opportunity costs	With more government income being used to meet our annual interest repayments, the government has less funds available The Government will have to cut back spending on certain public services E.g. Health care, education, infrastructure
Diminished international credit-rating	An increasing national debt means that UK’s credit-rating is deteriorating This may cause firms and foreign countries to stop lending money to UK This will constrain the country’s ability to grow in future.
Crowding out	When governments borrow money, they do so by selling bonds (treasury bills) to people who want to save This increases demand for savings and in turn increases interest rates A higher interest rate reduce incentive to borrow by firms/consumers Resulting in reduced aggregate demand

The Role of the Office for Budget Responsibility

The Office for Budget Responsibility (OBR) was established in 2010
The primary responsibility of OBR is to manage public sector finances
Other responsibilities include:
- Providing detailed forecasts on the current economic performance
- An analysis of UK public spending and taxation
- Assesses the performance of the government against the fiscal targets set
- Advises government on economic predictions to aid with future policymaking
- Uses long-term projections to analyse sustainability of government spending and revenue

Last updated: 15 October 2024

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