What Is Deficit Spending in Fiscal Policy?

As a part of its fiscal policy, a government sometimes engages in deficit spending to stimulate aggregate demand in an economy. However, the two are separate terms that need not necessarily overlap. Not all deficit spending is performed as part of fiscal policy, and not all fiscal policy proposals require deficit spending.

Fiscal policy refers to the use of the taxing and spending powers of the government to affect economic results. Nearly all fiscal policies promote, or at least purport to promote, full employment and higher levels of economic growth within a given region. Fiscal policy is almost always more specific and targeted in its implementation than monetary policy. For example, taxes are raised or cut on specific groups, practices or goods. Government spending must be directed toward particular projects or goods, and transfers require a recipient.

In macroeconomic models, the aggregate demand curve for the economy shifts to the right whenever governments increase expenditures or reduce taxes. An increase in aggregate demand should cause businesses to expand and hire more workers. In Keynesian economic models, aggregate demand is the driver of economic growth.

How Does Deficit Spending in Fiscal Policy Work?

When a government wants to stimulate the economy beyond the confines of its budget, it can elect to go into debt to make up the difference. The amount of annual government spending in excess of yearly government revenues makes up the fiscal deficit.

Deficit spending is only distinguishable from other forms of government spending in that a government must borrow money to perform it; the recipients of government funds do not care if the money is raised through tax receipts or bonds or if it is printed. However, on a macroeconomic scale, deficit spending poses some problems that other fiscal policy tools do not have; when the government funds the deficit with the creation of government bonds, net private investment and borrowing decrease due to crowding out, which can have the effect of lowering aggregate demand.

Keynesian economists argue that deficit spending need not cause crowding out, especially in a liquidity trap when interest rates are near zero. Neoclassical and Austrian economists argue that even if nominal interest rates do not rise when governments flood the credit markets with debt, the businesses and institutions that purchase government bonds still take money out of the private sector to do so. They also argue that the private use of money is more productive than public use, so the economy loses even if total levels of aggregate demand remain constant.

Keynesian economists counter that extra income is created by every additional dollar of government spending or every dollar reduction in taxes. This is known as the multiplier effect. Thus, deficit spending could theoretically be even more productive than private investment in terms of raising aggregate demand. However, there is still plenty of debate about the efficacy of the multiplier effect and its size.

Other economists argue that fiscal policy loses its effectiveness and may even be counterproductive in countries with high levels of debt, potentially yielding negative multipliers. If this is true, deficit spending would have diminishing marginal returns if the government consistently runs budget deficits.