How can a large budget deficit lead to inflation and what effect can it have on interest rates ?
A huge budget deficit effectively means that a goverment of a country is spending more money than it is earning. In simple terms governments can run a deficit when in an economic dowturn as they attempt to reflate the economy to stave off deflation which is a nightmare to resolve (eg Japan). This is classic Keynesian economics. As they pump more and more money into the economy you get a situation which Monetarists would describe as ‘too much money chasing too few goods’. This leads to price rises, or, in other words inflation. Running a budget deficit generally leads to higher interest rates than would be the case in a balanced budget scenario. There are 2 main reasons for this: • as the government needs to borrow more money it needs to offer lenders a higher rate to attract capital. This leads to higher ‘real’ rates of interest than would otherwise be the case and • as the economy reflates and inflation becomes apparent, ‘nominal’ interest rates are forced higher on top of the already
