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Financing a budget deficit


When the budget is in deficit it means that the government needs to raise funds to finance the deficit.  The Treasury department determines the amount of money required and issues Treasury bonds or Treasury notes (which are debt instruments).  The purchasers of the bonds or notes effectively become lenders to the federal government and, in return, they receive interest on the bonds.  Generally, there are three types of bond purchasers (i.e. lenders) and the extent to which a budget deficit 'expands' an economy will depend on who purchases the Bonds (i.e. who lends to the government).


Selling bonds to the RBA


This is most expansionary (and most inflationary) as money that was previously not in the money supply is now released into circulation.  This type of financing has become rare since the late 1980's because the government and the RBA were keen to have a clear separation of monetary and budgetary policies.


Selling bonds to Australian investors  


This is least expansionary because domestic bond sales place upward pressure on interest rates (because the demand for 'money' increases, which lifts the price of 'money').  These higher interest rates result in a crowding out of the private sector as consumers and businesses reduce Consumption and Investment.  In addition, the higher interest rates force some local borrowers (e.g. corporations) to borrow from overseas lenders, resulting in capital inflow and a higher exchange rate.  This contributes to crowding out of Australia's tradables sector, where exporters and import competing businesses lose market share.  The effect of crowding out constrains AD over time and reduces the expansionary impact of a budget deficit.  This type of financing is the most common.


Selling bonds to overseas investors


This results in capital inflow that exerts upward pressure on the value of the AUD, which in turn has a negative impact on net exports and AD.  This reduces the expansionary impact of a budget deficit and relates to the point made earlier with respect to the contractionary nature of budget deficits.  The degree to which Treasury issues bonds or notes in overseas markets depends on the state of financial markets.  


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