Most governments finance their budget deficits through
1. Borrowing funds from the public.
In the United States and other industrialized countries, this is the method through which governments finance the lion’s share of their deficit. Governments borrow funds from the public (households, businesses, and foreign investors) by issuing government bonds (long-term IOUs), notes (intermediate-term IOUs), and bills (short-term IOUs). These are nothing more than loans made by people or businesses to the government. You may have some government bonds of your own, and perhaps your pension fund or insurance company or financial institution has invested in government bonds. If so, you have loaned money to the government and are helping to finance the debt. This is not inflationary, because it constitutes a transfer of money from one economic group (households and businesses) to another (the government). However, it does decrease the availability of funds to the private sector. This is called “crowding out.” It leads to a decrease in private-sector spending and a decrease in private investments and economic growth. Crowding out usually raises interest rates beyond what they would be without government borrowing.
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2. Federal Reserve System financing.
When securities (bonds, notes and bills) are initially issued by the United States Treasury (in order to finance the federal government’s deficit), the public (households, businesses, foreign investors) buys them. Sometime later, the Federal Reserve buys these securities from the public. Thus, indirectly, the Fed buys securities from Treasury. This method of deficit financing is called Open Market Operations and is inflationary because the Fed pays for the securities with newly printed money. Nearly every day the Federal Reserve (the Fed) buys and sells billions of dollars in government bonds (and recently also mortgage backed securities) from the public. In Unit 9 we will learn that the Fed does this to inject funds into (or, if the Fed sells, withdraw from) the financial markets. This causes a change in the money supply. Mostly, the Fed buys securities from the public, and in this way, it indirectly finances government spending.