Deficit

What is a Deficit?

The literal meaning of the word deficit is a loss or shortfall. In terms of finance, deficit refers to a shortfall of certain economic resources, mostly money. An individual runs a deficit if they spend more money than what they earn in a month.

When a government spends more money than what it collects, it is said to run a fiscal deficit. Again, when the citizens of a country collectively buy more goods from abroad than what they sell to foreigners, the country is said to be facing a trade deficit. In short, a deficit occurs whenever negative items exceed positive items.

Understanding Deficits

Since a deficit implies a shortage of funds or an excess of cash outflows over inflows, it does not present a favorable situation for an entity. Such shortages always necessitate the addition of debt to overcome them, and it makes an entity indebted to external parties. It is why experts consider deficits to be highly unsustainable and detrimental to long-term economic stability.

However, there are situations when entities willingly incur deficits for some future benefit. A government sometimes spends more money to develop the economy and create jobs during a recession, even if it means increasing its fiscal deficit. The government’s current fiscal deficit is justified by the possibility that such actions can help the country recover from the recession in the near future.

Fiscal deficit and trade deficit are among the most important kinds of deficit. Others include current account deficit, capital account deficit, primary deficit, and budget deficit.

Fiscal Deficit

Fiscal deficit refers to the shortfall that arises when a government spends more money than what it collects. The amount of the deficit also represents how much the government needs to borrow to pay for its excess expenditure.

Governments can borrow money from the citizens of the country by issuing and selling government bonds. They can also borrow money from domestic commercial banks. These are internal sources of debt. External sources include getting a loan from foreign governments or international financial institutions, like the World Bank. Another way to finance the debt requirements of the government is by printing new currency. This is known as deficit financing.

As mentioned above, the creation of a fiscal deficit can be justified. However, fiscal deficits pose the following risks:

• When governments borrow, they need to pay additional interest on such loans. Interest payments drive up government expenditure in subsequent periods and increase the deficit in the future. It leads to a phenomenon called the vicious cycle of debt, wherein governments have to take additional loans to pay off past debts.
• Printing fresh currency leads to the inflow of an additional quantity of money in the economy. If people have more money to spend, more people will try to purchase goods that are available in limited quantities. Since market demand will exceed market supply, deficit financing can lead to inflation, that is, a rise in the prices of all commodities.
• Excessive dependence of a country on debt can hamper economic growth in the long term. If most of the government’s revenues are spent to settle past loans, there will be less money to invest in development and job creation, leading to economic growth.

Trade Deficit

When the value of a country’s imports exceeds the value of its exports, the resulting difference is termed a trade deficit. A trade deficit is not necessarily an unfavorable situation. In fact, such a deficit shows that the citizens of a country are able to access a wide range of products.

It also implies improved standards of living in the country. Moreover, the availability of better quality foreign products also encourages domestic industries to improve their products’ quality.

Despite its benefits, however, the trade deficit can result in a dampening impact on an economy in the long term. If domestic residents prefer foreign goods to domestic ones, domestic industries will lose their source of income. It can even lead to a permanent closure of the industries and a massive loss of employment. It poses a threat to a country’s future growth prospects.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Shortfall
• Balance of Trade
• Imports and Exports
• Short-Term Debt
• See all economics resources