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From budget deficits to international economic crisis

The economic story of how an outflow of international financial capital can cause a deep recession is laid out, step-by-step, in the Exchange Rates and International Capital Flows chapter. When international financial investors decide to withdraw their funds from a country like Turkey, they increase the supply of the Turkish lira and reduce the demand for lira, depreciating the lira exchange rate. When firms and the government in a country like Turkey borrow money in international financial markets, they typically do so in stages. First, banks in Turkey borrow in a widely used currency like U.S. dollars or euros, then convert those U.S. dollars to lira, and then lend the money to borrowers in Turkey. If the value of the lira exchange rate depreciates, then Turkey’s banks will find it impossible to repay the international loans that are in U.S. dollars or euros.

The combination of less foreign investment capital and banks that are bankrupt can sharply reduce aggregate demand, which causes a deep recession    . Many countries around the world have experienced this kind of recession in recent years: along with Turkey in 2002, this general pattern was followed by Mexico in 1995, Thailand and countries across East Asia in 1997–1998, Russia in 1998, and Argentina in 2002. In many of these countries, large government budget deficits played a role in setting the stage for the financial crisis. A moderate increase in a budget deficit that leads to a moderate increase in a trade deficit and a moderate appreciation of the exchange rate is not necessarily a cause for concern. But beyond some point that is hard to define in advance, a series of large budget deficits can become a cause for concern among international investors.

One reason for concern is that extremely large budget deficits mean that aggregate demand may shift so far to the right as to cause high inflation. The example of Turkey is a situation where very large budget deficits brought inflation rates well into double digits. In addition, very large budget deficits at some point begin to raise a fear that the borrowing will not be repaid. In the last 175 years, the government of Turkey has been unable to pay its debts and defaulted on its loans six times. Brazil’s government has been unable to pay its debts and defaulted on its loans seven times; Venezuela, nine times; and Argentina, five times. The risk of high inflation or a default on repaying international loans will worry international investors, since both factors imply that the rate of return on their investments in that country may end up lower than expected. If international investors start withdrawing the funds from a country rapidly, the scenario of less investment, a depreciated exchange rate, widespread bank failure, and deep recession can occur. The following Clear It Up feature explains other impacts of large deficits.

What are the risks of chronic large deficits in the united states?

If a government runs large budget deficits for a sustained period of time, what can go wrong? According to a recent report by the Brookings Institution, a key risk of a large budget deficit is that government debt may grow too high compared to the country’s GDP growth. As debt grows, the national savings rate will decline, leaving less available in financial capital for private investment. The impact of chronically large budget deficits is as follows:

  • As the population ages, there will be an increasing demand for government services that may cause higher government deficits. Government borrowing and its interest payments will pull resources away from domestic investment in human capital and physical capital that is essential to economic growth.
  • Interest rates may start to rise so that the cost of financing government debt will rise as well, creating pressure on the government to reduce its budget deficits through spending cuts and tax increases. These steps will be politically painful, and they will also have a contractionary effect on aggregate demand in the economy.
  • Rising percentage of debt to GDP will create uncertainty in the financial and global markets that might cause a country to resort to inflationary tactics to reduce the real value of the debt outstanding. This will decrease real wealth and damage confidence in the country’s ability to manage its spending. After all, if the government has borrowed at a fixed interest rate of, say, 5%, and it lets inflation rise above that 5%, then it will effectively be able to repay its debt at a negative real interest rate.

The conventional reasoning suggests that the relationship between sustained deficits that lead to high levels of government debt and long-term growth is negative. How significant this relationship is, how big an issue it is compared to other macroeconomic issues, and the direction of causality, is less clear.

What remains important to acknowledge is that the relationship between debt and growth is negative and that for some countries, the relationship may be stronger than in others. It is also important to acknowledge the direction of causality: does high debt cause slow growth, slow growth cause high debt, or are both high debt and slow growth the result of third factors? In our analysis, we have argued simply that high debt causes slow growth. There may be more to this debate than we have space to discuss here.

Questions & Answers

what economics is all about?
Nomuhle Reply
what is a new paradigm shift
Austen Reply
Paradigm shift it is the reconcilliation of fedural goods in production
Shyline
factors that affecting economic system
Bemen Reply
crux
Shyline
what is microeconomics
Nkanyiso Reply
what is the main problem in our economy
Nkanyiso
crux
Austen
what does crux mean
Shyline
what is demand
Jervis Reply
what are the factors of demand
Jervis
What is money and banking
Dorcas Reply
which one of the bank do product money
Dorcas
central bank
Mohamed
no .... all bank its self...
Buayadarat_Gaming
commercial banking
Mohamed
different types of products banking are .... 1 bills of exchange, 2 leasing, 3 project finance and so on
Mohamed
Demand and supply
Jervis
money can be defined as a medium of exchange
Jervis
how third party insurance premium is calculated?
Eshetu Reply
why scarcity is a problem in economics.
AYAABA Reply
don't worry about it, it's everywhere b/c no resources are full off in the world, b/c geometric increase of population growth.
Eshetu
okay
Shyline
price elasticity of demand is a percentage change in quantity demanded/percentage change in price.
Fadiga Reply
what is the formula for elasticity
Favy Reply
please be specific. Is it elasticity of demand or supply
Moses
we do not have a specific formulae for elasticity but we do have formulae for the types of elasticity and these are the types.Namely price elasticity of demand,Income elasticity of demand and cross elasticity of demand. please be a specific with your question.
Fadiga
sorry elasticity of Demand
Favy
The elasticity of demand is the change in demand due to the change in one or more of the variable factors that it depends on. ... The responsiveness of the quantity demanded to the change in income is called Income elasticity of demand while that to the price is called Price elasticity of demand.
ushindi
price-elasticity-demand-formula Price elasticity of demand = % change in Q.D. / % change in Price
ushindi
what is socialist economics
andy Reply
socialist economics is diffined as the reduction in production possibility curve where as production possibility curve frontial is when it shows the reduction in business and it will also lead to ceteris paribus
Shyline
Socialist economy, is a system of government, in which the means of product is in the hands of the government
Blessing
Change in quantity supplied
Haja Reply
what happened when there is a decrease in investment ?
simeon
what is a minimum wage?
Emelyn
Haja: Change in Quantity Supplied mostly is associated with the supply curve and changes in pricing strategy in response to the changes in market conditions. May in which context are you asking it?
AmarbirSingh
Simeon: When there is a decrease in the amount invested then the amount of funding available is less and the level of production is low leading to less amount of goods and services available for consumption in the economy. Increases on the other hand will lead to development if managed properly.
AmarbirSingh
Otherwise, lead to Bankruptcy
AmarbirSingh
Emelyn: Minimum Wage: This is the minimum sum of money that should be paid to employees across the country to be able to afford a life-style where they can pay their bills on time and have food on the table, roof over their heads and money to travel and commute to and from one place.
AmarbirSingh
Thank you so much, AmarbirSingh Sandhu..
Emelyn
Career Progression and getting your investments right leads to wealth Generation and Management and Transfer.
AmarbirSingh
Emelyn: Your Welcome.
AmarbirSingh
assalam aleykum,I would like to ask if the world has not security what would happen?
Abdoulkarim
how can we define marginal cost I mean I used TC devided Q but teacher said it is not true
Ixtiyor
could you give me exact formula
Ixtiyor
extra
Iyabo
meaning
Iyabo
Emelyn this is the definition of minimum wages. Minimum wage is a least legal wage fixed above the equilibrium(market) wage by the legislative authorities below which it is illegal to employ labour in the labour market.
Fadiga
Two indifference curves cannot cut each other because:
Bilal Reply
because it shows that the business will go down or it will lose profit
Shyline
differentiate between normative statement and positive statement
Nkanyiso
What is scarcity
Ohemaa Reply
What is elasticity
Ohemaa
Elasticity is a tool in economics to Measure the Fluctuations in product price and the Quantity of products and services being sold.
AmarbirSingh
In business and economics, elasticity refers to the degree to which individuals, consumers, or producers change their demand or the amount supplied in response to price or income changes. It is predominantly used to assess the change in consumer demand as a result of a change in a good or service's
AmarbirSingh
Scarcity is the shortage of raw materials in the economy due to inefficient management and incompetent leadership of xyz authority leading to production and supply issues in correlation to the demand of those products, services and commodities available.
AmarbirSingh
Hope that answers the questions
AmarbirSingh
Have a great day ahead
AmarbirSingh
OK..
Emelyn
Scarcity it is the production of goods in economics
Shyline
Scarcity is not the production of goods in economics.
MARTIN
okay
Shyline
what are the factors that causes change in demand?
Nomuhle Reply
competition for one
Kudzie
okay thanks
Nomuhle
competition for one
Kudzie
Double coincidence of one
Shyline
These are the factors that cause change in demand. (1) Taste and fashion (2)income of the consumer (3)price of related commodities (4)size of the population. (5) weather conditions can also cause change in demand.
Fadiga

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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