The Interplay between Government Deficit, Interest Rates, and Capital Inflow

Given the landslide the American economy has experienced within the past five years, I almost felt compelled to focus my paper on the issue of government deficit. In doing so, I came upon the textbook principle which states “If the government runs a deficit, interest rates increase and induce a capital inflow.” It is my hope that I can relate this generally accepted doctrine to a May 13th, 2004 article I found in the Africa News entitled Uganda: Government Deficit Blocks Cheaper Loans. 

Textbook Definition

Let us examine the aforementioned principle in greater detail in order to gain a true understanding of it in action. I think it helps to break down the standard piece by piece. For starters, it is apparent that there is a definite cause-and-effect relationship described in the doctrine, where the cause is government deficit. But, how does one define government deficit? Government deficit occurs when a country spends more on programs and the goods/services it purchases then it collects in tax revenue. 

As a result, the country will begin to realize two changes in the economy. First, the interest rates will increase. This happens because the business sector has reacted to the augmented government spending by increasing its own production (and employment), leading to a higher GDP and a higher demand for money. But, since the money supply has not changed during this time period, interest rates are bumped up to compensate. 

It does not take an Ivy League economist to know what happens when interest rates go up. In a nutshell, people begin to save more money so as to reap the higher returns. On the macro level, this is done domestically (when citizens place more money into savings) and in the international market, taking the form of a capital inflow into the country experiencing the budget deficit. Technically, the influx filters through the foreign exchange market first, where the dollar has by this point appreciated, due to the higher demand created by the raised interest rates.