Flow of Funds Accounts – Governments
Federal, State and local governments earn their revenue by taxing income generated by firms and individuals. They spend on defence, infrastructure, education, healthcare and many other expenditures. An excess of revenue over expenditure is called a budget surplus and an excess of expenditure over revenue is called a budget deficit.
The higher the budget deficits the higher the borrowings (uses of funds) by government. If the government borrowings start increasing to high levels they are known to â€œcrowd outâ€ private borrowings, which are borrowings from firms and households.
The factors that affect government borrowings (uses) are â€“ taxes, recessions, wars and many others.
Lets briefly discuss taxes and recessions as they are mainly relevant for our context (monetary policy determination).
In recessions the government budget runs in a deficit since economic activity is reduced therefore tax revenues reduce. In order to boost the GDP governments start to spend more. As we have seen one of the components of GDP is government expenditure along with consumption, investment expenditure by firms and net exports.
Therefore to boost growth the government starts to take up more projects creating employment to reduce unemployment insurance. As expenditures start to exceed revenues, the deficit increases and the government needs to borrow to finance these deficits. This increase the demand for funds which in turn shifts the demand curve to the right putting pressure on interest rates.
Sometimes politicians reduce taxes to win popularity. Tax cuts such as the famous Regan cuts of 1981 resulted in reduced tax revenue, and an increase in government deficit ever since in the US.
Next we look at foreign funds flows that cause a shift in interest rates as well as exchange rates. This is key to understand the connections between the economic entities, economic factors, interest rates and exchange rates.