Types of Deficits

Every day in newspapers we keep reading about various government deficits going up/down or international agencies commenting on India’s high fiscal deficit or India relying too much on foreign funding. In order to understand these statements, let us discuss various types of deficits which are important to understand and track.

Current Account Deficit: Suppose there is a small village called Farmville. Most of the people in Farmville are farmers and they all grow wheat. All other items that villagers need will have to be bought in from other villages and cities. Shopkeepers in Farmville go to other cities/villages and buy items that can be sold in Farmville. Similarly Farmville’s farmers also travel to other cities/villages to sell the wheat that they have grown. Let us call all goods bought from other places into Farmville’s boundaries as imports. All wheat that crossed Farmville’s boundary and got sold in other places will be regarded as exports. Current account deficit is the difference between value of imports and exports. If total goods bought by residents of Farmville are worth Rs 10,000 and wheat sold outside of Farmville is worth Rs 8,000, then current account deficit of Farmville is Rs 2,000. If imports are greater than exports, the difference is referred to as current account deficit of a country. On the other hand, if exports are greater than imports, the difference is referred to as current account surplus.

Capital Account Deficit: Let’s consider a similar example. Suppose there is a city called Capitalia. It’s a fast growing city and all the companies are opening their offices in this city. It represents a very good investment opportunity and many people who are not living in the city, might want to invest in things like housing, restaurants, small business etc in the city. Thus, a lot of money will pour in from other cities. At the same time, people working in the city might send money back to their hometowns or some residents of Capitalia might invest in other cities. If the total money going out of the city is more than total money coming in, the difference is called capital account deficit. On the other hand, if total money coming in is more than total money going out, the difference is called capital account surplus.

Fiscal Deficit: It is very easy to understand this concept, if we take the example of Prateek. Prateek earns Rs 10,000 on a monthly basis, but has a habit of spending much more. Every night he goes out to party and on an average spends around Rs 30,000 a month. He can do this, only if he borrows Rs 20,000 every month from someone else. Thus, Prateek’s expenditure is more than his income and difference is called as fiscal deficit. Now replace Prateek with the government of a country. Government gets its income in the form of taxes from citizens and spends this money on various public projects and schemes. If Government’s expenditure is more than its income, it also needs to borrow in order to fill the gap. This difference between expenditure and income is called fiscal deficit and it represents the Government’s borrowing requirement.