Why do people borrow money? There are different reasons. For instance, a person can take a loan to finance a deficit. Some use loans to pay college fees while others invest.
In this economic era, loans have become very important. However, their significance is not limited only to individuals. Even governments borrow. In other words, there are different types of borrowing. Countries can borrow from other countries. Governments can borrow from individuals, and individuals can as well borrow from governments. Whichever the case, borrowing, and lending of money are essential to the economy of a country. In this blog, we are going to discuss the reasons why loans are so crucial to the economy.
Loans are utilized in capital investments. The funds that go to capital expenditures stimulate business activities, leading to the overall growth of the economy. There are cases where governments have been compelled to spend significantly on revenue expenditures. What is the implication of revenue expenditure? For example, an item of revenue expenditure is financed with loans; it merely means future revenues used today, which is quite critical. It is a bad thing for a nation to compromise its sovereignty due to loans.
The Role of Loans in Economic Stability
Governments, through central banks, use loans to control the economy of the country. To contextualize these two points, let us look at two ways in which loans can be used to stabilize the economy.
- During Inflation
Inflation refers to a state in which there is a general increase in the prices of goods and services in the economy. As a result, the purchasing power of consumers decreases. In times of inflation, there is a lot of money in circulation chasing few goods. How does inflation come about? It is simple. Inflation sets in when there is an increase in credit and increases the supply of money in the economy. As a result, the prices of commodities increase, raising the inflation rate.
How can this situation be controlled? Well, the government, through the central bank, will increase the interest rates on loans and deposits. With high-interest rates on loans, individuals cannot borrow. Instead, the high rates favor saving, which reduces the amount of money in circulation. As a result, inflation decreases.
Inflation is not a good condition. Consumers often suffer due to reduced purchasing power. But is deflation better? Well, deflation is the direct opposite of inflation. The prices of goods and services significantly drop, and this may negatively affect the economy. How can this condition be corrected? In this case, there is a need for extra credit to stimulate investments. Therefore, the government, through the central bank, reduces the interest rates on loans and deposits. This condition stimulates consumption but limits savings, and as a result, deflation is controlled.
The effects of loans to the economy go beyond inflation and deflation. As we earlier stated, there are different types or levels of debt, and each impacts the economy differently. Again, to understand this point, let us briefly discuss two types of debt and see how they affect the economy.
- Investment Debt
How does debt investment work? Suppose you intend to start a business, and you do not have capital; you may have to borrow. This is because you need to bring all the necessary factors of production and any other resource required to start the business before you could earn anything from it. If you are wise, and I believe you are, you will project the revenues that the company is likely to generate from the sale of products acquired on debt. It is this revenue that you will have to use to pay workers and suppliers regularly, pay back the loan, and earn profit from it once all is settled. That is, the loan was used to open a business that repays the loan, cover the expenses, and still earn profits, something that could not have been possible without the loan.
So, what is the economic significance of an investment loan? From the illustration, an investment debt leads to the production of commodities that would not otherwise have been produced. The increased productivity helps to pay back the loan and earns a stream of income.
- Consumption Debt
Unlike an investment debt, consumer debt does not pay itself. This I because the debt cannot contribute to future productivity but instead offer consumption. For instance, think of a holiday loan. There is no way the vacation can add to future revenue. This means the loan does not lead to more future productivity or income. As a result, it has to be paid using the existing income. This implies that less of the future income stream will be available to cater to consumption since part of it has to be used to pay back the loan.
Therefore, consumption debt shifts future consumption to the present, leaving less expenditure for the future. Since future consumption has been used at present, an individual has to compensate for it by offering future productivity. Do you have to work in the future to repay a loan, something that you could do without? Spending what you do not have is living beyond your means, which is deplorable financial behavior.
Nevertheless, the consumption of debt is not always harmful. It depends on how the borrower uses the funds. For instance, if you need a car, you can save funds and acquire it only when you have saved enough but in case you take a loan, you can have the enjoyment as you keep to pay the debt. However, you will have to pay interest if you go this route. So, the benefit is realized by rating the enjoyment against the interest payment.
The Bottom Line
Loans are essential in the economy. We have looked at different ways in which loans can be beneficial to the economy. Should you worry about your credit? Not at all! Something of prime significance is the overall credit.
© Scoop Empire 2022. All rights reserved.