Government debt (also known as public debt, national debt, sovereign debt) is money (or credit) owed by a central government. In the US, “government debt” may also refer to the debt of a municipal or local government. By contrast, annual government deficit refers to the difference between government receipts and spending in a single year, that is, the increase of debt over a particular year.
As the government draws its income from a lot of the population, government debt is an indirect debt of the taxpayers. Government debt can be categorized as internal debt(owed to lenders within the country) and external debt (owed to foreign lenders). Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy countries sometimes borrow directly from supranational institutions.
A broader definition of government debt considers all government liabilities, including future pension payments and payments for goods and services the government has contracted but not yet paid.
Another common division of government debt is by duration until repayment is due. Short term debt is generally considered to be for one year or less, long term is for more than ten years. Medium term debt falls between these two boundaries.
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country’s debt rating is a crucial determinant of its exchange rate.