Deficit financing is practised whenever
government expenditure exceeds government receipts from the public such as
taxes, fees, and borrowings from the public.
Such an excess of government expenditure can be financed either by
drawing down the cash balances of the government or by borrowing from the
Aspects of Deficit Financing
Deficit financing as an income
generating expenditure has two aspects:
priming: Pump priming means the power of
deficit financing in stimulating private investment through giving small
doses of investment in the economy.
spending: Compensatory spending means that
deficit financing can be used for compensating and neutralising tendencies
towards over-saving and under-investment.
Financing and Deficit Budgeting
budgeting refers to the situation when current expenditure exceeds current
revenue. In this situation no
item on capital account is taken into consideration.
the other hand, when we take into consideration not only current receipts
but also receipts on capital account, e.g., public borrowing, and the gap
between receipts and expenditure is covered by deficit financing.
of Deficit Financing
prosecuting a war: During
the state of war, the government has to finance the purchase of arms and
ammunitions through deficit financing.
Deficit financing during war is very injurious for the economy.
Private investments and savings are at their worst level.
fighting depression: Deficit financing can
be really helpful for the government during the period of depression.
It can stimulate private consumption and investment. The government can increase its own expenditure on
public works programme. The
government’s tax revenue remains constant but its expenditure has gone up,
therefore, the deficit has to be met by borrowings.
In this case, as government investment rises, the level of national
income and employment also increases by more than the proportionate increase
in government investment. Deficit
financing can be used to create additional employment, when the economy is
suffering from a deficiency of effective demand.
financing economic development: The
economic problems faced by underdeveloped countries are different from that
of advanced countries. In advanced countries, the task of capital formation is
in the hands of private entrepreneurs but in poor countries there is a
dearth of people willing and able to undertake entrepreneurial functions.
Therefore, it is the government’s responsibility to boost up
investment in public sector, generate revenue from it and encourage people
to save and invest. But, in a country, where a majority of people are living
at the subsistence level, the margin between income and consumption is very
low so that the voluntary savings cannot provide sufficient resources for
development. The government may
attempt to increase the volume of resources by additional taxes.
Because of extreme poverty of the great mass of the people,
additional taxation beyond a point raises problems, both economical and
of Deficit Financing
in the money supply with the public
in the level of income, and
in the general price level.
Financing and Inflation
The inflationary implications of
deficit-financing is divided into two parts:
in a full-employment economy, and
in an under-developed country or less than full-employment economy.
first part is related to the inflationary impacts of deficit financing in a
full employment economy. In this regard some writers hold the view that even
under the conditions of full employment, in the long run, there is no
problem of inflation, particularly in economically advanced countries.
However, infact, at full employment a further increase in aggregate
demand through deficit financing results in raising the general price level
instead of adding to aggregate output and employment.
the second part, there are five reasons by which the deficit financing
results into inflation:
When there is a variety of channels into which increased money supply can
Non-homogeneity in skills or efficiency
Supply of resources is perfectly inelastic
Increase in wage rates
Increasing marginal cost
in the Use of Deficit Financing
financing should be used in moderate doses
watch on price index
of consumer goods and essential raw materials should be effectively
a corresponding increase in the availability of goods
on quick yielding projects
order to keep down the prices of food grains, food imports should be
arranged well in time and in adequate quantities.
in wages and salaries should be checked lest the country be caught in a
vicious circle of poverty
money supply should be mapped up through taxation and borrowings
clean and efficient administrative system tackling the difficult economic
situation with whole hearted cooperation from the people
to Minimise Inflationary Pressure of Deficit Financing
disinflationary fiscal policy,
monetary policy to control non-essential private investment,
controls through selective credit control, physical and fiscal controls, in
order to influence the behaviour of private investment and channelise it
into desirable lines,
allocation of resources with major focus on agriculture and small and medium
scale industries, and
import surpluses for increasing the supply of goods.
Fiscal policy with respect to inflation
includes all the measures of a monetary nature which the executive branch of the
government adopts in connection with:
Fiscal policy has come to be recognised
as the potentially most powerful instrument of economic stabilisation.
(a) Government spending:
During inflation the government is supposed to
decrease its own spending to counteract an increase in private spending.
The government must simultaneously reduce expenditures and increase
revenues to achieve a cash surplus to be used in an anti-inflationary manner.
It is axiomatic that during inflation the existing tax structure should be
retained, that tax cuts should be resisted, and the new taxes should be adopted
or tax rates increased, if possible – to reduce the amount of spendable money
in the hands of general public. But care must be taken not to deflate the money incomes of
the country via taxation so much as to provoke a recession of economic activity.
Saving is a type of public borrowing which has a deflationary effect on the
money supply and effective demand. The most effective anti-inflationary public borrowing takes
the form of compulsory saving.
(d) Debt Management:
Public debt may be managed in such a way as to reduce the money supply or to
prevent further credit expansion. Anti-inflation
debt management often refers to the retirement of bank-hold debt out of a
budgetary surplus. It includes the
retirement of public debts of the following categories:
Retirement of public debt by central banks out of a budgetary surplus is
Retirement of bank-held debt (i.e., commercial banks) is neutral in its
Retirement of a maturing portion of debt held by the non-bank public,
which has also neutral effect.
(e) Gold Sterilisation:
Whenever the gold inflow is deemed too dangerously inflationary in effect, the
government may decide to sterilise gold in order to keep bank reserves from
increasing gold acquisitions.
In order to control domestic inflation, a country might maintain the overvalued
exchange value of its currency, that is, an expensive currency relative to
foreign currency. An overvalued
currency is anti-inflationary in effect for three reasons, namely:
Because of its discouraging effect on exports and decreasing effect on
domestic money incomes
Because of its encouraging effect on imports and increasing effect on
Because of its cheapening effect on the price of those foreign materials
which enter into the domestic cost of product of its preventive effect on the
upward-cost price spiral.
and Principles of Federal Finance
Federal finance seeks to maximise total
welfare. The economic welfare in an
under-developed region in a federation can be increased by the diversion of
resources from the developed regions.
The general principle to maximise
economic welfare is that each regional or state government should try to equate
marginal social benefit (MSB) with marginal social cost (MSC). The federal government will try to do so for the whole
country. Thus the principle of
federal finance would be:
Equalising of MSB and MSC would require
a substantial inter-area transfer of resources in a federation for achieving
what Professor Buchanan calls ‘inter-personal equity’. Inter-personal equity means equal treatment to equals.
A transfer of resources is necessary to achieve ‘horizontal equity’.
If the same amount of expenditure were made in all states, it would mean
that the rich state would be subject to less tax than his equal income
counter-part in the poor state.
The principles of federal finance are
discrimination in levying taxes among the states.
It implies uniformity of taxation.
of federal finance to impose taxes and spend.
government and the federal units have no dependency on each other and should
carry their functions normally
should be capable of expansion as the requirements increase.
economy, i.e., minimum tax evasion, effective tax collecting system, minimum
cost of tax collection, minimised adverse effects on trade and industry,
for grants-in-aid to meet resource deficits.