Deficit Financing:

Deficit financing means generating funds to finance the deficit which results from excess of expenditure over revenue. The gap being covered by borrowing from the public by the sale of bonds or printing new money.

“Deficit financing means meeting the deficit between government expenditure and revenue through the creation of new money.”

In western countries, the excess of expenditure of the government over its current revenue, (i.e., taxes and non tax revenue comprising commercial revenue, administrative revenue, gifts and grants) is referred to as deficit financing.

This deficit is covered by market borrowing (public loans) and some times by creation of new money.

While in India, deficit financing is used to denote the excess of total government expenditure over total revenue, comprising current revenue and public borrowings.

The government may cover the deficit either by running down its accumulated cash balances or by borrowing from the central bank (Reserve Bank of India) .

Sources of Deficit Financing:

The deficit financing is done in three ways :

1. Printing new currency notes

2. Borrowing from internal sources (RBI, General Public, Ad – hoc Treasury Bills and Government Bonds etc) .

3. Borrowing from External sources ( like borrowing from developed countries and international institutions like World Bank, IMF etc.)

Why Deficit Financing: Purposes of Deficit Financing

1. To arrange fund for the unforeseen events and arrange resources for War time expenditure.

Since war is a costly proposition. It is difficult for the government to mobilise adequate resources for financing war expenditure through its normal methods of raising resources.

Deficit financing is the simplest and quickest method of meeting the war requirements. Use of additional money to meet war expenditure results in rise in prices and this feeds inflationary pressure in the economy.

2. Promote additional investment in the country to side away the adverse impacts of depression period of the country.

Deficit financing is used as an instrument of economic policy for overcoming depression and raising the level of output and employment.

According to Keynes, unemployment may be removed by increasing the aggregate demand .

During depression,private sector does not undertake large investment because of lack of incentive. Therefore the government have to step forward to increase its expenditure and finance it by creating new money.

Increased public expenditure will increase the purchasing power of public, leading to increase in aggregate demand. This will lead to a larger production by utilising unemployed resources.

This way deficit financing will lead to increase in output and employment in the economy and used as a tool to pull the economy out of depression.

3. To overcome the problem of lack of funds for speeding up the country’s development.

4. To arrange funds for ensuring the holistic development of the country.

5. To upgrade the infrastructure of the country so that the taxpayers of the country are convinced that the tax paid by them is spent on the right things.

6. To activate idle resources as well as divert resources from unproductive sectors to productive sectors with the objective of increasing national income and hence, higher economic growth.

7. To raise capital formation by mobilising forced savings made through deficit financing.

8. To mobilise resources to finance massive plan expenditure.

Deficit Financing and Economic Development :

Many economists has recommended deficit financing as a useful method of financing development plans in underdeveloped countries and in accelerating the rate of economic development.

The use of deficit financing for economic development has been supported on these grounds:

1. Raising of Additional Resources :

Deficit financing enables the government to raise financial resources quickly for financing development.

In a democratic country like India, the government find it difficult to raise large resources through taxable because of low taxation capacity of lower income level people.

Heavy taxation is always resented by people every where.

At the same time voluntary borrowings also have a limit due to lower savings of the people.

Therefore, deficit financing becomes an easy and attractive. Alternative.

2. Generation of Saving:

Deficit financing is a concealed and clever method of generating savings among the people.

Since deficit financing is more convenient and safer method of generating resources than taxation and public borrowing. Therefore deficit financing does not impose any direct burden on people, it does not arouse their opposition.

Deficit financing leads to rise in prices due to increase in public expenditure, and aggregate demand also increases but at the same time there is no corresponding increase in aggregate supply in short run. Thus prices rise.

This result in decrease in real consumption and saving is generated.

This increases savings in the hands of producer and the government.

Transfer of resources to the government through price rise is called forced savings.

Thus, deficit financing generates savings which are used for financing development expenditure by the government.

3. Increase in Aggregate Demand or Additional Purchasing Power:

Deficit financing is an efficient method of increasing purchasing power of consumers.

Government increase the public expenditure by means of deficit financing, which results in decrease in unemployment by increasing the aggregate demand.

This will lead to a larger production by utilising unemployed resources.

This way deficit financing will lead to increase in output and employment in the economy. This ultimately results in increase in income of people and hence their purchasing power is increased.

4. Price Rise Self – destructive in the Long Run:

As we know that deficit financing results in prices to rise, but this will be self destructive in the long run.

With the increase in money supply due to deficit financing aggregate demand is increased but the corresponding increase in aggregate supply does not occur in short run.

Therefore the prices rise only for a short period.

As soon as the demand is fulfilled and goods start flowing from development projects financed through deficit financing prices may move down.

5. Meeting increased demand for Money:

In the developing countries like India, there is an additional demand for money during the course of economic development.

Increased monetisation and rise in the income level generate more demand for money in the course of economic development.

Hence the money injected in the economy in the name of financing development serves other useful purposes as well.

Adverse Effects of Deficit Financing:

When deficit financing is used in a large magnitude it has certain adverse effects on the functioning of economy which are as follows :

1.Inflationary Rise in Price:

Excessive use of deficit financing may result in inflationary rise in prices.

As a result of deficit financing, there is an increase in money supply in the market. This result in increase in demand for goods and services.

Due to absence of corresponding increase in aggregate supply of goods and services in the short run, prices tend to rise.

Rising prices leads to rising costs, which lead to further rise in prices and thereby cost – price spiral may set in.

2. Unequal Distribution of Income:

Inflationary rise in prices due to excessive use of deficit financing, has undesirable effects on the distribution of income in a country.

Due to this rise in prices, purchasing power of the fixed income group is reduced.

On the other hand, profits tend to rise, which benefits only a certain group of people.

Therefore, deficit financing redistribute income and wealth in favour of profiteering classes i.e., producers, businessmen and treaders.

Hence deficit financing may results in unequal distribution of income and wealth.

3. Unequal impact of Forced Savings:

Excessive use of deficit financing results in rise in prices. This cause real consumption to fall, and saving is generated.

This type of forced savings, which is caused by reduced consumption of goods and services due to inflationary rise in prices, will adversely affect certain group of people in an economy.

The impact of forced saving may fall more on fixed income earners than on the higher income groups.

This way deficit financing results in unequal impact of forced savings on different groups.

4. Change in Pattern of Investment:

Deficit financing may lead to distortion of investment.

It may encourage those types of investments which are not desirable for developing economy like hoarding and speculation because inflationary rise in prices increase profitability in such activities.

Investing in real production activities like investing in purchase of machinery, equipment etc. becomes less attractive avenues of investments.

Thus, deficit financing is an important device for financing development plans of underdeveloped countries and accelerating their rate of economic development. But if deficit financing is not kept within limits, it may rise to serious adverse effects in the form of inflationary rise in prices, distorted investment and unjust and unequal distribution of income.

Therefore it is very essential that deficit financing is kept within the limits. Deficit financing ,like fire, is good servant but a bad mater and it should be used in right proportions.

Deficit Financing : Meaning, Purposes and Uses – Fiscal Policy Class 12

Deficit Financing:

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