CHAPTER-SIX (6)

• Chapter Outline
• Deficit Financing and Development
Meaning of Deficit Financing
Objectives of Deficit Financing
Effects of Deficit Financing on development
Limits to Deficit Financing
The role of Budgetary Deficit Financing
DEFICIT FINANCING & DEVELOPMENT
Meaning of deficit financing
Deficit financing in advanced countries is used to mean an
excess of expenditure over revenue.
It is the gap being covered by borrowing from the public, by
the sale of bonds & by creating new money.
It is used to denote the direct addition to gross national
expenditure through budget deficits, whether the deficits are
on revenue or on capital account.
Deficit financing, practice in w/h a gov’t spends more
money than it receives as revenue, the difference being
made up by borrowing or minting new funds.
The influence of government deficits upon a national
economy may be very great.
DEFICIT FINANCING & DEVELOPMENT
Some economists have abandoned the balanced budget
concept entirely, considering it inadequate as a criterion of
public policy.
Deficit financing, however, may also result from
government inefficiency, reflecting widespread tax evasion
or wasteful spending rather than the operation of a planned
counter cyclical policy.
Where capital markets are undeveloped, deficit financing
may place the government in debt to foreign creditors.
In addition, in many less-developed countries, budget
surpluses may be desirable in themselves as a way of
encouraging private saving.
 Objectives of Deficit Financing
In modern fiscal policy on account of consistent increases in
public expenditure of various layers of gov’t, deficit
financing assumes important role as a method of finance.
Therefore, in the economies of the world, deficit financing
is mainly resorted to attain the following objectives:
DF is used as the simple & effective fiscal device to meet the
financial requirements of the gov’t during emergencies.
Keynes popularized deficit financing as an effective fiscal
instrument to control the economic fluctuations & to raise the level
of employment & output.
In developing countries, it is considered as a method to mobilize
resources for planned economic development.
It is to raise the level of effective demand and thereby to stimulate
private spending in a depression economy.
 Objectives of Deficit Financing
Keynes advocated DF as instrument to mobilize surplus
labor & other idle & unutilized resources during depression,
for achieving economic dev’t.
In developing economies the main objective of deficit
financing is to remove the vital issue such as
unemployment, poverty & income inequality.
Sources of deficit financing
The deficit financing is done in three ways;
Printing new currency notes
Borrowing from internal sources (General Public, Ad-hoc
Treasury Bills & gov’t bonds etc.)
Borrowing from External Sources (like borrowing from
developed countries and International institutions)
 Effects of Deficit Financing
Deficit financing is a dangerous weapon to be handled
carefully.
Definitely deficit financing is capable of promoting
economic development in developing economies.
If it is used without any safeguard it may generate evil
consequence in the economy.
Therefore, deficit financing produces diverse effects
depending upon how it is planned and utilized.
i. Effects on Inflation
ii. Effects on capital formation and economic development
iii. Effects on income distribution
 Effects of Deficit Financing
i. Effects on Inflation
It is said that deficit financing is inherently inflationary.
Since deficit financing raises aggregate expenditure and, hence,
increases aggregate demand, the danger of inflation looms large.
This is particularly true when deficit financing is made for the
persecution of war.
This method of financing during wartime is totally unproductive
Since, it neither adds to society’s stock of wealth nor enables a
society to enlarge its production capacity.
The end result is hyperinflation.
On the contrary, resources mobilized through deficit financing
get diverted from civil to military production
Thereby, leading to a shortage of consumer goods.
 Effects of Deficit Financing
Being unproductive in character, war expenditure made
through deficit financing is definitely inflationary.
But if a developmental expenditure is made, deficit financing
may not be inflationary although it results in an increase in
money supply.
The most important thing about deficit financing is that it
generates economic surplus during the process of
development.
That is to say, the multiplier effects of deficit financing will
be larger if total output exceeds the volume of money supply.
As a result, inflationary effect will be neutralized.
Again, in LDCs, developmental expenditure is often pruned
due to the shortage of financial resources.
 Effects of Deficit Financing
It is the deficit financing that meets the liquidity
requirements of these growing economies.
Above all, a mild dose of inflation following deficit
financing is conducive to the whole process of
development.
In other words, deficit financing is not anti- developmental
provided the rate of price rise is slight.
However, the end result of deficit financing is inflation &
economic instability.
 Effects of Deficit Financing
ii. Effects on capital formation & Economic development
The technique of deficit financing may be used to promote
economic development in several ways.
Nobody denies the role of deficit financing in gathering
resources required for economic dev’t, though the method is an
inflationary one.
Economic development largely depends on capital formation.
The basic source of capital formation is savings.
But, LDCs are characterized by low saving-income ratio.
In these low-saving countries, deficit finance-led inflation
becomes an important source of capital accumulation.
During inflation, producers are largely benefited compared to
the poor fixed-income earners.
Saving propensities of the former are considerably higher.
 Effects of Deficit Financing
Further, deficit-led inflation tends to reduce consumption
propensities of the public.
Such is called ‘forced savings’ which can be utilized for the
production of capital goods.
Consequently, a rapid economic development will take place
in these countries.
In developed countries, deficit financing is made to boost
effective demand.
But in LDCs, deficit financing is made for mobilization of
savings. Savings thus collected encourages increasing capital.
The techniques of deficit financing results an increase in
gov’t expenditure, which produce a multiplier effect on
national income, saving, employment, and etc.
 Effects of Deficit Financing
3. Effects on Income Distribution
It is said that deficit financing tends to widen income inequality.
This is because of the fact that it creates excess purchasing power.
But due to inelasticity in the supply of essential goods, excess
purchasing power of the general public acts as an incentive to
price rise.
During inflation, it is said that rich becomes richer and the poor
becomes poorer.
Thus, social injustice becomes prominent.
However, all types of deficit expenditure, not necessarily tend to
disturb existing social justice.
If money collected through deficit financing is spent on public
good, some sort of favorable distribution of income and wealth
may be made.
 Effects of Deficit Financing
Ultimately, excess dose of deficit financing leading to
inflationary rise in prices will exacerbate income inequality.
Anyway, much depends on the volume of deficit financing.
However, if deficit financing is used for financing
development plans, this will accelerate production and
productivity in the economy.
So in the long run deficit financing will not generate any
adverse effect upon the economy.
Therefore, deficit financing will be a useful instrument of
development finance if it is judiciously employed.
 Pros & cons of Deficit Financing
Advantages
The easiest and the popular method of financing is the technique of
deficit financing.
Its popularity is due to the following reasons:
Firstly, massive expansion in governmental activities has forced
governments to mobilize resources from different sources.
Secondly, deficit financing is associated with the creation of
additional money by borrowing from the Reserve Bank.
Thirdly, financial resources that a gov’t can mobilize through deficit
financing are certain & known before hand.
Fourthly, deficit financing has certain multiplier effects on the
economy.
This method encourages the gov’t to utilize unemployed &
underemployed resources.
This results in more incomes & employment in the economy.
 Pros & cons of Deficit Financing
Fifthly, deficit financing is an inflationary method of
financing.
However, the rise in prices must be a short run phenomenon.
Above all, a mild dose of inflation is necessary for economic
development.
Thus, if inflation is kept within a reasonable level, DF will
promote economic dev’t thereby neutralizing the
disadvantages of price rise.
Finally, during inflation, private investors go on investing
more & more with the hope of earning additional profits.
Seeing more profits, producers would be encouraged to
reinvest their savings & accumulated profits.
Such investment leads to an increase in income, thereby
setting the process of economic dev’t rolling.
 Pros & cons of Deficit Financing
Disadvantages
The evil effects of deficit financing are:
Firstly, it is a self-defeating method of financing as it always
leads to inflationary rise in prices.
Unless inflation is controlled, the benefits of deficit-induced
inflation would not fructify.
Secondly, deficit financing-led inflation helps producing
classes and businessmen to flourish.
But fixed-income earners suffer during inflation.
This widens the distance between the two classes.
Thirdly, it distorts investment pattern.
Higher profit motive induces investors to invest their
resources in quick profit-yielding industries.
 Pros & cons of Deficit Financing
Fourthly, deficit financing may not yield good result in the
creation of employment opportunities.
Creation of additional employment is usually hampered in
backward countries due to lack of machineries.
Fifthly, as purchasing power of money declines consequent
upon inflationary price rise, a country experiences flight of
capital abroad for safe return thereby leading to a scarcity of
capital.
Finally, this inflationary method of financing leads to a
larger volume of deficit in a country’s balance of payments.
Following inflationary rise in prices, export declines while
import bill rises, and resources get transferred from export
industries to import competing industries.
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