Articles from General Knowledge Today

Deficit Financing
2012- 11- 24 12:11:12 GKToday

Def icit ref ers t o t he dif f erence bet ween expendit ure and receipt s. In public
f inance, it means t he government is spending more t han what it is earning.
Government expendit ure and revenue can be split int o capit al and revenue.
Capit al expendit ure generally includes t hose expenses which result in creat ion
of asset s. Revenue expendit ure is primarily t hat which does not result in asset
creat ion f or example int erest payment s, salaries, subsidies, et c. Similarly,
on t he receipt s side, what ever t he government receives as t axes is revenue
receipt . Receipt s not of a recurring nat ure are generally capit al receipt s.
T hese include domest ic and ext ernal borrowings, proceeds of disinvest ment ,
recovery of loans given by t he Union government , et c.
Def icit f inancing is a necessary evil in a welf are st at e as as t he st at es of t en
f ail t o generat e t ax revenue which is suf f icient enough t o t ake care of t he
expenses of t he st at e. Def icit f inancing allows t he st at e t o undert ake
act ivit ies which, ot herwise, would be beyond it s f inancial capacit y. T he
concept was popularised by not ed Brit ish economist JM Keynes wit h t he aim
of pumping a depressed economy.
T he basic int ent ion behind def icit f inancing is t o provide t he necessary
impet us t o economic growt h by art if icial means. However, def icit f inancing
helps t o a cert ain ext ent only and beyond t hat it may cause havoc. Here are
some of t he problems of def icit f inancing.
1. Leads to inf lation :- Def icit f inancing may lead t o inf lat ion. Due t o def icit
f inancing money supply increases & t he purchasing power of t he people also
increase which increases t he aggregat e demand and t he prices also
increases.
2. Adverse ef f ect on saving:- Def icit f inancing leads t o inf lat ion and inf lat ion
af f ect s t he habit of volunt ary saving adversely. Inf ect it is not possible f or t he
people t o maint ain t he previous rat e of saving in t he st at e of rising prices.
3. Adverse ef f ect on Investment ;- def icit f inancing ef f ect s invest ment
adversely when t here is inf lat ion in t he economy t rade unions make demand
f or higher wages f or t hat t hey go f or st rikes and lock out s which decreases
t he ef f iciency of Labour and creat es uncert aint y in t he business which a
decreases t he level of invest ment of t he count ry.
4. Inequality :- in case of def icit f inancing income dist ribut ion becomes
unequal. During def icit f inancing def lat ionary pressure can be seen on t he
economy which make t he rich richer and t he poor, poorer. T he f ix wage
earners are badly ef f ect ed and t heir st andard of living det eriorat es t hus no

gap b/w rich & poor increases.

5. Problem of balance of payment :- Def icit f inancing leads t o inf lat ion. A
high price level as compared t o ot her count ries will make t he export s more
expensive and t hus t hey st art declining. On t he ot her hand rise in domest ic
income and price may encourage people t o import more commodit ies f rom
abroad. T his will creat e a def icit in balance of payment and t he balance of
payment will become unf avourable.
6. Increase in the cost of production: - When def icit f inancing leads t o t he
rise in t he price level t he cost of development project s also rises t his means a
larger dose of def icit f inancing is required on t he port of government f or
complet ion of t hese project s.
7. Change in the pattern of investment:- Def icit f inancing leads t o inf lat ion.
During inf lat ion prices rise and reach t o a very high level in t hat case people
inst ead of indulging int o product ive act ivit ies t hey st art doing speculat ive
act ivit ies.

India and Deficit Financing:

India resort ed t o def icit f inancing, t hen largely f inanced t hrough Reserve
Bank's books eit her by print ing more money or use of it s f oreign exchange
reserves, right f rom t he early years of planned economic development .
However, our planners did not f act or in t he impact of def icit f inancing on
inf lat ion. But wit h large f oreign exchange reserves, t hey were conf ident of t he
government 's abilit y t o manage t he supply-side of t he economy.
For much of t he 1950s, t he Bank was part of t his consensus. Alt hough t he
impact of def icit f inancing on prices had aroused concern already in 1951-52 ,
price st abilit y did not ret urn as a major cause of worry at t he Bank unt il t he
mid-50 s. Besides, t he Bank recognised t he need f or any plan t o go beyond
what available resources dict at ed, even if some part of t he addit ional
invest ment had t o be f inanced t hrough addit ions t o money supply.

Is deficit financing inevitable?

Def icit f inancing is neither good nor bad. it depends upon t he circumst ances in
which it is resort ed t o and t he economic policy which is f ollowed t o neut ralize
it s adverse consequences. A cert ain measure of def icit f inancing is inevit able
in India under t he planned economic development as one of t he object ives of
t he planning is t o st ep up t he t empo of t he economic progress beyond what it
would have been in absence of planning. As f ar as def icit f inancing does not
lead t o inf lat ion , t here is no object ion t o it s use. However , unf ort unat ely,
ext ent t o which India has been pract icing def icit f inancing has gone way
beyond what could possibly have been cont emplat ed by Lord Keynes.

Relation of Deficit Financing and Inflation:

Deficit financing may not necessarily be inflationary there are certain conditions
under which deficit financing may not lead to inflation. With increase in money
supply due to deficit financing prices do rise but rise in price will only be temporary
for about a period. As flow of goods and services increase prices will began to fall.
deficit financing is an important device for financing development plans for
underdeveloped countries and accelerate their rate of economic development. But If
deficit financing is not kept with in limits It may give rise to prices, distorted
investment and unequal and unjust distribution of income. therefore it is essential
that deficit financing is kept within limits and its impact on prices and costs are
softened through various controls.