Deficit Financing

Deficit refers to the difference between expenditure and receipts. In public finance, it means the government is spending more than what it is earning. Government expenditure and revenue can be split into capital and revenue. Capital expenditure generally includes those expenses which result in creation of assets. Revenue expenditure is primarily that which does not result in asset creation —for example interest payments, salaries, subsidies, etc. Similarly, on the receipts side, whatever the government receives as taxes is revenue receipt. Receipts not of a recurring nature are generally capital receipts. These include domestic and external borrowings, proceeds of disinvestment, recovery of loans given by the Union government, etc.

Deficit financing is a necessary evil

Deficit financing is a necessary evil in a welfare state as the states often fail to generate tax revenue which is sufficient enough to take care of the expenses of the state. Deficit financing allows the state to undertake activities which, otherwise, would be beyond its financial capacity. The concept was popularised by noted British economist JM Keynes with the aim of pumping a depressed economy.

Problems of Deficit Financing

The basic intention behind deficit financing is to provide the necessary impetus to economic growth by artificial means. However, deficit financing helps to a certain extent only and beyond that it may cause havoc. Here are some of the problems of deficit financing.

Deficit Financing Leads to inflation

Deficit financing may lead to inflation. Due to deficit financing money supply increases & the purchasing power of the people also increase which increases the aggregate demand and the prices also increases.

Adverse effect on saving

Deficit financing leads to inflation and inflation affects the habit of voluntary saving adversely. Infect it is not possible for the people to maintain the previous rate of saving in the state of rising prices.

Adverse effect on Investment

Deficit financing effects investment adversely when there is inflation in the economy trade unions make demand for higher wages for that they go for strikes and lock outs which decreases the efficiency of Labour and creates uncertainty in the business which a decreases the level of investment of the country.

Inequality

In case of deficit financing income distribution becomes unequal. During deficit financing deflationary pressure can be seen on the economy which make the rich richer and the poor, poorer. The fix wage earners are badly effected and their standard of living deteriorates thus no gap b/w rich & poor increases.

Problem of balance of payment

Deficit financing leads to inflation. A high price level as compared to other countries will make the exports more expensive and thus they start declining. On the other hand rise in domestic income and price may encourage people to import more commodities from abroad. This will create a deficit in balance of payment and the balance of payment will become unfavourable.

Increase in the cost of production

When deficit financing leads to the rise in the price level the cost of development projects also rises this means a larger dose of deficit financing is required on the port of government for completion of these projects.

Change in the pattern of investment

Deficit financing leads to inflation. During inflation prices rise and reach to a very high level in that case people instead of indulging into productive activities they start doing speculative activities.

India and Deficit Financing:

India resorted to deficit financing, then largely financed through Reserve Bank’s books either by printing more money or use of its foreign exchange reserves, right from the early years of planned economic development. However, our planners did not factor in the impact of deficit financing on inflation. But with large foreign exchange reserves, they were confident of the government’s ability to manage the supply-side of the economy.

For much of the 1950s, the Bank was part of this consensus. Although the impact of deficit financing on prices had aroused concern already in 1951-52 , price stability did not return as a major cause of worry at the Bank until the mid-50 s. Besides, the Bank recognised the need for any plan to go beyond what available resources dictated, even if some part of the additional investment had to be financed through additions to money supply.

Is deficit financing inevitable?

Deficit financing is neither good nor bad. it depends upon the circumstances in which it is resorted to and the economic policy which is followed to neutralize its adverse consequences. A certain measure of deficit financing is inevitable in India under the planned economic development as one of the objectives of the planning is to step up the tempo of the economic progress beyond what it would have been in absence of planning. As far as deficit financing does not lead to inflation , there is no objection to its use. However , unfortunately, extent to which India has been practicing deficit financing has gone way beyond what could possibly have been contemplated 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.