Deficit Financing

Meaning of Deficit financing Deficit financing is a method of meeting government deficits through the creation of new money. The deficit is the gap caused by the excess of government expenditure over its receipts. The expenditure includes disbursement on revenue as well as on capital account. The receipts similarly comprise revenues on current account as well as capital account. Creation of new money to meet the deficit in use for a long time. 

Deficit Financing: Deficit Financing has been variously defined: Deficit Financing is the method used to finance the overall or net budget deficit. Deficit Financing is the creation of additional purchasing power in the form of currency notes. 2

Deficit Financing: Deficit Financing is said to have been practiced whenever the government expenditures exceeds the government receipts from taxes, fee etc it then adopts any one or all of the following methods: Utilization of the past savings: A government draws upon the cash balances of the past for meeting the budget deficit. Printing New Currency: A government borrows from the central bank of the country. The central bank prints new currency in the amount borrowed by the government. Foreign Aid: The government borrows from developed countries 2

Why Deficit Financing? Deficit financing is a very delicate tool of resource mobilization. It is liberally used by a hard pressed government for raising revenue. The main reasons for the use of deficit financing are: 1. Covering the Receipt-Expenditures Gap: the government receipts through taxes and other sources are not adequate to finance the development expenditures. The government has not been able to fill the gap between the total receipt and the total expenditure by levying new taxes or increasing the rates of existing tax beyond a certain limits to avoid displeasure of the people, the government has been choosing an easy path of deficit financing or creation of new currency. 2. Low Savings: The people in LDCs are consumption-oriented. Due to high propensity to consume, the domestic saving rate as a percentage of GNP is very low. As such the government is compelled to use deficit financing as an instrument of economic development. 2

Reasons for Deficit Financing…continued 3. Inadequate Banking Facilities: the financial institutions which mobilize savings particularly in the rural areas are inadequate. The government is therefore, not able to mobilize resources to the desired extent. 4.Rapid Growth of Population: The rapid rate of population growth is swallowing up whatever little economic progress is made. The government is anxious to speed up the economic development in the shortest possible period of time and is using the method of deficit financing. 5. Uncertainty in getting foreign assistance: Though the LDCs have been receiving foreign assistance yet the amount of aid received has always remained uncertain. The government for increasing the rate of investment and coming out of the vicious circle of poverty has no other way but to resort to deficit financing. 2

Deficit Financing is a Useful Tool? Deficit Financing is a useful weapon for stimulating economic development in the country. The main advantages claimed of deficit financing are: Mobilizes additional resources for economic development: in LDCs the rate of capital formation is very low due to the unavailability of resources. The rate of economic development is very low. The capital is considered as life blood of the economy. Thus the deficit financing is a source of capital formation. Helps up in utilizing our unutilized or underutilized resources: the rate of economic growth of the LDCs is slow because they can’t utilize these resources fully due to the lack of capital. Deficit financing creates additional purchasing power in the hands of government with which the government can utilize the underutilized and unutilized resources. 2

Deficit Financing a Useful Weapon? Helps in building up infrastructure: the LDCs have very low infrastructure facilities like highways, banks, education etc. a big sum is required by the government in providing such facilities like construction of highways, provision of electricity, water & gas, provision of health facilities. In such situations, when the revenue of the government is low, deficit financing is the way to meet the needs of the government for providing these facilities. Ensuring higher level of employment in the country: in LDCs, the unemployment is a real problem. The number of unemployed people is increasing day by day as the population increases and also due to the unavailability of capital with the people and government. Thus deficit financing is the way to increase the employment in the country. When the revenue created through deficit financing is spent on different projects like construction of roads, irrigation, hydro-electric generation etc. this will absorb the unemployed portion of the people. 2

C a u t i o n: Deficit Financing creates inflationary pressure in the economy. If the time lag between the injection of created money into the economy and the completion of development projects is long and the extra demand for goods is not matched by additional output, there is greater inflationary pressure in the economy. 2

How to reduce inflation pressure of Deficit Financing: The economists recommend following measures for minimizing the inflationary potential of deficit financing: Proper Import and Export Policy: A country should frame its imports and exports policy in such a way that the supply of essential commodities does not fall and they are provided at reasonable prices in the country. Control on supply of commodities: The inflationary pressure generated by deficit financing can be reduced by having an effective control on the supply and prices of essential commodities. The basic commodities can be provided to the consumers at fixed prices. 2

How to reduce inflation pressure of Deficit Financing: 3. Fiscal Policy: the inflationary rise in prices can be controlled or minimized through an anti-inflationary fiscal policy. If a government increases the rates of taxes of the luxury good, reduces its non-essential expenditures, the magnitude of inflationary pressure will be reduced. 4. Monetary Policy: An effective monetary policy can also go a long way in minimizing the inflationary pressure of deficit financing.. Summing Up, the use of deficit financing for economic development may be linked to fire which if unregulated produce havoc while regulated gives light and warmth. 2

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