Question: what is
deficit financing? Explain it.
Answer:
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. But it has now being given up. Instead a new scheme called
ways and Means Advances is being ushered in with effect from April 1997. Under
this system the government can get only temporary loans to overcome the
mismatch between its receipts and expenditures.
When government expenditure tends to exceed public income,
the government may resort to deficit financing to meet the deficit in the
budget. Keynes organised the idea of deficit financing as a compensatory
spending meant to solve the problem of unemployment and depression. Modern
economists prescribe deficit financing for developmental purposes.
Dr. V.K.R.V. Rao defines deficit financing as “the financing
of a deliberately created gap between public revenue and public expenditure or
a budgetary deficit, the method of financing resorted to being borrowing or a
type those results in a net addition to national outlay or aggregate
expenditure.” Deficit financing implies creation of additional money supply.
In Indian terminology, the term “deficit financing” connotes
that financial scheme of the government expenditure in which the deficit is met
by utilising the cash balances with the Reserve Bank or by taking loans from
the Reserve Bank. In practice, however, the latter system has been favoured by
the government.
The government transfers its securities to the Reserve Bank;
on the strength of these securities the Reserve Bank is empowered to print more
currency notes which are put into circulation by making increased payments on
behalf of the government. This process of deficit financing obviously implies
the creation of money.
The technique of deficit financing has its historical origin
in war finance. In war times, the government tends to resort to deficit
financing in order to quickly acquire a command over resources to meet the
growing war expense. As a rule, however, deficit financing is unproductive
while used in the case of war finance.
In 1936, Keynes, however, advocated deficit spending by the
State as a means of overcoming depression. He contended that in an advanced
economy, deficiency of effective demand causes unemployment and, thus cyclical
depression.
He therefore, suggested the programme of government spending
through creation of new money which would stimulate private investment by
reviving the marginal efficiency of capital through consumption multiplier
effect in income generation which would uplift the level of employment in the
country’s economy.
For, when a given volume of investment is undertaken by the
government through deficit spending, the increased investment leads to successive
increments in consumption over a period of time and as such the national income
increases more than the initial investment. This sort of multiplier effect is
based upon the marginal propensity to consume.
In case of war deficit, the productivity of expenditure by
the government is not the criterion, but is designed out of sheer necessity.
Depression deficit is, however, advocated on the criterion of the net benefit
of public spendings, as to what extent it would stimulate private investment
and bring forth recovery.
Then, in the early post-Keynesian period, when most of the
underdeveloped countries started becoming conscious of their economic
development, many economists translated Keynesian solution of “depression
deficits” into “developmental deficits” to solve the problem of unemployment in
the poor countries.
Like depression deficits, developmental deficits are
expected to provide stimulus to economic growth by affecting investment,
employment, and real income, with their due multiplier and cumulative
expansionary effects.
Deficit financing for developmental purpose is resorted to
mainly because, when the government in an underdeveloped country takes up the
responsibility of promoting economic growth, it has to compensate for the lack
of private investment through expansion of public sector. But, due to paucity
of current resources at its disposal, it normally finds it difficult to finance
the huge public outlay necessary for accelerating the tempo of growth.
Since, due to overall poverty in an underdeveloped country,
taxation has a narrow coverage amounting to hardly 8 to 10 per cent of total
national income, and the real voluntary savings are very low on account of low
per capita income and the high marginal propensity to consume, the government tends
to mobilise resources from high consumption and unproductive uses to productive
uses and capital formation purposes through deficit financing.
In democratic underdeveloped countries, deficit financing is
preferred to taxation for political reasons. The government always finds it
easier to print more notes and meet expenditure rather than raising the same
amount through taxation measures, as there is always public resentment to
additional taxes in normal times.
Thus, a country resorting to planning for development finds
it easier to obtain additional resources for the plans through deficit
financing. In India, for instance, deficit financing constitutes an important
source of obtaining financial resources for the plans. When the target
requirements exceed resources realised through taxation, borrowings, public
sector profits, foreign aid, etc., additional resources are raised by resorting
to deficit financing.
Purpose of Deficit
Financing:
In India, the deficit financing resorted mainly to enable
the government to obtain the necessary resources for the plans. The levels of
outlay laid down are of an order which cannot be met only by taxation and
borrowing from the public.
The gap in resources is made up partly through external
assistance, but when external assistance is not enough to fill the gap; deficit
financing has to be resorted to. The targets of production and employment in
the plans are fixed primarily with reference to what is considered as the
desirable rate of growth for the economy.
When these targets cannot be achieved by levels of
expenditure possible with resources obtained from taxation and borrowing,
additional resources have to be found.
Advantages of Deficit Financing:
When the Government resorts to deficit financing, it usually
borrows from the Reserve Bank. The interest paid to the Reserve Bank actually
comes back to the Government in the form of profits.
Through deficit financing, resources are used much earlier
than they can be otherwise. The development is accelerated. This technique
enables the Government to get resources without much opposition.
Defects of Deficit
Financing:
The defects of deficit financing are:
(i) It leads to increase in inflationary rise of prices of
goods and services in the country.
(ii) Inflationary forces created by deficit financing are
reinforced by increased credit credition by banks.
(iii) Investment caused by inflation may not be of the
pattern sought under the plan. It normally changed.
(iv) If as a result of deficit financing inflation
goes too far, it becomes self-defeating
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