But there is one serious danger inherent in deficit financing, viz., it breeds inflation.
Deficit financing practiced in developed countries during a depression does not generate inflationary pressures because of the elastic nature of the supply curves of their output.
Additional government expenditure leads to an increase in effective demand, depending on the magnitude of the multiplier.
Similarly, when the supply of output can be increased easily to match additional demand, there need be no inflationary pressures. In developed countries, during a depression, there is a lot of excess capacity in the system so that an increase in output presents no difficult problems.
The situation in under-developed countries, however, is different. Here an increase in investment does create additional demand but a corresponding increase in the supply of output cannot be taken for granted. Firstly, an under-developed country suffers from the dearth of capital and there is no excess capacity to be utilised for creating additional supply of consumers’ goods. Besides, the basic wage-goods industry, i.e., agriculture, suffers from an inelastic supply curve in the short run.
In a subsistence agriculture, when the demand for agricultural products goes up, the farmer often lacks the willingness as well as the ability to increase his output. The farmer’s demand for non-agricultural goods to be used for his consumption is limited, so that when agricultural prices rise relatively to the prices of industrial products, the farmer can satisfy his needs with a lower effort than before, and his reaction may well be to work less in the next period.
Besides, even if he wants to increase his output, his ability to do so is very limited. His holding is a tiny one and often lies scattered all over the village; he lacks resources to buy more and better seeds and manures; and irrigation facilities are lacking.
The result is that even with the best of wills in the world, unaided by any outside agency, the farmer’s efforts to increase his output may not bear fruit. In the absence of an elastic supply of consumers’ goods, a development plan carries with it a great inflationary bias.
In the earlier stages of development, the inflationary danger is very real indeed. This is because of the urgent need to invest large sums in the creation of an adequate system of transport and communications or building multipurpose projects or modern steel plants having long gestation period. Such investments generate demand like any other investment outlay, yet they do not directly add to the supply of output of consumer goods.
For all these reasons, deficit financing, in under-developed countries, is full of inflationary potentialities. These have to be watched carefully so as to keep them under control. Deficit financing results in a net increase in the money supply with the public which means additional purchasing power. Not being matched by additional supply of goods, it must push up the price level and usher in inflation.