It is also interesting at this stage to learn the comparison between deficit financing (money creation) and borrowing. An easy way of financing government expenditure is by money creation.
There are, in fact, two ways of creating money:
(1) printing money, and
(2) borrowing money from the central bank. Such ‘borrowing’ is essentially money creation, not borrowing in the true sense.
Amounts are simply credited to the government’s account with the central bank. The government then draws on this account. This method is preferred by some people because it does not impose any direct burden on the members of society.
The method appear to be painless in the sense that the government gets its funds without requiring anyone to make any sacrifice (such as curtailment of current consumption). Yet this method is not universally favoured.
Most people object to money creation on the ground that this method does not reduce private spending (consumption and investment). Instead, by increasing commercial bank reserves, borrowing may actually increase private spending as well as finance government spending. (This happens because as the government draws on its accounts with the central bank the persons who receive the cheques deposits them in their accounts, the deposits of their banks with the central bank are increased). The consequence, under conditions of full or near-full employment, is price inflation.
Inflation is disliked by most people and for various reasons. As John F. Due has convincingly argued, “The burden of the transfer of resources from the private sector rests upon those persons whose incomes lag behind the increase in the general price level and those whose assets, such as bonds, decline in real value. Persons whose incomes rise with the price level and who own no fixed-money-value assets escape any contribution to the costs of government. Inflation is also disliked for other reasons: the fear that incomes will lag behind prices; the labour strike generated; the lack of desire to buy bonds; the uncertainty and distortion introduced into the economy. Financing by money creation would also remove the direct restraint on government spending and prevent attainment of optimal levels of governmental activity.”
However, in periods of unemployment, there is strong justification for the use of money creation to avoid reducing private spending, as Keynes pointed out.
A preferable alternative to money creation is borrowing money from the people by selling bonds. In this case, the provision of funds is voluntary. People also buy bonds are forced to curtail their current consumption. But people are confident that the government will repay the borrowed money with interest at a later date.
The IS-LM Interpretation:
If growing government expenditures are financed by money creation, the government must increase the monetary base by the amount of the increased government expenditures. It can do this by putting new money into circulation or by drawing down its accounts held at the Reserve Bank of India. In either case, the change in government expenditures will affect the IS curve, while the change in the monetary base will affect the LM curve.
The ultimate impact of the increased expenditures upon the equilibrium level of income will depend upon the relative magnitudes of the shifts in the two curves, assuming that the rate of interest has not reached its lowest level (i.e., there is no liquidity trap in the demand curve for money).
If the government sells bonds to finance the deficit, the result will generally be less expansionary than if it had printed new money. By increasing its purchase of goods and services, the government puts additional funds into the income stream by the same amount, which ultimately causes the change in the money supply to be greater than the increase in expenditures.
By selling bonds to finance this increase in expenditures, it then takes an equal amount of funds out of the income stream. If the funds are borrowed simultaneously with the expenditures, the monetary base and therefore the money supply and the LM curve remains constant.