In this article we will discuss about the role of deficit financing in developing countries.
If the usual sources of finance are inadequate for meeting public expenditure, a government may take resort to deficit financing particularly in a developing country like India. Deficit financing refers to the creation of new money for filling up the gap between planned expenditure and estimated receipts.
It implies deliberate budgeting for a deficit. The government budget is said to be in deficit when its current expenditure exceeds its current revenue. Budgetary deficit is the excess of total budgetary expenditure (both on revenue and capital accounts) over total budgetary receipts (on both accounts).
Keynes suggested that, during deep depression and severe unemployment, a budgetary deficit should be deliberately incurred, taxes being reduced in order to make more purchasing power available as a stimulus to demand.
A budget deficit arises when the expenditure planned for the current year exceeds the revenues expected to be obtained during the same period. The deficit may be met by rising the rates of taxation or by charging higher prices for goods and services supplied by the government (e.g., railway fares).
The deficit may also be met from the accumulated cash balances of the government or by borrowing from the banking system. If the last two methods (expenditure from cash balances or borrowing) are followed, there is said to be deficit financing.
The public sector borrowing requirement (PSBR, i.e., the difference between planned government expenditure and anticipated tax revenue) or the budgetary deficit of the government establishes a link between budgetary deficit and money supply. There are three basic ways in which the government can finance the PSBR. First, the government can sell its bonds to the non-bank private sector.
Secondly, it can sell bonds to the banking sector. Thirdly, it can sell bonds to the central bank, its own bonds, which virtually amounts to printing of money. The government may also borrow from abroad (external debt).
In this context, we refer to high-powered money which is equal to currency plus bankers’ deposits at the central bank. All government spending increases high-powered money.
The government’s budget constraint, relating the PSBR to the methods of finance available, helps to emphasise the point that fiscal policy and monetary policy cannot in general be examined independently.
Two methods of financing the PSBR, viz., printing money and of selling bonds to the banking sector, imply an increase in the supply of money. On the other hand, selling bonds to the non-bank private sector does not increase the supply of money.
The basic relationship may be set out as follows:
If the Government authorities wish to restrict the growth of the money supply, they must attempt to sell as many bonds as possible (given the needs of the PSBR) to the non-bank private sector. This may involve substantial increases in interest rates, and may conflict with other policy requirements, as well as imposing a future burden of paying high interest. If the government wishes to keep interest rates at low levels, then it will be difficult to control the money-supply growth.
Deficit financing in India is made in two ways: either by drawing down the cash balances of the government or by borrowing from the Reserve Bank, which gives this loan by printing additional notes. Thus, in both cases, ‘new money’ comes into circulation. As a result, inflation may occur, because the supply of goods does not simultaneously increase with the increase in money supply.
Deficit financing occupies a pivotal position in any programme of planned economic development. But, it has one major defect. It creates excess purchasing power. Hence, it is inherently inflationary, unless accompanied by a corresponding and proportionate fall in the income velocity of money. In other words, it inflates the money value of the national income through the price effect.
On the positive side, it increases effective demand which, if there exist unemployed labour and other factors of production, may raise employment and output and to some extent offset the price effect.
To quote Prof. Alka Ghosh:
“Deficit financing, undertaken for the purpose of building up useful capital during a short period of time, is likely to improve productivity and ultimately increase the elasticity of supply curves.”
And the increase in productivity can neutralise, at least partly, price inflation.
The most important thing to secure from deficit financing is the generation of economic surplus during the process of development. If this saving is productively employed, it will lead to a substantial amount of capital formation and growth. The essence of the matter is whether additional public expenditure on development projects is equal to the saving generated in the process.
If there is an exact balancing between the two and public investment is made on the productive projects, which give a steady rate of return year by year, there is likely to be a mild dose of inflation which is conducive to the whole process of development.
In developing countries like India the root cause of inflation lies in inelasticity of supply of essential goods. If their supply can be increased money supply grows, there is no danger of inflation. But, in reality, this does not happen and some amount of inflation is inevitable.
However, everything depends upon the magnitude of deficit financing undertaken by the government and its phasing over the time horizon of the development plan. If there is continuous deficit in the budget, this must be accompanied by additional taxation so as to reduce the excess purchasing power that is likely to be created through printing of paper money. There is also need for price control-cum-rationing in such periods.