What Is Deficit Financing?
Deficit financing is a policy in which government spending is more than it receives as revenue. The difference between the government spending and revenue received is being made by borrowing or minting new funds. Although the budget deficit may occur for several reasons, the term generally refers to the deliberate efforts to stimulate the economy by lowering the tax rate and increasing government expenditure. As we have understood, what is deficit financing? This article lets us learn its objectives, causes, advantages, and limitations.
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Types of Deficit Financing
The Different Types of Deficit Financing or Budget Deficit Are:
Revenue Deficit
Fiscal Deficit
Primary Deficit
Let us Discuss the Types of Deficit Financing in Brief:
Revenue Deficit: Revenue deficit is the excess of revenue expenditure over revenue receipts.
Revenue Deficit Formula: Revenue Expenditure - Revenue Receipts, when RE > RD
Fiscal Deficit: Fiscal Deficit is the excess of total expenditure over total receipt other than borrowings.
Fiscal Deficit Formula: Total expenditure (Revenue expenditure + Capital Expenditure) - Total Receipts other than borrowing (Revenue receipts + Capital receipt other than borrowing).
Primary Deficit: Primary deficit implies the difference between fiscal deficit and interest payments.
Primary Deficit Formula: Fiscal deficit - Interest Payment
While the fiscal deficit shows the borrowing requirement of the government inclusive of interest payment on the past loan, the primary deficit shows the borrowing requirement of the government exclusive of interest payment on the past loan. In other words, a primary deficit indicates government borrowing on account of current year expenditure and current year revenues.
How Does Government Budget Deficit Occur?
A budget deficit or deficit financing occurs when the estimated government expenditures increase more than the estimated government revenue. Such differences may be met by either increasing the tax rate or imposing the higher price of goods and public utility services. The deficit can also be met out by the accumulated cash balance of the government or by borrowing from the banking system.
In India, deficit financing is said to occur when the union government’s current budget deficit is covered by the withdrawal of the government’s cash balance and by borrowing money from the Reserve Bank of India. When the government withdraws its cash balance, this cash becomes active and comes into circulation.
Again when the government borrows from the RBI, then in such cases, RBI gives loans by printing additional currency. Hence, in both cases, the new money comes into circulation. It should be noted that government borrowing from the bank by selling bonds is not considered deficit financing.
What are the main Objectives of Deficit Financing?
The Main Objectives of Deficit Financing are:
To finance expenditures related to defence during war.
To lift the economy out of depression so that employment, income, investments rise.
To instigate the ideal resources and divert resources from unproductive sectors to productive sectors with the main objective of increasing national income, leading to higher economic growth.
To improve the country's infrastructure so that the taxpayer may be certain that the money they spent in tax is used wisely.
Role of Deficit Financing In Developed Economy
In a Developed Economy, deficit financing played a significant role during the depression. During the depression period, the level of expenditure and demand falls to a very low level and the banks and the general public are not willing to undertake the risk of investment. Instead, they prefer to accumulate idle cash balances.
All the machinery and capital equipment are available but what lacks is the incentive to produce due to deficiency in aggregate demand. Suppose the government instigates additional purchasing power in the economy (through deficit financing). In that case, the level of effective demand is likely to increase to meet this demand, the machinery and capital equipment lying idle will be pressed into operation. Accordingly, the level of production will increase. If this increase can cope with the increase in aggregate spending level, inflationary tendencies will not be generated.
What are the Advantages of Deficit Financing?
The foremost thing to be considered is that the deficit is not only worse. When the economy goes into recession, deficit spending through tax cuts or the purchase of goods and services made by the government can stop the devaluation and help to turn the economy back into a position. Hence, deficit financing helps to stabilize the economy. Also, the outlook of the business improves as the economy improves due to the deficit financing, and this can lead to increased investment, an effect known as crowding in.
Deficits enable us to purchase infrastructure and spread the ball across the time, similar to the way households finance the purchase of a car or house or the way local governments finance schools with bond issues. This enables us to purchase infrastructure that we might not be able to afford if it has to be financed all at once.
When the government employs deficit financing, it usually borrows from the RBI. The interest paid to the RBI comes back to the government in the form of profit. Through deficit financing, resources are used much earlier than differently. The development is accelerated. This enables the government to acquire resources without much opposition.
What are the Measures to Overcome Deficit Financing?
Following are the measures are taken to overcome the deficit financing:
The amount of deficit financing should be limited to the needs of the economy.
Efforts should be made to eliminate the surplus money hence injected for a new part. So that saved money is not permitted to return back again to the mainstream soon after its withdrawal.
Control on the price of goods, specifically in wage-good, and their equitable distribution through formal or informal rationing will go a long way in eliminating the inflationary impact on low-income groups of people and on the cost structure of the economy.
The above-discussed methods suggest that deficit financing can be an effective method for economic development. However, if these measures are not adopted and safety limits are crossed, then the result will surely be harmful.
What is the Relation Between Deficit Financing and Inflation
It is observed that deficit financing is inflationary in nature. As deficit financing increases aggregate expenditure and hence increases demand, the danger of inflation becomes larger. This is specifically true when deficit financing is made for the ill-treatment of war.
This method of financing, specifically during the war, is totally unproductive as it neither increases the society's stock of wealth nor enables a society to enlarge its production capacity. The outcome of this results in hyperinflation.
In contradiction, resources arranged through deficit financing get diverted from civil to military production, hence leading to a shortage of consumer goods. Thus, the creation of additional money generates inflationary fire. However, whether deficit financing is inflationary in nature or not depends on the nature of deficit financing. Being sterile in character, war expenditure made through deficit financing is definitely inflationary. But if a developmental expenditure is made through deficit financing, it may not be inflationary but may increase the money supply.
In other words, “Deficit financing”, adopted for the purpose of strengthening useful capital during a short period of time, is likely to improve productivity and eventually enhance the elasticity of supply curves.
Conclusion
Deficit financing as a process of resource mobilization has played a significant role in public finance in recent years. It refers to the medium of financing over income through printing currency or borrowing from RBI. In this article, we have discussed deficit financing meaning, its role in economic development. Deficit financing is inflationary, and its various effects on economic development are also discussed in this unit.
FAQs on Deficit Financing: Meaning and Impacts
1. What is deficit financing in the context of a government's budget?
Deficit financing is a method used by governments to fund their expenditure when it exceeds their revenue. In simple terms, it's the process of covering a budget deficit by either borrowing money from the central bank (like the RBI in India) or by printing new currency. This injects new money into the economy to meet the government's spending commitments.
2. What are the key differences between Fiscal Deficit, Revenue Deficit, and Primary Deficit?
These three terms represent different aspects of a government's budgetary shortfall:
- Revenue Deficit: This occurs when the government's day-to-day revenue expenditure is greater than its revenue receipts. It shows the government is borrowing to finance its regular consumption expenses.
- Fiscal Deficit: This is the most comprehensive measure, representing the excess of total government expenditure (both revenue and capital) over its total receipts, excluding borrowings. It indicates the total amount of borrowing the government needs.
- Primary Deficit: This is calculated by subtracting interest payments on previous loans from the fiscal deficit. It shows the borrowing required for the current year's expenses, excluding the burden of past debt.
3. Why do governments choose to use deficit financing?
Governments resort to deficit financing for several key objectives, especially in developing economies. The primary goals include:
- Financing extraordinary expenses, such as for defence during a war.
- Stimulating the economy during a recession or depression by increasing aggregate demand.
- Funding large-scale infrastructure projects that the country cannot afford all at once.
- Mobilising resources for economic development and moving them from unproductive to productive sectors.
4. How does deficit financing directly cause inflation?
Deficit financing can lead to inflation because it increases the money supply in the economy. When the government borrows from the central bank or prints new money, more currency enters circulation. This boosts the purchasing power of the people, leading to a rise in aggregate demand. If the supply of goods and services in the economy does not increase at the same pace, this excess demand pulls the prices up, resulting in inflation.
5. What are the main advantages and potential dangers of deficit financing?
Deficit financing is a tool with both significant benefits and risks.
Advantages include: It can help lift an economy out of a recession, finance crucial development projects, and utilise idle resources.
Disadvantages (dangers) include: The primary danger is triggering hyperinflation if not controlled. It can also lead to an increase in public debt and may encourage wasteful government spending, creating long-term economic instability.
6. Can deficit financing ever be good for economic growth?
Yes, under certain conditions, deficit financing can be beneficial for economic growth. During a recession, when private investment is low and resources are idle, government spending funded by a deficit can create jobs and boost demand. This is known as the 'crowding-in' effect, where initial government spending encourages private businesses to invest, leading to a cycle of economic recovery and growth. The key is to direct the funds towards productive capital formation, like building roads and ports, rather than unproductive expenditure.
7. Is all government borrowing considered deficit financing?
No, not all government borrowing is classified as deficit financing. The crucial distinction lies in the source of the funds. As per the Indian context, deficit financing specifically refers to borrowing from the Reserve Bank of India (RBI) or using government cash balances, which creates new money. When the government borrows from the public or commercial banks by selling bonds, it is considered debt but not deficit financing because it only transfers existing money from the public to the government without creating new currency.
