DEFICIT FINANCING - CONCEPT AND MEANING

Deficit financing refers to means of financing the deliberate excess of expenditure over income
through printing of currency notes or through borrowings. The term is also generally used to
refer to the financing of a planned deficit whether operated by a government in its domestic
affairs or with reference to balance of payment deficit.
In the West, the phrase "Deficit financing" has been used to describe the financing of a
deliberately created gap between public revenue and expenditure or a budgetary deficit. This gap
is filled up by government borrowings which include all the sources of public borrowings viz.,
from people, commercial banks and the Central Bank. In this manner idle savings in the country
are made active. This increases employment and output.
But according to Indian budgetary documents government resorting to borrowing from the public
and the commercial banks does not come under deficit financing. These are included under the
head of 'Market Borrowings' and government spending to the extent of its market borrowings
does not result in or lead to deficit financing. In the Indian context, public expenditure, which is
financed by borrowing from the public, commercial banks are excluded from deficit financing.
While borrowing from the central bank of the country, withdrawal of accumulated cash balances
and issue of new currency are included within its purview.
Deficit financing in Indian context occurs when there'are budgetary deficits. Let us now discuss
the meaning of budgetary deficit. Budgetary deficit refers to the excess of total expenditure (both
revenue and capital) over total receipts (both revenue and capital). In the words of the First Plan
document, the term 'deficit financing' is used to denote the direct addition to gross national
expenditure through budget deficits, whether the deficits are on revenue or on capital account.
The essence of such a policy I lies, therefore, in government spending in excess of the revenue it
receives in the shape of taxes, earnings of state enterprises, loans from the public, deposits and
funds and other miscellaneous sources. The government may cover the deficit either by running
down its accumulated balances or by borrowing from the banking system (mainly from the
Central Bank of the country) and thus 'creating money'. Thus, the government tackles the deficit
financing through approaching the Central Bank of the country i.e. Reserve Bank of India, and
commercial banks for credit and also by withdrawing its cash balances from the Central Bank.
The magnitude of actual budget deficit during the seventh plan had been of the order of Rs.
29,503 crore (at 1984-85 prices) which was more than double the estimate of Rs. 14,000 crore.
The Budget for 1990-91 laid stress on limiting the size of the budget deficit through containment
of expenditure growth and better tax compliance. The budget programmed a deficit of Rs.
1,10,592 crore in 1989-90. The revised estimates for the year 1990-91 placed the budgetary
deficit at Rs. 10,772 crore which is nearly 50% higher than the budget estimate. Proper financial
management demands that the revenue receipts of the government, which are in the shape of
taxes, loans from the public, earnings of the state enterprises etc., should not only meet the
revenue expenditure but also leave a surplus for financing the plan. Contrary to this deficits on
revenue account are growing year after year. For example the revised estimates place the deficit
on revenue account during 1990-91 at Rs. 17,585 crore as against the budget deficit of Rs.
10,772 crore. A higher revenue deficit implies higher borrowed resources to cover the deficit
leading to higher interest payments thus creating a sort of vicious circle.
Role of Deficit Financing as an Aid to Financing Economic Development
Deficit financing has been resorted to during three different situations in which
objectives and impact of deficit financing are quite different. These three situations
are war, depression and economic development.
Deficit financing during war
Deficit financing has its historical origin in wlr finance. At the time of war, almost
every government has to spend more than its revenue receipts from taxes and
borrowings. Government has to create new money (printed notes or borrowing
from
the Central Bank) in order to meet the requirements of war finance. Deficit
financing
during war is always inflationary because monetary incomes and demand for
consumption goods rise but usually there is shortage of supply of consumption
goods.
Deficit financing during depression
The use of deficit financing during times of depression to boost the economy got
impetus during the great depression of the thirties. It was Keynes who established a
Xgositive role for deficit financing in industrial economy during the period of
,depression. It was advocated that during depression, government should resort to
construction of public works wherein purchasing power would go into the hands of
people and thereby demand would be stimulated. This will help in fuller utilisation
of already existing but temporarily idle plants and machinery. Deficit spending by
the
government during depression helps to start the stagnant wheels of productive
machinery and thus promotes prosperity.
Deficit financing and economic development
Deficit financing for development, like depression deficit financing, provides
stimulus to economic growth by financing investment, employment and output in
the economy. On the other hand "development deficit financing7' resembles "war
deficit financing" in its effect on the economy. Both are inflationary though the
reasons for price rise in both the cases are quite different. When government
resorts to deficit financing for development, large sums are invested in basic heavy
industries with long gestation periods and in economic and social overheads. This
leads to immediate rise in monetary incomes while production of consumption
goods cannot be increased immediately with the result that prices go up. It is also
called the inflationary way of financing development. However, it helps rapid
capital formation for economic development.

DEFICIT FINANCING AND INFLATION

Deficit financing in a developing country is inflationary while it is not so in an
advanced country. In an advanced country the government resorts to deficit
financing
for boosting up the economy. There is alround unemployment of resources which
can
be employed by raising government investment through deficit financing. The
result
will be an increase in output, income and employment and there is no danger of
inflation. The increase in money supply leading to demand brings about a
corresponding increase in the supply of commodities and hence there is no increase
'
in price level.
But, when, in a developing economy, the government resorts to deficit financing
for
financing economic development the effects of this on the economy are quite
different. Public outlays financed by newly-created money immediately create
monetary incomes and, due to low standards of living and high marginal
propensity
to consume in general, the demand for consumption of goods and services
increases.
But if the public investment is on capital goods, then the increased demand for the
consumer goods will not be satisfied and prices will rise. Even if the outlay is on
the
production of consumption goods the prices may rise because the monetary
incomes
will rise immediately while the production of consumer goods will take time and in
the meanwhile prices will rise. Though investment is being continuously raised
(through taxation, borrowing and external assistance), most of it goes to industrieq
with long gestation period and for providing basic infrastructure. Though there is
effective demand, resource5 lie under or unemployed. Lack of capital, technical
skill,
entrepreneurial skills etc. are responsible in many cases for unemployment or
underemployment of resources in a developing economy. Under such conditions,
when deficit financing is resortea to, it is sure to lead to inflationary conditions.
Besides, in a developing economy, during the process of economic development,
the
velocity of circulation of money increases through the operation of the multiplier
effect. This factor is also inflationary in character because, on balance, effective
demand increases more than the initial increases in money supply. Deficit
financing
gives rise to credit creation by commercial banks because their liquidity is
increased
by the creation of new money. This shows that in a developing economy total
money
supply tends to increase much more than the amount of deficit financing, which
also
aggravates inflationary conditions. The use of deficit financing being expansionary
becomes inflationary also on the basis of quantity theory of money.
DEFICIT FINANCING AND PRICE BEHAVIOUR
IN INDIA

Price stability is an essential condition for stability in economic life as well as

economic growth. On the contrary, fluctuations in prices create an atmosphere of
uncertainty which is not conducive to development activity. When we examine the
price mcvements during the planning period in India, there are three clear trends.
First during the first plan period (i.e. 1951 to 1956) the general price level had fallen.
From 1955-56 to 1965-66. the prices rose steadily at an annual rate of 6%. Finally.
from 1966-67 onwards (except 1975-76 and 1977-78) prices rose at the rate of about
0% per annum and now it is in the double digit range.
Deficit financing as a tool for covering the financial gap in India was introduced at
the time of formulation of first five year plan. During the first plan deficit financing
was of the order of Rs. 333 crore and the money supply with the public increased by
about 22 per cent. Since this expansion in the supply of money fell short of the
increase in output, the general price level came down by about 18 per cent. During
second plan. actual deficit financing was less than the targeted amount,
The third plan was very abnormal (adverse weather conditions. 1962 Chinese
\ aggression. 1965 Pakistan war). Deficit financing during the third plan amounted to

Rs. 1333 crore - more than double the target. Money supply with the public
increased more rapidly.
In the fourth plan (1969-71), the amount of deficit financing stood at Rs. 2060 crorc
-about two-and-a-half times the target. Money supply increased from 6387 crore to
Rs. 11,172 crore at the end of 1973-74. Prices increased by 47% approximately. No
doubt there were certain factors beyond the control of the government such as war
with Pakistan in 1971, substantial expenditure on account of Bangladesh refugees, oil
price hike etc. Besides, the reluctance on the part of the states to mobilise adequate
resources, their general financial indiscipline and overdrafts from the Reserve Bank
also compelled the government to take resort to deficit financing.
111 view of severe inflationary pressures in the economy since 1972-73. the draft fifth
plan 1974-79 laid utmost stress on non-inflationary methods of financing. But. as
against the target of Rs. 1354 crore for the fifth five year plan, the actual amount of
deficit financing was much more.
During this period, although the money supply increased by about 50 per cent, the
overall increase in wholesale prices was 33% because of the imposition of emergency
in 1975 resulting in comfortable position in regard to the availability of sever:~l
commodities through the effective management of supplies.
During the sixth plan (1980-8.5) deficit financing was of the order of Rs. 15.681 crore
as against the estimated target of Rs. 5000 crore. During this period money supply
increased from Rs. 23,117 crore-in 1980-81 to Rs. 39,380 crore in 1984-85. Seventh
plan paper indicated a cautious approach towards deficit financing and stated that
"The required resources have to be mobilised in a manner which minimise
dependence on external sources or on deficit financing which has a high inflationary
potential." Still the target for deficit financing was placed at Rs, l1,OOU crore and
according to the latest estimates the actual deficit financing has been of the order of
Rs. 34,182 crore i.e. more than 2.4 times the target. Money supply with the public
has increased from Rs. 43.599 crore in 1985-86 to Rs. 76.259 crore in 1988-89 and
index of..wholesale prices has gone up from 357.8 to 435.8 during the same period.
There were many other factors like mismanagement of the war economy. excessive
dependence on monsoon, power shortagz, labour strikes, increase in the rates of
commodity taxation, rise in wage rates, black money, rise in the international price
of petroleum products which have been responsible for price rise in India. However,
experience shows that the increase in money supply has led to a rise in prices. There
has been a close relationship between the rate of increase in prices and the rate of
growth in money supply and prices have a tendency to rise to new heights at every
successive increase in money supply resulting from deficit financing.
When deficit financing is inflationary, it will go against the very purpose for which it
is used because it will simply lead to continuous inflation and no development.
Inflation creates uncertainty, labour unrest, work stoppages and decline in
production because of the demand for higher wages and salarieh to compensate for
higher cost of living. Inflation reduces the real income and the real consumption of
all classes of people in the society except the rich. This is objectionable on grounds
of economic efficiency, labour productivity and social justice. Moreover, there is no
certainty that higher levels of income accruing to profit earners will be invested in1
productive enterprises, for the rich may waste windfall gains in con'spicuous
consumption or indulge in speculative activities. Besides, inflation is a sort of invisible
tax on all incomes and cash balances. Their value is automatically reduced with every
rise in prices. Inflation leads to balance of payments difficulties because due to rising
prices the country loses export market and people prefer imported goods. which
appear cheaper as compared to domestic goods.
Inflation is charged with distorting the pattern of investment and production in the
economy. Inflation is beset with the danger of channelising economic resources into
less urgent and speculative fields where the scope for profits to private enterprises is
Illore and such fields are generally of little importance to the nation. Inflationary
deficit financing increases the administrative expenditure of the government because
whenever government resorts to large doses of deficit financing, it has to neutralise
its effects by sanctioning new dearness allowances, revision of controlled prices.
distribution of essentials through fair price shops, compulsory requisition of
foodstuffs etc. All these measures lead to an increase in the administrative burden of
the government in order to ward off inflation caused by the use of deficit financing.
ADVANTAGES OF DEFICIT FINANCING
Uptill now, we have seen that deficit financing is inflationary and it destroys its own
purpose of aiding economic development. But it is not always so. Secondly inflation
13 not always harmful for economic development. On the contrary, to a certain extent
inflation is conducive to economic development and hence deficit financing is
beneficial.
During the process of development, increase in national production is bound to give
rise to the demand for increased money supply for transactions. This can be met by
injecting new money in the economy through deficit financing. If deficit financing is
resorted to for productive purposes especially for the production of consumer goods
and that too for quick results then deficit financing is not that inflationary. For
example, if any land reclamation activity is to be undertaken which would lead to
agricultural production, resort to deficit financing for this activity will not be
inflationary. Even if there is a moderate price increase of 4 to 5% per annum, its
impact on the economy will not be too severe. Besides, deficit financing will not be
inflationary if it is matched by a balance of payment deficit. To the extent to which
past savings of foreign balances can be used to pay for such imports, it would be
deflationary. But much reliance cannot be put on balance of payments deficit because
balance of payments deficit depends on our foreign exchange reserves and our credlt
worthiness in the world market. Moreover, a developing country aims at reducing
this deficit by increasing exports and reducing imports.
Deficit financing will be non-inflationary if the government is able to mop up the
additional money incomes, created by deficit financing, through taxation and saving
schemes. Properly controlled and efficiently managed programme of deficit financing
may help the process of economic development. In fact a certain measure of deficit
financing is inevitable under planned economic development to activate unutilised or
dormant resources especially when one of the objectives of planning is to step up the tempo of economic
process.
Inflationary impact of deficit financing is helpful for economic development to a
certain extent and under certain circumstances like :
a) Under developed countries, with their low incomes, low or negative savings,
inadequate investment and traditional resistance to change and modernisation, j
will remain stagnant or develop at an intolerably slow pace unless they are
restructured and activised. This can be done with the stimulus of inflation.
b) Inflation stimulates economic activities and rising prices induce more '
investments. In a developing economy the major goal is rapid economic
development through speedy capital formation. The additional income that is
earned through inflation can be ploughed back and if the same process is
repeated there is every possibility of a rapid rate of capital formation in the
country. For this, inflation may be tolerated to a certain extent.
c) Inflation is said to be a useful method of increasing saving in a forced way. There
will be redistribution within the private sector of the economy, from the personal
sector to corporate sector. Inflation reduces real consumption and provides
resources for investment purposes.
Thus, deficit financing is a necessary and positive instrument to accelerate the rate
of economic growth in countries suffering from acute shortage of capital. But any
deficit financing has to be undertaken in the context of an efficient and well executed
plan for economic development.
LIMITATIONS OF DEFICIT FINANCING
Deficit financing (as we have examined uptill now) can be regarded as a necessary
evil which has to be tolerated, at least in the developing economies, only to the extent
it can promote capital formation and economic development. This extent of tolerance
is called the safe limit of deficit financing. This safe limit shows the amount of deficit
financing that the economy can absorb and beyond which inflationary forces may be
set in motion. Though it is not possible to quantify it, yet it is desirable to identify
the factors that affect it.
Factors that affect deficit financing, can be put under two categories : (a) factors
related to demand for money and (b) factors related to supply of money. If the
demand for money is low in the economy, the safe limit of deficit financing will be
low. Then creation of new money or deficit financing must be kept at a low level
otherwise evil consequences will follow. Reverse will be the case when demand for
money is high. On the supply side of money, if due to some factors the supply of
money or purchasing power with the public increases, other things being equal, it will
have an inflationary tendency and the safe limit of deficit financing will be low.
However, safe limit will be high in the opposite situation.
The concept of 'safe limit' of deficit financing can be reduced to the age old theory
of demand and supply. The point at which demand for and supply of money are equal
is the point of safe limit of,deficit financing. Unfortunately conditions in a developing
country are not so simple. Various factors simultaneously exert contradictory effects
on each side.
Factors Affecting Safe Limit
i) The safe limit of deficit financing depends on the supply elasticity of consumption
goods in the country. Usually, the supply of consumption goods, specially
foodgrains, cannot be increased to any extent for a long time due to many
constraints in a developing economy. Under such circumstances even a little
deficit financing would be inflationary and the safe limit of deficit financing will
be very low.
ii) Safe limit of deficit financing also depends on the nature of government
expenditure for which new money is created, i.e., the purpose of deficit
financing. If the newly created money is used for unproductive purposes, the use
of deficit financing will be inflationary and the safe limit of deficit financing will
be lower than if the newly created money is to be used for industrial development
or for intensive farming.
iii) If the foreign exchange reserves are increasing the scope of using deficit financing
will increase because that way the country will be able to import more goods
which will have deflationary effect.
iv) Time lag between the initial investment and the flow of final products also
determines the safe limit of deficit financing. If this time lag is long, then inflation
will set in from the very initial stage of investment and it will not be possible to
control the rapidly rising prices.
v) Low safe limit of deficit financing is required if the economy consists of large
speculative business community.
vi) If government is not in position to implement successfully its economic policies
accompanying the policy of deficit financing, low safe limit of deficit financing is
prescribed.
vii) If a country is already passing through inflationary phase, low deficit financing is
advised.
viii) If the rate of growth of population is high then low deficit financing is good and
vice versa.
ix) Safe limit deficit financing also depends on a country's tax structure and the
borrowing schemes through which the government can take away at least a
portion of additional incomes thereby reducing the purchasing power with the
public. But all this is not easy in a developing economy where there are rigidities
in the tax system. There is large scale tax evasion so that government is not able
to take away any substantial part of additionalincomes. The country is,
therefore, more prone to inflation and the safe limit of deficit financing is low
In a developing economy, all the aforesaid factors exert their influence
simultaneously. The effect of each factor may be favourable or unfavourable for the
use of deficit financing and sometimes the effects of some factors may counter effect
each other and, thus, be cancelled out. This safe limit of deficit financing will be
different for different countries because conditions vary from country to country. The
safe limit of deficit financing also depends on the measure of popular cooperation
which the government gets and the willingness of the people to submit to austerity.
Even if this limit is calculated, it will go on changing with every change in the
economic conditions of the country. With efforts in the right direction this limit can
be shifted upwards so that a larger amount of deficit financing\ can be resorted to by
a government which is conducive to economic development and not inflation.
MEASURES TO CONTROL DEFICIT FINANCING

Besides open deficit financing undertaken by the goyernment, there is concealed

deficit financing in developing economies. In all government departments, in a
developing country most of the expenditure is incurred recklessly in the last few
weeks of the financial year so that the amount sanctioned may not lapse. This reckless
expenditure is largely a waste and is not accompanied by expected results. This
expenditure is fairly large every year. It is not productive and it leads to price rise
and operates in the economy in a manner similar to deficit financing. Most of the
havoc created in the economy is actually created by this concealed deficit financing.
If, by efficient and honest administratithi, this vast wasteful expenditure can be
avoided, the officially acknowledged deficit financing will not be so inflationary.
Anti-social acts such as evasion of taxes, black marketing, cash transactions to
supplement recorded cheque transactions, under invoicing and over invoicing of
export and imports, and a variety of such forms of corruption on the part of the
private parties lead to large volume of 'unaccounted money'. This money is to be
spent recklessly and it leads to inflationary rise in prices. Government must try to
remove reckless expenditure in public and private sectors caused by 'concealed deficit
financing' and 'unrecorded gains' instead of stopping the use of deficit financing
which is likely to be spent productively and therefore help in the economic
development of the country.
In order to minimise the inflationary effects of deficit financing during the process of
development the government will have to keep a vigilant and constant watch on
changing economic situations, study the repercussions of measures adopted in several
spheres and, above all, take effective action on following lines :
a) Government should try to drain off a larger proportion of funds resulting from
deficit financing through saving campaign and higher taxation.
b) The policy of deficit financing should be adopted as a last resort, after exhausting
all other possible sources of development finance.
c) Investment should be channelled into those areas where capital output ratio is
low so that returns are quick and price rise is not provoked.
d) Along with deficit financing, government should adopt policies of physical
controls like price control and rationing etc.
e) Import policy should allow import of necessary capital equipment for economic
development and consumer goods required by the masses alone. Import of luxury
and semi-luxury goods should be discouraged.
f) Deficit financing and credit creation policies should be integrated in such a way
that neither of the two sectors (public or private) is handicapped due to shortage
of financial resources and, at the same time, inflation is also kept in check in the
economy.
Above all these policies, what is more required is that the government should try to seek full public
cooperation and people should have full faith in the policies of the government so that government policies can
be successfully implemented. Deficit financing or no deficit financing, the process of economic development
itself is inflationary. Whenever new investment is financed by taxation or borrowing, the result is an increase
in monetary incomes, increase in demand for consumption goods, and price rise. With this background the
important question, in a developing country, is not whether deficit financing should be resorted to or not for
economic development, but, rather, how far inflation can be pushed without upsetting the productive process.
Thus deficit financing is a necessary and positive instrument to accelerate the rate of economic growth in
countries suffering from acute shortage of the capital, though it is necessary to emphasise here that it must be
undertaken with an efficient and well executed plan for economic development.