Deficit Financing: Meaning, Objectives and Effect of Deficit Financing

on Economic Growth and Employment

Meaning of Deficit Financing

Deficit financing is a measure to meet the deficit of the government's budget. When
the government's total expenditure exceeds its total revenue, it suffers a deficit. This deficit
is made good by mainly adopting three steps: (i) Borrowing from within the country, (ii)
Borrowing loan from foreign countries, and (iii) Creating additional money. According to
Prof. Shinoey, "Deficit financing refers to the financing operations of the government to cover
the gap between the receipts and disbursements." Deficit financing is interpreted in India
and in western countries differently.
(1) Meaning of Deficit Financing in Western Countries: In Western countries, government
compensates the deficit budget by taking recourse to any one of the above mentioned steps,
it is called deficit financing. In Western countries, like America, if the government makes up
for the deficit budget by borrowing money from the people, it is also called deficit financing.
By this arrangement money collected from the people is utilised for the purpose of war or
development of the country. This leads to increase in output and employment.
(2) Meaning of Deficit Financing in India: In India, deficit financing does not refer to the
financing of government's budgetary deficit by borrowing money from the people. Here, the
government adopts any of the following methods to meet the deficit in budget and that is
called deficit financing:
(a) The government may withdraw its cash balances from the central bank,
(b) Government may borrow fund from the central bank, or
(c) Government may resort to printing of additional currency.
The volume of money in the country increases as a result of the above mentioned
three methods. In India, the major portion of the deficit financing is met by borrowing from
the Reserve Bank. The government gives to the Reserve bank government securities in lieu
of this loan. The Reserve Bank deposits government securities in the Reserve Fund and
prints new notes and issues them to the government. In this way, supply of money increases.

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Difference between Deficit Financing and Deficit Budget
By deficit budget is meant that budget of the government in which government expenditure
exceeds government revenue. On the other hand, the method adopted to meet the deficit of
the budget is called deficit financing.
Need of Deficit Financing
It was in the late 1920s that the idea and need of deficit financing was felt. It is when
government needs to spend more money than it was expected to earn or generate in a
particular period, to go for a desired level of growth and development. Had there been some
means to go for more expenditure with less income and receipts, socio-political goals could
have been realised as per the aspirations of the public policy. And once the growth had taken
place, the extra money spent above the income would have been reimbursed or repaid. This
was a good public/government wish which was fulfilled by the evolution of the idea of deficit
financing.
It was by the early 1930s that the US first tried its hand at deficit financing soon to be
followed by the whole Euro-American governments. Through this route the developed world
was able to come out of the menace of the Great Depression (1929). The idea became popular
around the world by the 1960s. India tried its hand at deficit financing in 1969 and since the
1970s it became a routine phenomenon, till it became wild and illogical, demanding
immediate redressal. The fiscal deficits in India did not only peak to unsustainable levels but
its composition was also not justified and not based on sound fundamentals of economics.
Finally, India headed for a slow but confident process of fiscal reforms that is also known as
the process of fiscal consolidation
Means of Deficit Financing
Once deficit financing became an established part of public finance around the world, the
means of going for it were also evolved by that time. These means, basically are the ways in
which the government may utilise the amount of money created as the deficit to sustain its
budget for developmental or political needs. These means are given below in order of their
suggested and tried preferences.
i. External Aids are the best money as a means to fulfil a government’s deficit
requirements even if it is coming with soft interest. If they are coming without
interest nothing could be better.
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 When India went to borrow from the IMF in the wake of the financial crisis of 1990-
91, the body advised India to keep its fiscal deficit to the tune of 4.5 per cent of its GDP and
noted it to be sustainable for the economy. What was the rationale behind this data?
Basically, in those times with the foreign aids (soft loans either from the WB or from the Aid
India forum) India was able to manage its budget to the tune of 4.5 per cent of its GDP. In
2002, when India’s fiscal deficit was around 6 per cent (5.7 per cent to be precise) the IMF
validated it to be sustainable, the reasons were two-first, India was able to show a check on
fiscal deficit and secondly, at the same time the forex reserves of the country were suitably
higher to neutralise the negative impacts of the higher fiscal deficit than the suggested levels
(4.5 per cent).
External Grants are even better elements in this case (which comes free- neither interest nor
any repayments) but it either did not come to India (since 1975, the year of the first Pokhran
testings) or India did not accept it (as happened post-Tsunami, arguing grants/aids coming
with a tag/condition). That is why here this segment has not been discussed as a means to
manage deficit.
ii. External Borrowings are the next best way to manage fiscal deficit with the condition that
the external loans are comparatively cheaper and long-term. Though external loans are
considered an erosion in the nation's sovereign decision making process, this has its own
benefit and is considered better than the internal borrowings due to two reasons:
a) External borrowing bring in foreign currency/hard currency which gives extra edge to the
government spending as by this the government may fulfil its developmental requirements
inside the country as well as from outside the country.
b) It is preferred over the internal borrowings due to 'crowding out effect. If the government
itself goes on borrowing from the banks of the country, from where will others borrow for
investment purposes?
iii. Internal Borrowings come as the third preferred route of fiscal deficit management. But
going for it in a huge way hampers the investment prospects of the public and the corporate
sector. It has the same impact on the expenditure pattern in the economy. Ultimately,
economy heads for a double negative impact-lower investment (leading to lower production,
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lower GDPs and lower per capita income, etc.) and lower demands (by the general public as
well as by the corporate world) in the economy-the economy moves either for stagnation or
for a slowdown (one can see them happening in India repeatedly throughout the 1960s,
1970s, 1980s). The situation improved after the mid 1990s.
iv. Printing Currency is the last resort for the government in managing its deficit. But it has
the biggest handicap that with it the government cannot go for the expenditures which are
to be made in the foreign currency. Even if the government is satisfied on this front, printing
fresh currencies does have other damaging effects on the economy:
a) It increases inflation proportionally. (India regularly went for it since the early 1970s and
usually had to bear double digit inflations.)
b) It brings in regular pressure and obligation on the government for upward revision in
wages and salaries of government employees- ultimately increasing the government
expenditures necessitating further printing of currency and further inflation-a vicious cycle
into which economies entangle themselves.
Now, it remains a matter of choice and availability of the above-given means, and
which means a government adopts and in what proportion, for fulfilling its deficit
requirements.
Major Objectives of Deficit Financing
In modern fiscal policy on account of consistent increases in public expenditure of
various layers of government, deficit financing assumes important role as a method of
finance. Therefore in the economies of the world, deficit financing is mainly resorted to attain
the following objectives:
1. Deficit financing is used as the simple and effective fiscal device to meet the financial
requirements of the government during emergencies such as war.
2. Keynes popularized deficit financing as an effective fiscal instrument to control the
economic fluctuations and to raise the level of the employment and output.
3. In developing countries, deficit financing is considered as a method to mobilize resources
for planned economic development.
4. Another objective of deficit financing is to raise the level of effective demand and thereby
to stimulate private spending in a depression economy.

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5. J.M. Keynes advocated deficit financing as instrument to mobilize surplus labour and other
idle and unutilized resources during depression, for achieving economic development.
6. In developing economies the main objective of deficit financing is to remove the vital issue
such as unemployment, poverty and income inequality.
Effect of Deficit Financing on Employment
Prof. J.M. Keynes argues that the root cause of unemployment in a developing economy is the
deficiency in effective demand. Therefore Keynes suggested public expenditure, financed
through deficit financing, as an instrument to increase effective demand and remove
unemployment during dispersion. For this he proposed the implementation of public works
programme, which may inject additional purchasing power in the hand of the people and
increase the level of effective demand.
Through multiplier effect, this will further increase employment and correspondingly
the effective demand of the community. During period of 1930’s depression, countries like
USA and UK resorted to deficit financing to fight the problem of massive unemployment.
However Keynes analysis does not hold good in a developing economy.
His analysis is based on two conditions. The multiplier effect of deficit financing on
employment depends on two conditions. They are:
(a) Existence of excess capacity in industrial as well as agricultural sector, and
(b) Relative elastic supply of working capital. However these two conditions are non-
existent in developing economics.
Therefore deficit financing is ineffective in fighting the unemployment problem of
developing economies owing to the absence of the two conditions. Moreover factors like
market imperfections lack of entrepreneurship infra-structure bottlenecks etc., obstruct the
effective functioning of deficit financing as a tool to fight unemployment.
Effect of Deficit Financing on Economic Growth
The government needs a lot of money to achieve the objective of economic development. The
government cannot manage to collect sufficient revenue through taxes, saving and public
loans. Therefore, it resorts to deficit financing. But if the deficit financing crosses a certain
limit, there is possibility of immense price rise, which affects the growth adversely.
Therefore, deficit financing has both favourable and unfavourable effects:

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Favourable Effects of Deficit Financing on Economic Growth
Deficit financing helps the economic growth in the following ways:
(1) Mobilisation of Surplus and Unutilised Resources: In underdeveloped countries, labour
and other resources are not fully utilised because of the lack of financial resources. These
resources remain unexploited. The government gets enough financial resources through
deficit financing. By procuring money through deficit financing, the government provides
employment to unemployed resources. Consequently, output increases and the rate of
economic growth rises. In underdeveloped countries, the production capacity is less in
agricultural and industrial fields. This production capacity is increased as a result of deficit
financing. Increase in production capacity leads to increase in output. The prices may rise in
the beginning but a little rise in prices will encourage increase in production.
(2) Deficit Financing and Creation of New Resources: Underdeveloped countries suffer from
lack of voluntary saving. The available quantity of saving is not sufficient for implementing
plans. When deficit financing is undertaken in these countries, the prices rise. But the
people's income does not rise much and therefore, they have to consume less. In other words,
they have to do forced saving. This saving can be utilised for creation of new resources for
economic growth. Consequently, the rate of economic growth accelerates. Prof. Lewis is of
the opinion that "Inflation for the purpose of capital formation is self- destructive."
(3) Utilisation of Natural Resources: Natural resources are found in abundance in
underdeveloped countries. But they are not profitably exploited in the absence of adequate
financial resources. Government monetary resources are increased as a result of deficit
financing. Government can spend more amount of money on proper utilisation of natural
resources. The increase in expenditure can be met by resorting to deficit financing.
Therefore, proper utilisation of natural resources can be made possible through deficit
financing.
(4) Increase in Employment: The renowned economist, J.M. Keynes was in great favour of
adoption of deficit financing. According to him, the main cause of unemployment found in
developed countries is deficiency in aggregate demand. It is necessary to increase aggregate
expenditure in the country in order to compensate for the deficiency in aggregate demand.
Therefore, deficit financing will be of great help. As a result of deficit financing, aggregate
demand can be raised by increasing public expenditure. Increase in aggregate demand leads
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to more opportunities for employment. In underdeveloped countries, investment increases
as a result of deficit financing. Increase in investment leads to more demand for workers.
They are paid more wages. As a result of increase in wages and employment, disguisedly
unemployed from the rural areas will get employment in the towns. Consequently,
employment will increase without there being any decline in the output in rural sector.
(5) Increase in Infrastructure: In underdeveloped countries there is lack of infrastructure,
that is, railways, roads, canals, power projects, schools, hospitals, etc. Much money is needed
for their development. In underdeveloped countries, the government is not in a position to
collect sufficient revenue through taxes, loans and other sources of income. Therefore,
increase in infrastructure is made possible by procuring funds through deficit financing. Its
development accelerates the rate of economic growth of the country.
(6) Financial Resources for Economic Planning: A great amount of financial resources are
needed to implement economic plans in underdeveloped countries. This finance cannot
possibly be arranged through ordinary budgetary resources. The government has to adopt
deficit financing to achieve this end. The finance for economic planning can be easily
arranged through deficit financing.
(7) To Meet the Monetary Demand: In developed economies demand for money increases
for various reasons; for example, (ii) Demand for money increases as a result of non-
monetary sector changing into monetary field. (ii) Transactions increase as a result of
increase in investment. (iii) Income rises as a result of economic planning. Consequently,
demand for money increases because of increase in the demand for liquidity. (iv) Increase
in imports as a result of increasing foreign aid, raises the demand for money. This increased
demand for money is met by deficit financing.
(8) Rapid Rate of Growth: The agricultural and industrial development as well as
development of infrastructure are necessary for accelerating the rate of growth. Money in
adequate quantity can possibly be procured for their development through deficit financing.
Adverse Affects of Deficit Financing on Economic Growth
Deficit financing can produce the following adverse affects:
(1) Change in the Pattern of Investment: Deficit financing often encourages investment in
those things that are not conducive to planned development. Rise in prices encourages the
sale of luxury and foreign goods. Rise in demand for these is not proper from the angle of
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planned development, As a result of it, tendency for speculation is encouraged. Thus,
inflation may lead to increase in such investment that is not essential for growth.
(2) Credit Creation by Banks: Deficit financing increases government expenditure. But
expenditure in private sector does not increase much. Therefore, the deposits with the banks
increase. Banks create more credit on the basis of these deposits. Price rise still more as a
result of credit creation by banks. Thus, there starts a spiral of prices. This affects growth
adversely.
(3) Increase in Smuggling: People's income increases as a result of deficit financing. They
make a greater demand for imported consumer goods. But the supply of legally imported
goods falls short of their demand because of less exports from the country. The increasing
demand for imported goods encourages smuggling. This has unfavourable affect on the
development of the country.
(4) Problem of Balance of Payments: The price level rises as a result of deficit financing.
Exports start declining and imports start picking up as a result of rise in prices. If restriction
is imposed on imports, pressure of demand on internal production of the country increases.
Consequently, prices rise still higher. Further increase in prices reduces the export still
further. Thus, the gap between imports and exports widens and balance of payments is tilted
against the country. This is not good for development.
(5) Forced Saving: Prices rise as a result of deficit financing. Consequently, the poor and the
low income people can consume less goods and services than they did before. Thus, this
forced saving of goods and services affects adversely the standard of living of poor people
and salaried class. Their consumption decreases. But there is no decrease in the consumption
by the rich. They need not do forced saving. Thus, deficit financing results into unequal
distribution of wealth and gives rise to many social evils. This situation in not conducive to
development.
(6) Increase in the Cost of Economic Planning: Deficit planning has to be resorted for the
sake of economic planning. As a result of this prices rise. Because of increase in prices, a still
bigger deficit financing is undertaken to achieve the targets of economic planning. Thus, the
prices rise still higher. The deficit financing, therefore, raises the prices very high by
increasing the cost of economic planning.
Advantages of Deficit Financing in India
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Firstly, as deficit financing does not impinge any trouble either to the taxpayers or to the
lenders who lend their surplus money to the government, this technique is most popular to
meet developmental expenditure. Deficit financing does not take away any money from
anyone’s pocket and yet provides massive resources.
Secondly, in India, deficit financing is associated with the creation of additional money by
borrowing from the Reserve Bank of India. Interest payments to the RBI against this
borrowing come back to the Government of India in the form of profit. Thus, this borrowing
or printing of new currency is virtually a cost-free method. On the other hand, borrowing
involves payment of interest cost to the lenders.
Thirdly, financial resources (required for financing economic plans) that a government can
mobilize through deficit financing are certain and known beforehand. The financial strength
of the government is determinable if deficit financing is made. As a result, the government
finds this measure handy.
Fourthly, deficit financing has certain multiplier effects on the economy. This method
encourages the government to utilize unemployed and underemployed resources. This
results in more incomes and employment in the economy.
Fifthly, deficit financing is an inflationary method of financing. However, the rise in prices
must be a short run phenomenon. Above all, a mild dose of inflation is necessary for
economic development. Thus, if inflation is kept within a reasonable level, deficit financing
will promote economic development, thereby, neutralizing the disadvantages of price rise.
Finally, during inflation, private investors go on investing more and more with the hope of
earning additional profits. Seeing more profits, producers would be encouraged to reinvest
their savings and accumulated profits. Such investment leads to an increase in income,
thereby, hereby setting the process of economic development rolling.
Adverse Effects of Deficit Financing
Deficit financing has several adverse effects on economy. Important evil effects of deficit
financing are given below
(1) Leads to inflation – Deficit financing may lead to inflation. Due to deficit financing
money supply increases and so does the purchasing power of the people, which
increases the aggregate demand and thud, the prices increase.

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(2) Adverse effect on saving- Deficit financing leads to inflation and inflation affects the
habit of voluntary saving adversely. In fact, it becomes impossible for people to
maintain the previous rate of savings in the state of rising prices.
(3) Adverse effect on Investment – Deficit financing affects investment adversely. When
there is inflation in the economy, the trade unions tend to demand an increase in
wages, for which they engage in strikes and lock outs. This is turn decreases the
efficiency of labour and creates uncertainty in the business, which decreases the
extent of investment in the country.
(4) Inequality – in case of deficit financing income distribution becomes unequal. During
deficit financing deflationary pressure can be seen on the economy which makes the
rich, richer and the poor, poorer. The fixed wage earners are badly affected and their
standard of living deteriorates.
(5) Problem of balance of payment – Deficit financing leads to inflation. A high price level
as compared to other countries makes the exports more expensive On the other hand
rise in domestic income and price may encourage people to import more
commodities from abroad. This creates a deficit in balance of payment, and the
balance of payment becomes unfavourable.
(6) Change in the pattern of investment- Deficit financing leads to inflation. During
inflation, prices rise and reach to a very high level in that case people instead of
indulging into productive activities they start practising speculative activities.

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