Deficit financing 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.
The economic impacts of deficit financing are:
Deficit Financing and Price Level
There are two opinions regarding the effect of deficit financing on the price level especially in a developing country. According to one view, deficit financing need not be inflationary in character especially if it is used during the peace time. The advocates of this view argued that:
- In a developing economy the existence of non-monetized sector will absorb the issue of new currency and shrink in its size over a period of time. Therefore the additional money pumped into the economy will not go to affect the price level.
- Over a period of time the demand for money for transactions and liquidity purpose will increase. Therefore the additional money injected will not be spent but will only be kept by the people. Therefore, deficit financing need not be inflationary.
- A developing economy will have a large amount of unutilized resources and during peace time when the government resorts to deficit financing the additional money will be used only for resource utilization and so it need not be inflationary in nature.
However, the following arguments are leveled to claim that deficit financing is essentially inflationary in character:
- There will be a lag in the expansion of output and the injection of additional money in the economy, such that the output will increase at a lesser rate than the money supply.
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Deficit financing is understood in different ways in different countries. It is understood as the excess of current expenditure over current revenue which is financed either through public borrowing or the creation of new money by the government. So the deficit budget is also called deficit financing in USA. But in India deficit financing is understood in a different way from deficit budget. While the former refers to a situation where the current expenditure exceeds current revenue of the government, the latter is taken to mean the excess of aggregate expenditure (both on current and capital accounts) over aggregate revenue. The former is called deficit budgeting and the latter deficit financing in India.
Deficit financing in Indian context refers to the meeting of budgetary deficit through the creation of new money adding to the existing money supply in the economy. Deficit financing includes any or all of the following in India:
- The government withdrawing its cash balance with the Central bank,
- The government borrowing funds from the Central bank, and
- The government resorting to printing of new currency notes with a view to cover the budget deficit
Purpose of Deficit Financing
There are several purposes for resorting to deficit financing. The following are the major purposes:
- War Finance: A country in war experiences severe shortage of financial, resources, especially the cost of modem warfare is so prohibitive that the country resorts to deficit financing. During this period the country cannot resort to taxation or public borrowing because of the situation in the economy.
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It has been already pointed out that the way in which the three basic economic questions are answered depends on the economic system which functions in a country. To understand how these answers differ among the economic systems, we should understand the different types of economic systems.
Major Types of Economic Systems
Economic systems may broadly be classified into three categories: Capitalism, Socialism and Mixed economy. A number of other types also emerged but all of them came close to any one of the above three types of economic systems. Let us now discuss the features, strengths and weaknesses of each one of these economic systems.
Capitalism is an economic system based on the principle of free enterprise. Individual ownership of resources is an important feature. With control and command over resources, individuals can conduct any type of business. The object in such a system is to maximize private gains. Any type of enterprise or production of any commodity or service is permitted, so long it is wanted by the society. In such a system the market forces determine the resource allocation and price. That is, the demand and supply forces together determine what to produce, how to produce and for whom to produce. Price mechanism is the nucleus of the capitalistic society. The price mechanism clearly reflects the wants of the people. Once this is known, the producers would allocate the resources to manufacture and sell the products in great demand. While doing so, there is no control or regulation over production.… Read the rest
Economic system refers to the organizations and institutions created for the purpose of satisfying the wants of human beings. In a country, available resources have to be utilized to manufacture and distribute goods and services, which would meet the needs of the people so that they are satisfied. These institutions and organizations function with their own rules and regulations.
The economic system has certain broad characteristics.
- The economic system always functions with scarcity of resources. How the system effectively and efficiently uses the resources will determine the extent to which the needs of the people are met.
- An economic system comprises people. That is, a society of human beings alone can constitute economic system.
- A set of institutions are created and used for the purpose of smooth functioning of an economic system. For example, banks, money, technology, government, price mechanism, planning etc., are all institutions through which the systems operate.
- The basic objective with which an economic system functions is to satisfy the wants of the people. Unless there is want for a commodity or service, nothing can be produced. Hence, the economic system allocates the resources in such a way that the wants of the people are satisfied.
On the basis of the above characteristics of an economic system, it should be clear that the economic system is very dynamic in nature. That is, the economic system undergoes changes with every change in the institutions, though the rate of change would differ from institution to institution.
The economic system functions to answer three vital questions:
What to produce ?
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The economic environment of business is composed of various set of economic policies, economic system, strategy of economic growth and development, resource endowment, size of market and status of infrastructural facilities in a country. All these economic policies affecting business environment one way or the other.
Economic policies include fiscal policy, monetary policy, foreign trade policy, price policy, etc. These policies lay the framework within which every organization has to function. To understand the impact of these policies on business environment, let us discuss each one of these components in detail.
1. Fiscal Policy
By fiscal policy we mean, the government’s tax efforts, public expenditure and public borrowing. Through these the government can effectively encourage consumption, investment and savings habits and also restrict them. For example, suppose there is inflation in a country. Inflation implies that the people have high purchasing power and so they demand goods. To curb this, the government may raise the personal tax and also the corporate tax. Consequently, individuals will be left with lesser disposable income and to minimize tax, they may start saving through various tax-saving schemes. As far as the corporate are concerned, they have to part with more by way of tax to the government and this would bring down the rate of profit and dividend declared. As a result the corporate would resort to upward price revision, which might lead to further fall in demand for their products and services. During deflationary period, the government would reduce the tax so as to encourage more spending and investment.… Read the rest
Business involves activities, which links an organization with outside world. Within an organization, a business is governed by the behavior of its employees, management or decision makers. But externally a business is influenced by a score of factors, which range from customers to competitors and government. Therefore, a business cannot be independent of the influence of these external factors. It should also be noted that a business has absolute control over all the internal factors, it has no control over the external factors. So often it becomes necessary for business houses to modify their internal decisions and policies, on the basis of the pressure from external factors. This highlights the need to be ever- cognizant of changes and influences of external factors so as to conduct business on healthy lines. It is in this context that business environment assumes all significance. Business environment therefore refers to the influences and pressures exerted by external factors on the business.
External Environment Factors of Business
To develop a right perspective about business environment, let us discuss briefly about each one of the external environment constituents.
1. Demographic Environment
This refers to the size and behavior of population in a country. Suppose a country has a huge size of population, then, the country would provide extensive business or marketing opportunities for all types of business organizations. On the other hand, a country with low size of population would force the business organizations to seek external market for their products or services. Similarly, if the population in a country is well – tuned to ‘use and throw concept’ [like most of the developed western countries] then there would be limited scope for repair shops and employment scope in that segment would be almost nil.… Read the rest