Economic Impacts of Deficit Financing

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:

  1. 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.
  2. 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.
  3. 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:

  1. 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. Consequently, there will be inflation in the economy. This is because of certain rigidities in the effort to increase the output. Therefore, the actual output will fail short of the potential output.
  2. Developing economies follow unbalanced growth strategy and so they invest heavily on capital intensive projects which have a long gestation period. As a result the return on investment in terms of higher output will take a longer time and meanwhile increased use of deficit financing will only affect the price level causing inflation.
  3. In a developing economy majority of the people are poor and so their marginal propensity to consume is very high. Hence, when their income increases due to deficit financing, the demand for goods will outstrip the supply causing the prices to go up.
  4. Governments also resort to deficit financing for unproductive purposes, which will only fuel the inflationary pressure.
  5. The developing countries have neither the necessary expertise nor the efficient administrative set up to keep the inflationary pressure caused by deficit financing under check. As a result deficit financing should lead to inflation. Considering the above arguments and also the practical experience, it is found that deficit financing is inflationary in character.

Deficit Financing and Income Distribution 

Deficit financing is inflationary in character and as a result it affects a section of the society favorably and the other section unfavorably. Rich people become richer and the poor turns out to be poorer because of deficit financing especially during the war period. The businessmen, traders, speculators, industrialists and other benefit by deficit financing through inflationary pressure while the workers, salaried income group, and others are affected badly. Hence, the existing inequality in a developing country will be widened more by deficit financing thereby defeating the ultimate purpose of socialism in bringing about equality. Therefore deficit financing is unjust and it not only worsens the income inequalities, it also prevents the attempt to improve the standard of living.

Deficit Financing and Unemployment

Regarding the effect of deficit financing on unemployment, we have to classify the economies as developed and developing economies. This is because the Keynesian prescription of deficit financing helps the developed countries to overcome the unemployment but it has not helped the developing countries in this respect. This is because in developed countries, when the economy faces depression, to revive the economy the government should undertake a large scale public investment. Funds for this purpose cannot be raised through taxation or public borrowing and so only deficit financing is the ideal method. Defied financing has helped the developed countries to overcome unemployment, because during depression the government increases the public investment which will increase the effective demand and thereby constitute the ground for increasing the private investment. With the operation of multiplier, then the output, employment and effective demand continue to increase pulling the economy out of the pit. But such a result in a developing economy is not possible because,

  1. The nature of unemployment is not cyclical but chronic and caused because of deficiency of capital.
  2. There exists a large scale voluntary unemployment and disguised unemployment in the developing countries. Those who are coming under the second category do not know that they are unemployed.
  3. In developing economics the multiplier process takes place regularly and smoothly and so unemployment is very much reduced. But the conditions for the successful operation of multiplier are not found in developing countries and so the unemployment persists.
  4. Further in developing economies because of rigidities, large scale investment in capital intensive industries, high marginal propensity to consume and high marginal propensity to import affect the possible increase in investment and employment opportunities. With every increase in money supply, only the price level goes up and not the output and employment. Hence, the use of deficit financing in developing countries to solve the unemployment problem calls for a lot of precautions and careful administration as otherwise it would create several other complications.

Deficit Financing and Economic Growth

It has been clearly proved that deficit financing in developing countries will accelerate economic growth, provided certain precautions are taken. The positive, role played by deficit financing in developing countries is because of the following reasons:

  1. In developing economies, the physical and human resources are under utilized and so the created money will facilitate for the fuller utilization of these resources.
  2. In developing countries, because of economic planning the national income will be increasing and along with that the money supply should also increase. This should happen, as otherwise, the prices may fall and discourage any productive investment which should be disadvantageous for the economy.
  3. The developing countries are characterized by the existence of non-monetized sector. When the economy grows, the size of this sector will shrink, which in fact means, that the additional money supply is being absorbed by this sector and so there is very little scope for inflationary pressure in the economy due to deficit financing.
  4. With economic growth the standard of living of the people also goes up. Then they would require more money to meet their increased demand or otherwise, their liquidity preference will go up. This can be met only with increased money supply.

In spite of all the above arguments in favor of deficit financing, care should be taken to take notice of certain points. Firstly, in developing countries the existence of idle-human power is due to the limited growth of complementary capital resources. Therefore, the country concerned should aim at developing more labor intensive industries. Secondly, in developing countries deficit financing may be inflationary affecting the balance of payments position distorting the pattern of investment.

The diversion of resources to the production and consumption of non-essential resources cannot be ruled out. This in turn will aggravate inflation. Therefore, the countries concerned should take the following steps to avoid facing the above consequences.

  1. The country should resort to a moderate dose of deficit financing due to the poor absorption capacity of the country.
  2. The authorities concerned should effectively check the rising prices of essential commodities, may be by following strict rationing and public distribution policies.
  3. A well planned taxation policy will also help to contain the inflationary pressure.
  4. The financial resources mobilized through deficit financing should be used for investment in short period high yielding productive projects. That is care should be taken to identify industries with short gestation period so that with the increase in money supply there can be corresponding increase in production.

Inspite of all these efforts, the country may experience inflation. But such inflation need not be taken as a serious problem, and in one way it is also required to keep the initiative of the private sector investment. In other words, it will only help in achieving a higher economic growth. Hence, deficit financing does promote economic growth, provided the inflationary pressure is held under complete control.

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