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.