Deficit Financing: Meaning, Effects and Limitations

After reading this article you will learn about:- 1. Meaning and Definition of Deficit Financing 2. Objectives of Deficit Financing 3. Effects 4. Limitations.

Meaning and Definition of Deficit Financing:

The term deficit financing means the direct addition to gross national expenditure through budget deficits whether the budget deficits are on revenue or on capital account. This policy implies that the govern­ment is spending in excess of the revenue it receives in the form of taxes, surplus from public enterprises, loans borrowing from central bank of the country, which leads to the creation of money.


According Mc. Graw Hill Dictionary of Modern Economics defi­cit financing is a practice by a government of spending more than what receives in revenue. Thus a government is said to be practicing deficit financing when it spends in excess of its current revenue. Deficit financing assumes different meanings in the western context and in India.

The term deficit financing has been used in the west to describe the financing of a deliberately created gap between public revenue and public expenditure, the method of finance being borrowing of a type that results in a net addition to national outlay or aggregate expenditure.

This means that the borrowing either results in the activation of idle deposits in banks by private individuals or the creation of deposits by banks directly undertaking the purchase of government securities.

In these cases there is a net increase in aggregate national expenditure as compared to that prevalent in the absence of deficit financing. For example in USA deficit financing implies an excess of expenditure incurred by the government over the current revenue. This deficit is financed through public borrowing or through the creation of new money by the government. In USA both the method results in deficit financing.

In India the term deficit financing is used in a different sense. It is considered as the most popular method of raising additional resources for economic development. In India deficit financing has been treated mainly in terms of expansions of currency.

In the first five year plan document. Planning commission has defined the term as “deficit financing is used to denote the direct addition to gross national ex­penditure through budget deficit whether the deficits are on the rev­enue account or on capital account.


The essence of such a policy lies therefore in governments spending; in excess of the revenue it receives in the shape of the taxes earnings of state enterprises, loans from 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”. It includes borrowing from the central bank and withdrawal of cash balances, and excludes market borrowing.

That is borrowing from the public and from the commercial banks. Public loans are raised out of the savings of the people. It results merely in the transfer of purchasing power from the hands of the public to the government without a net addition to total money supply. In short in the Indian context deficit financing took place.

When a budgetary deficit is fi­nanced by using any one of the following methods:


(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.

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.

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.

Effects of Deficit Financing:

Deficit financing is a dangerous weapon to be handled carefully. Definitely deficit financing is capable of promoting economic develop­ment in developing economies. If it is used without any safeguard it may generate evil consequence in the economy.

Therefore deficit financing produces diverse effects depending upon how it is planned and utilized.

Effects of deficit financing can be studied under the following heads:

1. Effect on Price Level:

Deficit financing as defined by Indian planning commission involves the net addition to money supply in the economy. Increased govern­ment expenditure made possible by deficit financing generates, ad­ditional purchasing power to the people in the form of wages, rent, interest payment; profit etc.

This in turn raises the demand for the goods and services. In the absence of a matching increase, “aggre­gate supply of goods and services deficit financing leads to rise in gene al price level.” This happens during the time of war.

However surprise that deficit financing is used for development activities, which in turn produce more goods and services in future. In such situation inflationary impact of deficit financing is neutralized by correspond­ing increase in output. But usually a time lag creeps between invest­ment made and output realized.

During this gap inflationary rise in price occur. Prof. W. A. Lewis visualizes a three stage impact of deficit financing in an economy. In the first stage, by using deficit financing, capital goods industry is developed and created.

Since there exist a long gestation period in the investment in capital goods industry, price rise sharply. In the second stage, the rise in price, force the people to reduce their consumption. This result in forced saving and thereby enhance investment. In the third stage the initial capital formation materialized in the 1st stage, starts generating production of consumer goods to the market which help to reduce price level.

Therefore Lewis argues that deficit financing is danger­ous and painful only in the first stage. Its inflationary potential is therefore self-destructive. This may be true but when deficit financ­ing cross the safe limit, it leads to cost push inflation that is often considered as a tonic to economic development.

In this context, Sir T. T Krishnamachary, the former Finance Minister of India rightly pointed out that “deficit financing is a medicine to be taken in small dose; it is not a food that would sustain the system”. Therefore gov­ernment should take necessary steps to ensure reasonable rises in price.

2. Effect 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.

3. Effect on Distribution of Income:

Deficit financing adversely affects the distribution of income. Deficit financing is inflationary in character. Hence deficit financing and in­flation affect different sections of the society differently.

The busi­ness classes will be benefitted out of rise in price and increased profit earnings. On the contrary wage earners and fixed income group suffer on account of reduction in purchasing power resulting from sharp rise in price and decreased value of money. As a result in­equality in the distribution of income increases.

A redistribution of income take place in favour of the industrial and business class during periods of price rise resulting from deficit financing. Therefore deficit financing is fundamentally against the principle of equitable distribution of income.

However if deficit financing is used for financ­ing development plans, this will accelerate production and productiv­ity in the economy. So in the long run deficit financing will not gen­erate any adverse effect upon the economy. Therefore deficit financ­ing will be a useful instrument of development finance if it is judi­ciously employed.

Limitations of Deficit Financing:

In the case of developing economies deficit financing has been proved to be a tonic to economic development, if used prudently. However it may generate all ill effects if it is used without any limit.

The appli­cation of the tool of deficit financing is justifiable only under unavoid­able circumstances. It should be applied only when the advantages derived from deficit finance far outweigh the disadvantages gener­ated to the economy.

During periods of war deficit financing becomes inevitable to mobilize resources quickly. However the magnitude of deficit financing should be limited to the needs and requirements of the economy. There is no precise way to calculate the extent and limit of deficit financing as a useful fiscal tool. The safe limit of deficit financing depends on a number of factors.

Generally this limit is related to the rate of increase of output of goods and service pro­duced within the country. Deficit financing adopted during periods in which agricultural and industrial production shows upward trend, will not lead to inflationary rise in price.

The limit of deficit financing depends on the extent of the unutilised capacity of the economy. It also depends upon the extent to which people prefer to hoard their savings in cash balances.

The extent of deficit financing also de­pends upon the efficacy of regulatory devices in the economic sys­tem. The inflationary pressure generated by deficit financing also depends upon the form of government expenditure.

However specifically, we cannot prescribe any hard fast rule to safe limit for deficit financing. It is usually said that a mild doze of inflation is a tonic to economic development. So government should be extra cautious while resorting to deficit financing.

Carelessness on the part of the authorities of the country can lead the economy into inflationary spiral. Therefore administrated in controlled dozes, deficit financing may function as a tonic. It is therefore to be treated as a medicine, and not as daily bread.

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