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Advantages and Disadvantages of Deficit Financing

Deficit financing is the process by which the government invests higher funds than it collects in taxes and makes up the deficit by borrowing money or creating additional funds. When the government's overall income (revenue account + capital account) is less than its total expenditures, deficit financing may result.

Advantages and Disadvantages of Deficit Financing

The government might decide to borrow money from the public by issuing bonds and other securities, ordering the RBI to create fresh currency notes, or withdrawing funds from its cash balance deposited with the RBI. Ad-hoc Treasury Bills are used to get loans from the central bank, private banks, or even state governments to cover the deficit.

Why is Deficit Financing Necessary?

Higher economic growth is a priority for growing nations like India. Finances are necessary for greater economic growth. The government is responsible for raising money since the private sector is reluctant to invest significantly.

  • When there are insufficient resources to support economic activity, deficit financing is used to achieve fiscal deficit goals.
  • As the price increase is viewed as a lesser evil, it is favoured over a slower growth rate.
  • Additionally, it happens when expenses are expanding quickly.
  • Deficit finance may also result from more expenditure on useless and non-developmental activities.
  • Often, neither tax nor non-tax revenues can raise enough money only through taxes. The shortfall is frequently covered by borrowing money or printing new banknotes.

Types of Deficit Financing

There are several ways to finance a budget deficit, including:

  • Revenue Deficit
  • Fiscal Deficit
  • Primary Deficit
Advantages and Disadvantages of Deficit Financing

1. Revenue Deficit: The revenue deficit is the difference between revenue expenditures and revenue receipts.

  • The formula for calculating revenue deficits: Revenue Expenditure - Revenue Receipts, where RE > RD

2. Fiscal Deficit: The fiscal deficit is the difference between total expenditure and total receipt, excluding borrowings.

  • The formula for calculating fiscal deficit: (Revenue Expenditure + Capital Expenditure) Total Expenditure - Total Receipts Apart From Borrowing (Revenue Receipts + Capital Receipts except Borrowing).

3. Primary Deficit: The primary deficit denotes the distinction between interest expenses and the fiscal deficit.

  • The formula for Primary Deficit: Fiscal Deficit - Interest Payment

While the primary deficit depicts the government's borrowing demands without considering interest payments on prior loans, the fiscal deficit depicts the government's borrowing demands with interest payments on previous loans included. In other terms, a primary deficit denotes borrowing by the government to cover current-year expenses and receipts.

What are the primary goals of Deficit Financing?

Deficit financing's primary goals are as follows:

  • To pay for defence-related costs during a war.
  • To recover the economy from a downturn and increase investments, revenue, and jobs.
  • To mobilize the best resources and shift funding from underutilized to overutilized industries with the primary goal of raising national income and encouraging faster economic growth.
  • To upgrade the nation's infrastructure so taxpayers may be sure their money is being used appropriately.

Deficit financing's Purpose

Advantages and Disadvantages of Deficit Financing
  • To solve the issue of inadequate funding for accelerating the nation's growth.
  • Encourage more investment in the nation to offset the negative effects of the country's depression era.
  • To set up funding to guarantee the nation's total growth.
  • To save money for unforeseen circumstances and gather supplies for military expenses.
  • To improve the nation's infrastructure to reassure its taxpayers that their money is being used wisely.

Impacts on the Country's Deficit Financing

  • An expansion of the money supply brought on a rise in inflation.
  • Lower average consumption levels as a result of rising inflation.
  • Widening income gaps result from wealthier people having access to more options due to an increased money supply.
  • Negative Impact on Saving: Inflation is a direct result of deficit financing, and inflation harms the practice of voluntary saving. The growing cost of goods makes it impossible for consumers to continue saving at their prior rate.
  • Negative Impact on Investment: Deficit financing harms investment. Trade unions and employees seek greater salaries when the economy is experiencing inflation to survive. The manufacturing cost will rise if their demands are granted, demotivating the investors.

What Causes Government Budget Deficit?

When expected government spending grows faster than estimated revenues, a budget imbalance or deficit financing results. Either raising the tax rate or mandating higher prices for commodities and essential public services can be used to account for these discrepancies. Additionally, the government's built cash reserves or borrowing from the banking sector can be used to cover the deficit.

Advantages and Disadvantages of Deficit Financing

In India, the current budget deficit of the union government is claimed to be financed by borrowing from the RBI (Reserve Bank of India) and drawing down the government's cash reserve. The government's cash balance is made active and enters circulation when it is withdrawn.

It should be emphasized that deficit financing does not include government borrowing from the bank through the sale of bonds. Once more, the RBI issues loans in these circumstances when the government borrows money from it. Consequently, new money enters the economy in both instances.

Deficit financing's function in developed economies

During the Great Depression, deficit financing was a major factor in a developed economy. Banks and the general public are unwilling to accept the risk of investing during the recession since demand and spending are at extremely low levels. Instead, they favour building up their financial reserves.

The machinery & capital equipment are all there; nevertheless, the motivation to create is lacking because of a lack of inflationary pressures. Let's say the government increases the economy's purchasing power (through deficit financing).

Advantages and Disadvantages of Deficit Financing

The effective demand is thus likely to rise to fulfil this need, forcing idle machinery & capital equipment into service. The output level will increase, and inflationary tendencies won't be created if this growth can keep up with the rise in overall expenditure levels.

Inflation and Deficit Financing

Deficit financing is noted to have an inflationary effect. Inflation risk grows when deficit financing raises total expenditure, which increases demand. This is especially true when deficit funding is used to finance war's inhuman treatment.

This kind of funding, especially during the war, is completely ineffective since it doesn't allow society to expand its production capacity or add to its stock of wealth. Consequently, hyperinflation is the outcome.

Contrarily, resources secured by deficit financing are switched from civil to military manufacturing, resulting in a shortage of consumer products. Therefore, the production of new money ignites the inflationary fire. However, the type of deficit financing will determine whether it has inflationary effects. Spending on war with deficit financing is undoubtedly inflationary because of its dry nature. However, if a development expenditure is funded by deficit financing, it could not cause inflation but expand the money supply.

In other words, "Deficit financing," implemented for the short-term objective of strengthening useable capital, is likely to increase productivity and, eventually, the supply curve's flexibility.

Capital Formation and Economic Growth, and Deficit Financing

Numerous methods exist to employ the deficit financing strategy to advance economic growth. Nobody doubts that deficit financing helps raise funds needed for economic growth, even if it is an inflationary strategy.

Capital formation plays a significant role in economic development. Savings are the main driver of capital formation. However, LDCs are distinguished by a low saving-to-income ratio. In these nations with low savings rates, inflation driven by deficit financing emerges as a significant source of capital formation.

Advantages and Disadvantages of Deficit Financing

Contrary to the impoverished fixed-income earners, manufacturers profit greatly from inflation. The former group had much higher saving propensities. As a result, the community's total savings grow, which may be used toward capital formation to quicken the pace of economic development.

Additionally, inflation that is driven by deficits tends to decrease public consumption preferences. Such can be used to produce capital goods and is referred to as "forced savings." Consequently, these nations will see a quickening of their economic development.

In developed societies, deficit financing is designed to raise effective demand. But in lower advanced societies, deficit financing is designed for savings and investment, and savings accumulated in this way support capital growth. Deficit financing techniques enhance government spending, which has a positive multiplier effect on things like national income, savings, employment, etc.

What steps are being taken to combat deficit financing?

The following steps are performed to overcome deficit financing:

  • Deficit financing should only be used as much as the economy requires.
  • The excess funds used to purchase the replacement component should be eliminated. To prevent stored money from entering the mainstream again shortly after its departure.
  • The impact of inflation on low-income categories of people and the pricing structure of the country's economy may be significantly reduced by controlling the price of products, particularly wage goods, and distributing them fairly through official or informal rationing.
  • These strategies point to the potential of deficit finance as a tool for fostering economic growth. However, the outcome will undoubtedly be disastrous if these precautions are not taken or safety limits are exceeded.

Advantages of deficit financing

  1. Deficit financing is the easiest, quickest, and most popular method for funding any deficit.
  2. It is beneficial to utilize extra resources. Additionally, neither taxpayers nor lenders have voiced any opposition, making this technique the most widely used of the bunch.
  3. Borrowing from the central bank generates more funds, and the interest payments are returned to the government as income, making deficit financing a cost-free strategy.
  4. The government may easily deploy underutilized resources by borrowing money, which makes this policy particularly practical.
  5. It encourages the government's use of underused, underemployed, and jobless resources, which raises earnings and creates jobs.
  6. Since deficit financing is inflationary and, to some extent, is important for economic development, we may claim that it will encourage economic growth, which will ultimately combat inflation.
  7. Investment rises during inflation due to the need for more money, and this investment causes an increase in income that promotes economic growth.

Disadvantages of Deficit Financing

  1. If deficit finance is not handled carefully, inflation might restrict economic growth.
  2. Income distribution is uneven as a result of deficit financing.
  3. Because investors constantly want to invest in companies that can provide quick money, it changes how investments are designed.
  4. Deficit financing may not produce enough outcomes in boosting employment due to developing nations' shortages of other resources and raw materials.
  5. Because of inflation's decline in the buying power of money, there may be a capital shortage.
  6. As a result of inflation, exports are down, and imports are up. It demonstrates a nation's extreme inefficiency concerning its payment balance statement.

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