Deficit-Financing[1].docx

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Defcit Financing in India

INTRODUCTION

The government is committed to socio-economic responsibilities for

breaking the vicious circle of poverty and uplifting the economic conditions of the

masses and developing the economy into a self-reliant one. In 1950, it as thought

that these ob!ectives could be achieved through the process of planned economic

development. Throughout the period of planned economic development in the

country one basic problem has been that of mobili"ation of resources.

#ources of financing economic development are broadly divided into

domestic and foreign sources. $omestic sources of finance at the disposal of the

government consist of ta%ation, public borroing, and government savings hich

include surpluses of public enterprises and deficit financing. The foreign finances

consist of loans, grants and private investments. &ll these sources of finance have

their social costs and benefits on the basis of hich an upper limit can be

determined for the use of any one method of financing development. #ince the

financial re'uirements of development are enormous and all various sources have

their on limitations, it becomes almost essential to make use of all the sources as

far as possible. The choice is not beteen hich one is to be used but beteen the

various combinations of using all of them. Thus both the domestic and foreign

sources of finance have their on place and importance in a developing country. It

is essential to formulate appropriate policies for different sources of finance and

successful implementation of these policies is re'uired for achieving the desired

ob!ectives of rapid economic development.

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Ta%ation is an old source of government revenue. (ot only that, it is also

regarded as the most desirable method of financing public investment in

developing countries. )ut it is a ell knon fact that ta%ation has a narro

coverage in developing countries and the ta% revenue national income ratio is not

only lo but the increase in this ratio is also very slo during the process of

development. *ublic borroing is considered a better method of collecting public

revenue ta%ation +on the one hand government ill get sources for development

programmes and, on the other, conspicuous consumption ill be reduced. )ut it

cannot substitute ta%ation completely because there are certain limitations to the

use of this source of financing development. irstly public borroing depends on

the credit orthiness of the government. #econdly, people do not ant to lend to

the government because the rates of interest offered by the government are loer

than those offered by the borroers in the private sector. &nd thirdly, if the prices

are rising, people ill not be interested in saving and lending because of

depreciation in the value of money. e shall be discussing about public borroing

as a source of resource mobili"ation in detail in the ne%t /nit i.e. 15.

$omestic sources of financing economic development are sure to fall short

of the huge financial re'uirements for rapid economic development in developing

economies. #o e%ternal sources of finance have become almost essential for the

developing economy. In spite of the necessity of foreign assistance, it remains only

a subordinate source of financing development in a developing economy. In the

early stages of development a substantial foreign assistance may be needed but

gradually foreign assistance as a percentage of development e%penditure goes on

diminishing as the developing nations must learn gradually to become self reliant.

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ence various conventional sources of finance, such as ta%ation. *ublic

borroing, having been found to be inade'uate, deficit financing has been resorted

to for meeting the resource gap. The idea of resorting to deficit financing for

economic development, hich is of relatively recent origin, has remained very

controversial.

)ut there are no to opinions regarding the evil conse'uences of deficit

financing, hen adopted carelessly for capital formation and economic

development. )ut the problem before the country is to choose beteen the to

evils i.e. to adopt deficit financing for capital formation and face inflation or to go

ithout development programmes due to paucity of funds. In this unit e ill

discuss the meaning of deficit financing and its role as an aid to financing

economic development. e shall also highlight the relationship beteen deficit

financing and inflation and its impact on price behavior in India. The advantages

and limitations of deficit financing are also dealt ith.

The use of deficit financing to maintain total spending or effective demand

as an important discovery of the economic depression of 190. Today it is a

ma!or instrument in the bands of government to ensure high levels of economic

activity. The definition of deficit financing is likely to vary ith the purpose for

hich such a definition is needed. $eficit financing is an approach to money

management that involves spending more money than is collected during the same

period. #ometimes referred to as a budget deficit, this strategy is employed by

corporations and small businesses, governments at !ust about every level, and even

household budgets. hen used properly, deficit financing helps to launch a chain

of events that ultimately enhances the financial condition rather than simply

creating debt that may or may not be repaid.

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2ne of the more common e%amples of government deficit financing has to

do ith stimulating the economy of a nation in order to bring an end to a period of

recession. )y establishing a specific plan of action that involves using borroed

resources to make purchases, the government can increase the demand for output

from various sectors of the business community. This in turn motivates businesses

to hire additional employees, reversing the usual trend of higher unemployment

that takes place during a recession. &t the same time, the reneed vigor in the

marketplace helps to restore consumer confidence, making it more likely for

consumers to buy more goods and services. hen monitored closely, a carefully

crafted deficit financing initiative ill restore a measure of stability to the national

economy over a period of months or years.

The concept of deficit spending in economics is not limited to government

use. )usinesses of all si"es may choose to spend more money up front in hopes of

generating funds to pay off the investment at a later date. or e%ample, a

manufacturer may choose to purchase ne machinery for a factory, ith the

understanding that the neer e'uipment ill allo the business to produce more

units of goods in less time, and possibly at a loer unit cost. 2ver time, the

benefits derived from this strategy pay off the accumulated debt and allo the

business oners to en!oy a budget surplus rather than a budget deficit.

ousehold budgets also engage in this form of money management,

although the role of deficit financing on an individual level takes a slightly

different form than ith businesses and governments. &n individual may choose to

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purchase items no ith an eye to improving the home in some manner that

ultimately increases the value of the property. The accumulated debt is eventually

paid in full, leaving the homeoner ith an asset that has a higher fair market

value than it ould ithout the enhancements. hile the ultimate reard from the

deficit financing is reali"ed hen the property is sold at a higher profit,

homeoners and their families do get to en!oy the enhanced amenities of the home

in the interim.

The idea of deficit financing in economic development is not ne.

3conomists from 4ohn aynard 6eynes up to the present day have recogni"ed this

strategy, its benefits, and its possible liabilities if not applied properly. hile not

automatically the best option to correct an undesirable financial situation, the

responsible use of deficit financing can ultimately improve the 'uality of life and

the financial status of everyone concerned.

In one sense by deficit financing e mean the e%cess of government

e%penditure over its normal receipts raised by ta%es, fees, and other sources. In this

definition such e%penditure hether obtained through borroing or from the

banking system measures the budget deficit. $eficit financing is said to have been

used henever government e%penditure e%ceeds its receipts.

In under-developed countries deficit financing may be in to forms7

a $ifference beteen overall revenue receipts and e%penditure

b $eficit financing may be e'ual to borroing from the banking system of the

country.

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DEFICIT FINANCING - CONCEPT AND MEANING

$eficit financing refers to means of financing the deliberate e%cess of

e%penditure over income through printing of currency notes or through borroings.

The term is also generally used to refer to the financing of a planned deficit

hether operated by a government in its domestic affairs or ith reference to

balance of payment deficit. In the est, the phrase 8$eficit financing8 has been

used to describe the financing of a deliberately created gap beteen public revenue

and e%penditure or a budgetary deficit. This gap is filled up by government

borroings hich include all the sources of public borroings vi"., from people,

commercial banks and the entral )ank. In this manner idle savings in the country

are made active. This increases employment and output.

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)ut according to Indian budgetary documents government resorting to

borroing from the public and the commercial banks does not come under deficit

financing. These are included under the head of :arket )orroings: and

government spending to the e%tent of its market borroings does not result in or

lead to deficit financing. In the Indian conte%t, public e%penditure, hich is

financed by borroing from the public, commercial banks are e%cluded from

deficit financing. hile borroing from the central bank of the country,

ithdraal of accumulated cash balances and issue of ne currency are included

ithin its purvie.

$eficit financing in Indian conte%t occurs hen there;re budgetary deficits.

9,50 crore +at 19?@-?5 prices hich

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as more than double the estimate of =s. 1@,000 crore. The )udget for 1990-91

laid stress on limiting the si"e of the budget deficit through containment of

e%penditure groth and better ta% compliance. The budget programmed a deficit of

=s. 1,10,59> crore in 19?9-90. The revised estimates for the year 1990-91 placed

the budgetary deficit at =s. 10,AA> crore hich is nearly 50B higher than the

budget estimate. *roper financial management demands that the revenue receipts

of the government, hich are in the shape of ta%es, loans from the public, earnings

of the state enterprises etc., should not only meet the revenue e%penditure but also

leave a surplus for financing the plan. ontrary to this deficits on revenue account

are groing year after year. or e%ample the revised estimates place the deficit on

revenue account during 1990-91 at =s. 1A,5?5 crore as against the budget deficit of

=s. 10,AA> crore. & higher revenue deficit implies higher borroed resources to

cover the deficit leading to higher interest payments thus creating a sort of vicious

circle.

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SOURCES O DEFICIT FINANCING IN INDIA

IMF (INTERNATIONAL MONITARY FUND): -

The I provides policy advice and financing to members ineconomic difficulties and also orks ith developing nations to help them achievemacroeconomic stability and reduce poverty.arked by massive movements ofcapital and abrupt shifts in comparative advantage, globali"ationaffects countries:

policy choices in many areas, including labor, trade, and ta% policies. elping acountry benefit from globali"ation hile avoiding potential donsides is an

important task for the I. The global economic crisis has highlighted !ust hointerconnected countries have become in today;s orld economy.

Key IMF activitie

The I supports its membership by providing

policy advice to governments and central banks based on analysis of

economic trends and cross-country e%periencesC

research, statistics, forecasts, and analysis based on tracking of global,regional, and individual economies and marketsC

loans to help countries overcome economic difficultiesC

concessional loans to help fight poverty in developing countriesC and

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technical assistance and training to help countries improve the management

of their economies.

O!i"i#a$ ai%

The I as founded more than D0 years ago toard the end of orldar II +see istory. The founders aimed to build a frameork for economiccooperation that ould avoid a repetition of the disastrous economic policies thathad contributed to the Ereat $epression of the 190s and the global conflict thatfolloed.

#ince then the orld has changed dramatically, bringing e%tensive prosperity andlifting millions out of poverty, especially in &sia. In many ays the I:s main

purposeFto provide the global public good of financial stabilityFis the same

today as it as hen the organi"ation as established. ore specifically, the Icontinues to

provide a forum for cooperation on international monetary problems

facilitate the groth of international trade, thus promoting !ob creation,

economic groth, and poverty reductionC

promote e%change rate stability and an open system of international

paymentsC and

lend countries foreign e%change hen needed, on a temporary basis and

under ade'uate safeguards, to help them address balance of paymentsproblems.

The I:s ay of operating has changed over the years and has undergone rapidchange since the beginning of the 1990s as it has sought to adapt to the changingneeds of its e%panding membership in an globali"ed orld economy. ostrecently, the I:s anaging $irector, $omini'ue #trauss-6ahn, has launched an

ambitious reform agenda, aimed at making sure the I continues to deliver theeconomic analysis and multilateral consultation that is at the core of its missionFensuring the stability of the global monetary system.

The I has evolved along ith the global economy throughout its D5-yearhistory, alloing the organi"ation to retain its central role ithin the internationalfinancial architecture. &s the orld economy struggles to restore groth and !obs

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after the orst crisis since the Ereat $epression, the I has emerged as a verydifferent institution. $uring the crisis, it mobili"ed on many fronts to support itsmember countries. It increased its lending, used its cross-country e%perience toadvice on policy solutions, supported global policy coordination, and reformed theay it makes decisions.

The result is an institution that is more in tune ith the needs of its 1?A membercountries.

Ste&&i#" '& c!ii $e#i#" The I responded 'uickly to the global

economic crisis, ith lending commitments reaching a record level of morethan /#G>50 billion in >010. This figure includes a sharp increase inconcessional lending +that;s to say, subsidi"ed lending at rates belo those

being charged by the market to the orld;s poorest nations.

G!eate! $e#i#" *$e+i,i$ityThe I has overhauled its lending frameork

to make it better suited to countries; individual needs. It is also orking ithother regional institutions to create a broader financial safety net, hichcould help prevent ne crises.

P!vii#" a#a$yi a# aviceThe I;s monitoring, forecasts, and policy

advice, informed by a global perspective and by e%perience from previouscrises, have been in high demand and have been used by the E->0, as notedin #ection @.

D!a.i#" $e# *!% t/e c!ii The I is contributing to the ongoing

effort to dra lessons from the crisis for policy, regulation, and reform of theglobal financial architecture.

0it!ic !e*!% * "ve!#a#ceThe I;s member countries also agreed to

a significant increase in the voice of dynamic emerging and developingeconomies in the decision making of the institution, hile preserving thevoice of the lo-income members.

Gve!#%e#t 1#: -

& government bond is a bond issued by a national governmentdenominated in the country:s on currency. )onds issued by national governments

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in foreign currencies are normally referred to as sovereign bonds. The first evergovernment bond as issued by the 3nglish government in 1D9 to raise money tofund a ar against rance. Eovernment bonds are usually referred to as risk-free

bonds, because the government can raise ta%es to redeem the bond at maturity.#ome counter e%amples do e%ist here a government has defaulted on its domesticcurrency debt, such as =ussia in 199? +the 8ruble crisis8, though this is very rare.&s an e%ample, in the /#, Treasury securities are denominated in /# dollars. Inthis instance, the term 8risk-free8 means free of credit risk. oever, other risksstill e%ist, such as currency risk for foreign investors +for e%ample non-/#investors of /# Treasury securities ould have received loer returns in >00@

because the value of the /# dollar declined against most other currencies.

#econdly, there is inflation risk, in that the principal repaid at maturity illhave less purchasing poer than anticipated if the inflation outturn is higher than

e%pected. any governments issue inflation-inde%ed bonds, hich should protectinvestors against inflation risk. )onds are issued by public authorities, creditinstitutions, companies and supranational institutions in the primary markets. Themost common process of issuing bonds is through underriting. In underriting,one or more securities firms or banks, forming a syndicate, buy an entire issue of

bonds from an issuer and re-sell them to investors. The security firm takes the riskof being unable to sell on the issue to end investors. oever government bondsare instead typically auctioned. & bond is a debt security, in hich the authori"edissuer oes the holders a debt and, depending on the terms of the bond, is obligedto pay interest +the coupon andHor to repay the principal at a later date, termedmaturity. & bond is a formal contract to repay borroed money ith interest atfi%ed intervals. Thus a bond is like a loan7 the issuer is the borroer +debtor, theholder is the lender +creditor, and the coupon is the interest. )onds provide the

borroer ith e%ternal funds to finance long-term investments, or, in the case ofgovernment bonds, to finance current e%penditure. ertificates of deposit +$s orcommercial paper are considered to be money market instruments and not bonds.)onds must be repaid at fi%ed intervals over a period of time.

2!$ 1a#3: -

India;s involvement ith the orld )ank dates back to its earliest

days. India as one of the 1A countries hich met in &tlantic ity, /#& in 4une

19@@ to prepare the agenda for the )retton oods conference, and one of the @@

countries hich signed the final &greement that established the )ank. In fact, the

name 8International )ank for =econstruction and $evelopment8 I)=$J as first

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suggested by India to the drafting committee. The Indian delegation as led by #ir

4eremy =aisman, inance ember of the Eovernment of India and included #ir .

$. $eshmukh +Eovernor of the =eserve )ank of India, later to become India:s

inance inister, #ir Theodore Eregory +the first 3conomic &dvisor to the

Eovernment of India, #ir =.6. #hanmukhan hetty +later independent India:s firstinance inister, r. &.$. #hroff +one of the architects of the )ombay *lan and

r ).6. adan +later India:s 3%ecutive $irector in I.The )ank lending to

India started in 19@9, hen the first loan of G@ million as approved for the

Indian =ailays. The first decade of the )ank:s lending to India +19@9 - 1959 sa

!ust about >0 loans for a total amount of GD11 million. $uring the years 19D0-D9,

overall lending to India from the )ank rose to G1.? billion, about three times the

level in the previous decade. )eteen 19A0-A9, there as a large increase in the

absolute volume of I$& lending and the I$& share in total )ank assistance reacheda high of ?0B in this decade. oever, in the 19?0s, India:s share in total I$&

lending declined to >5B and as updated by the more e%pensive ) lending. The

volume of the ) lending rose to [email protected] billion during 19?0-?9, almost 10 times

the level of G1.5 billion in the previous decade.

The aggregate of the )ank:s lending in India in the last @5 years as

appro%imately G@> billion. India is the single largest borroer of ) and I$&.

India has claimed about 15B of total orld )ank lendingF9B of ) and >?B of

I$& commitments.The 50 years +19@@-9@ of relationship beteen the )ank and

India clearly shos certain trends. In the early years of relationship, the )ank

involvement as not direct and visible as compared to 19?0s and 90s. In the initial

years, the )ank closely collaborated ith the more active /#&I$ to force policy

changes. In fact, an unholy alliance of /#&I$, the )ank, the I and Trans-

national orporations +T(s orked hand in hand to pursue economic changes.

oever, after the ?0s, the )ank along ith the I has started a direct and

visible role in India:s policy making.J

I1RD-IDA Ne+' i# I#ia

Kears I)=$ I$&

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19@9-59 100 -

19D0-D9 >A A

19A0-A9 >0 ?0

19?0-?9 D> ?

1990-9 5 @?

4565-57 84 65

igures in

B

#ource7 The orld

)ank199@J

(evertheless, there has been continuity in the basic philosophy and ideology of the)ank over the past 50 years. The philosophy of diluting the basis of economic

planning, dismantling of public sector, encourage-ment to private sector +both

national and foreign, and greater emphasis to market forces has been forcefully

articulating by the )ank since 1950s. The )ank has been proceeding in a

methodically manner to force India to accept its philosophy.

The )ank created conditions so that the *lanning ommission as relegated

to the background in the late 19D0s. $uring the oil shocks of 19A and 19?0, the

)ank as able to push forard its ideology of market forces ith great impetus.

)y 1990, the entire economic environment as made conducive for foreign capital

to clay a leading role in tapping emerging markets of middle class consumers in

India. &nd the foreign e%change crisis of 1991 provided the opportunities to the

)ank to clinch this ob!ective through structural ad!ustment program. The past 50

years of )ank operations in India clearly reveals that the )ank has e%ploited the

foreign e%change crisis periods. #o far, India has faced five ma!or foreign

e%change crisis +195A, 19DD, 19A, 19?0, 1991. In each crisis period, the )ank did

not miss the opportunity to force its ideology on the government of India. In thefolloing paras, e ill understand in details ho did this happen.

9T/e 1a#3 .e$c%e t/e a!!a#"e%e#t t/at /ave ,ee# %ae t aciate

*!ei"# *i!% .it/ t/e c#t!'cti# a# &e!ati# * a $a!"e #'%,e! * %a!

'#e!ta3i#"; ,t/ i# &',$ic a# &!ivate ect!9

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The )ank as influential in India:s policy making right from the early years of

Independence. In 19@9, the )ank sent its first ission to survey the potentialities

of Indian economy. olloing this, *rime inister, 4aahar


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The 195D policy marked out the areas in hich private sector could e%pand in an

uninhibited manner.

#hortly thereafter, the (ehru government earnestly began to flout its on

industrial policy. or instance, of the 1A industries listed in #chedule & of theIndustrial *olicy =esolution, 8industries the future development of hich ill be

the e%clusive responsibility of the state +and in hich all ne units ill be set up

only by the state8, at least seven ere opened to (s through !oint ventures.

#chedule ) industries hich according to 195D Industrial *olicy, ere to be

progressively state-oned, 1> industries ere listed. 2ut of 1>, private sector set

up units in 9 industries.

R1I: -

The =eserve )ank of India is the main monetary authority of the country

and beside that the central bank acts as the bank of the national and state

governments. It formulates, implements and monitors the monetary policy as ell

as it has to ensure an ade'uate flo of credit to productive sectors. 2b!ectives are

maintaining price stability and ensuring ade'uate flo of credit to productive

sectors.

1a#3 Rate7 -

=)I lends to the commercial banks through its discount indo to help thebanks meet depositor;s demands and reserve re'uirements. The interest rate the=)I charges the banks for this purpose is called bank rate. If the =)I ants toincrease the li'uidity and money supply in the market, it ill decrease the bankrate and if it ants to reduce the li'uidity and money supply in the system, it illincrease the bank rate. &s of 5 ay, >011 the bank rate as DB.

Ca/ Ree!ve Rati(CRR)7-

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3very commercial bank has to keep certain minimum cash reserves ith=)I. =)I can vary this rate beteen B and 15B. =)I uses this tool to increase ordecrease the reserve re'uirement depending on hether it ants to affect adecrease or an increase in the money supply. &n increase in ash =eserve =atio+== ill make it mandatory on the part of the banks to hold a large proportion oftheir deposits in the form of deposits ith the =)I. This ill reduce the si"e oftheir deposits and they ill lend less. This ill in turn decrease the money supply.The current rate is DB.

Stat't!y Li


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4 Pa!t * t/e i#te!et !ate t!'ct'!e ie # %a$$ avi#" a# &!vie#t

*'#; a!e a%i#it!ative$y et

= 1a#3 a!e %a#at!i$y !e


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e%ercise became futile ith banks being over cautious of lending in highly shaky

market conditions. )anks invested almost A0B of this money to rather safe Eovt

securities than lending it to corporate.

ROLE OF DEFICIT FINANCING AS AN AID TO FINANCING

ECONOMIC DEELOPMENT

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$eficit financing has been resorted to during three different situations in

hich ob!ectives and impact of deficit financing are 'uite different. These three

situations are ar, depression and economic development.

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De*icit *i#a#ci#" '!i#" .a!

$eficit financing has its historical origin in lr finance. &t the time of ar,

almost every government has to spend more than its revenue receipts from ta%es

and borroings. Eovernment has to create ne money +printed notes or borroing

from the entral )ank in order to meet the re'uirements of ar finance. $eficit

financing during ar is alays inflationary because monetary incomes and demand

for consumption goods rise but usually there is shortage of supply of consumption

goods.

De*icit *i#a#ci#" '!i#" e&!ei#

The use of deficit financing during times of depression to boost the economy

got impetus during the great depression of the thirties. It as 6eynes ho

established a 3%positive role for deficit financing in industrial economy during the

period of, depression. It as advocated that during depression, government should

resort to construction of public orks herein purchasing poer ould go into the

hands of people and thereby demand ould be stimulated. This ill help in fuller

utili"ation of already e%isting but temporarily idle plants and machinery. $eficit

spending by the government during depression helps to start the stagnant heels of

productive machinery and thus promotes prosperity.

De*icit *i#a#ci#" a# ec#%ic eve$&%e#t

$eficit financing for development, like depression deficit financing,

provides stimulus to economic groth by financing investment, employment and

output in the economy. 2n the other hand 8development deficit financingA:

resembles 8ar deficit financing8 in its effect on the economy. )oth are

inflationary though the reasons for price rise in both the cases are 'uite different.

hen government resorts to deficit financing for development, large sums are

invested in basic heavy industries ith long gestation periods and in economic and

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social overheads. This leads to immediate rise in monetary incomes hile

production of consumption goods cannot be increased immediately ith the result

that prices go up. It is also called the inflationary ay of financing development.

oever, it helps rapid capital formation for economic development.

De*icit *i#a#ci#" a# i#*$ati#

$eficit financing in a developing country is inflationary hile it is not so in

an advanced country. In an advanced country the government resorts to deficit

financing for boosting up the economy. There is all-round unemployment of

resources hich can be employed by raising government investment through

deficit financing. The result ill be an increase in output, income and employment

and there is no danger of inflation. The increase in money supply leading to

demand brings about a corresponding increase in the supply of commodities and

hence there is no increase : in price level.

)ut, hen, in a developing economy, the government resorts to deficit

financing for financing economic development the effects of this on the economy

are 'uite different. *ublic outlays financed by nely-created money immediately

create monetary incomes and, due to lo standards of living and high marginal

propensity to consume in general, the demand for consumption of goods and

services increases. )ut if the public investment is on capital goods, then the

increased demand for the consumer goods ill not be satisfied and prices ill rise.

3ven if the outlay is on the production of consumption goods the prices may rise

because the monetary incomes ill rise immediately hile the production of

consumer goods ill take time and in the meanhile prices ill rise.

Though investment is being continuously raised +through ta%ation,

borroing and e%ternal assistance, most of it goes to industries ith long gestation

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period and for providing basic infrastructure. Though there is effective demand,

resource5 lie under or unemployed.


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/p till no, e have seen that deficit financing is inflationary and it destroys

its on purpose of aiding economic development. )ut it is not alays so. #econdly

inflation 1 not alays harmful for economic development. 2n the contrary, to a

certain e%tent inflation is conducive to economic development and hence deficit

financing is beneficial.

1. $uring the process of development, increase in national production is bound

to give rise to the demand for increased money supply for transactions.>. This can be met by in!ecting ne money in the economy through deficit

financing. If deficit financing is resorted to for productive purposes

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especially for the production of consumer goods and that too for 'uick

results then deficit financing is not that inflationary. or e%ample, if any land

reclamation activity is to be undertaken hich ould lead to agricultural

production, resort to deficit financing for this activity ill not be

inflationary.. 3ven if there is a moderate price increase of @ to 5B per annum, its impact

on the economy ill not be too severe. )esides, deficit financing ill not be

inflationary if it is matched by a balance of payment deficit.@. To the e%tent to hich past savings of foreign balances can be used to pay

for such imports, it ould be deflationary. )ut much reliance cannot be put

on balance of payments deficit because balance of payments deficit depends

on our foreign e%change reserves and our credlt orthiness in the orld

market.5. oreover, a developing country aims at reducing this deficit by increasing

e%ports and reducing imports.$eficit financing ill be non-inflationary if the

government is able to mop up the additional money incomes, created by

deficit financing, through ta%ation and saving schemes.

D. *roperly controlled and efficiently managed programme of deficit financing

may help the process of economic development. In fact a certain measure of

deficit financing is inevitable under planned economic development to

activate unutilised or dormant resources especially hen one of the

ob!ectives of planning is to step up the tempo of economic process.

Inflationary impact of deficit financing is helpful for economic development to acertain e%tent and under certain circumstances like 7

1. /nder developed countries, ith their lo incomes, lo or negative savings,

inade'uate investment and traditional resistance to change and

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moderni"ation, I ill remain stagnant or develop at an intolerably slo pace

unless they are restructured and activated. This can be done ith the

stimulus of inflation.>. Inflation stimulates economic activities and rising prices induce more :

investments. In a developing economy the ma!or goal is rapid economic

development through speedy capital formation. The additional income that is

earned through inflation can be ploughed back and if the same process is

repeated there is every possibility of a rapid rate of capital formation in the

country. or this, inflation may be tolerated to a certain e%tent.. Inflation is said to be a useful method of increasing saving in a forced ay.

There ill be redistribution ithin the private sector of the economy, from

the personal sector to corporate sector. Inflation reduces real consumption

and provides resources for investment purposes.@. Thus, deficit financing is a necessary and positive instrument to accelerate

the rate of economic groth in countries suffering from acute shortage of

capital. )ut any deficit financing has to be undertaken in the conte%t of an

efficient and ell e%ecuted plan for economic development.

LIMITATIONS OF DEFICIT FINANCING

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$eficit financing +as e have e%amined up till no can be regarded as a

necessary evil hich has to be tolerated, at least in the developing economies, only

to the e%tent it can promote capital formation and economic development. This

e%tent of tolerance is called the safe limit of deficit financing. This safe limit shos

the amount of deficit financing that the economy can absorb and beyond hich

inflationary forces may be set in motion. Though it is not possible to 'uantify it,

yet it is desirable to identify the factors that affect it.

actors that affect deficit financing can be put under to categories7

a) Fact! !e$ate t e%a# *! %#ey a#

,) Fact! !e$ate t '&&$y * %#ey

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1. If the demand for money is lo in the economy, the safe limit of deficit

financing ill be lo.>. Then creation of ne money or deficit financing must be kept at a lo level

otherise evil conse'uences ill follo.. =everse ill be the case hen demand for money is high. 2n the supply side

of money, if due to some factors the supply of money or purchasing poer

ith the public increases, other things being e'ual, it ill have an

inflationary tendency and the safe limit of deficit financing ill be lo.

oever, safe limit ill be high in the opposite situation.@. The concept of :safe limit: of deficit financing can be reduced to the age old

theory of demand and supply.5. T/e &i#t at ./ic/ e%a# *! a# '&&$y * %#ey a!e e


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financing ill be loer than if the nely created money is to be used for

industrial development or for intensive farming.. If the foreign e%change reserves are increasing the scope of using deficit

financing ill increase because that ay the country ill be able to import

more goods hich ill have deflationary effect.@. Time lag beteen the initial investment and the flo of final products also

determines the safe limit of deficit financing. If this time lag is long, then

inflation ill set in from the very initial stage of investment and it ill not be

possible to control the rapidly rising prices.5.


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1>.This safe limit of deficit financing ill be different for different countries

because conditions vary from country to country.1.The safe limit of deficit financing also depends on the measure of popular

cooperation hich the government gets and the illingness of the people to

submit to [email protected] if this limit is calculated, it ill go on changing ith every change in the

economic conditions of the country. ith efforts in the right direction this

limit can be shifted upards so that a larger amount of deficit financingN can

be resorted to by a government hich is conducive to economic development

and not inflation.

CAUSES OF DEFICIT FINANCING IN INDIA

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& situation in hich outflo of money e%ceeds inflo. That is, a deficit

occurs hen a government, company, or individual spends more than heHsheHit

receives in a given period of time, usually a year. 2ne:s deficit adds to one:s debt,

and, therefore, many analysts believe that deficits are unsustainable over the long-

term. #ee also7 #urplus.

The government is committed to socio-economic responsibilities for

breaking the vicious circle of poverty and uplifting the economic conditions of the

masses and developing the economy into a self-reliant one. In 1950, it as thought

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that these ob!ectives could be achieved through the process of planned economic

development. Throughout the period of planned economic development in the

country one basic problem has been that of mobili"ation of resources.

1. #ources of financing economic development are broadly divided into

domestic and foreign sources.>. $omestic sources of finance at the disposal of the government consist of

ta%ation, public borroing, and government savings hich include surpluses

of public enterprises and deficit financing.. The foreign finances consist of loans, grants and private investments. &ll

these sources of finance have their social costs and benefits on the basis of

hich an upper limit can be determined for the use of any one method of

financing development.@. #ince the financial re'uirements of development are enormous and all

various sources have their on limitations, it becomes almost essential to

make use of all the sources as far as possible.5. The choice is not beteen hich one is to be used but beteen the various

combinations of using all of them. Thus both the domestic and foreign

sources of finance have their on place and importance in a developing

country.D. It is essential to formulate appropriate policies for different sources of

finance and successful implementation of these policies is re'uired for

achieving the desired ob!ectives of rapid economic development.A. Ta%ation is an old source of government revenue. (ot only that, it is also

regarded as the most desirable method of financing public investment in

developing countries.?. )ut it is a ell knon fact that ta%ation has a narro coverage in developing

countries and the ta% revenue national income ratio is not only lo but the

increase in this ratio is also very slo during the process of development.

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1A.)ut the problem before the country is to choose beteen the to evils i.e. to

adopt deficit financing for capital formation and face inflation or to go

ithout development programmes due to paucity of funds.

In this unit e ill discuss the meaning of deficit financing and its role as an

aid to financing economic development. e shall also highlight the relationship

beteen deficit financing and inflation and its impact on price behaviour in

India. The advantages and limitations of deficit financing are also dealt ith.

IMPACT OF DEFICIT FINANCING IN INDIA

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*rice stability is an essential condition for stability in economic life as ell

as economic groth. 2n the contrary, fluctuations in prices create an atmosphere of

uncertainty hich is not conducive to development activity. hen e e%amine the

price movements during the planning period in India, there are three clear trends.

irst during the first plan period +i.e. 1951 to 195D the general price level

had fallen. rom 1955-5D to 19D5-DD. the prices rose steadily at an annual rate of

DB. inally. from 19DD-DA onards +e%cept 19A5-AD and 19AA-A? prices rose at

the rate of about 0% per annum and no it is in the double digit range. $eficit

financing as a tool for covering the financial gap in India as introduced at the

time of formulation of first five year plan. $uring the first plan deficit financing

as of the order of =s. crore and the money supply ith the public increased

by about >> per cent. #ince this e%pansion in the supply of money fell short of the

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increase in output, the general price level came don by about 1? per cent. $uring

second plan. actual deficit financing as less than the targeted amount, The third

plan as very abnormal +adverse eather conditions. 19D> hineseN aggression.

19D5 *akistan ar. $eficit financing during the third plan amounted to =s. 1

crore - more than double the target. oney supply ith the public

increased more rapidly.

In the fourth plan +19D9-A1, the amount of deficit financing stood at =s.

>0D0 crore -about to-and-a-half times the target. oney supply increased from

D?A crore to =s. 11,1A> crore at the end of 19A-A@. *rices increased by @AB

appro%imately. (o doubt there ere certain factors beyond the control of the

government such as ar ith *akistan in 19A1, substantial e%penditure on account

of )angladesh refugees, oil price hike etc. )esides, the reluctance on the part of the

states to mobili"e ade'uate resources, their general financial indiscipline and

overdrafts from the =eserve )ank also compelled the government to take resort to

deficit financing. 111 vie of severe inflationary pressures in the economy since

19A>-A. the draft fifth plan 19A@-A9 laid utmost stress on non-inflationary

methods of financing. )ut, as against the target of =s. 15@ crore for the fifth five

year plan, the actual amount of deficit financing as much more. $uring this

period, although the money supply increased by about 50 per cent, the overall

increase in holesale prices as B because of the imposition of emergency in

19A5 resulting in comfortable position in regard to the availability of sever7Ol

commodities through the effective management of supplies.

$uring the si%th plan +19?0-?.5 deficit financing as of the order of =s.

15.D?1 crore as against the estimated target of =s. 5000 crore. $uring this period

money supply increased from =s. >,11A crore-in 19?0-?1 to =s. 9,?0 crore in

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19?@-?5. #eventh plan paper indicated a cautious approach toards deficit

financing and stated that 8The re'uired resources have to be mobilised in a manner

hich minimi"e dependence on e%ternal sources or on deficit financing hich has

a high inflationary potential.8 #till the target for deficit financing as placed at =s,

l1,22/ crore and according to the latest estimates the actual deficit financing has

been of the order of =s. @,1?> crore i.e. more than >.@ times the target. oney

supply ith the public has increased from =s. @.599 crore in 19?5-?D to =s.

AD.>59 crore in 19??-?9 and inde% of..holesale prices has gone up from 5A.? to

@5.? during the same period. There ere many other factors like mismanagement

of the ar economy. 3%cessive dependence on monsoon, poer shortage, labour

strikes, increase in the rates of commodity ta%ation, rise in age rates, black

money, rise in the international price of petroleum products hich have been

responsible for price rise in India. oever, e%perience shos that the increase in

money supply has led to a rise in prices. There has been a close relationship

beteen the rate of increase in prices and the rate of groth in money supply and

prices have a tendency to rise to ne heights at every successive increase in money

supply resulting from deficit financing.

hen deficit financing is inflationary, it ill go against the very purpose for

hich it is used because it ill simply lead to continuous inflation and no

development. Inflation creates uncertainty, labour unrest, ork stoppages and

decline in production because of the demand for higher ages and salaries to

compensate for higher cost of living. Inflation reduces the real income and the real

consumption of all classes of people in the society e%cept the rich. This is

ob!ectionable on grounds of economic efficiency, labour productivity and social

!ustice. oreover, there is no certainty that higher levels of income accruing to

profit earners ill be invested in1 productive enterprises, for the rich may aste

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indfall gains in conspicuous consumption or indulge in speculative activities.

)esides, inflation is a sort of invisible ta% on all incomes and cash balances. Their

value is automatically reduced ith every rise in prices. Inflation leads to balance

of payments difficulties because due to rising prices the country loses e%port

market and people prefer imported goods. hich appear cheaper as compared to

domestic goods.

Inflation is charged ith distorting the pattern of investment and production

in the economy. Inflation is beset ith the danger of channeli"ing economic

resources into less urgent and speculative fields here the scope for profits to

private enterprises is Illore and such fields are generally of little importance to the

nation. Inflationary deficit financing increases the administrative e%penditure of

the government because henever government resorts to large doses of deficit

financing, it has to neutrali"e its effects by sanctioning ne dearness alloances,

revision of controlled prices. $istribution of essentials through fair price shops,

compulsory re'uisition of foodstuffs etc. &ll these measures lead to an increase in

the administrative burden of the government in order to ard off inflation caused

by the use of deficit financing.

59 3conomic researches over the years have shon that deficit financing

results in a number of economic conse'uences, particularly for economic groth

and development. &lso numerous macro-economic aggregates are affected in the

process of deficit financing. or instance, interest rates, e%change rates, money

supply, public debt, etc have conse'uences and burdens on both the present and

future generation and determination of payment position-8. 3conomic studies have

also found a high degree of linkage beteen deficit financing and inflation. The

6eynesian analysis ascribes inflation to be the result of e%cess of aggregate

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e%penditure over national income at flill employment level. The aim of this paper

is to consider the inflationary effect of deficit financing in India and ascertain the

measures that are put in place by government to eradicate the negative impact of

deficit financing in India.

The ork covers the period beteen 19?0 and >005 as this period as

e%posed to an analytical revie of deficit financing in Indian and reveals different

changes in deficit budget in Indian fiscal operations. The paper ansers several

similar 'uestions, hich are related to deficit financing in India and its possible

inflationary impact on the economy. It is intended that this report ould benefit

policy makers and other government and non-government bodies ho ould be

concerned about inflation and deficit financing as the report brings to light the

revelation and causative effects of deficit financing in India. oncept of $eficit

inancing & budget deficit can be defined as the situation that arises hen

government e%penditure is greater than estimated government revenue +usually

from ta%ation and charges for government service. The main concern ith budget

deficit is its financing aspect. If borroing from the private sector finances

government deficit, it is !ust a reali"ation of resources in the economy. The

government can also finance its fiscal deficit either by raising additional ta% or it

may incur debts. This form generally is the least e%pansionary, but due to the

problem encountered in generating more revenue from ta%ation in India, the

government usually resorts to creating debt, hich is inflationary. The debt can be

incurred domestically or e%tremely.

The portfolio of the domestic debt in India consists of government

securitiesC treasury bills, treasury bonds, and development stocks. The development

of budget deficit in India started in the early 19D0s. *rior to the 19D0s, the public

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e%penditure as generally more, so the available resources ere able to sustain

government outlays because of the impressive agricultural performance in the

country. oever, misallocation of the resources to finance e%penditure

programme in India made government to resort to deficit financing hich seems to

have become a regular characteristic of government budgeting policy. &lthough

constant efforts ere put in place by Indian government recently, yet the issue of

deficit funding remains unsolved. or e%ample, inflation rate as released by

ederal 2ffice of #tatistics in 199 as 1?.9 per cent but this reduced to 1>.9 per

cent in >00>. This shos that the trend of inflationary impact on deficit financing

in India is fluctuating in nature.

$eficit financing is the most useful method of promoting economic

development in developing countries. urther that due to the nature of developing

economies characteri"ed by insufficient private investment resulting in various

social economic and institutional factors, the responsibility of augmenting the rate

of net investment results to deficit financing. $ay also argued that government

could engage in incurring deficit in order to ac'uire assets, attain the aim of

development of economic and social overhead and maintaining full employment

by running a budget deficit. This is a universal phenomenon that is peculiar to

every government in the orld. It is the act of spending more than one:s income.

This also refers to the act of government making up for e%cess of e%penditure over

revenue. &ccording to #ergeant and allaceP it means any public e%penditure that

is in e%cess of current public revenue. In broad terms deficit financing can be seen

as a net increase in the amount of money in circulation here such an increase

results from a conscious government policy designed to encourage economic

activities hich ould otherise not have taken place. #uch activities may be for

economic developments and other ob!ectives.

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$eficit financing amounts to domestic credit creation that is not offset by

increase in ta%ation, more restriction in bank credit policy, and similar deflationary

measures. The government may cover the deficit either by raining don its

accumulated balances +reserves or by borroing from the banking sector. There

are to ays of to close the gap created by budget deficit. The financing can be

made either through internal sources or e%treme sources.

$eficit financing through these sources include7 -

+i M#ey c!eati# ! &!i#ti#" * #e. %#ey7 -The printing of ne money to close

deficit financing +budget is the most regrettable effort made by the

government to raise money. It is not contractionC neither does it give rise to

interest charges or problems arising from servicing and retirement of debts.

This is also referred to as borroing from the central bank,

+ii 1!!.i#" *!% c%%e!cia$ a# %e!c/a#t ,a#3 i#v$vi#" t/e

&'!c/ae * "ve!#%e#t ec'!itie ,y ,a#37 -

)orroing from the non-bank public,

government securities available for purchasing include treasury bills,

treasury certificates, $evelopment #tock, Treasury )onds. &part from the

above listed ays of financing deficit, some economists like &nyanuadd

the sale of assets, privati"ation of public enterprises, and delaying debt

service payment. oncept of Inflation can be defined as a sharp and

persistent rise in the general price of goods and services characteri"ed byprevalent increases in the prices generally and not !ust a temporary

fluctuation. Inflation is one of the most crucial macro-economic problems

facing most countries of the orld especially the underdeveloped countries.

#ome of its adverse effects include decreasing purchasing poer of the

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country:s currency, creating unemployment, uneven distribution of income,

and conse'uently makes money loose its function as a store of value.

Inflation also causes uncertainty about future prices. This affects decisions

on e%penditures, savings and investment, and misallocation of resources.

our ma!or factors have been identified as the causes of inflation in India,

namely money supply, nature of government spendingHe%penditure, e%change rate

and price earnings product:. Inflationary pressures as reflected in persistently

rising prices have been an issue of concern in India in recent years particularly

since the adoption of the IH orld )ank #upported #tructural &d!ustment

programme +#&* in 19?D. & broadly defined inflation as basically a

dise'uilibrium phenomenon arising largely from an imbalance beteen an

economy:s spending poer and the availability to its supplies +represented by the

sum of its productive capacity and its import. To him, such underlying

dise'uilibria set in motion a process of sustained rise in money income and

general prices. &ntibody as of the opinion that social conse'uences of inflation

have been regarded as serious threat of effort of nation building and social

harmony in a young social economic system.

e stated further that inflation has negative impact on decision about

consumption, investment and savings of the people in an economy. There are

various ays of financing inflationary impact including Q money creation and

printing of ne money, Q borroing from the non-)ank *ublic, Q inancing

deficit from e%treme sources, Q borroing from $eposit oney )ank. If bankshave e%cess reserves, they can absorb an amount of government stocks and

securities considerably greater than the e%cess reserves ithout curtailing other

loans, so that credit given and the money supply possibly act to increase the price

level prevailing in the economy.

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There have been various studies that e%amine the possibility of a causal

relationship beteen deficit financing and the general price level. hile most of

these studies indicate fuelling inflation, a fe others found no evidence to

confirm that deficit financing is a ma!or cause of inflation. )ailey considered

deficit financing as an inherent force that has either negative or positive effects. It

is said further that deficit financing increases the general level of prices and

reduces the real value of the monetary unit. The 6eynesian vie on deficit

financing is also identical to the classical theory hich is a reduction in private

capital formation, increased interest rates and consumption thereby leading to

inflation if not accompanied by reduction in money stock.

&ccording to arrison, there is a causal link beteen deficit financing and

inflation through credit creation by the banking system. In his study on

government spending and inflation.


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does not e%pand as rapidly as aggregate demand due to the e%istence of

bottlenecks and rigidities. hether prices ill rise in response of output to

demand stimulus and the e%tent of the price increase depends on the response of

output to that stimulus. In a developing country like India here production

capacity is lo, output respond to demand stimulus is very lo. *attern of

Eovernment =evenue and 3%penditure in India The pattern of financing

government deficits has a ma!or effect on the economy. )oth the pattern and

structure of government revenue and e%penditure have impacted on the level of

government deficit. The trend in the economy arose primarily from the discovery

of petroleum, hich since the early 19A0s has been the ma!or source of

government revenue. &griculture had its significance as the ma!or source of

resources in terms of its share in employment and before the oil sector became

the dominant force in the Indian economy, the economy as able to ithstand

sudden fluctuations in economic ealth. The boom in the oil sector increased

government revenue substantially and gave the government the opportunity to

increase its e%penditure at ill. The government embarked on a number of

ambitious pro!ects and programmes. The government as able to e%pand the

economy through the different pro!ects and programmes initiated at that period.

any of the programmes and pro!ects engaged in ere ild pro!ects, hich

could be said to be unreliable and unproductive. The paten of policies made by

the government then led to the e%posure of the economy to e%ternal shocks

resulting in the distortion to the economy.

$uring this period, the government also relied heavily on the oil sector

leading to partial neglect of the other sectors for revenue generation to the

economy. The substantial revenue from the oil boom made the government to

embark on e%pansionary pro!ects ithout a measurable indicator to sho the

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adverse effects. $ue to the significance of the oil sector in India, hat happened

to oil receipts ere transmitted immediately to the fiscal operations of the federal

government. &lso, because most of the revenue accruing to the government as

generated from the oil sector, the glut in the orld oil market, hich began in

19?1 led to loss in oil revenue in India. $uring this period, there as also a

decline in the groth rate of E$* and deficit in balance of payment. In other

ords, there as a collapse in the oil market and the resulting short fall in

government revenue, yet government e%penditure continued to rise as the

government did not make any effort to streamline e%penditure ith revenue

inflo.

&s the government financing position deteriorated rapidly, the government

as unable to finance its programmes and due to the underdevelopment of the

financial market, it became increasingly necessary for the government to resort to

deficit financing by borroing from the domestic banking system and draing on

e%ternal reserves. The government resorted to deficit financing to fill the deficit

gap ith the hope of offsetting the impact of dindling oil revenue. The increase

in government deficit reflected the e'uilibrium beteen government revenue and

e%penditure. oever, ith the government e%penditure maintaining its level in

the face of government revenue dontimes, the deficit idened. Ruantity Theory

of oney The 'uantity theory of money relates to the level of an economy in

terms of 'uantity price or commodity price to 'uantity of money in the economy

and the level of its commodity production.

In other ords, it indicates that the general price level is directly

proportional to the 'uantity of money in circulation. This is given as MS*K +I

here K S 2utput, M S Melocity of circulation, * S Eeneral price level and S

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oney supply. M and K are assumed to be constant. The only reason hy people

hold money balances is to finance day-to-day transactions and any additional

balances are immediately used for purchases. rom the e'uation above *MM S -

+II this shos that for any given value of there is one

IMPACT OF DEFICIT FINANCING ON 1ANKING

OPERATION

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In the early years of planning, there as consensus among India:s

policymakers about the need for deficit financing as a means of plugging the gap

beteen ambitious investment plans and the lo levels of savings in an

underdeveloped economy. Indian planners ere not unaare of the dangers of the

inflation hich might result. )ut ith large foreign e%change reserves, they ere

confident of the government:s ability to manage the supply-side of the economy.

This consensus as also largely echoed by the International onetary und

mission headed by 3dard )ernstein hich came to India in 195 at the invitation

of the government.

or much of the 1950s, the )ank as part of this consensus. &lthough the

impact of deficit financing on prices had aroused concern already in 195 1-5>,

price stability did not return as a ma!or cause of orry at the )ank until the mid-

fifties. )esides, the )ank recogni"ed the need for any plan to go beyond hat

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available resources dictated, even if some part of the additional investment had to

be financed through additions to money supply. Ironically despite the first plan

document highlighting the important role of the central bank, the =eserve )ank

also took a rather modest and self-effacing vie about its on part in the planning

process during these years, insisting that hile it as entitled to be consulted by

the government regarding the dimensions of the plan effort, the final decisions

rested ith the latter. The monetary policy authorities: ere, conse'uently, content

to :function ithin the limitations created by the effort to carry out the plans:.

The =eserve )ank of India as not given sufficient time to consider the first

five-year plan, the plan document arriving in )ombay only toards the close of

2ctober 195>. &ny contribution the )ank made to the first plan document appears

to have been cosmetic, rather than substantial, ith the Eovernor, ). =ama =au,

for instance, choosing merely to ob!ect to the plan document:s suggestion that :real

democracy: implied the :e'uality of incomes:. hile the intervening years may

have revealed the )ank:s earlier fears about : In keeping ith the definition in

vogue at the time, :money supply: in this volume refers to :narro money: +I,

comprising currency in circulation and demand deposits. Inflation to be

e%aggerated, concern about prices resurfaced toards the end of 1955, though

more in the conte%t of the second plan:s priorities than its financing proposals.

ommenting on the former, =arna =au cautioned the inance inistry that the

public investment envisaged in the plan ould lead to e%cess demand for consumer

goods, and to :serious inflationary pressures:.

Though not seemingly ithin the )ank:s remit, =ama =au added, it as his duty to

bring these dangers to the government:s attention since the )ank as :partly, if not

mainly, responsible for applying appropriate remedies to curb inflation:.

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The )ank:s entral )oard of $irectors as given an opportunity to reflect

on the draft documents of the second plan in 4anuary 195D. #everal members of the

)oard ere apprehensive that the financing re'uirements of so large an investment

programme ith a planned public sector outlay of =s @,?00 crores ould involve

substantial recourse to the )ank and generate inflationary pressures. #imilar vies

had been voiced earlier during the 3conomists: *anel:s rather cursory discussions

of the second plan, among others by $.=. Eadgil, a $irector of the entral )oard

and ).6. adan, 3conomic &dviser at the )ank. The )ank:s Annual Report for

1955-5D emphasi"ed the need for financial stability promoted by a :!udicious mi%:

of monetary and fiscal policies and arned against taking too sanguine a vie

based on recent e%perience, of the pressure that the stepped up plan effort and the

manner of financing it as likely to e%ert on prices. This already marked a

departure from the more hopeful vie the publication had taken a year earlier.

)ut the )ank also persisted in its belief that no government sensitive to the

elfare of the people and, one may add, having at regular intervals to rene its

popular mandate, ould go very far don the path of inflation. ence the vie

prevailed that :calculated risks: in regard to inflation ere !ustified and that

development plans should not be sacrificed to allay fears on the price front unless

stabili"ation ere to prove impossible. There ere several reasons hy the )ank:s

overall attitude toards deficit financing during this period as nuanced and

pragmatic, rather than doctrinaire. #ome of these emerged clearly in the course of

the visit to )ombay in ebruary 195? of *er 4acobson, the anaging $irector of

the I. The latter:s discussions at the )ank revealed that hile not

altogether unsympathetic toards India:s development problems and efforts, he

as sceptical about the policy of deficit financing and doubtful that it ould give

the government any substantial command over additional real resources for

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investment. oming at the end of nearly to stressful Kears of the second plan, *er

4acobsson:s plea for monetary stability ould not have failed to strike a responsive

chord in )ombay. )ut placed as it so often as in the position of a credible

protagonist of the government:s vies to the und and an interpreter of those of its

interlocutors to the authorities in (e $elhi, the )ank used three arguments to

e%plain to the visitor hy the level of deficit financing envisaged in the second

plan as unlikely to affect prices as severely as feared, or unduly e%pand money

supply.

The second plan provided for net reserve losses of =s >00 crores over five

years to finance part of a payments deficit :planned: ith the ob!ect of transferring

real resources to India from the rest of the orld. +The remainder as e%pected to

be covered by capital inflos and e%ternal assistance.: ence, the )ank:s credit to

the government sector ould not translate directly into an increase in money

supply but ould be moderated by changes in the country:s foreign e%change

reserves. #econdly, the process of moneti"ation hich as reserve losses during

the first year of the second plan ere larger than plan estimates for the entire five-

year period. )ut the )ank and the government continued at this time to maintain,

in public, the validity of the second plan:s assumptions. ontinuously under ay in

the economy could be e%pected to accelerate as a result of the development effort

and lead to changes in the income velocity of money.: inally, there as the

prospect of rising incomes and standards of living. )oth these factors ere likely,

in the first instance, to increase the public:s demand for cash balances. $eclining

reserves and rising cash balances ith the public could, the )ank argued, be

e%pected greatly to moderate the inflationary potential of the government:s

budgetary outlays during the second

plan.

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In !udging the effects of deficit financing on the economy, the )ank as also

disposed to consider a number of other factors some of hich in turn, helped

determine the range of monetary policy instruments deployed to stabili"e prices.

or e%ample it regarded the availability of age goods, chiefly food grains, as a

ma!or influence upon the e%tent to hich any given level of deficit financing or

public investment affected domestic prices. Eenerally speaking, the )ank also

e%pected the relatively small role played by bank money in overall money supply

and the substantial leakages of currency from the banking system to mitigate the

inflationary impact of the e%pansion of its credit to the government. )riefly in the

mid-fifties, the )ank apprehended rapid deposit groth eakening its control over

the commercial banks: credit mechanism, and armed itself ith poers to regulate

it.

These poers ere even used tice in 19D0. )ut throughout these years,

currency formed about to-thirds or more of money supply and the )ank:s

!udgment as, on the hole, that the potential for multiple credit creation as

realistically still 'uite limited for any given level of base money. The )ank:s efforts

to persuade *er 4acobsson that deficit financing in India as not beyond the limits

of prudence ere not entirely unavailing. Though his :basic ideas: did not change

very much, *er 4acobsson appears to have recogni"ed that his early reactions ere

based on :first hurried impressions: and that the issue shoed itself, on closer

e%amination, to be :not 'uite so simple:. )ut ithin the )ank itself, a sense of

unease had long been palpable.

&s the volume of deficit financing gre during 195D-5? and the price and

e%ternal payments environments deteriorated, the )ank gre progressively more

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vocal in e%pressing its vies that deficit financing should be kept ithin

manageable limits, and that plan e%ercises should bear a closer : =eaders may note

that as used in these chapters, the term :moneti"ation: lends itself to to meanings.

irstly, it refers, as in this instance, to the process by hich the so-called non-

moneti"ed sector is brought into the :moneti"ed: sector of the economy. 3lsehere

in these pages, the term is also used in the more contemporary sense to represent

the monetary effects of deficit financing relation to the availability of real

investible resources in the economy and to the ability of the government to

mobili"e them.

The =eserve )ank of India:s understanding of inflation during much of our

period as more structurali"e than monetarist in the narro sense of the term.

2fficials at the )ank ere sensitive to a number of structural factors hich, in the

short and medium term, mediated the relationship beteen e%planatory variables

such as public e%penditure, change in the government:s indebtedness to the

=eserve )ank, and changes in money supply on the one hand, and the rate of

inflation on the other. The arguments the )ank brought up in its discussions ith

*er 4acobsson, though intended merely to highlight some characteristics of the

Indian monetary system, already had a structurali"e ring to them. 2ther

considerations hich the )ank understood to influence the price outcome of any

given policy included changing income distribution and the availability of foreign

e%change, the latter not being vieed as solely a monetary variable. )ut by far the

most important of such factors ere bottlenecks in the age goods, intermediate

goods, and infrastructure sectors, an influential )ank study citing discontinuities in

the :aggregate supply function ... due toJ structural rigidities: as a feature affecting

the impact of monetary policy in a developing economy such as Indi a :O.InO

keeping ith this line of :structuralist thinking:, the )ank believed that hile

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monetary policy orked to :dampen the pressures originating on the side of

demand: to the e%tent the latter e%ceeded supply, it could not by itself ... be

e%pected to restore balance in prices hen the underlying trends make for increase

either due to forces on the supply side or due to the impact of other factors such as

fiscal deficits operating on demand.

The above diagnosis yielded a prescription hich underlined the

complementarily beteen fiscal and monetary measures even to curb inflationary

tendencies. )ut the )ank as also usually at pains to emphasi"e longer-term

measures hich ould give the country:s economic managers greater physical

control over the functioning of key markets such as those for food grains. Thus,

despite harbouring some reservations about the inflationary impact of buffer-stock

financing, the =eserve )ank as generally supportive, particularly as some of the

ider structural constraints began discernibly to affect the economic environment,

of policies to guarantee minimum prices to cultivators and maintain buffer stocks

of the most important age good-food grains. Inevitably, the )ank:s structuralist,

rather than narroly monetarist, perspective influenced the formulation and

e%ecution of its monetary policies. It might also be said to have had important

longer-run conse'uences for the structure of the Indian financial system. 2n the

one hand, policy could never be indifferent to hat might be regarded as the

genuine needs of the productive sectors of the economy. Thus hile credit hich

might fuel speculation in essential commodities might have to be s'uee"ed, the

needs of the infrastructure sectors or the demand for credit to build a buffer stock

of food grains could not for instance be overlooked even in an environment

otherise characteri"ed by monetary tightness. This meant in turn considerable

fle%ibility in the deployment of the traditional instruments of monetary policy, and

some innovation in the development of ne ones. Instruments hich orked in a

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generali"ed ay, such as the )ank rate, ere sometimes vieed ith reservation

because they ere feared to :discourage developmental activity in the private

sector, loer the prices of Eovernment securities and therefore raise the cost of

future Eovernment borroings:. ar better in the circumstances to deploy selective

instruments hich favoured borroing for essential purposes and penali"ed

borroing for non-essential or speculative ones

Mies such as these ere already present both ithin the )ank and outside

from the early 1950s. or e%ample, as pointed out earlier, even the otherise

modest first plan document had ambitious e%pectations from the central bank of a

planned economy. The central bank, the plan document affirmed, could not confine

itself merely to a :negative regulation: of the :overall supply of credit:, but should

instead direct it into the desired channels. $espite high rates of inflation in the

intervening years, this vie of the role of central banking as reinforced as the

country came face to face ith a daunting set of simultaneous economic and

military challenges during the 19D0s. The underlying logic and the actions floing

from it culminated in the policy of directed credit and interest rate regulation

hich, for better or for orse, became important features of the Indian financial

system for over three decades thereafter.

MEASURES TO CONTROL DEFICIT FINANCING

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)esides open deficit financing undertaken by the government, there is

concealed deficit financing in developing economies. In all governmentdepartments, in a developing country most of the e%penditure is incurred recklessly

in the last fe eeks of the financial year so that the amount sanctioned may not

lapse. This reckless e%penditure is largely a aste and is not accompanied by

e%pected results. This e%penditure is fairly large every year. It is not productive and

it leads to price rise and operates in the economy in a manner similar to deficit

financing. ost of the havoc created in the economy is actually created by this

concealed deficit financing. If, by efficient and honest administrative, this vast

asteful e%penditure can be avoided, the officially acknoledged deficit financing

ill not be so inflationary. &nti-social acts such as evasion of ta%es, black

marketing, cash transactions to supplement recorded che'ue transactions, under

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invoicing and over invoicing of e%port and imports, and a variety of such forms of

corruption on the part of the private parties lead to large volume of :unaccounted

money:. This money is to be spent recklessly and it leads to inflationary rise in

prices. Eovernment must try to remove reckless e%penditure in public and private

sectors caused by :concealed deficit financing: and :unrecorded gains: instead of

stopping the use of deficit financing hich is likely to be spent productively and

therefore help in the economic development of the country.

In order to minimi"e the inflationary effects of deficit financing during the process

of development the government ill have to keep a vigilant and constant atch on

changing economic situations, study the repercussions of measures adopted in

several spheres and, above all, take effective action on folloing lines 7

1. Eovernment should try to drain off a larger proportion of funds resulting from

deficit financing through saving campaign and higher ta%ation.>. The policy of deficit financing should be adopted as a last resort, after

e%hausting all other possible sources of development finance.. Investment should be channeled into those areas here capital output ratio is

lo so that returns are 'uick and price rise is not provoked.@. &long ith deficit financing, government should adopt policies of physical

controls like price control and rationing etc.5. Import policy should allo import of necessary capital e'uipment for

economic development and consumer goods re'uired by the masses alone.

Import of lu%ury and semi-lu%ury goods should be discouraged.D. $eficit financing and credit creation policies should be integrated in such a

ay that neither of the to sectors +public or private is handicapped due to

shortage of financial resources and, at the same time, inflation is also kept in

check in the economy.

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&bove all these policies, hat is more re'uired is that the government should

try to seek full public cooperation and people should have full faith in the policies

of the government so that government policies can be successfully implemented.

$eficit financing or no deficit financing, the process of economic development

itself is inflationary. henever ne investment is financed by ta%ation or

borroing, the result is an increase in monetary incomes, increase in demand for

consumption goods, and price rise. ith this background the important 'uestion, in

a developing country, is not hether deficit financing should be resorted to or not

for economic development, but, rather, ho far inflation can be pushed ithout

upsetting the productive process. Thus deficit financing is a necessary and positive

instrument to accelerate the rate of economic groth in countries suffering from

acute shortage of the capital, though it is necessary to emphasi"e here that it must

be undertaken ith an efficient and ell e%ecuted plan for economic development.

CONCLUSION

$eficit financing as a method of resource mobili"ation has assumed an

important place in public finance in recent times. It refers to the means of financing

the deliberate e%cess of e%penditure over income through printing of currency

notes or b through borroing. In this unit, e have discussed the meaning of

deficit financing, its role as an aid to financing economic development in various

situations. $eficit financing in a developing country becomes inflationary and it

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has varied effects on economic development hich have been highlighted in the

unit. e have also e%amined the impact of deficit financing on price behaviour in

India during the plan period. It shos that, apart from other factors, there has been

a close relationship beteen rate of groth of money supply resulting from deficit

financing and rate of increase in prices.

)ut to a certain reasonable e%tent, deficit financing has proved to be

conducive to economic development, especially in countries ith acute shortage of

capital. The advantages of deficit financing in this conte%t have been dealt ith in

the unit. &s e have discussed in the unit deficit financing in developing

economies can be regarded as a necessary evil hich can be tolerated only to the

e%tent it promotes capital formation and economic development. This e%tent of

tolerance is knon as safe limit of deficit financing. To minimi"e the inflationary

effects of deficit financing during the process of development, certain measures

have to be taken like proper channeli"ing of investment in areas ith lo capital

output ratio, adoption of policies of physical control like rationing, import of only

necessary capital e'uipment etc. In economies ith lo capital formation, deficitfinancing becomes a necessary and positive instrument if used ith efficient and

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