Deficit Financing

Deficit 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 was thought
that these objectives 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 mobilization of resources.
Sources of financing economic development are broadly divided into
domestic and foreign sources. Domestic sources of finance at the disposal of the
government consist of taxation, public borrowing, and government savings which
include surpluses of public enterprises and deficit financing. The foreign finances
consist of loans, grants and private investments. All these sources of finance have
their social costs and benefits on the basis of which an upper limit can be
determined for the use of any one method of financing development. Since the
financial requirements of development are enormous and all various sources have
their own limitations, it becomes almost essential to make use of all the sources as
far as possible. The choice is not between which one is to be used but between the
various combinations of using all of them. Thus both the domestic and foreign
sources of finance have their own 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 required for achieving the desired
objectives of rapid economic development.
Taxation is an old source of government revenue. Not only that, it is also

regarded as the most desirable method of financing public investment in
developing countries. But it is a well known fact that taxation has a narrow
coverage in developing countries and the tax revenue national income ratio is not
only low but the increase in this ratio is also very slow during the process of
development. Public borrowing is considered a better method of collecting public
revenue taxation (on the one hand government will get sources for development
programmes and, on the other, conspicuous consumption will be reduced). But it
cannot substitute taxation completely because there are certain limitations to the
use of this source of financing development. Firstly public borrowing depends on
the credit worthiness of the government. Secondly, people do not want to lend to
the government because the rates of interest offered by the government are lower
than those offered by the borrowers in the private sector. And thirdly, if the prices
are rising, people will not be interested in saving and lending because of
depreciation in the value of money. We shall be discussing about public borrowing
as a source of resource mobilization in detail in the next Unit i.e. 15.
Domestic sources of financing economic development are sure to fall short
of the huge financial requirements for rapid economic development in developing
economies. So external 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 expenditure goes on
diminishing as the developing nations must learn gradually to become self reliant.
Hence various conventional sources of finance, such as taxation. Public

borrowing, having been found to be inadequate, deficit financing has been resorted
to for meeting the resource gap. The idea of resorting to deficit financing for
economic development, which is of relatively recent origin, has remained very
controversial.
But there are no two opinions regarding the evil consequences of deficit
financing, when adopted carelessly for capital formation and economic
development. But the problem before the country is to choose between the two
evils i.e. to adopt deficit financing for capital formation and face inflation or to go
without development programmes due to paucity of funds. In this unit we will
discuss the meaning of deficit financing and its role as an aid to financing
economic development. We shall also highlight the relationship between deficit
financing and inflation and its impact on price behavior in India. The advantages
and limitations of deficit financing are also dealt with.
The use of deficit financing to maintain total spending or effective demand
was an important discovery of the economic depression of 1930. Today it is a
major instrument in the bands of government to ensure high levels of economic
activity. The definition of deficit financing is likely to vary with the purpose for
which such a definition is needed. Deficit financing is an approach to money
management that involves spending more money than is collected during the same
period. Sometimes referred to as a budget deficit, this strategy is employed by
corporations and small businesses, governments at just about every level, and even
household budgets. When 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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One of the more common examples of government deficit financing has to

do with stimulating the economy of a nation in order to bring an end to a period of
recession. By establishing a specific plan of action that involves using borrowed
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. At the same time, the renewed vigor in the
marketplace helps to restore consumer confidence, making it more likely for
consumers to buy more goods and services. When monitored closely, a carefully
crafted deficit financing initiative will 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. Businesses of all sizes may choose to spend more money up front in hopes of
generating funds to pay off the investment at a later date. For example, a
manufacturer may choose to purchase new machinery for a factory, with the
understanding that the newer equipment will allow the business to produce more
units of goods in less time, and possibly at a lower unit cost. Over time, the
benefits derived from this strategy pay off the accumulated debt and allow the
business owners to enjoy a budget surplus rather than a budget deficit.
Household 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 with businesses and governments. An individual may choose to
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purchase items now with 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 homeowner with an asset that has a higher fair market
value than it would without the enhancements. While the ultimate reward from the
deficit financing is realized when the property is sold at a higher profit,
homeowners and their families do get to enjoy the enhanced amenities of the home
in the interim.
The idea of deficit financing in economic development is not new.
Economists from John Maynard Keynes up to the present day have recognized this
strategy, its benefits, and its possible liabilities if not applied properly. While not
automatically the best option to correct an undesirable financial situation, the
responsible use of deficit financing can ultimately improve the quality of life and
the financial status of everyone concerned.
In one sense by deficit financing we mean the excess of government
expenditure over its normal receipts raised by taxes, fees, and other sources. In this
definition such expenditure whether obtained through borrowing or from the
banking system measures the budget deficit. Deficit financing is said to have been
used whenever government expenditure exceeds its receipts.
In under-developed countries deficit financing may be in two forms:
a) Difference between overall revenue receipts and expenditure
b) Deficit financing may be equal to borrowing from the banking system of the
country.
DEFICIT FINANCING - CONCEPT AND MEANING
Deficit financing refers to means of financing the deliberate excess of

expenditure over income through printing of currency notes or through borrowings.
The term is also generally used to refer to the financing of a planned deficit
whether operated by a government in its domestic affairs or with reference to
balance of payment deficit. In the West, the phrase "Deficit financing" has been
used to describe the financing of a deliberately created gap between public revenue
and expenditure or a budgetary deficit. This gap is filled up by government
borrowings which include all the sources of public borrowings viz., from people,
commercial banks and the Central Bank. In this manner idle savings in the country
are made active. This increases employment and output.
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But according to Indian budgetary documents government resorting to

borrowing from the public and the commercial banks does not come under deficit
financing. These are included under the head of 'Market Borrowings' and
government spending to the extent of its market borrowings does not result in or
lead to deficit financing. In the Indian context, public expenditure, which is
financed by borrowing from the public, commercial banks are excluded from
deficit financing. While borrowing from the central bank of the country,
withdrawal of accumulated cash balances and issue of new currency are included
within its purview.
Deficit financing in Indian context occurs when therere budgetary deficits.
Let us now discuss the meaning of budgetary deficit. Budgetary deficit refers to the
excess of total expenditure (both revenue and capital) over total receipts (both
revenue and capital). In the words of the First Plan document, the term 'deficit
financing' is used to denote the direct addition to gross national expenditure
through budget deficits, whether the deficits are on revenue or on capital account.
The essence of such a policy I lies, therefore, in government spending in excess of
the revenue it receives in the shape of taxes, earnings of state enterprises, loans
from the public, deposits and funds and other miscellaneous sources. The
government may cover the deficit either by running down its accumulated balances
or by borrowing from the banking system (mainly from the Central Bank of the
country) and thus 'creating money'. Thus, the government tackles the deficit
financing through approaching the Central Bank of the country i.e. Reserve Bank
of India, and commercial banks for credit and also by withdrawing its cash
balances from the Central Bank. The magnitude of actual budget deficit during the
seventh plan had been of the order of Rs. 29,503 crore (at 1984-85 prices) which
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was more than double the estimate of Rs. 14,000 crore. The Budget for 1990-91
laid stress on limiting the size of the budget deficit through containment of
expenditure growth and better tax compliance. The budget programmed a deficit of
Rs. 1,10,592 crore in 1989-90. The revised estimates for the year 1990-91 placed
the budgetary deficit at Rs. 10,772 crore which is nearly 50% higher than the
budget estimate. Proper financial management demands that the revenue receipts
of the government, which are in the shape of taxes, loans from the public, earnings
of the state enterprises etc., should not only meet the revenue expenditure but also
leave a surplus for financing the plan. Contrary to this deficits on revenue account
are growing year after year. For example the revised estimates place the deficit on
revenue account during 1990-91 at Rs. 17,585 crore as against the budget deficit of
Rs. 10,772 crore. A higher revenue deficit implies higher borrowed resources to
cover the deficit leading to higher interest payments thus creating a sort of vicious
circle.
SOURCES O DEFICIT FINANCING IN INDIA
IMF (INTERNATIONAL MONITARY FUND): The IMF provides policy advice and financing to members in
economic difficulties and also works with developing nations to help them achieve
macroeconomic stability and reduce poverty.Marked by massive movements of
capital and abrupt shifts in comparative advantage, globalization affects countries'
policy choices in many areas, including labor, trade, and tax policies. Helping a
country benefit from globalization while avoiding potential downsides is an
important task for the IMF. The global economic crisis has highlighted just how
interconnected countries have become in todays world economy.
Key IMF activities
The IMF supports its membership by providing
policy advice to governments and central banks based on analysis of
economic trends and cross-country experiences;
research, statistics, forecasts, and analysis based on tracking of global,
regional, and individual economies and markets;
loans to help countries overcome economic difficulties;
concessional loans to help fight poverty in developing countries; and
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technical assistance and training to help countries improve the management

of their economies.
Original aims
The IMF was founded more than 60 years ago toward the end of World
War II (see History). The founders aimed to build a framework for economic
cooperation that would avoid a repetition of the disastrous economic policies that
had contributed to the Great Depression of the 1930s and the global conflict that
followed.
Since then the world has changed dramatically, bringing extensive prosperity and
lifting millions out of poverty, especially in Asia. In many ways the IMF's main
purposeto provide the global public good of financial stabilityis the same
today as it was when the organization was established. More specifically, the IMF
continues to
provide a forum for cooperation on international monetary problems
facilitate the growth of international trade, thus promoting job creation,
economic growth, and poverty reduction;
promote exchange rate stability and an open system of international
payments; and
lend countries foreign exchange when needed, on a temporary basis and
under adequate safeguards, to help them address balance of payments
problems.
The IMF's way of operating has changed over the years and has undergone rapid
change since the beginning of the 1990s as it has sought to adapt to the changing
needs of its expanding membership in an globalized world economy. Most
recently, the IMF's Managing Director, Dominique Strauss-Kahn, has launched an
ambitious reform agenda, aimed at making sure the IMF continues to deliver the
economic analysis and multilateral consultation that is at the core of its mission
ensuring the stability of the global monetary system.
The IMF has evolved along with the global economy throughout its 65-year
history, allowing the organization to retain its central role within the international
financial architecture. As the world economy struggles to restore growth and jobs
10
after the worst crisis since the Great Depression, the IMF has emerged as a very
different institution. During the crisis, it mobilized on many fronts to support its
member countries. It increased its lending, used its cross-country experience to
advice on policy solutions, supported global policy coordination, and reformed the
way it makes decisions.
The result is an institution that is more in tune with the needs of its 187 member
countries.
Stepping up crisis lending. The IMF responded quickly to the global
economic crisis, with lending commitments reaching a record level of more
than US$250 billion in 2010. This figure includes a sharp increase in
concessional lending (thats to say, subsidized lending at rates below those
being charged by the market) to the worlds poorest nations.
Greater lending flexibility. The IMF has overhauled its lending framework
to make it better suited to countries individual needs. It is also working with
other regional institutions to create a broader financial safety net, which
could help prevent new crises.
Providing analysis and advice. The IMFs monitoring, forecasts, and policy
advice, informed by a global perspective and by experience from previous
crises, have been in high demand and have been used by the G-20, as noted
in Section 4.
Drawing lessons from the crisis. The IMF is contributing to the ongoing
effort to draw lessons from the crisis for policy, regulation, and reform of the
global financial architecture.
Historic reform of governance.The IMFs member countries also agreed to
a significant increase in the voice of dynamic emerging and developing
economies in the decision making of the institution, while preserving the
voice of the low-income members.
Government Bonds: A government bond is a bond issued by a national government

denominated in the country's own currency. Bonds issued by national governments
11
in foreign currencies are normally referred to as sovereign bonds. The first ever
government bond was issued by the English government in 1693 to raise money to
fund a war against France. Government bonds are usually referred to as risk-free
bonds, because the government can raise taxes to redeem the bond at maturity.
Some counter examples do exist where a government has defaulted on its domestic
currency debt, such as Russia in 1998 (the "ruble crisis"), though this is very rare.
As an example, in the US, Treasury securities are denominated in US dollars. In
this instance, the term "risk-free" means free of credit risk. However, other risks
still exist, such as currency risk for foreign investors (for example non-US
investors of US Treasury securities would have received lower returns in 2004
because the value of the US dollar declined against most other currencies).
Secondly, there is inflation risk, in that the principal repaid at maturity will
have less purchasing power than anticipated if the inflation outturn is higher than
expected. Many governments issue inflation-indexed bonds, which should protect
investors against inflation risk. Bonds are issued by public authorities, credit
institutions, companies and supranational institutions in the primary markets. The
most common process of issuing bonds is through underwriting. In underwriting,
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 risk
of being unable to sell on the issue to end investors. However government bonds
are instead typically auctioned. A bond is a debt security, in which the authorized
issuer owes the holders a debt and, depending on the terms of the bond, is obliged
to pay interest (the coupon) and/or to repay the principal at a later date, termed
maturity. A bond is a formal contract to repay borrowed money with interest at
fixed intervals. Thus a bond is like a loan: the issuer is the borrower (debtor), the
holder is the lender (creditor), and the coupon is the interest. Bonds provide the
borrower with external funds to finance long-term investments, or, in the case of
government bonds, to finance current expenditure. Certificates of deposit (CDs) or
commercial paper are considered to be money market instruments and not bonds.
Bonds must be repaid at fixed intervals over a period of time.
World Bank: Indias involvement with the World Bank dates back to its earliest
days. India was one of the 17 countries which met in Atlantic City, USA in June
1944 to prepare the agenda for the Bretton Woods conference, and one of the 44
countries which signed the final Agreement that established the Bank. In fact, the
name "International Bank for Reconstruction and Development" [IBRD] was first
12
suggested by India to the drafting committee. The Indian delegation was led by Sir
Jeremy Raisman, Finance Member of the Government of India and included Sir C.
D. Deshmukh (Governor of the Reserve Bank of India, later to become India's
Finance Minister), Sir Theodore Gregory (the first Economic Advisor to the
Government of India), Sir R.K. Shanmukhan Chetty (later independent India's first
Finance Minister), Mr. A.D. Shroff (one of the architects of the Bombay Plan) and
Mr B.K. Madan (later India's Executive Director in IMF).The Bank lending to
India started in 1949, when the first loan of $34 million was approved for the
Indian Railways. The first decade of the Bank's lending to India (1949 - 1959) saw
just about 20 loans for a total amount of $611 million. During the years 1960-69,
overall lending to India from the Bank rose to $1.8 billion, about three times the
level in the previous decade. Between 1970-79, there was a large increase in the
absolute volume of IDA lending and the IDA share in total Bank assistance reached
a high of 80% in this decade. However, in the 1980s, India's share in total IDA
lending declined to 25% and was updated by the more expensive WB lending. The
volume of the WB lending rose to $14.7 billion during 1980-89, almost 10 times
the level of $1.5 billion in the previous decade.
The aggregate of the Bank's lending in India in the last 45 years was
approximately $42 billion. India is the single largest borrower of WB and IDA.
India has claimed about 15% of total World Bank lending9% of WB and 28% of
IDA commitments.The 50 years (1944-94) of relationship between the Bank and
India clearly shows certain trends. In the early years of relationship, the Bank
involvement was not direct and visible as compared to 1980s and 90s. In the initial
years, the Bank closely collaborated with the more active USAID to force policy
changes. In fact, an unholy alliance of USAID, the Bank, the IMF and Transnational Corporations (TNCs) worked hand in hand to pursue economic changes.
However, after the 80s, the Bank along with the IMF has started a direct and
visible role in India's policy making.]
IBRD-IDA Nexus in India
Years
IBRD
13
IDA
1949-59
100
1960-69
27
73
1970-79
20
80
1980-89
62
38
1990-93
53
48
1949-93
51
49
Figures
%
inSource: The
Bank[1994]
World
Nevertheless, there has been continuity in the basic philosophy and ideology of the
Bank 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 Bank since 1950s. The Bank has been proceeding in a
methodically manner to force India to accept its philosophy.
The Bank created conditions so that the Planning Commission was relegated
to the background in the late 1960s. During the oil shocks of 1973 and 1980, the
Bank was able to push forward its ideology of market forces with great impetus.
By 1990, the entire economic environment was made conducive for foreign capital
to clay a leading role in tapping emerging markets of middle class consumers in
India. And the foreign exchange crisis of 1991 provided the opportunities to the
Bank to clinch this objective through structural adjustment program. The past 50
years of Bank operations in India clearly reveals that the Bank has exploited the
foreign exchange crisis periods. So far, India has faced five major foreign
exchange crisis (1957, 1966, 1973, 1980, 1991). In each crisis period, the Bank did
not miss the opportunity to force its ideology on the government of India. In the
following paras, we will understand in details how did this happen.
"The Bank welcomes the arrangements that have been made to associate
foreign firms with the construction and operation of a large number of major
undertakings, both in public and private sector."
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The Bank was influential in India's policy making right from the early years of
Independence. In 1949, the Bank sent its first Mission to survey the potentialities
of Indian economy. Following this, Prime Minister, Jawahar Lal Nehru submitted a
special policy statement on foreign capital to Parliament on April 6, 1949. It
remains the only document where the role and place of foreign capital in India is
stated in explicit terms. It also marked a retreat from the Industrial Policy
Statement of 1948. It included the following principles:
Existing foreign interests to be given 'national treatment'.
New foreign capital would be encouraged. "government would frame
policies to enable foreign capital investment on terms and conditions that are
mutually advantegeous".
Profits and remittances abroad to be allowed.
Although majority ownership by Indians was preferred, "Government will
not object to foreign capital having control of a concern for a limited period,
if it is found to be in the national interest.
The above liberal principles towards foreign capital were fully implemented in
the following year's (1949-50) budget. It provided depreciation allowances and
income-tax exemption to a wide range of foreign companies. As a follow-up, in
1949-50, the Government fully abolished capital Gains Tax, while the Business
Profits Tax, Personal Income-Tax and Super Tax were reduced in 1950-51 budget.
All these concessions and commitments to foreign capital were incorporated into
the Industrial Development Regulation Act, 1951.
Meanwhile, the World Bank began to intervene in Indian economic affairs in a
significant manner. A second World Bank mission visited India in mid-50s. On the
basis of its instructions to facilitate the close integration of private capital with
foreign capital, the Nehru Government established the Industrial Credit and
Investment Corporation of India (ICICI) in January 1955.
However, the Government announced the Industrial Policy in 1956. This policy
was a major departure from the early industrial policy of 1948. While the 1948
statement had given private sector ten years to operate before being nationalized.
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The 1956 policy marked out the areas in which private sector could expand in an
uninhibited manner.
Shortly thereafter, the Nehru government earnestly began to flout its own
industrial policy. For instance, of the 17 industries listed in Schedule A of the
Industrial Policy Resolution, "industries the future development of which will be
the exclusive responsibility of the state (and in which) all new units will be set up
only by the state", at least seven were opened to MNCs through joint ventures.
Schedule B industries which according to 1956 Industrial Policy, were to be
progressively state-owned, 12 industries were listed. Out of 12, private sector set
up units in 9 industries.
RBI: The Reserve Bank 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 well
as it has to ensure an adequate flow of credit to productive sectors. Objectives are
maintaining price stability and ensuring adequate flow of credit to productive
sectors.
Bank Rate: RBI lends to the commercial banks through its discount window to help the
banks meet depositors demands and reserve requirements. The interest rate the
RBI charges the banks for this purpose is called bank rate. If the RBI wants to
increase the liquidity and money supply in the market, it will decrease the bank
rate and if it wants to reduce the liquidity and money supply in the system, it will
increase the bank rate. As of 5 May, 2011 the bank rate was 6%.
Cash Reserve Ratio (CRR):-
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Every commercial bank has to keep certain minimum cash reserves with
RBI. RBI can vary this rate between 3% and 15%. RBI uses this tool to increase or
decrease the reserve requirement depending on whether it wants to affect a
decrease or an increase in the money supply. An increase in Cash Reserve Ratio
(CRR) will make it mandatory on the part of the banks to hold a large proportion of
their deposits in the form of deposits with the RBI. This will reduce the size of
their deposits and they will lend less. This will in turn decrease the money supply.
The current rate is 6%.
Statutory Liquidity Ratio (SLR):Apart from the CRR, banks are required to maintain liquid assets in the form
of gold, cash and approved securities. Higher liquidity ratio forces commercial
banks to maintain a larger proportion of their resources in liquid form and thus
reduces their capacity to grant loans and advances, thus it is an anti-inflationary
impact. A higher liquidity ratio diverts the bank funds from loans and advances to
investment in government and approved securities.
In well-developed economies, central banks use open market operations-buying and selling of eligible securities by central bank in the money market--to
influence the volume of cash reserves with commercial banks and thus influence
the volume of loans and advances they can make to the commercial and industrial
sectors. In the open money market, government securities are traded at market
related rates of interest. The RBI is resorting more to open market operations in the
more recent years.
Generally RBI uses three kinds of selective credit controls:

1. Minimum margins for lending against specific securities.
2. Ceiling on the amounts of credit for certain purposes.
3. Discriminatory rate of interest charged on certain types of advances.
Direct credit controls in India are of three types:

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1. Part of the interest rate structure i.e. on small savings and provident
funds, are administratively set.
2. Banks are mandatorily required to keep 24% of their deposits in the
form of government securities.
3. Banks are required to lend to the priority sectors to the extent of 40% of
their advances.
The objectives of SLR are:
1. To restrict the expansion of bank credit.
2. To augment the investment of the banks in Government securities.
3. To ensure solvency of banks. A reduction of SLR rates looks eminent to
support the credit growth in India.
The SLR is commonly used to contain inflation and fuel growth, by increasing
or decreasing it respectively. This counter acts by decreasing or increasing the
money supply in the system respectively. Indian banks holdings of government
securities (Government securities) are now close to the statutory minimum that
banks are required to hold to comply with existing regulation. When measured in
rupees, such holdings decreased for the first time in a little less than 40 years (since
the nationalization of banks in 1969) in 2005-06.
These include:
1. Interest rate increases.
2. Changes in the prudential regulation of banks investments in G-Sec.
Most G-Sec held by banks are long-term fixed-rate bonds, which are sensitive
to changes in interest rates. Increasing interest rates have eroded banks income
from trading in G-Sec. Recently a huge demand in G-Sec was seen by almost all
the banks when RBI released around 108000 crore rupees in the financial system.
This was by reducing CRR, SLR & Repo rates. This was to increase lending by the
banks to the corporate and resolve liquidity crisis. Providing economy with the
much needed fuel of liquidity to maintain the pace of growth rate. However the
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exercise became futile with banks being over cautious of lending in highly shaky
market conditions. Banks invested almost 70% of this money to rather safe Govt
securities than lending it to corporate.
ROLE OF DEFICIT FINANCING AS AN AID TO FINANCING

ECONOMIC DEVELOPMENT
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Deficit financing has been resorted to during three different situations in

which objectives and impact of deficit financing are quite different. These three
situations are war, depression and economic development.
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Deficit financing during war

Deficit financing has its historical origin in wlr finance. At the time of war,
almost every government has to spend more than its revenue receipts from taxes
and borrowings. Government has to create new money (printed notes or borrowing
from the Central Bank) in order to meet the requirements of war finance. Deficit
financing during war is always inflationary because monetary incomes and demand
for consumption goods rise but usually there is shortage of supply of consumption
goods.
Deficit financing during depression
The use of deficit financing during times of depression to boost the economy
got impetus during the great depression of the thirties. It was Keynes who
established a Expositive role for deficit financing in industrial economy during the
period of, depression. It was advocated that during depression, government should
resort to construction of public works wherein purchasing power would go into the
hands of people and thereby demand would be stimulated. This will help in fuller
utilization of already existing but temporarily idle plants and machinery. Deficit
spending by the government during depression helps to start the stagnant wheels of
productive machinery and thus promotes prosperity.
Deficit financing and economic development
Deficit financing for development, like depression deficit financing,
provides stimulus to economic growth by financing investment, employment and
output in the economy. On the other hand "development deficit financing7'
resembles "war deficit financing" in its effect on the economy. Both are
inflationary though the reasons for price rise in both the cases are quite different.
When government resorts to deficit financing for development, large sums are
invested in basic heavy industries with long gestation periods and in economic and
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social overheads. This leads to immediate rise in monetary incomes while

production of consumption goods cannot be increased immediately with the result
that prices go up. It is also called the inflationary way of financing development.
However, it helps rapid capital formation for economic development.
Deficit financing and inflation
Deficit financing in a developing country is inflationary while 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 which can be employed by raising government investment through
deficit financing. The result will 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.
But, when, in a developing economy, the government resorts to deficit
financing for financing economic development the effects of this on the economy
are quite different. Public outlays financed by newly-created money immediately
create monetary incomes and, due to low standards of living and high marginal
propensity to consume in general, the demand for consumption of goods and
services increases. But if the public investment is on capital goods, then the
increased demand for the consumer goods will not be satisfied and prices will rise.
Even if the outlay is on the production of consumption goods the prices may rise
because the monetary incomes will rise immediately while the production of
consumer goods will take time and in the meanwhile prices will rise.
Though investment is being continuously raised (through taxation,
borrowing and external assistance), most of it goes to industries with long gestation
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period and for providing basic infrastructure. Though there is effective demand,
resource5 lie under or unemployed. Lack of capital, technical skill, entrepreneurial
skills etc. are responsible in many cases for unemployment or underemployment of
resources in a developing economy. Under such conditions, when deficit financing
is resorted to, it is sure to lead to inflationary conditions. Besides, in a developing
economy, during the process of economic development, the velocity of circulation
of money increases through the operation of the multiplier effect. This factor is
also inflationary in character because, on balance, effective demand increases more
than the initial increases in money supply. Deficit financing gives rise to credit
creation by commercial banks because their liquidity is increased by the creation of
new money. This shows that in a developing economy total money supply tends to
increase much more than the amount of deficit financing, which also aggravates
inflationary conditions. The use of deficit financing being expansionary becomes
inflationary also on the basis of quantity theory of money.
ADVANTAGES OF DEFICIT FINANCING
23
Up till now, we have seen that deficit financing is inflationary and it destroys
its own purpose of aiding economic development. But it is not always so. Secondly
inflation 13 not always harmful for economic development. On the contrary, to a
certain extent inflation is conducive to economic development and hence deficit
financing is beneficial.
1. During the process of development, increase in national production is bound
to give rise to the demand for increased money supply for transactions.
2. This can be met by injecting new money in the economy through deficit
financing. If deficit financing is resorted to for productive purposes
24
especially for the production of consumer goods and that too for quick
results then deficit financing is not that inflationary. For example, if any land
reclamation activity is to be undertaken which would lead to agricultural
production, resort to deficit financing for this activity will not be
inflationary.
3. Even if there is a moderate price increase of 4 to 5% per annum, its impact
on the economy will not be too severe. Besides, deficit financing will not be
inflationary if it is matched by a balance of payment deficit.
4. To the extent to which past savings of foreign balances can be used to pay
for such imports, it would be deflationary. But much reliance cannot be put
on balance of payments deficit because balance of payments deficit depends
on our foreign exchange reserves and our credlt worthiness in the world
market.
5. Moreover, a developing country aims at reducing this deficit by increasing
exports and reducing imports.Deficit financing will be non-inflationary if the
government is able to mop up the additional money incomes, created by
deficit financing, through taxation and saving schemes.
6. Properly 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 when one of the
objectives of planning is to step up the tempo of economic process.
Inflationary impact of deficit financing is helpful for economic development to a
certain extent and under certain circumstances like :
1. Under developed countries, with their low incomes, low or negative savings,
inadequate
investment
and
traditional
25
resistance
to
change
and
modernization, I will remain stagnant or develop at an intolerably slow pace

unless they are restructured and activated. This can be done with the
stimulus of inflation.
2. Inflation stimulates economic activities and rising prices induce more '
investments. In a developing economy the major 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. For this, inflation may be tolerated to a certain extent.
3. Inflation is said to be a useful method of increasing saving in a forced way.
There will be redistribution within the private sector of the economy, from
the personal sector to corporate sector. Inflation reduces real consumption
and provides resources for investment purposes.
4. Thus, deficit financing is a necessary and positive instrument to accelerate
the rate of economic growth in countries suffering from acute shortage of
capital. But any deficit financing has to be undertaken in the context of an
efficient and well executed plan for economic development.
LIMITATIONS OF DEFICIT FINANCING
26
Deficit financing (as we have examined up till now) can be regarded as a

necessary evil which has to be tolerated, at least in the developing economies, only
to the extent it can promote capital formation and economic development. This
extent of tolerance is called the safe limit of deficit financing. This safe limit shows
the amount of deficit financing that the economy can absorb and beyond which
inflationary forces may be set in motion. Though it is not possible to quantify it,
yet it is desirable to identify the factors that affect it.
Factors that affect deficit financing can be put under two categories:
a) Factors related to demand for money and
b) Factors related to supply of money.
27
1. If the demand for money is low in the economy, the safe limit of deficit
financing will be low.
2. Then creation of new money or deficit financing must be kept at a low level
otherwise evil consequences will follow.
3. Reverse will be the case when demand for money is high. On the supply side
of money, if due to some factors the supply of money or purchasing power
with the public increases, other things being equal, it will have an
inflationary tendency and the safe limit of deficit financing will be low.
However, safe limit will be high in the opposite situation.
4. The concept of 'safe limit' of deficit financing can be reduced to the age old
theory of demand and supply.
5. The point at which demand for and supply of money are equal is the
point of safe limit of, deficit financing.
6. Unfortunately conditions in a developing country are not so simple. Various
factors simultaneously exert contradictory effects on each side.
Factors Affecting Safe Limit

1. The safe limit of deficit financing depends on the supply elasticity of
consumption goods in the country. Usually, the supply of consumption goods,
specially foodgrains, cannot be increased to any extent for a long time due to
many constraints in a developing economy. Under such circumstances even a
little deficit financing would be inflationary and the safe limit of deficit
financing will be very low.
2. Safe limit of deficit financing also depends on the nature of government
expenditure for which new money is created, i.e., the purpose of deficit
financing. If the newly created money is used for unproductive purposes, the
use of deficit financing will be inflationary and the safe limit of deficit
28
financing will be lower than if the newly created money is to be used for
industrial development or for intensive farming.
3. If the foreign exchange reserves are increasing the scope of using deficit
financing will increase because that way the country will be able to import
more goods which will have deflationary effect.
4. Time lag between the initial investment and the flow of final products also
determines the safe limit of deficit financing. If this time lag is long, then
inflation will set in from the very initial stage of investment and it will not be
possible to control the rapidly rising prices.
5. Low safe limit of deficit financing is required if the economy consists of large
speculative business community.
6. If government is not in position to implement successfully its economic
policies accompanying the policy of deficit financing, low safe limit of deficit
financing is prescribed.
7. If a country is already passing through inflationary phase, low deficit
financing is advised.
8. If the rate of growth of population is high then low deficit financing is good
and vice versa.
9. Safe limit deficit financing also depends on a country's tax structure and the
borrowing schemes through which the government can take away at least a
portion of additional incomes thereby reducing the purchasing power with the
public. But all this is not easy in a developing economy where there are
rigidities in the tax system. There is large scale tax evasion so that government
is not able to take away any substantial part of additional incomes.
10.The country is, therefore, more prone to inflation and the safe limit of deficit
financing is low In a developing economy, all the aforesaid factors exert their
influence simultaneously.
11.The effect of each factor may be favourable or unfavourable for the use of
deficit financing and sometimes the effects of some factors may counter effect
each other and, thus, be cancelled out.
29
12.This safe limit of deficit financing will be different for different countries
because conditions vary from country to country.
13.The safe limit of deficit financing also depends on the measure of popular
cooperation which the government gets and the willingness of the people to
submit to austerity.
14.Even if this limit is calculated, it will go on changing with every change in the
economic conditions of the country. With efforts in the right direction this
limit can be shifted upwards so that a larger amount of deficit financing\ can
be resorted to by a government which is conducive to economic development
and not inflation.
CAUSES OF DEFICIT FINANCING IN INDIA.
30
A situation in which outflow of money exceeds inflow. That is, a deficit

occurs when a government, company, or individual spends more than he/she/it
receives in a given period of time, usually a year. One's deficit adds to one's debt,
and, therefore, many analysts believe that deficits are unsustainable over the longterm. See also: Surplus.
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 was thought
31
that these objectives 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 mobilization of resources.
1. Sources of financing economic development are broadly divided into
domestic and foreign sources.
2. Domestic sources of finance at the disposal of the government consist of
taxation, public borrowing, and government savings which include surpluses
of public enterprises and deficit financing.
3. The foreign finances consist of loans, grants and private investments. All
these sources of finance have their social costs and benefits on the basis of
which an upper limit can be determined for the use of any one method of
financing development.
4. Since the financial requirements of development are enormous and all
various sources have their own limitations, it becomes almost essential to
make use of all the sources as far as possible.
5. The choice is not between which one is to be used but between the various
combinations of using all of them. Thus both the domestic and foreign
sources of finance have their own place and importance in a developing
country.
6. It is essential to formulate appropriate policies for different sources of
finance and successful implementation of these policies is required for
achieving the desired objectives of rapid economic development.
7. Taxation is an old source of government revenue. Not only that, it is also
regarded as the most desirable method of financing public investment in
developing countries.
8. But it is a well known fact that taxation has a narrow coverage in developing
countries and the tax revenue national income ratio is not only low but the
increase in this ratio is also very slow during the process of development.
32
9. Public borrowing is considered a better method of collecting public revenue

than taxation (on the one hand government will get sources for development
programmes and, on the other, conspicuous consumption will be reduced).
10.But it cannot substitute taxation completely because there are certain
limitations to the use of this source of financing development. Firstly public
borrowing depends on the credit worthiness of the government.
11.Secondly, people do not want to lend to the government because the rates of
interest offered by the government are lower than those offered by the
borrowers in the private sector.
12.And thirdly, if the prices are rising, people will not be interested in saving
and lending because of depreciation in the value of money. We shall be
discussing about public borrowing as a source of resource mobilization.
13.Domestic sources of financing economic development are sure to fall short
of the huge financial requirements for rapid economic development in
developing economies. So external sources of finance have become almost
essential for the developing economy.
14.In spite of the necessity of foreign assistance, it remains only a subordinate
source of financing development in a developing economy.
15.In the early stages of development a substantial foreign assistance may be
needed but gradually foreign assistance as a percentage of development
expenditure goes on diminishing as the developing nations must learn
gradually to become self reliant. Hence various conventional sources of
finance, such as taxation. public borrowing, having been found to be
inadequate, deficit financing has been resorted to for meeting the resource
gap.
16.The idea of resorting to deficit financing for economic development, which
is of relatively recent origin, has remained very controversial. But there are
no two opinions regarding the evil consequences of deficit financing, when
adopted carelessly for capital formation and economic development.
33
17.But the problem before the country is to choose between the two evils i.e. to
adopt deficit financing for capital formation and face inflation or to go
without development programmes due to paucity of funds.
In this unit we will discuss the meaning of deficit financing and its role as an
aid to financing economic development. We shall also highlight the relationship
between deficit financing and inflation and its impact on price behaviour in
India. The advantages and limitations of deficit financing are also dealt with.
IMPACT OF DEFICIT FINANCING IN INDIA.
34
Price stability is an essential condition for stability in economic life as well

as economic growth. On the contrary, fluctuations in prices create an atmosphere of
uncertainty which is not conducive to development activity. When we examine the
price movements during the planning period in India, there are three clear trends.
First during the first plan period (i.e. 1951 to 1956) the general price level
had fallen. From 1955-56 to 1965-66. the prices rose steadily at an annual rate of
6%. Finally. from 1966-67 onwards (except 1975-76 and 1977-78) prices rose at
the rate of about 0% per annum and now it is in the double digit range. Deficit
financing as a tool for covering the financial gap in India was introduced at the
time of formulation of first five year plan. During the first plan deficit financing
was of the order of Rs. 333 crore and the money supply with the public increased
by about 22 per cent. Since this expansion in the supply of money fell short of the
35
increase in output, the general price level came down by about 18 per cent. During
second plan. actual deficit financing was less than the targeted amount, The third
plan was very abnormal (adverse weather conditions. 1962 Chinese\ aggression.
1965 Pakistan war). Deficit financing during the third plan amounted to Rs. 1333
crore - more than double the target. Money supply with the public
increased more rapidly.
In the fourth plan (1969-71), the amount of deficit financing stood at Rs.
2060 crore -about two-and-a-half times the target. Money supply increased from
6387 crore to Rs. 11,172 crore at the end of 1973-74. Prices increased by 47%
approximately. No doubt there were certain factors beyond the control of the
government such as war with Pakistan in 1971, substantial expenditure on account
of Bangladesh refugees, oil price hike etc. Besides, the reluctance on the part of the
states to mobilize adequate resources, their general financial indiscipline and
overdrafts from the Reserve Bank also compelled the government to take resort to
deficit financing. 111 view of severe inflationary pressures in the economy since
1972-73. the draft fifth plan 1974-79 laid utmost stress on non-inflationary
methods of financing. But, as against the target of Rs. 1354 crore for the fifth five
year plan, the actual amount of deficit financing was much more. During this
period, although the money supply increased by about 50 per cent, the overall
increase in wholesale prices was 33% because of the imposition of emergency in
1975 resulting in comfortable position in regard to the availability of sever:~l
commodities through the effective management of supplies.
During the sixth plan (1980-8.5) deficit financing was of the order of Rs.
15.681 crore as against the estimated target of Rs. 5000 crore. During this period
money supply increased from Rs. 23,117 crore-in 1980-81 to Rs. 39,380 crore in
36
1984-85. Seventh plan paper indicated a cautious approach towards deficit

financing and stated that "The required resources have to be mobilised in a manner
which minimize dependence on external sources or on deficit financing which has
a high inflationary potential." Still the target for deficit financing was placed at Rs,
l1,OOU crore and according to the latest estimates the actual deficit financing has
been of the order of Rs. 34,182 crore i.e. more than 2.4 times the target. Money
supply with the public has increased from Rs. 43.599 crore in 1985-86 to Rs.
76.259 crore in 1988-89 and index of..wholesale prices has gone up from 357.8 to
435.8 during the same period. There were many other factors like mismanagement
of the war economy. Excessive dependence on monsoon, power shortage, labour
strikes, increase in the rates of commodity taxation, rise in wage rates, black
money, rise in the international price of petroleum products which have been
responsible for price rise in India. However, experience shows that the increase in
money supply has led to a rise in prices. There has been a close relationship
between the rate of increase in prices and the rate of growth in money supply and
prices have a tendency to rise to new heights at every successive increase in money
supply resulting from deficit financing.
When deficit financing is inflationary, it will go against the very purpose for
which it is used because it will simply lead to continuous inflation and no
development. Inflation creates uncertainty, labour unrest, work stoppages and
decline in production because of the demand for higher wages 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 except the rich. This is
objectionable on grounds of economic efficiency, labour productivity and social
justice. Moreover, there is no certainty that higher levels of income accruing to
profit earners will be invested in1 productive enterprises, for the rich may waste
37
windfall gains in conspicuous consumption or indulge in speculative activities.

Besides, inflation is a sort of invisible tax on all incomes and cash balances. Their
value is automatically reduced with every rise in prices. Inflation leads to balance
of payments difficulties because due to rising prices the country loses export
market and people prefer imported goods. Which appear cheaper as compared to
domestic goods.
Inflation is charged with distorting the pattern of investment and production
in the economy. Inflation is beset with the danger of channelizing economic
resources into less urgent and speculative fields where 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 expenditure of
the government because whenever government resorts to large doses of deficit
financing, it has to neutralize its effects by sanctioning new dearness allowances,
revision of controlled prices. Distribution of essentials through fair price shops,
compulsory requisition of foodstuffs etc. All these measures lead to an increase in
the administrative burden of the government in order to ward off inflation caused
by the use of deficit financing.
59 Economic researches over the years have shown that deficit financing
results in a number of economic consequences, particularly for economic growth
and development. Also numerous macro-economic aggregates are affected in the
process of deficit financing. For instance, interest rates, exchange rates, money
supply, public debt, etc have consequences and burdens on both the present and
future generation and determination of payment position-". Economic studies have
also found a high degree of linkage between deficit financing and inflation. The
Keynesian analysis ascribes inflation to be the result of excess of aggregate
38
expenditure 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 work covers the period between 1980 and 2005 as this period was
exposed to an analytical review of deficit financing in Indian and reveals different
changes in deficit budget in Indian fiscal operations. The paper answers several
similar questions, which are related to deficit financing in India and its possible
inflationary impact on the economy. It is intended that this report would benefit
policy makers and other government and non-government bodies who would be
concerned about inflation and deficit financing as the report brings to light the
revelation and causative effects of deficit financing in India. Concept of Deficit
Financing A budget deficit can be defined as the situation that arises when
government expenditure is greater than estimated government revenue (usually
from taxation and charges for government service). The main concern with budget
deficit is its financing aspect. If borrowing from the private sector finances
government deficit, it is just a realization of resources in the economy. The
government can also finance its fiscal deficit either by raising additional tax or it
may incur debts. This form generally is the least expansionary, but due to the
problem encountered in generating more revenue from taxation in India, the
government usually resorts to creating debt, which is inflationary. The debt can be
incurred domestically or extremely.
The portfolio of the domestic debt in India consists of government
securities; treasury bills, treasury bonds, and development stocks. The development
of budget deficit in India started in the early 1960s. Prior to the 1960s, the public
39
expenditure was generally more, so the available resources were able to sustain
government outlays because of the impressive agricultural performance in the
country. However, misallocation of the resources to finance expenditure
programme in India made government to resort to deficit financing which seems to
have become a regular characteristic of government budgeting policy. Although
constant efforts were put in place by Indian government recently, yet the issue of
deficit funding remains unsolved. For example, inflation rate as released by
Federal Office of Statistics in 1993 was 18.9 per cent but this reduced to 12.9 per
cent in 2002. This shows that the trend of inflationary impact on deficit financing
in India is fluctuating in nature.
Deficit financing is the most useful method of promoting economic
development in developing countries. Further that due to the nature of developing
economies characterized 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. Day also argued that government
could engage in incurring deficit in order to acquire 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 world. It is the act of spending more than one's income.
This also refers to the act of government making up for excess of expenditure over
revenue. According to Sergeant and Wallace^ it means any public expenditure that
is in excess of current public revenue. In broad terms deficit financing can be seen
as a net increase in the amount of money in circulation where such an increase
results from a conscious government policy designed to encourage economic
activities which would otherwise not have taken place. Such activities may be for
economic developments and other objectives.
40
Deficit financing amounts to domestic credit creation that is not offset by

increase in taxation, more restriction in bank credit policy, and similar deflationary
measures. The government may cover the deficit either by raining down its
accumulated balances (reserves) or by borrowing from the banking sector. There
are two ways of to close the gap created by budget deficit. The financing can be
made either through internal sources or extreme sources.
Deficit financing through these sources include: (i)
Money creation or printing of new money : The printing of new money to close
deficit financing (budget) is the most regrettable effort made by the
government to raise money. It is not contraction; neither does it give rise to
interest charges or problems arising from servicing and retirement of debts.
This is also referred to as borrowing from the central bank,
(ii)
Borrowing from commercial and merchant banks involving the

purchase of government securities by banks: Borrowing from
the
non-bank
public,
government securities available for purchasing include treasury bills,

treasury certificates, Development Stock, Treasury Bonds. Apart from the
above listed ways of financing deficit, some economists like Anyanwuadd
the sale of assets, privatization of public enterprises, and delaying debt
service payment. Concept of Inflation can be defined as a sharp and
persistent rise in the general price of goods and services characterized by
prevalent increases in the prices generally and not just a temporary
fluctuation. Inflation is one of the most crucial macro-economic problems
facing most countries of the world especially the underdeveloped countries.
Some of its adverse effects include decreasing purchasing power of the
41
country's currency, creating unemployment, uneven distribution of income,

and consequently makes money loose its function as a store of value.
Inflation also causes uncertainty about future prices. This affects decisions
on expenditures, savings and investment, and misallocation of resources.
Four major factors have been identified as the causes of inflation in India,
namely money supply, nature of government spending/expenditure, exchange 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 IMF/ World Bank Supported Structural Adjustment
programme (SAP) in 1986. A broadly defined inflation as basically a
disequilibrium phenomenon arising largely from an imbalance between an
economy's spending power and the availability to its supplies (represented by the
sum of its productive capacity and its import). To him, such underlying
disequilibria set in motion a process of sustained rise in money income and
general prices. Antibody was of the opinion that social consequences of inflation
have been regarded as serious threat of effort of nation building and social
harmony in a young social economic system.
He stated further that inflation has negative impact on decision about
consumption, investment and savings of the people in an economy. There are
various ways of financing inflationary impact including money creation and
printing of new money, borrowing from the non-Bank Public, Financing
deficit from extreme sources, borrowing from Deposit Money Bank. If banks
have excess reserves, they can absorb an amount of government stocks and
securities considerably greater than the excess reserves without curtailing other
loans, so that credit given and the money supply possibly act to increase the price
level prevailing in the economy.
42
There have been various studies that examine the possibility of a causal
relationship between deficit financing and the general price level. While most of
these studies indicate fuelling inflation, a few others found no evidence to
confirm that deficit financing is a major cause of inflation. Bailey 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 Keynesian view on deficit
financing is also identical to the classical theory which is a reduction in private
capital formation, increased interest rates and consumption thereby leading to
inflation if not accompanied by reduction in money stock.
According to Marrison, there is a causal link between deficit financing and
inflation through credit creation by the banking system. In his study on
government spending and inflation. Lord John Maynard Keynes developed his
theory during the early 1930s following the great depression with persistent
unemployment to which problem the quantity theory had no policy prescription
to resolve. He argued that the income velocity of money depends on the apparent
effort on the rate of inflation. Oyejide'" found that deficit financing was
accompanied 61 by increase in domestic price level. Asoju" in his analysis of the
nature and cause of inflation in India acknowledged the contribution of deficit
financing in increasing the general price level prevailing in the country. Ariyo
and Raheem' said that while fiscal deficit can be inflationary, it can also be
caused by inflation.
The Indian experience shows that money creation is the most popular
deficit financing method used and this has the tendency of putting the economy
in a permanent state of excess demand if aggregate supply of goods and services
43
does not expand as rapidly as aggregate demand due to the existence of

bottlenecks and rigidities. Whether prices will rise in response of output to
demand stimulus and the extent of the price increase depends on the response of
output to that stimulus. In a developing country like India where production
capacity is low, output respond to demand stimulus is very low. Pattern of
Government Revenue and Expenditure in India The pattern of financing
government deficits has a major effect on the economy. Both the pattern and
structure of government revenue and expenditure have impacted on the level of
government deficit. The trend in the economy arose primarily from the discovery
of petroleum, which since the early 1970s has been the major source of
government revenue. Agriculture had its significance as the major 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 was able to withstand
sudden fluctuations in economic wealth. The boom in the oil sector increased
government revenue substantially and gave the government the opportunity to
increase its expenditure at will. The government embarked on a number of
ambitious projects and programmes. The government was able to expand the
economy through the different projects and programmes initiated at that period.
Many of the programmes and projects engaged in were wild projects, which
could be said to be unreliable and unproductive. The paten of policies made by
the government then led to the exposure of the economy to external shocks
resulting in the distortion to the economy.
During 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 expansionary projects without a measurable indicator to show the
44
adverse effects. Due to the significance of the oil sector in India, what happened
to oil receipts were transmitted immediately to the fiscal operations of the federal
government. Also, because most of the revenue accruing to the government was
generated from the oil sector, the glut in the world oil market, which began in
1981 led to loss in oil revenue in India. During this period, there was also a
decline in the growth rate of GDP and deficit in balance of payment. In other
words, there was a collapse in the oil market and the resulting short fall in
government revenue, yet government expenditure continued to rise as the
government did not make any effort to streamline expenditure with revenue
inflow.
As the government financing position deteriorated rapidly, the government
was 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 borrowing from the domestic banking system and drawing on
external reserves. The government resorted to deficit financing to fill the deficit
gap with the hope of offsetting the impact of dwindling oil revenue. The increase
in government deficit reflected the equilibrium between government revenue and
expenditure. However, with the government expenditure maintaining its level in
the face of government revenue downtimes, the deficit widened. Quantity Theory
of Money The quantity theory of money relates to the level of an economy in
terms of quantity price or commodity price to quantity of money in the economy
and the level of its commodity production.
In other words, it indicates that the general price level is directly
proportional to the quantity of money in circulation. This is given as MV=PY (I)
where Y = Output, V = Velocity of circulation, P = General price level and M =
45
Money supply. V and Y are assumed to be constant. The only reason why people
hold money balances is to finance day-to-day transactions and any additional
balances are immediately used for purchases. From the equation above PVV = M (II) this shows that for any given value of M there is one
IMPACT OF DEFICIT FINANCING ON BANKING

OPERATION.
46
In the early years of planning, there was consensus among India's

policymakers about the need for deficit financing as a means of plugging the gap
between ambitious investment plans and the low levels of savings in an
underdeveloped economy. Indian planners were not unaware of the dangers of the
inflation which might result. But with large foreign exchange reserves, they were
confident of the government's ability to manage the supply-side of the economy.
This consensus was also largely echoed by the International Monetary Fund
mission headed by Edward Bernstein which came to India in 1953 at the invitation
of the government.
For much of the 1950s, the Bank was part of this consensus. Although the
impact of deficit financing on prices had aroused concern already in 195 1-52,
price stability did not return as a major cause of worry at the Bank until the midfifties. Besides, the Bank recognized the need for any plan to go beyond what
47
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 Reserve Bank
also took a rather modest and self-effacing view about its own part in the planning
process during these years, insisting that while it was entitled to be consulted by
the government regarding the dimensions of the plan effort, the final decisions
rested with the latter. The monetary policy authorities' were, consequently, content
to 'function within the limitations created by the effort to carry out the plans'.
The Reserve Bank of India was not given sufficient time to consider the first
five-year plan, the plan document arriving in Bombay only towards the close of
October 1952. Any contribution the Bank made to the first plan document appears
to have been cosmetic, rather than substantial, with the Governor, B. Rama Rau,
for instance, choosing merely to object to the plan document's suggestion that 'real
democracy' implied the 'equality of incomes'. While the intervening years may
have revealed the Bank's earlier fears about ' In keeping with the definition in
vogue at the time, 'money supply' in this volume refers to 'narrow money' (MI),
comprising currency in circulation and demand deposits. Inflation to be
exaggerated, concern about prices resurfaced towards the end of 1955, though
more in the context of the second plan's priorities than its financing proposals.
Commenting on the former, Rarna Rau cautioned the Finance Ministry that the
public investment envisaged in the plan would lead to excess demand for consumer
goods, and to 'serious inflationary pressures'.
Though not seemingly within the Bank's remit, Rama Rau added, it was his duty to
bring these dangers to the government's attention since the Bank was 'partly, if not
mainly, responsible for applying appropriate remedies to curb inflation'.
48
The Bank's Central Board of Directors was given an opportunity to reflect

on the draft documents of the second plan in January 1956. Several members of the
Board were apprehensive that the financing requirements of so large an investment
programme with a planned public sector outlay of Rs 4,800 crores would involve
substantial recourse to the Bank and generate inflationary pressures. Similar views
had been voiced earlier during the Economists' Panel's rather cursory discussions
of the second plan, among others by D.R. Gadgil, a Director of the Central Board
and B.K. Madan, Economic Adviser at the Bank. The Bank's Annual Report for
1955-56 emphasized the need for financial stability promoted by a 'judicious mix'
of monetary and fiscal policies and warned against taking too sanguine a view
based on recent experience, of the pressure that the stepped up plan effort and the
manner of financing it was likely to exert on prices. This already marked a
departure from the more hopeful view the publication had taken a year earlier.
But the Bank also persisted in its belief that no government sensitive to the
welfare of the people and, one may add, having at regular intervals to renew its
popular mandate, would go very far down the path of inflation. Hence the view
prevailed that 'calculated risks' in regard to inflation were justified and that
development plans should not be sacrificed to allay fears on the price front unless
stabilization were to prove impossible. There were several reasons why the Bank's
overall attitude towards deficit financing during this period was nuanced and
pragmatic, rather than doctrinaire. Some of these emerged clearly in the course of
the visit to Bombay in February 1958 of Per Jacobson, the Managing Director of
the IMF. The latter's discussions at the Bank revealed that while not
altogether unsympathetic towards India's development problems and efforts, he
was sceptical about the policy of deficit financing and doubtful that it would give
the government any substantial command over additional real resources for
49
investment. Coming at the end of nearly two stressful Years of the second plan, Per
Jacobsson's plea for monetary stability would not have failed to strike a responsive
chord in Bombay. But placed as it so often was in the position of a credible
protagonist of the government's views to the Fund and an interpreter of those of its
interlocutors to the authorities in New Delhi, the Bank used three arguments to
explain to the visitor why the level of deficit financing envisaged in the second
plan was unlikely to affect prices as severely as feared, or unduly expand money
supply.
The second plan provided for net reserve losses of Rs 200 crores over five
years to finance part of a payments deficit 'planned' with the object of transferring
real resources to India from the rest of the world. (The remainder was expected to
be covered by capital inflows and external assistance.)' Hence, the Bank's credit to
the government sector would not translate directly into an increase in money
supply but would be moderated by changes in the country's foreign exchange
reserves. Secondly, the process of monetization which was reserve losses during
the first year of the second plan were larger than plan estimates for the entire fiveyear period. But the Bank and the government continued at this time to maintain,
in public, the validity of the second plan's assumptions. Continuously under way in
the economy could be expected to accelerate as a result of the development effort
and lead to changes in the income velocity of money.' Finally, there was the
prospect of rising incomes and standards of living. Both these factors were likely,
in the first instance, to increase the public's demand for cash balances. Declining
reserves and rising cash balances with the public could, the Bank argued, be
expected greatly to moderate the inflationary potential of the government's
budgetary outlays during the second
plan.
50
In judging the effects of deficit financing on the economy, the Bank was also
disposed to consider a number of other factors some of which in turn, helped
determine the range of monetary policy instruments deployed to stabilize prices.
For example it regarded the availability of wage goods, chiefly food grains, as a
major influence upon the extent to which any given level of deficit financing or
public investment affected domestic prices. Generally speaking, the Bank also
expected 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 expansion of its credit to the government. Briefly in the
mid-fifties, the Bank apprehended rapid deposit growth weakening its control over
the commercial banks' credit mechanism, and armed itself with powers to regulate
it.
These powers were even used twice in 1960. But throughout these years,
currency formed about two-thirds or more of money supply and the Bank's
judgment was, on the whole, that the potential for multiple credit creation was
realistically still quite limited for any given level of base money. The Bank's efforts
to persuade Per Jacobsson that deficit financing in India was not beyond the limits
of prudence were not entirely unavailing. Though his 'basic ideas' did not change
very much, Per Jacobsson appears to have recognized that his early reactions were
based on 'first hurried impressions' and that the issue showed itself, on closer
examination, to be 'not quite so simple'. But within the Bank itself, a sense of
unease had long been palpable.
As the volume of deficit financing grew during 1956-58 and the price and
external payments environments deteriorated, the Bank grew progressively more
51
vocal in expressing its views that deficit financing should be kept within
manageable limits, and that plan exercises should bear a closer ' Readers may note
that as used in these chapters, the term 'monetization' lends itself to two meanings.
Firstly, it refers, as in this instance, to the process by which the so-called nonmonetized sector is brought into the 'monetized' sector of the economy. Elsewhere
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
mobilize them.
The Reserve Bank of India's understanding of inflation during much of our
period was more structuralize than monetarist in the narrow sense of the term.
Officials at the Bank were sensitive to a number of structural factors which, in the
short and medium term, mediated the relationship between explanatory variables
such as public expenditure, change in the government's indebtedness to the
Reserve Bank, and changes in money supply on the one hand, and the rate of
inflation on the other. The arguments the Bank brought up in its discussions with
Per Jacobsson, though intended merely to highlight some characteristics of the
Indian monetary system, already had a structuralize ring to them. Other
considerations which the Bank understood to influence the price outcome of any
given policy included changing income distribution and the availability of foreign
exchange, the latter not being viewed as solely a monetary variable. But by far the
most important of such factors were bottlenecks in the wage goods, intermediate
goods, and infrastructure sectors, an influential Bank study citing discontinuities in
the 'aggregate supply function ... [due to] structural rigidities' as a feature affecting
the impact of monetary policy in a developing economy such as Indi a '~.In~
keeping with this line of 'structuralist thinking', the Bank believed that while
52
monetary policy worked to 'dampen the pressures originating on the side of

demand' to the extent the latter exceeded supply, it could not by itself ... be
expected to restore balance in prices when 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 which underlined the
complementarily between fiscal and monetary measures even to curb inflationary
tendencies. But the Bank was also usually at pains to emphasize longer-term
measures which would 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 Reserve Bank was generally supportive, particularly as some of the
wider 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 wage good-food grains. Inevitably, the Bank's structuralist,
rather than narrowly monetarist, perspective influenced the formulation and
execution of its monetary policies. It might also be said to have had important
longer-run consequences for the structure of the Indian financial system. On the
one hand, policy could never be indifferent to what might be regarded as the
genuine needs of the productive sectors of the economy. Thus while credit which
might fuel speculation in essential commodities might have to be squeezed, 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
otherwise characterized by monetary tightness. This meant in turn considerable
flexibility in the deployment of the traditional instruments of monetary policy, and
some innovation in the development of new ones. Instruments which worked in a
53
generalized way, such as the Bank rate, were sometimes viewed with reservation
because they were feared to 'discourage developmental activity in the private
sector, lower the prices of Government securities and therefore raise the cost of
future Government borrowings'. Far better in the circumstances to deploy selective
instruments which favoured borrowing for essential purposes and penalized
borrowing for non-essential or speculative ones
Views such as these were already present both within the Bank and outside
from the early 1950s. For example, as pointed out earlier, even the otherwise
modest first plan document had ambitious expectations 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. Despite high rates of inflation in the
intervening years, this view of the role of central banking was reinforced as the
country came face to face with a daunting set of simultaneous economic and
military challenges during the 1960s. The underlying logic and the actions flowing
from it culminated in the policy of directed credit and interest rate regulation
which, for better or for worse, became important features of the Indian financial
system for over three decades thereafter.
MEASURES TO CONTROL DEFICIT FINANCING
54
Besides open deficit financing undertaken by the government, there is

concealed deficit financing in developing economies. In all government
departments, in a developing country most of the expenditure is incurred recklessly
in the last few weeks of the financial year so that the amount sanctioned may not
lapse. This reckless expenditure is largely a waste and is not accompanied by
expected results. This expenditure 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. Most of the havoc created in the economy is actually created by this
concealed deficit financing. If, by efficient and honest administrative, this vast
wasteful expenditure can be avoided, the officially acknowledged deficit financing
will not be so inflationary. Anti-social acts such as evasion of taxes, black
marketing, cash transactions to supplement recorded cheque transactions, under
55
invoicing and over invoicing of export 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. Government must try to remove reckless expenditure in public and private
sectors caused by 'concealed deficit financing' and 'unrecorded gains' instead of
stopping the use of deficit financing which is likely to be spent productively and
therefore help in the economic development of the country.
In order to minimize the inflationary effects of deficit financing during the process
of development the government will have to keep a vigilant and constant watch on
changing economic situations, study the repercussions of measures adopted in
several spheres and, above all, take effective action on following lines :
1. Government should try to drain off a larger proportion of funds resulting from
deficit financing through saving campaign and higher taxation.
2. The policy of deficit financing should be adopted as a last resort, after
exhausting all other possible sources of development finance.
3. Investment should be channeled into those areas where capital output ratio is
low so that returns are quick and price rise is not provoked.
4. Along with deficit financing, government should adopt policies of physical
controls like price control and rationing etc.
5. Import policy should allow import of necessary capital equipment for
economic development and consumer goods required by the masses alone.
Import of luxury and semi-luxury goods should be discouraged.
6. Deficit financing and credit creation policies should be integrated in such a
way that neither of the two 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.
56
Above all these policies, what is more required 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.
Deficit financing or no deficit financing, the process of economic development
itself is inflationary. Whenever new investment is financed by taxation or
borrowing, the result is an increase in monetary incomes, increase in demand for
consumption goods, and price rise. With this background the important question, in
a developing country, is not whether deficit financing should be resorted to or not
for economic development, but, rather, how far inflation can be pushed without
upsetting the productive process. Thus deficit financing is a necessary and positive
instrument to accelerate the rate of economic growth in countries suffering from
acute shortage of the capital, though it is necessary to emphasize here that it must
be undertaken with an efficient and well executed plan for economic development.
CONCLUSION
Deficit financing as a method of resource mobilization has assumed an
important place in public finance in recent times. It refers to the means of financing
the deliberate excess of expenditure over income through printing of currency
notes or b through borrowing. In this unit, we have discussed the meaning of
deficit financing, its role as an aid to financing economic development in various
situations. Deficit financing in a developing country becomes inflationary and it
57
has varied effects on economic development which have been highlighted in the
unit. We have also examined the impact of deficit financing on price behaviour in
India during the plan period. It shows that, apart from other factors, there has been
a close relationship between rate of growth of money supply resulting from deficit
financing and rate of increase in prices.
But to a certain reasonable extent, deficit financing has proved to be
conducive to economic development, especially in countries with acute shortage of
capital. The advantages of deficit financing in this context have been dealt with in
the unit. As we have discussed in the unit deficit financing in developing
economies can be regarded as a necessary evil which can be tolerated only to the
extent it promotes capital formation and economic development. This extent of
tolerance is known as safe limit of deficit financing. To minimize the inflationary
effects of deficit financing during the process of development, certain measures
have to be taken like proper channelizing of investment in areas with low capital
output ratio, adoption of policies of physical control like rationing, import of only
necessary capital equipment etc. In economies with low capital formation, deficit
financing becomes a necessary and positive instrument if used with efficient and
well executed plan of economic development.
58

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Deficit Financing in India