Deficit Finance | Role | Adverse Effects | Measures to overcome limitations

What is Deficit finance?

Deficit financing is a method of meeting Government deficits. In India, Government deficit was filled up through the creation of new money. But now it has been given up and a new scheme, called Ways And Means Advances, is being adopted.

Deficit Finance - Role, Adverse Effects, Measures
Image: Deficit Finance – Role, Adverse Effects, Measures

Role of Deficit Financing

The role of deficit financing can be described with its merits.

1. Promoting Economic Development

Deficit financing is the most useful method of promoting economic development in less developed countries where the sufficient private investment is not forthcoming.

2. Developing Economic and Social Overheads

Major economic development and social overheads such as basic infrastructures projects are financed by deficit financing.

3. Augments Community Savings

Deficit financing, by increasing money incomes augments community savings. It is an effective instrument of forced saving.

4. Raise the Income of Entrepreneurs

Deficit financing tends to raise the income of the entrepreneurial class, which has a high propensity to save.

5. Expansionary

Deficit financing is always expansionary in its effects. When growth of economy gains momentum, deficit financing fills the gap where money is required to meet the demanding needs of economic development. So deficit financing is considered a valuable means for capital formation in underdeveloped countries.

Adverse effects of deficit financing

Deficit financing is a tool of economic development. However, it is not an unmixed blessing. It has its dangers. The dangers are inherent in its inflationary potential. We shall now state the adverse effects of deficit financing.

1. Less developed countries are characterized by market imperfections where immobility of resources is the common feature and leads to low elasticity of supplies.

2. When incomes increase as a result of deficit spending, they tend to increase the demand for food products. If the supply of food does not increase much due to low-level of agricultural productivity, the prices of food articles rise and spread to the entire economy.

3. It is argued that inflation affects the habit of voluntary saving a lot. Its ability to enforce and encourage savings is also very much limited. In the face of rising prices, people find it difficult to maintain the same rate of saving.

4. Inflation by bringing about uncertainty in future expectations affects investment decisions adversely.

5. Inflation may retard economic development in another way. With the rise in the price level, the cost of development projects also rises resulting in larger doses of deficit financing on the part of the Government.

6. Severe inflation also leads to balance of payments difficulties. Since the marginal propensity to import is high in underdeveloped countries, rise in domestic incomes and prices may encourage people to import more commodities from abroad.

But increased imports cannot be matched by increased exports due to lack of diversification in the economy. Efforts to restrict imports may lead to greater rise in prices by bringing excessive pressure on domestic supplies.

Measures to overcome limitations of deficit financing

The following measures are suggested to overcome the limitations of deficit financing.

1. The amount of deficit financing should be limited to the needs of the economy.

2. Efforts should be taken to mop up surplus money thus injected for new part. So that saved money is not allowed to go back again into the money-stream soon after its withdrawal.

3. Controls on the prices of goods, in particular wage-goods, and their equitable distribution through formal or informal rationing will go a long way in curbing the inflationary impact on low-income group people and on cost structure of the economy.

These measures together suggest that deficit financing can be an effective method of financing development. If, however, these measures are not adopted and safety limits are crossed, then the results will obviously be harmful, putting into disrepute the very instrument itself. This is what has happened in India.