Does Deficit Financing necessarily Lead to Inflation?
It is not necessary that deficit financing may add to the purchasing power of the community. There may be some disbursements which do not have this effect. For instance, if the budget provides a grant of Rs. 5 crores to the Industrial Finance Corporation to be used in emergencies, this amount, though spent by the Government, will not make any addition to the spending power of the community till an emergency actually occurs. Similarly, when the Government redeems the securities held by commercial banks, the cash resources of the latter increase; but unless the increased cash balances induce the banks to increase the credit granted by them to their customers, there will be no increase in the community's spending power. Thus, a budget deficit does not, therefore, necessarily cause an addition of equal magnitude to the community's spending power.
Whether deficit financing will lead to inflation will depend upon (i) the general economic situation; (ii) the nature and extent of productive expenditure; and (iii) compensatory policies of the Government. If deficit financing were resorted to when there is depression, it would have no unhealthy effect on the economy of the country. On the contrary, to the extent it revives business activity and increases employment, it would have a wholesome effect. But if deficit financing were to be undertaken at a time when private investment is booming, it would generate inflation of the unhealthiest type.
Productive expenditure also takes out the sting from deficit financing and serves as an antidote to inflation. In the first place, the productive expenditure holds out the promise of increasing, at a future date, the production of goods in the country by widening the opportunities for employment and by bringing into use unexploited material resources. Secondly, as national income rises on account of the current productive investment, the Government's revenue and borrowing capacity would rise and consequently the need for deficit in future would either diminish or disappear.
Thirdly, productive expenditure by augmenting the stock of capital may cheapen production, i.e., lower the average unit cost of production. If this happens, the expenditure is a deflationary force. Thus, deficit financing, if undertaken for productive purpose, contains in itself a corrective which will begin to operate, after a time-lag, against the inflationary forces generated in the initial stages.
Another factor which will determine the inflationary impact of deficit financing on the economy is the Government policy in non-budgetary spheres like external trade, monetary and credit controls and commodity controls. If in any year there is an excess of imports over exports, such an excess would lead to offset the additional spending power created by deficit budgeting. Thus, a liberal import policy may neutralize the adverse effect of deficit financing.
The Government may also counteract the inflationary effects of its own deficit financing by controlling the volume of investment and income in the private sector, through monetary and credit restrictions. However, if money is spent largely on social services and not for producing more goods, it will have an inflationary effect. There is, therefore, the overriding need for cutting down drastically expenditure which causes no addition to the fund of goods and services which constitutes the real national income.
There is a factor peculiar to under-developed countries which mo the inflationary impact of deficit financing. By and large the economies of under-developed countries are not fully monetized, more particularly the areas. As development proceeds, the economy becomes increasingly more so that substantial amounts of new money are needed to meet the needs of increasing monetisation. A part of the new money created through financing may, therefore, be offset by this process of monetisation and extent its inflationary effects may be avoided.