CHAPTER VIII DEFICIT FINANCING. Deficit financing is financing the budget deficit. budget deficit and deficit financing.

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1 CHAPTER VIII DEFICIT FINANCING Deficit financing is financing the budget deficit by created money, Thus there is a difference between budget deficit and deficit financing. Deficit financing is a method of financing the budget deficit# We note two important characteristics of deficit financing. (1) One is the fact of financing the budget deficit and(2 ) the other is that, this financing is done by the increase in money supply. This is a very general definition of deficit financing, but it would be better if we take into accout some more technical' definitions cf it. The import of all the -technical definitions of deficit financing would be the same, but going through these technical definitions will bring about certain implicit aspects of it into explicit relief and thus will enable us to understand the effects of deficit financing on the economy better. There are three ways in which deficit financing may take place (B.R. Shenoy, 1958) 1, When the Central Bank of the country (which is

2 the RBI in India) gives credit to the government or 2, when the commercial banks and other banks give credit to the Government or 3» when the government withdraws its own cash balances from the Central Bank, the money supply is increased which is utilised to finance the excess of expenditure of the government over its revenue - that is budget deficit. In the first and the third cases, money comes from the RBI and hence it is by increasing the supply of reserve money that the budget deficit is financed. Even in the case of the commercial banks investing in government securities, it is done so with the help of the cash reserves of the banks lying with the RBI. Cash reserves with the banks or with the RBI are not the part of money supply. So when the banks invest in government securities, their cash reserves with the RBI are debited in their accounts and credited to the account of the government and when the government spends this amount, the supply of the reserve money in the economy gets increased. So we observe that in all the three cases of deficit financing, the money comes from the RBI. So deficit financing can 'toeas wall defined as financing the budget deficit with the help of money coming from the RBI. Money that comes from the

3 - 200 RBI has "been given various names e.g. reserve money, Government money, high-powered money, legal tender money etc. The difference between currency and the reserve money is that only currency with the public is taken into account when the word 'currency' is mentioned, while the reserve money is the sum of the currency with the public and with the banks. By 'currency' it is meant only the currency with the public, while the reserve money includes both, namely currency with the public and the currency with the banks. We know that money supply represents the liabilities of the RBI and to a minor extent, the liabilities of the Treasury. The Treasury issues one rupee notes and other small coins which form a very insignificant part of the total supply of reserve money. These one rupee notes and small coins issued by the Government are also a part of reserve money, but we have already observed that they constitute a very insignificant part of the total supply of reserve money. Rupee notes of the higher dcmviination are issued by the RBI. Thus the money issued by the RBI and the Treasury are the liabilities of the RBI and the Government respectively. When money is issued by those two agencies, the Government is the beneficiary and credit

4 201 -.is taken for this money by the Government in the "budget and it is usod to finance its own expenditure. As this money is not the part of revenue of the Government and still it is usod to finance the Government expenditure and there "by the budget deficit, it is also considered to be a part of deficit financing. In the process, money supply has been augmented which has boon used to finance Government expenditure and budget deficit and hence it is definitely the case of deficit financing. There are three different ways in which the RBI gives credit to the Government. and advances to the Government. 1. by providing loans 2. the other method is to purchase the Treasury bills and 3. the third one is to purchase the Government securities. Thus loans, advances, purchase of treasury bills and the purchase of Government securities by the RBI are the different ways of giving credit to the Government and all these ways of giving credit to the Government constitute deficit financing. The investment in Government securities or the purchase of treasury bills of the Government by the commercial banks and co-operative banks are the different ways of giving credit to the Government by the banks.

5 When the deposits of the Government with the RBI or the cash balances of the Treasury are withdrawn by the Government, then it also constitutes a case of deficit financing. Deposits of the Government with the RBI and the cash balances of the Government with the Treasury are called non-monetary liabilities of the RBI and the Treasury. They are the liabilities of the RBI and the Treasury respectively. But they are non-monetary liabilities, because money lying with the RBI or the Treasury is not considered to be a part of money supply and hence these liabilities are not considered to be monetary in character. When the Government withdraws its deposits or balances and thus when they come into the hands of the Government, they become the part of money supply. When they are spent by the Government, the total supply of reserve money in the economy gets increased. On the other hand, as the deposits with the RBI and the cash balances with the Treasury are reduced in the process, the non-monetary liabilities of the RBI and the Treasury also got reduced. Thus the reduction in the non-monetary liabilities of the RBI and the Treasury implies an increase in the monetary liabilities of the RBI and the Treasury and hence it implies an increase in money supply

6 (i.e. of reserve money) in the economy. This is done to finance the Government expenditure and budget deficit and so the case of the reduction of the non-monetary liabilities of the RBI and the Treasury that takes place on account of Government transactions, is also a case of deficit financing. So in order to take into account the quantum -of deficit financing, the variations in the following items must be taken into account (S.B.I., 1961): 1, Issue of Rupee notes and coins by the RBI. 2, Issue of one rupee notes and small coins by the Treasury. 3» Loans and advances by the RBI to the Government. 4, Purchase of treasury bills and Government securities by the RBI, 5, Purchase of treasury bills and investment in Government securities by the commercial banks and the state co-operative banks, 6, Withdrawal of its own deposits by the Government from RBI. 7«Withdrawal of its balances by the Government from the Treasury, The sum of the variations in the above mentioned seven items is considered to be the quantum of deficit financing during that given period of time.

7 In practice,.an easy way to know the quantum of deficit financing is to take into account the variations in the financial assets and the non-monetary liabilities of the RBI and of the Treasury, assets and liabilities are equal. arc two sides of the same coin. In the balance sheet, Assets and lia bilities In practice, the money supply on account of Government transactions is increased when the credit is given by the banking system (RBI, Scheduled and unscheduled commercial banks and the state co-operative banks) to the Government. By the word Government', it is meant the Central Government as well as the State Governments. The credit given by the banking system constitutes the assets for the banking system. In the process, money supply increases and it constitutes the liabilities of the RBI also. But in practice, it is better to take Into account the credit side or the asset side in order to gauge the quantum of deficit financing. In the same way, the withdrawal of the deposits or the cash balances from the RBI or the Treasury, implies reduction of the non-monetary liabilities of the RBI and Treasury respectively. But in fact, it is the increase in monetary liabilities of the RBI and Treasury. Deposits and cash balances being non-monetary liabilities, it is

8 better and more convenient to take into account the reduction in these non-monetary liabilities rather than increase in monetary liabilities of RBI and the Treasury in order to arrive at the true quantum of deficit financing. The simple definition of deficit financing is net bank credit to the Government, This item includes all the items enumerated above that give rise to deficit financing. As for example, when the RBI gives advances or loans to the Government or purchases treasury bills of the Government or invests in Government securities, they all happen to be different cases or versions of giving credit to the Government by the Central Bank. When the commercial banks invest in Government securities or purchase treasury bills with the help of their cash reserves lying with the Central Bank, they thereby advance credit to the Government. When on account of Government transactions, non-monetary liabilities of the RBI alter, this change involves change in money supply (high-powered money) which is meant to finance Government expenditure. Inversely, if the deposits of the Government with the Reserve Bank or the Treasury increase, the non-monetary liabilities of the RBI and the Treasury increase and the

9 206 - money supply (.high-powered money) in the economy is reduced due to Government transactionsi So this fall in money supply is on account of increase in the non-monetary liabilities of the RBI which is the consequence of the Government transactions* This change in non-monetary liabilities of RBI and the Treasury must be deducted from the gross bank credit to the Government. Thus we observe that in order to gauge the true measure of bank-credit to the Government, the change in the non-monetary liabilities of the RBI must be taken into account simultaneously with their monetary liabilities, because as the increase in the monetary liabilities implies the increase in money supply, so the increase in the non-monetary liabilities reduces the money supply. When the RBI issues rupee notes and coins, it is doing so on behalf of the Government. The RBI then gives these rupee notes and coins to the Government as if, by way of loans. Thus the supply of reserve money is injected into the economy by the RBI through the channel of the Government, Thus this is also the part of RBI s credit to the Government and the Government uses it to finance its own expenditure and so it is a case of deficit financing.

10 207 - When tile Treasury issues one x-upee notes and small coinst it is as good as withdrawal of its own cash balances ty the Government from the RBI or the Treasury & So this also constitutes a part of bank credit to the Government. Hence when we take into account all types of credit given to the Government and from this gross amount, deduct the change in the non-monetary liabilities of the RBI, we get the true measure of net bank credit to the Government which is deficit financing. Here a recent example regarding the budget provision for the year will clarify the issue. The Government resolved to borrow Rs.900 crores against the foreign exchange reserves of the RBI. This use of accumulated foreign exchange reserves to the extent of Rs.900 crores, has been dubbed as inflationary. It has sparked a heated controversy in the newspapers and also in the learned academic journals. When we analyse this phenomenon, we have to distinguish between deficit financing, change in money supply and inflation. exchange reserves of RBI are the assets of RBI. Foreign The Government purchases these foreign exchange reserves. But how is the Government enabled to do so? Against the treasury bills, the Government borrows money from

11 RBI,' and with the help of this money, the Government purchases the foreign exchange reserves1. The foreign, exchange reserves of the RBI are reduced which implies the reduction of the assets of the RBI which in turn implies a fall in money supply. But at the same time, the Government has borrowed money from the RBI and has purchased these foreign exchange reserves, so the consequent deficit financing increases the money supplyi Thu the reduction of foreign exchange reserves of the RBI reduces money supply, but the manner of financing the purchase of foreign exchange reserves by the Government increases the money supply. These two opposite forces cancel each other and therefore the total money supply does not change at all. This can be represented, in another way also. Treasury bills take the place of the reduced foreign exchange reserves. Treasury bills are also the assets of the RBI as the foreign exchange reserves are. So the total assets and hence the total liabilities of the RBI do not change and hence the total money supply in the economy does not alter, as the money supply is nothing but the monetary liabilities of the banking system and the Treasury. Thus here we have a case of deficit financing which does not increase money

12 ~ supply* In this case, in order to purchase the foreign exchange from the RBI, the Government, has to Borrow money from the RBI which is a case of deficit financing. But that money is to be given to the RBI and not spent in the economy. Therefore borrowing from the RBI implies expansion of money supply, but purchasing foreign exchange from the RBI by the Government like any other importer is the case of contraction of money supply So in this entire process of purchase of foreign exchange from RBI by the Government, there is deficit financing which does not increase the money supply. Some may hot even call it deficit financing, because it does not increase money supply in the economy. The important characteristic of deficit financing is that it increases the money supply. Still however if at all it is considered to be a case of deficit financing, then it is merely a formal kind of deficit financing and it should be clarified that it does not result into increase in money supply. Now the third category which is that of inflation remains to be discussed. The question is whether this purchase of foreign exchange by the Government from RBI becomes responsible for the rise in the price level or. not. We have already noted that there is no increase

13 in money supply* So there is no possibility of price- rise,, But then, the question arises whether the price- level remains stable or it falls. We should not gloss over the fact that the Government will import goods from abroad with the help of these foreign exchange reserves acquired. This will increase the total available supply of goods in the domestic economy while the money supply has not increased on account of it. Increase in the available supply of goods in the context of the constant money supply would lead to a.fall in the price level. This shows that the purchase of foreign exchange by the Government from the RBI is anti-inflationary, though it is neutral in terms of change in money supply. So in order to arrive at the true magnitude of total deficit financing, it is always advisable to deduct the deficit financing resorted to by the Government for the purchase of foreign exchange from the RBI, as the total of deficit financing includes this kind of formal deficit financing also. If the rupee value of the foreign exchange acquired by the Government is not deducted from the total deficit financing, it will give a wrong picture regarding the true quantum of deficit financing. So from the bank

14 credit given to the Government by the banking system* the value of foreign exchange purchased by the Government must be deducted* as the total bank credit already includes credit given to the Government-for the purchase of foreign exchange reserves. Deficit financing (bearing in mind* the above mentioned exception) results into increase in money supply, but every increase in money supply is not necessary inflationary* In this regard* two factors must be taken into account 1. First is change in money supply due to other contributory factors like credit creation by the banks when loans are given to the commercial sector and the change in the foreign exchange reserves of the banking system and 2. the other (factor which neutralises the effect of increase in money supply on prices) is growth in national output. Here we are dealing with altogether a different type of a problem than what we had dealt with previously. Here we are not trying to understand the correct magnitude of deficit financing,but we are taking into account the entire amount of deficit financing, the sum of the true deficit financing as well as the formal deficit financing (of a kind that we just discussed above). Because now we are endeavouring to understand

15 the safe limits of deficit financing which is nen-infla- tionary (B.R. Shenoy, 1958)i There are three factors tha.t affect the growth of money supply in the economy? 1* Net "bank credit to the Government (Deficit financing), 2k Net bank credit to the commercial sector, 3, Change in the foreign exchange reserves of the banking system. Upto a certain limit, total expansion of money supply is not inflationary, but beyond it, it grows to be inflationary. Deficit financing being only one of the three factors that influence money supply, the fixing up of the safe limit of deficit financing requires the knowledge abotxt the contribution of the other two factors in changing the money supply. The safe limit of deficit financing cannot be judged in an isolated way. Inflation is a persistent rise in the general price level,- Change in the price-level is not a matter of money supply alone, though the cause of inflation is monetary. The effect of the increase in money supply on the general price level can be neutralised by the increase in national output. As the volume of national output increases, the demand for money to function as a general

16 medium of exchange and a store of value also increases* Demand for money is the obverse of the demand for goods* That part of one's income which is not spent on goods, constitutes one's demand/for money* The sum total of individuals' demand for money goes to make the total demand for money in the society; Corresponding to demand for money, there is outpiit in the market, because demand for money is a part of income and income is a result of contribution to output. So the demand for money implies the supply of goods being undemanded and the purchasing power being hoarded in the liquid form, So if money supply is increased, it takes the place of the hoarded money when it appears in the market for demanding goods and the goods are already there in the market. So money supply can safely be augmented to the extent of the increase in the demand for money. By the safe increase in money supply, it is meant, that much expansion of money supply which does not endanger price-stability. The expansion of money supply which maintains price stability is the sa.fe limit of the expansion of money supply. Deficit financing is also a case of expansion of money supply. Suppose the annual national output has

17 - 214 increased by 4 per cent and hence demand for money has also increased by 4 per cent. So the total money supply can s-fely be increased by 4 per cent without endangering price stability. Now suppose foreign exchange reserves of the banking system have been responsible for the increase in money supply by 2fo and also suppose, money supply has increased by 1 per cent through credit creation by banks. So through other sources, money supply has already been increased by 3$. Hence only 1 per cent increase in money supioly through deficit financing is the possible safe limit of deficit financing in this context. Because the increase in total supply of money is 4 per cent and the increase in the demand for money is also 4 per cent as a result of 4 per cent increase in national output. Hence the real value of money will remain the same and the general price level will not alter. Price-stability would be maintained if deficit financing is limited to this safe limit (B.R. Shenoy, 1958).

Unit 9: Money and Banking

Unit 9: Money and Banking Name: Date: / / Functions of Money The first and foremost role of money is that it acts as a medium of exchange. Barter exchanges become extremely difficult in a large economy