Deficit financing can play a useful role during the phase of depression in a developed economy. During this phase, the level of expenditure and demand falls down to a very low level and the banks and the general public are in no mood to undertake the risk of investment.
They prefer to accumulate idle cash balances instead. The machinery and capital equipment are all there, what lacks is the incentive to produce due to deficiency in aggregate demand. If the govt, pumps in additional purchasing power in the economy (through deficit financing), the level of effective demand is likely to increase to meet this demand, the machinery and capital equipment lying hitherto unused will be pressed into operation. The level of production will accordingly increase. If this increase is able to match the increase in aggregate spending level, inflationary tendencies will not be generated.
However, conditions in under-developed countries are different. This is on account of the fact that in these countries, the adequate capital stock does not exist but has to be built up. Thus, while newly created money (as a result of deficit financing) leads to an immediate increase in the purchasing power in the hands of the people, the production of goods does not increase simultaneously. In fact, there is likely to be a considerable time-lag in the generation of extra purchasing power and the availability of additional consumer goods.
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In the meantime, the level of prices increases. According to Meier and Baldwin, capital accumulation through deficit financing is likely to generate inflation also because in the underdeveloped counties “the propensity to consume high, there is little excess capacity in plant and equipment and the elasticities of food supplies are low. Because of the general poverty of the masses, their levels of food consumption are very low.
Therefore, their first temptation is to spend more on food consequent upon an increase in income. However, it is difficult to increase the supply of food items in the short run. Even in the long run, the task is not very easy. Therefore, demand for food items is likely to be pushed up to a far higher level as compared to their supply resulting in a rise in their prices.
In the developing countries, prices of food items work as ‘signal’ for the prices of other goods also start rising. The high propensity to consume compounds in the inflationary impact of deficit financing as a substantial proportion of the increased income is spent in consumption. Because of market imperfections, the composition of total output and the productivity in an underdeveloped country as is less flexible and low compared to a developed country. This makes for low elasticity of supply of output.
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If additional resources generated through deficit financing are utilised for the production of consumption goods, the inflationary impact is likely to be restricted as the additionally created money supply will be matched by an increased amount of consumption goods. Examples of programmes wherein increased expenditure is not likely to result in inflation are small scale enterprises, distribution of new HYV seeds, fertilizers to farmers, minor irrigation schemes etc.
However, the important task before developing countries is not to increase the output of consumption goods but too built up costly capital equipment, lay down railway tracks, improve communication facilities, etc.
Therefore, the extra-money created though likely to be spent on deficit financing these projects. As a result, there is no likelihood of an increase in consumer goods in the near future and inflation would almost inevitably result.
While supporting deficit financing in underdeveloped countries, some economists have argued that because of large scale unemployment in these countries, deficit financing is not likely to be inflationary since increase in money supply will result in absorption of the unemployed resources, factors etc. and there will be increased output of goods and services.
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According to some economists, even deficit financing tends to be inflationary; it carries no danger as long as the inflationary pressures are mild. Infarct, a mild inflationary situation affords incentives to the producers who, in the expectation of increasing profits, are likely to raise the level of production and in the process, utilize idle capital and labour resources of the economy.