Deficit Financing

Deficit financing is practised whenever government expenditure exceeds government receipts from the public such as taxes, fees, and borrowings from the public.  Such an excess of government expenditure can be financed either by drawing down the cash balances of the government or by borrowing from the central bank.

Two Aspects of Deficit Financing

Deficit financing as an income generating expenditure has two aspects:

1. Pump priming: Pump priming means the power of deficit financing in stimulating private investment through giving small doses of investment in the economy.
2. Compensatory spending: Compensatory spending means that deficit financing can be used for compensating and neutralising tendencies towards over-saving and under-investment.

Deficit Financing and Deficit Budgeting

1. Deficit budgeting refers to the situation when current expenditure exceeds current revenue.  In this situation no item on capital account is taken into consideration.
2. On the other hand, when we take into consideration not only current receipts but also receipts on capital account, e.g., public borrowing, and the gap between receipts and expenditure is covered by deficit financing.

Uses of Deficit Financing

1. For prosecuting a war: During the state of war, the government has to finance the purchase of arms and ammunitions through deficit financing.  Deficit financing during war is very injurious for the economy.  Private investments and savings are at their worst level.

2. For fighting depression: Deficit financing can be really helpful for the government during the period of depression.  It can stimulate private consumption and investment.  The government can increase its own expenditure on public works programme.  The government’s tax revenue remains constant but its expenditure has gone up, therefore, the deficit has to be met by borrowings.  In this case, as government investment rises, the level of national income and employment also increases by more than the proportionate increase in government investment.  Deficit financing can be used to create additional employment, when the economy is suffering from a deficiency of effective demand.

3. For financing economic development: The economic problems faced by underdeveloped countries are different from that of advanced countries.  In advanced countries, the task of capital formation is in the hands of private entrepreneurs but in poor countries there is a dearth of people willing and able to undertake entrepreneurial functions.  Therefore, it is the government’s responsibility to boost up investment in public sector, generate revenue from it and encourage people to save and invest.  But, in a country, where a majority of people are living at the subsistence level, the margin between income and consumption is very low so that the voluntary savings cannot provide sufficient resources for development.  The government may attempt to increase the volume of resources by additional taxes. Because of extreme poverty of the great mass of the people, additional taxation beyond a point raises problems, both economical and political.

Consequences of Deficit Financing

1. Increase in the money supply with the public
2. Rise in the level of income, and
3. Rise in the general price level.

Deficit Financing and Inflation

The inflationary implications of deficit-financing is divided into two parts:

1. Inflation in a full-employment economy, and
2. Inflation in an under-developed country or less than full-employment economy.

1. The first part is related to the inflationary impacts of deficit financing in a full employment economy. In this regard some writers hold the view that even under the conditions of full employment, in the long run, there is no problem of inflation, particularly in economically advanced countries.  However, infact, at full employment a further increase in aggregate demand through deficit financing results in raising the general price level instead of adding to aggregate output and employment.

2. In the second part, there are five reasons by which the deficit financing results into inflation:

(a)    When there is a variety of channels into which increased money supply can flow

(b)   Non-homogeneity in skills or efficiency

(c)    Supply of resources is perfectly inelastic

(d)   Increase in wage rates

(e)    Increasing marginal cost

Precautions in the Use of Deficit Financing

1. Deficit financing should be used in moderate doses
2. Constant watch on price index
3. Prices of consumer goods and essential raw materials should be effectively controlled
4. Ensure a corresponding increase in the availability of goods
5. Concentrate on quick yielding projects
6. In order to keep down the prices of food grains, food imports should be arranged well in time and in adequate quantities.
7. Rise in wages and salaries should be checked lest the country be caught in a vicious circle of poverty
8. Excess money supply should be mapped up through taxation and borrowings
9. Ensure clean and efficient administrative system tackling the difficult economic situation with whole hearted cooperation from the people

Measures to Minimise Inflationary Pressure of Deficit Financing

1. Proper disinflationary fiscal policy,
2. Restrictive monetary policy to control non-essential private investment,
3. Economic controls through selective credit control, physical and fiscal controls, in order to influence the behaviour of private investment and channelise it into desirable lines,
4. Proper allocation of resources with major focus on agriculture and small and medium scale industries, and
5. Developing import surpluses for increasing the supply of goods.

Anti-Inflationary Fiscal Policy

Fiscal policy with respect to inflation includes all the measures of a monetary nature which the executive branch of the government adopts in connection with:

(a)   Government spending

(b)   Taxes, and

(c)   Public borrowing

Fiscal policy has come to be recognised as the potentially most powerful instrument of economic stabilisation.

(a) Government spending: During inflation the government is supposed to decrease its own spending to counteract an increase in private spending.  The government must simultaneously reduce expenditures and increase revenues to achieve a cash surplus to be used in an anti-inflationary manner.

(b) Taxes: It is axiomatic that during inflation the existing tax structure should be retained, that tax cuts should be resisted, and the new taxes should be adopted or tax rates increased, if possible – to reduce the amount of spendable money in the hands of general public.  But care must be taken not to deflate the money incomes of the country via taxation so much as to provoke a recession of economic activity.

(c) Savings: Saving is a type of public borrowing which has a deflationary effect on the money supply and effective demand.  The most effective anti-inflationary public borrowing takes the form of compulsory saving.

(d) Debt Management: Public debt may be managed in such a way as to reduce the money supply or to prevent further credit expansion.  Anti-inflation debt management often refers to the retirement of bank-hold debt out of a budgetary surplus.  It includes the retirement of public debts of the following categories:

(i)      Retirement of public debt by central banks out of a budgetary surplus is most deflationary

(ii)    Retirement of bank-held debt (i.e., commercial banks) is neutral in its effects

(iii)   Retirement of a maturing portion of debt held by the non-bank public, which has also neutral effect.

(e) Gold Sterilisation: Whenever the gold inflow is deemed too dangerously inflationary in effect, the government may decide to sterilise gold in order to keep bank reserves from increasing gold acquisitions.

(f) Overvaluation: In order to control domestic inflation, a country might maintain the overvalued exchange value of its currency, that is, an expensive currency relative to foreign currency.  An overvalued currency is anti-inflationary in effect for three reasons, namely:

(i)      Because of its discouraging effect on exports and decreasing effect on domestic money incomes

(ii)    Because of its encouraging effect on imports and increasing effect on import expenditure

(iii)   Because of its cheapening effect on the price of those foreign materials which enter into the domestic cost of product of its preventive effect on the upward-cost price spiral.

Difference between Balance of Trade and Balance of Payment

Basis of Difference		Balance of Trade (BOT)		Balance of  Payment (BOP)
1. Definition		Balance of trade may be defined as difference between export and import of goods and services.		Balance of payment is flow of cash between domestic country and all other foreign countries. It includes not only import and export of goods and services but also includes financial capital transfer.
2. Formula		BOT = Net Earning on  Export - Net payment for imports		BOP = BOT + (Net Earning  on foreign investment - payment made to foreign investors) + Cash  Transfer + Capital Account +or - Balancing Item or  BOP = Current Account + Capital Account  + or - Balancing item ( Errors and omissions)
3. Favourable  or  Unfavourable		If export is more than  import, at that time, BOT will be favourable. If import is more than export, at that time, BOT will be unfavourable.		Balance of Payment will be  favourable, if you have surplus in current account for paying your all  past loans in your capital account. Balance of payment will be unfavourable, if you have current account deficit and you took more loan from foreigners. After this, you have to  pay high interest on extra loan and this will make your BOP  unfavourable.
4. Solution of Unfavourable  Problem		To Buy goods and services  from domestic country.		To stop taking of loan  from foreign countries.
5. Factors		Following are main factors  which affect BOT a) cost of production b) availability of raw materials c) Exchange rate d) Prices of goods manufactured at home		Following are main factors  which affect BOP a) Conditions of foreign lenders.  b) Economic policy of Govt.  c) all the factors of BOT
6. Meaning of Debit and  Credit		If you see RBI' Overall  balance of payment report, it shows debit and credit of current account.  Credit means total export of different goods and services and debit means total import of goods and services in current account.		Credit means to receipt and earning both current and capital account and debit means total outflow of cash both current and capital account and difference between debit and credit will be net balance of payment.

Principle of Effective Demand: Aggregate Demand and Aggregate Supply Introduction

Principle of Effective Demand: Aggregate Demand and Aggregate Supply

Introduction

            The logical starting point of Keynes’s theory of employment is the principle of effective demand. In a entrepreneurial economy, the level of employment is based on effective demand. Thus employment results from a deficiency of effective demand and the level of employment can be raised by increasing the level of effective demand.

Aggregate Demand Price

       “The aggregate demand price for the output of any given amount of employment is the total sum of money or proceeds which is expected from the sale of the output produced when that amount of labor is employed.” Thus the aggregate demand price is the amount of money which the entrepreneurs expect to get by selling the output produced by the number of men employed. In other words it refers to the expected revenue from the sale of output produced at a particular level of employment. Different aggregate demand prices relate to different levels of employment in the economy.

       A statement showing the various aggregate demand prices at different levels of employment is called the aggregate demand price schedule or aggregate demand function. “The aggregate demand function.” according to Keynes, “relates any given level of employment to the expected proceeds from that level of employment.”

       The below tablet represents the aggregate demand schedule where it reveals that, with the increase in the level of employment proceeds, expected rise and at lower levels of employment decline. When 900 thousand people are provided employment the aggregate demand price is $560 million and when 250 thousand people are provided jobs, it is $480 million.

   

According to Keynes the aggregate demand function is an increasing function of the level of employment and is expressed as D = F (N), where D is the proceeds which entrepreneurs expect from the employment of N men.

Level of Employment In 100 thousands	Aggregate Demand Price (D) In Million $
4	460
5	480
6	500
7	520
8	540
9	560
10	580

       The aggregate demand curve can be drawn on the basis of the above schedule. It inclines upward from the left to right for the reason that the level of employment increases aggregate demand price also rises, shown as AD curve in the upcoming diagram 1.

Aggregate Supply Price

            When an entrepreneur gives employment to a definite amount of labor, it requires certain quantities of co-operant factors like land, capital, raw materials etc. which will be paid remuneration along with labor. Thus each level of employment involves certain money costs of production including normal profits which the entrepreneur must cover. “At any given level of employment of labor aggregate supply price is the total amount of money which all the entrepreneurs in the economy, taken together must expect to receive from the sale of the output produced by that given number of men, if it is to be just worth employing them.”

            In brief, the aggregate supply price refers to the proceeds necessary from the sale of output at a particular level of employment. Thus each level of employment in the economy is related to a particular aggregate supply price and these are different aggregate supply prices for different levels of employment.

            A statement showing the various aggregate supply prices at different levels of employment is called aggregate supply price schedule or aggregate supply function. In the words of Prof. Dillard, “The aggregate supply function is a schedule of the minimum amounts of proceeds required to induce varying quantities of employment.” The below tablet reveals the aggregate supply schedule,

Level of Employment (N) in 100 Thousands	Aggregate Supply Prize (Z) In Million $
4	430
5	460
6	490
7	520
8	550
9	580
10	610

            The above table reveals that the aggregate supply prices rise with the hike in the level of employment. If entrepreneurs are to provide employment to 400 thousand workers, they must receive $430 millions from the sale of output produced by them. It is only when they expect to receive minimum amounts of proceeds ($460 millions, $490 million and $520 million) that they will provide employment to more workers (5, 6 and 7 hundred thousand dollars respectively).

            But when the economy reaches the level of full employment (at 800 thousand workers, the aggregate supply price ($550 million, $580 million and $610 millions) continues to increase but there is no further is an increasing function of the level of employment and is expressed as Z = ɸ N, Z is the aggregate supply price of the output level from employing N men.

            The aggregate supply curve can be drawn on the basis of the schedule. It inclines upward from left ro right for the reason that the necessary expected proceeds hikes; the level of employment also rises. But when the economy reaches the level of full employment, the aggregate supply curve becomes vertical. Even with the hike in the aggregate supply price, it is not possible to provide more employment as the economy has attained the level of full employment.

                                    

Reflationary policies and Deflationary policies

Reflationary policies and Deflationary policies

Keynesians - Policies                                  

The other sections about Keynesians show that they believe that the economy can settle at any equilibrium. This means that they recommend that the government gets actively involved in the economy to manage the level of demand. You will then be stunned to learn that these policies are known as demand-management policies.

Demand management means adjusting the level of demand to try to ensure that the economy arrives at full employment equilibrium. If there is a shortfall in demand, such as in a recession (a deflationary gap) then the government will need to reflate the economy. If there is an excess of demand, such as in a boom, then the government will need to deflate the economy.

Reflationary policies

Reflationary policies to boost the level of economic activity might include:

    * Increasing the level of government expenditure

    * Cutting taxation (either direct or indirect) to encourage spending

    * Cutting interest rates to encourage saving

    * Allowing some money supply growth

The first two policies would be considered expansionary fiscal policies, while the second two are expansionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Reflationary policies] 

The reflationary policies have boosted the level of output from Q1 to Q2. The impact on the price level has been small, though if demand increased any more it may well be inflationary.

Deflationary policies

Deflationary policies to dampen down the level of economic activity might include:

    * Reducing the level of government expenditure

    * Increasing taxation (either direct or indirect) to discourage spending

    * Increasing interest rates to discourage saving

    * Reducing money supply growth

The first two policies would be considered contractionary fiscal policies, while the second two are contractionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Deflationary policies] 

The initial level of aggregate demand was inflationary - prices were increasing rapidly.  However, the deflationary policies have reduced demand to AD2 and thus reduced the level of inflation.

Tax

Tax:

In honor of the filing date for taxes here in the US (today), I thought we could take a look at all the different kinds of taxes that exist. Last year, I did a whole tax week that looks at some of these in greater detail. I encourage you to explore those if you want to know more about some of these taxes, but today’s post will be much shorter. This list is by no means absolute, there are hundreds of different kinds of taxes, but these are the primary sources of income for most governments, local and national.

Sales Tax: In the US, we most often see this tax as a method for states to raise revenue for themselves. Customers make purchases at the retail level (not wholesale) and pay a tax that is a percentage of the sales price. States vary the rates they charge, and the rate also varies based on the product. For example a t-shirt has one tax, food has another, and gas has still another. Some states do not have a sales tax (such as Delaware) while others may charge more than 8% on a transaction. Retailers don’t like sales taxes because they have to collect that tax from the customer. They’ll claim it deters certain sales, but I find that unlikely unless someone lives near a state border. Speaking of which, states love the sales tax since they can get revenue from people outside the state. Places where tourism is big obviously benefit quite a bit. It’s arguable that the sales tax is the fairest of all taxes. It is a tax on consumption. If you want to save on taxes, don’t buy stuff (or buy less). Those that make more money tend to consume more, so they’ll pay more taxes. The catch is near the poverty line, where almost all purchases are just for basic living.

Capital Gains Tax: This is a tax on the profit made from the sale of an asset. It’s most commonly cited when it comes to profits made from selling stocks. If you buy a share of Stock A at $10 and then sell it for $15 you have a $5 capital gain. You must pay taxes on this gain. Currently, the United States has a favorable tax treatment of capital gains thanks to the Bush tax cuts, however those are likely to be allowed to expire. States will also take a chunk of the capital gains. The great thing about this tax is it only taxes people with enough excess income to actually invest. In other words, it’s a tax the poor don’t have to think about. The problem with the capital gains tax is during times of high inflation the value of an asset may increase simply due to inflation. Selling it would result in a tax on nominal, but not real, profits. This was part of the reasoning behind the Bush cut.

Income Tax: This is the big fish. Most states and the federal government rely heavily on income taxes. It taxes the financial income of individuals and companies. Most systems tax income in different brackets. So a person making $30,000 a year will pay less as a % of their income than someone making $60,000 a year. This system provides governments with a relatively stable income, simply because our earnings tend to be predictable. People are taxed on gross income, while companies generally are taxed on net income (profits). The downside for individuals is they tend to overpay their taxes every year and receive a refund. Though this is often celebrated, the net effect is giving the government a free short-term loan. That money could have been used by the individual to retire debt or invest. In the US, the income tax system is regularly criticized for being too complicated.

Property Tax: Like all taxes, this one is self-explanatory. It’s a tax based on the value of an asset. The most common reference is to a tax on your home, but it also includes your car and anything else the government wants to tax. The government is generally responsible for establishing the tax value of an asset, and they have a tendency to be conservative, but not always. Interestingly, the focus is on private assets in public view, such as your home, car, or boat. But if you loan a piece of art to a museum it can now be subject to the property tax. Like the capital gains tax, this tax tends to get revenue from those that make enough to obtain assets worth taxing.

Value Added Tax: This tax is familiar to our friends in Europe. It’s more complicated than a sales tax or income tax, but potentially more appropriate. Imagine a sales tax at every point in the supply chain. Generally, each stop in the chain of a product being converted from raw materials to something worth buying, has value added to it. So in the gas industry you might have 3 stops. The first group pumps oil and sells it to the refiner – tax. The refiner converts the oil to gasoline and sells it to gas station – tax. You pump the gas and pay the station – tax. Like any system it has its holes that allow people to commit fraud, but nothing is perfect. This system is also considered the most fair, since everyone gets taxed based on the contribution they make to the economy.

Regressive Tax: A tax that is less strenuous on the rich as it is on the poor. Sales taxes like that used in the US and the VAT in Europe are regressive taxes. The US income tax is the opposite in that it is progressive; the more you make, the more your tax burden is. Tariff: A tax designed to discourage a behavior. It’s most often applied on imports to protect domestic industries. Russia might impose a wheat tariff so that it’s more expensive for Russians to import wheat than just buy the wheat grown in the country. Tariffs are very disruptive on free markets and pricing.

Fair Tax: A tax system that is a universal sales tax. It was proposed as a solution to the complicated tax code the US currently has. It is a regressive tax, however breaks for the poor could be made to make it work.