Home » What is deficit financing? what role does it play in the economic development

What is deficit financing? what role does it play in the economic development

What is deficit financing? what role does it play in the economic development

Deficit Financing :-
Professor Dillard says that “The programme of public investment should be financed by the borrowing rather than by taxation this kind of borrowing is called deficit financing.”

If during a given period of time the expenditure of government exceeds than it revenue and the deficit is met by borrowing it is called deficit financing.
Government adopts two method in this regard :
1. Government uses the cash balances of the past.
2. Government borrows from the central bank which issues the paper currency.
So we can say that deficit financing ultimate result is the issuance certain of paper money.

There is a difference in deficit financing and deficit budgeting. When current expenditure is excess than the current revenue it is called capital account, on the other hand when current capital receipts are not adequate to meet the development expenditure and this gap is financed by borrowing from the banking system is called deficit financing.


In the developing countries capital resources are inadequate for financing the economic development. The rate of taxes can not be increased because the rate of saving and consumption will fall. The rate of saving is already very low in the less developing countries due to low per capita income. So government adopts the deficit financing policy to break the vicious circle of poverty. The main reasons for using this policy are as under :

1. To Cover the Gap :-
When the Govt. is unable to fill the gap between the total receipts and total expenditure by imposing taxes then Govt. adopts the policy of deficit financing. By adopting this way Govt. can avoid the displeasure of the people.

2. Low Savings :-
In the under developed countries normally rate of savings is 10% to 14% of the GNP which is very low. As such the Govt. of these countries is compelled to use this policy as an instruments for economic development.

3. Rapid Growth of Population :-
In the less developed countries population growth is very high. To met the needs of the people and to speed up the economic development Govt. is using the deficit financing policy.

4. Lack of Banking Facilities :-
Savings are mobilized by the financing institutions. But in the underdeveloped countries there is a shortage of these institutions particularly in rural areas. So resources are not mobilized to the desired extent and Govt. is helpless to use this policy.

5. Suspension of Foreign Aid :-
Due to delay ans suspension of foreign aid Govt. has to adopt the deficit financing policy to break the vicious circle of poverty.


Following are the important advantages of deficit financing :

1. High level of employment is ensured by the policy of deficit financing.
2. Utilized and underutilized resources can be build up with the help of this policy.
3. Additional resources can be mobilized for the economic development by using this policy.
4. Social and economic over heads can be build up by adopting the policy of deficit financing.


When the government expenditure financed by the created money, it leads to inflation in the country. The classical economists say that in a capitalistic economy there is always a tendency for the economy to operate at the level of full employment.
When there is full employment and we use this policy the inflation rate will rise.

But Prof. Keynes is not agree with them. He says that “When there is large scale of unemployment and the resources of the country are not being fully utilized deficit financing policy is very helpful in improving the economic condition without inflation.”

Today this policy is commonly used in the all countries. The poor countries are using this policy to utilize their unemployed resources. These countries are using the deficit financing for the construction of roads, railways, canals and factories.
There is a time gap between the pumping of money into the hands of the people and the establishment of scheme of development.
If the extra demand is increased due to the created money, is matched by the extra supply of goods then prices will not rise. If the time period between input and output is long the prices will rise for the particular time period and economy will face the inflationary pressure. On the other hand if the time is shorter between the consumption and completion of development schemes, then inflationary pressure will be slow.
One thing should be noted that the relation between prices and created money may be different. A 100% rise in the money supply may create only 10% rise in the price of the commodity.
The rising of prices due to the deficit financing depends upon various factors such as time period, consumption, savings and habits of the people.
For example if people hold or save all the created money then there will be no inflationary pressure.


Deficit financing is very useful weapon for ensuring the high level of employment in the advanced countries. They increase the effective demand and adopt various measures to reduce the inflationary pressure. Following are the important measures which can be adopted to control inflation :

1. Formulation of Import and Export Policy :-
A country should frame its import and export policy in such a manner that the supply of an essential goods may not fall.

2. Proper Allocation Of Resources :-
The rise in price due to deficit financing can be controlled by proper allocation of resources. Developing countries should prepare effective plans and resources of the country may not be wasted in unproductive projects.

3. Fiscal Policy :-
The inflationary pressure can be controlled, if a government increases the rate of taxes on luxuries and introduces the compulsory saving schemes.

4. Monetary Policy :-
An effective monitory policy can be adopted to reduce the inflationary pressure. Most of developing countries are also using these weapons against the inflationary pressure to reduce the inflation.

5. Supply of Commodities :-
Inflationary pressure can be controlled by providing the basic goods to the consumer at fixed rates through the utility stores.


importance of capital formation or capital accumulation in the less developing countries and suggest measures to promote the rate of capital accumulation


Capital Formation or Capital Accumulation :-
Meaning :- Capital accumulation or capital formation means to increase the real assets of the country. In other words to increase the man made capital goods like machinery and buildings.

Importance of Capital Accumulation or Capital Formation :-
In the less developing countries economy depends upon capital accumulation. If the rate of investment increases, it increases the national income. On the other hand if investment falls national income. On the other hand if investment falls national income also falls. To break the vicious circle of poverty we will have t increase the investment by increasing the saving s in the country.

According to Prof. Ellis “The shortage of capital accumulation is the main obstacle in the way of economic development.”

We should increase the rate of savings and then these savings should be utilized for investment.The marginal efficiency of capital should be higher than the rate of interest then we can increase the rate of investment in the country. By increasing the rate of investment we can increase the rate of employment, and rate of production in the country, the pr capita income will rise and it will improve the standard of living. So better utilization of resources and prosperity can prevail by increasing the rate of investment in the country.
Following are the important sources of capital formation :

1. Savings :-
In the less developed countries rate of saving is very low due to low per capita income. There are two types of savings, household savings and business sector savings. House hold savings are voluntary savings which are used for further investment. In the under developed countries rate of savings is 10% to 14% of national income.

2. Taxes :-
The government imposes the taxes on the public and this revenue is used for investment. These taxes are called compulsory savings.

3. Government Borrowing :-
Sometimes government borrows the money from the people and uses it for investment. It is an important source of capital formation.

4. Use of Idle Resources :-
By using idle resources government increases the production and investment. For instance in underdeveloped countries large area of land still barren, it can be cultivated by employing the services of unemployed people and role of capital formation can increase

5. Deficit Financing :-
The poor countries commonly use this source to increase the rate of investment in the country. By using this policy unemployed resourced are utilized and savings are generated for capital formation.

6. Foreign Aid :-
The developing countries also borrow from outside the country to increase the capital formation in the country. It can be obtained from a number of sources. Sometimes Govt. borrows from outside the country and sometimes from inside the country. Govt. also borrows from the international financial institutions like IMF, IBRD and UN agencies.

Measure To Promote the Capital Formation or Capital Accumulation :-
The following measures can be adopted to increase the rate of capital formation in the less developed countries :

1. Increase in Financial Institutions :-
The government of poor countries should increase the branches of banks in the rural areas. So villagers may be able to deposit their money in banks, instead of keeping it at home. Private financial institutions based on sound footing should be allowed to play their role.

2. Incentive To the People :-
To encourage the savings government should introduce various national savings schemes to attract the people. Higher rate of interest also attracts the people. When saving rate will rise, it will enhance the rate of investment.

3. Investment Opportunities :-
The government should increase the investment opportunities in the country and there should be no fear of nationalization. It will increase the rate of investment. Suitable environment is also compulsory for capital formation.

4. Increase in Taxes :-
The government may increase the taxes and this revenue can be utilized for investment. But due to the raise in taxes, there should be no reduction in investment.

5. Restriction on Imports :-
The government should restrict the imports of consumption goods. So the rate of consumption will fall and rise of saving will raise. It will increase the investment in their country.

6. Increase in Exports :-
By increasing the exported, government can earn foreign exchange which can be used on the import of capital goods.

7. Cut on Unproductive Expenditure :-
The government should reduce unproductive expenditure and increase the rate of investment, The expenditure on administration and defence can be reduced to promote investment.

8. Use of Foreign Aid :-
It is very useful for increasing the rate of capital formation. But it is curse when it is misused. In most of developing countries are face the burden of debt so that is the major reason of low investment.

9. Increase in Employment :-
In underdeveloped countries manpower is surplus. If we use it for productive purpose, it can increase the rate of investment. Govt. can introduce the various social welfare schemes and can increase the rate of employment.

10. Increase in Foreign Investment :-
The government should invite the foreigners to increase the rate of capital formation. Today the most of developing countries also offered various incentives to the foreigners to increase the rate of investment in their country.


Causes of Unemployment :-

In the advanced countries rate of unemployment is low while in the less developing countries rate of unemployment is very high. In the less developing countries disguised unemployment is also found.

1. Lack of Capital :-
The less developing countries are facing the problem of capital shortage. While for the development of any country there is need of a huge amount of capital. When new projects buildings and factories are constructed a large number of people are engaged in these projects. So lack of capital is the major cause of unemployment.

2. Overpopulation :-
In the developing countries, the rate of population growth is 3% per annum while the natural resources are limited and they can not meet the increasing demand of job.

3. Seasonal Variations :-
There are many industries which produce the goods seasonally like ice factory. These work only few months and remain close in the remaining period. So a large number of people who are engaged with these industries becomes unemployed. Due to inventions, new goods replacing the old commodities. So the people who are engaged with old industries are unemployed.

4. Lack of Effective Demand :-
According to Keynes when aggregate supply increases than the aggregate demand the unemployment prevails,. So he stresses that the rate of consumption may not fall.

5. Lack of Skill :-
In the less developing countries, majority of the people is uneducated and they have no any skill about any particular job. So they cannot get the job.

6. Poor Performance of Agriculture Sector :-
Under developed countries depends upon the agriculture sector and production of agriculture depends upon nature. Second problem is this that there is subdivision of land.Farmers have very small holdings neither they can sell it nor they can cultivate it.


1. Increase in Capital Formation :-
Government should establish the labour intensive industries to increase the rate of employment.

2. Incentive for Private Sector :-
Government should provide the liberal concessions and tax holiday to the private investors, to increase the rate of employment.

3. Establishment of Small Scale Industries :-
In the rural areas small scene industry should be established to remove the disguise unemployment.

4. Technical Training Centers :-
Technical and commercial centers should be established to provide training and skill to the public. It will be very useful in curtailing the unemployment.

5. Control on Population :-
There should be an effective check on the population growth. Family planning programme should be introduced and population should be reduced according the size of natural resources.

6. Increase in Effective Demand :-
Government should increase the rate of investment by establishing the various industries to increase the rate of employment.

7. Employment Exchange Offices :-
The offices should be established to provide the proper information about the employment to the public.

8. Monetary and Fiscal Policy :-
Monetary and fiscal policy should framed in such a manner that there should be maximum chances of employment to public.

About the author

Salman Qureshi

Salman Qureshi is an Accountant by profession & he loves to write on Commerce & Management Sciences Subject to assist Students. Hope you guys will like his effort.

Add Comment

Click here to post a comment