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What is the effect of deficit financing on economy?
1. Inflation
2. Deflation
3. Depression
4. None of these

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Correct Answer - Option 3 : Depression

The correct answer is Depression.

  • Effects of Deficit financing on the economy:
    • Deficit financing can have a useful role during the phase of depression in a developed economy.
    • During this phase, the level of expenditure 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, which leads to an increase in the money supply.
    • The machinery and the capital equipment are all present there but the incentive to produce is lacking due to a deficiency in aggregate demand.
    • It is in this scenario that the government pumps in additional purchasing power in the economy through deficit financing the level of effective demand is likely to increase.

  • Deficit financing:
    • Deficit financing means generating funds to finance the deficit which results from an excess of expenditure over revenue.
    • The gap is covered by borrowing from the public by the sale of bonds or by printing new money.
    • For developing countries like India, higher economic growth is a priority.
    • higher economic growth requires finances.
    • With the private sector being shy of making a huge expenditure, the responsibility of drawing financial resources rests on the government.
    • Often both the tax and non-tax revenues fail to mobilize enough resources just through taxes.
    • The deficit is often funded through borrowings or printing new currency notes.
    • Deficit financing affects investment adversely.
    • When there is inflation in the economy employees demand higher wages to survive.
    • If their demands are accepted it increases the cost of production which de-motivates the investors.

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