Question

What is the effect of deficit financing on economy?
1. Reduction in taxes
2. Increase in wages
3. Increase in the money supply
4. Decrease in money supply

Answer 1

Correct Answer - Option 3 : Increase in the money supply

The correct answer is Increase in the money supply.

• 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.
  • A 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.