Advantages and Disadvantages of Deficit Financing - Essay Example

Deficit financing has many advantages that benefit the economy in times of economic trouble but it has many disadvantages and overemphasis on it may turn hazardous for the economy.

2.1 Advantages of deficit financing

            In a modern economy, budget deficits often evolve due to some common reasons like an increase in government expenditure, a fall in aggregate income level, inefficiency in the tax collection mechanism, subsidies granted by the government in diverse sectors of the economy, and so on. All these result in a diminished pool of the state exchequer causing a budget deficit wherein the mechanism of budget deficit by the government makes its intervention come with its own set of advantages. As discussed earlier, with two major tools borrowing and printing new currency, the economy experiences development in infrastructure with a capital infusion which in turn propels a productivity boom in essential sectors like education, medicine, and real estate to name a few. Money supply within the economy increases that as a spillover effect increases the price level (although inflation acts as a predicament) of the economy that fetches gains to the producers in the supply side luring investments. One of the major advantages of deficit financing is that it increases the aggregate demand within the economy increasing employment opportunities, income, and thus more investments (Hajela, 2010, p. 348).

2.2 Disadvantages

            After analyzing the advantages of deficit financing, it can be stated that there are some disadvantages of it as well. Inflation is one of the most prominent disadvantages or evil effects of deficit financing. If deficit financing cannot be controlled properly then inflationary pressure will increase. For instance, in the case of production owing to excess capacity deficiency, discrepancies between demand and supply of goods within the market and shortage of complementary factors coupled with an increase in money supply accelerates inflationary pressure. Apart from that some other disadvantages of deficit financing are an increase in national debt and discouraging private investments (as government intervenes in deficit financing, the prime focus is entailed on socially useful public goods) (Hajela, 2010, pp. 349-350). Here lies the crux of the crowding-out effect.

3. Crowding-out effect

            The crowding-out effect can be regarded as a forced fall in private investment as a result of deficit financing by different governments of nations. The government borrows money from the central bank or through open market operations (basically through the sale of bonds). This in turn diminishes the price of bonds and interest rates which are inversely proportional to bond prices go up. The rise in interest rates shies away from interest-sensitive private investment and tightens the capital market. Private investments fall vigorously and thus deficit financing acts as a backburner (Dwivedi, 2010, p. 617).

4. Conclusion

            Deficit financing is one of the most sought-after tools in the hands of the government for controlling the deficit created in the economy and bringing back stability within the economy enhancing the aggregate demand. On the positive side, it injects money flow within the economy and increases social infrastructure development, employment, and income generation. On the darker side, it entices inflationary pressure and majorly shies away from private investment which is very much essential for dynamic development in a modern economy.