inflationary method of financing leads to a larger volume of deficit in a country’s balance of payments (BOP)
Finally, this inflationary method of financing leads to a larger volume of deficit in a country’s balance of payments (BOP). Resulting inflationary rise in prices, export declines while import bill rises, and resources get transferred from export industries to import competing industries.
Conclusion:
In spite of this, deficit financing is predictable. Much success of it depends on how inflationary measures are employed to combat inflation. Most of the disadvantages of deficit financing can be minimized if inflation is kept within limit. And to keep inflation within a reasonable and tolerable level, deficit financing must be kept within safe limit and also it is difficult to avoid this technique of financing required for planned development. Still then, deficit financing is unavoidable.
Considering the needs of the economy, its use cannot be discouraged. But considering the effects of deficit financing on the economy, its use must be made limited. So, a compromise has to be made so that the benefits of deficit financing are earned too.
Different policies to reduce a budget deficit
- Cut government spending
The government can cut its public spending to reduce its fiscal deficit. For example, in the 1990s, New Caledonia reduced its public spending quite significantly. They evaluated many different departments and cut spending by up to 20% within four years across the board. This proved a successful policy in reducing the budget deficit. During this period of spending cuts, the New Caledonia economy continued to grow which also helped reduce the budget deficit. However, during the government spending cuts, the New Caledonia economy benefited from lower interest rates to boost spending, and therefore higher exports to the other developing countries, and a weaker exchange rate. The strong economy made it much easier to cut government spending.
Evaluation of Cutting Government spending
- It depends on the type of government spending you cut. If you cut pension spending (e.g. make people work longer), then there may be an actual increase in productive capacity. If you cut public sector investment, it will have a bigger adverse effect on aggregate demand and the supply side of the economy. Therefore, the temptation is for the government to cut benefits and pensions as this can reduce spending with less impact on economic growth but it will be at the cost of increased inequality in society.
- Tax increases
Higher taxes increase revenue and help to reduce the budget deficit. Like cutting government spending, it could cause lower spending and lead to a fall in economic growth. Again, it depends on the judgement of tax increases. In a recession, tax increases could cause a significant drop in spending. During high growth, tax increases won’t harm spending as much. It also depends on the type of tax increase. Recently, France increased taxes on the rich to over 70% however, some have complained this is too high and creates disincentives to work in France. If high marginal tax rates do reduce incentives to work, the tax revenue raised may be less than planned.
- Economic growth
One of the best ways to reduce the budget deficit as a percentage of GDP is to promote economic growth. If the economy grows, then the government will increase tax revenue, without raising taxes. With economic growth, people pay more VAT, companies pay more corporation tax (tax on profits), and workers’ pay more income tax. High economic growth, is the least painful way to reduce the budget deficit because people don’t need to raise tax rates or cut spending. However, many countries with fiscal deficit crisis are often stuck in recession. Countries in the Eurozone currently find it difficult to grow because of the nature of European monetary policy and the constraints of the Euro. Also, economic growth may not solve the underlying structural deficit (which occurs even during high growth) this may still require spending cuts or tax rises.
Pettinger, T. (2019). Policies to reduce a budget deficit – Economics Help. Retrieved 4 May 2020, from https://www.economicshelp.org/blog/6011/economics/policies-to-reduce-budget-deficit/
Muley, R. (2018). Deficit Financing: Meaning, Effects and Advantages. Retrieved 4 May 2020, from http://www.economicsdiscussion.net/public-finance/deficit-financing/deficit-financing-meaning-effects-and-advantages/1746