Deficit Financing

Concept of Deficit Financing

Suppose the government cannot fulfill its expenditures through traditional revenue sources. In that case, it may turn to deficit financing to close the gap. Simply put, deficit financing is the process of creating new money to cover the gap between government spending and receipts. On the other hand, the word deficit funding is defined differently in developed and developing countries.

Deficit financing is the practice of a government exceeding its existing revenue (i.e., taxes and non-tax revenue such as commercial revenue, administrative revenue, donations, and grants) in developing countries. Market borrowings (government loans) and, on rare occasions, the creation of new money are used to pay the deficit. Thus, even when loans pay the deficit, there is deficit financing in the western sense.

On the other hand, deficit funding is defined differently in developing countries. It's a term that refers to the difference between total government spending and total revenue, as measured by current revenue and government borrowings. In developing countries, deficit finance refers to spending exceeding current revenue and government borrowing. The government can use either fund the deficit by depleting its cash reserves or borrowing from the central bank. When the government depletes its cash reserves, it withdraws cash from the central bank, increasing the money supply. When the government asks the central bank for money, the latter responds by printing more currency notes. As a result, the money supply rises in both scenarios.

It is evident from the preceding that, while the idea of deficit financing in Western countries does not treat government borrowing as revenue, it is treated as such in developing countries. Thus, deficits in developed countries are financed primarily through government loans. In contrast, deficits in poor countries are financed primarily by creating new money.