Public Debt: Concept and Need for Public Debt

Public Debt: Concept

The practice of raising public debt by the state to finance government expenditure started only since 19th. Century. But the royalties used to borrow on their personal goodwill even since ancient times. These days government borrowing has been almost a normal method of financing government expenditure.

J.L.Hansen, “Public debt is the debt owned by a government to people and institutions within its own borders and/or to foreign creditors.”

Philip E. Taylor, "Government debt arises out of borrowing by the treasury from banks, business organizations and individuals. The debt is in the form of promises by the treasury to pay back the holders of these promises a principal sum and interest on the principal."

Public debt is raised internally by floating the securities like bonds and treasury bills, and overdrafts from the central bank. Externally, it is raised from foreign individuals and organizations, donor governments and international financial institutions. Normally, government borrowing is voluntary in nature, but sometimes it may be coercive or with some influence.

Generally, the classical economists were against public debt. They strongly believed on the laissez-faire policy, and so favored minimum size of the government as far as possible to them. Government borrowings is mostly unproductive, inflationary and burdensome. However, they approved debt financing in the productive projects called as the self-liquidating projects. According to Musgrave, "The self-liquidating projects may be defined as investment on public enterprises that provide a fee or sales income sufficient to serve the debt incurred in their financing. It can be defined in a broader way as expenditure on projects that increase future income and the tax-base. Such projects permit serving of the debt incurred in their financing without requiring an increase in the future level of tax-rates.”

The Keynesian view after the 1930’s Great Depression advocated the need for the use of public financial operations as fiscal policy for maintaining economic stability. To them borrowing may not necessarily be unproductive, inflationary and burdensome always. It is accepted as the best option in a period of depression, and to some extent even to control inflation. According to Lerner, government should borrow only when it wants to make people hold more bonds in place of money. The desirability or otherwise of public borrowing should be judged in terms of its effects on aggregate demand and the economic situation.

The modern view is concerned about its importance in raising and mobilization of financial resources, its management, and relationship with the monetary policy. It has been accepted that debt financing beyond the limit is certain to invite severe economic problems.

Need for Public Debt

Borrowing by the state has been a normal method to finance public expenditure in both the developed and developing countries. In different situations or for different purposes public debt is raised.

1. To manage current budget deficit: Governments do not have large accumulated reserves or cash balances to meet any current budget deficits. Normally, it is said that the regular expenditure should be financed from revenue sources. But due to many reasons sometimes income from revenue sources may not be sufficient to meet even the regular expenditure as required. Besides, the unexpected emergencies like fire, floods, famines earthquakes and other natural disasters necessitates a large amount of government expenditure for rescue and relief works. In such situation governments are compelled to borrow.
2. To meet war expenses: Borrowing to finance wars is in practice since ancient times. In modern times, the cost of warfare has been tremendously increased with the development in war technology and techniques. In a situation of war, income from revenue sources will not be sufficient to meet war expenses. Besides, in such situation, economic activities generally decreases leading to low level of national income and low yield from taxation sources. In such situation it is not desirable to increase rate of taxes beyond desirable limits which may create serious socio-economic and even political problems in the country. So, it is better and convenient for government to borrow in a warfare situation.
3. To maintain economic stability: The idea of compensatory finance and functional finance has recognized the importance of borrowings to maintain economic stability. In a situation of depression. Government is to increase its expenditure, mainly by borrowings, to increase effective demand in the economy. To control inflation, government is to borrow out of the peoples’ fund which is likely to be used for increasing consumption expenditure. At the same time, the borrowed money is to be invested on production of goods and services by itself or private sector, Besides, government may borrow from external sources to manage trade deficit.
4. To promote the rate of economic growth: One of the main constraints in the process of economic growth in the developing countries is lack of sufficient investment resources. To exploit or utilize the potentiality of natural and human resources, it is necessary to make a significant investments on them. For this, the savings of individuals and private corporate bodies can be increased voluntarily by borrowings with attractive monetary benefits. Borrowing from banking and financial institutions including central bank, is needed for productive use of unused or idle resources. Besides, borrowing from external sources in a wise way and effective investments helps in increasing productive capacity of the economy and national production.
5. To manage the problem of Balance of Payments: In a situation of deficit in the balance of payments, government may borrow from external sources for funding the import requirements.

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Measures needed to control Inflation | Monetary Policy, Fiscal Policy and Other Measures

There are three lines of action to check and contain an inflationary boom namely, Monetary Measures, Fiscal Measures and other Measures.

i) Monetary Policy Measures         

Following are the monetary measures, which can be used to curb inflationary pressures:

1. Increased re-discount

To curb inflation, the Central Bank generally increases the re-discount rates. An increase in the re-discount rates leads to an increase in bank rates, because there is a definite relationship between the two. An increase in bank rates tends to discourage borrowing by businessmen from banks, resulting in a fall in the intensity of inflationary pressures in the economy. An increase in interest-rates consequent upon the increase in the bank rate will make savings attractive than before and induce people to spend less on consumer goods. But the increase in re-discount rates as a weapon to check an inflationary boom has its limitations tool. Firstly, if the bank rates do not rise with the rise in re-discount rates, there will be no decline in business borrowings, and hence, the inflationary pressures will continue, even though the re-discount rates have been raised. Secondly, the effectiveness of higher re-discount rates as an anti-inflationary weapon shall be considerably undermined if the commercial banks have an easy access to additional reserves.

2. Sales of government securities in the open market

Another method to check the inflationary boom is to resort to sale of government securities to the public by the central bank. As the buying public purchases and pays for those government securities, the commercial banks’ reserves with the central bank are correspondingly reduced and they are obliged to adopt a restriction credit policy in relation to business requirements. But the sale of government securities as an anti-inflationary weapon is also subject to limitations. Firstly, this policy may be rendered ineffective if the commercial banks are able to increase their reserves by selling their stocks of government securities to the central bank. Secondly, this policy may also be offset by increased borrowing from or by increased sales of treasury bills to the central banks of the commercial banks.

3. Higher reserve requirements

An increase in reserve requirements of the member banks also serves as an anti-inflationary weapon during inflation. It absorbs the excess reserves of the banking system and, thus, prevents them from forming a basis for further credit expansion. But this method is also subject to limitations. Firstly, if the commercial banks happen to have very large excess reserves, even the raising of the reserve requirements may not significantly curtail their power to create credit. Secondly, the ability of commercial banks to increase the reserves through sale of government securities may render higher reserve requirements ineffective to check credit expansion. 

4. Consumer credit control

During an inflationary boom, facilities for installment buying are reduced to the minimum to curtail excessive spending on the part of the consumers. This is done (i) by raising the minimum initial payments on specified goods, (ii) by extending the application of consumer credit control to a large number of consumer goods, and (iii) by reducing the length of the payment period, etc.

5. Higher margin requirements

It is a method of selective credit control. The central bank is its pursuance of higher levels. The central bank in its pursuance of an anti-inflationary policy may raise the margin requirements of loans to higher levels. The higher the margin requirements, the lower the amount of loan that the borrower can obtain from the bank. Thus, higher margin requirements have the effect of checking undue monetary expansion.

ii) Fiscal Policy Measures         

The major anti-inflationary fiscal measures are the following:

1. Government expenditure

To counteract increased private spending at a time of inflation, the government should, at such a time, reduce its own expenditure to the minimum extent possible to help limit the aggregate demand. As against this, it may, however, be said that it is not so easy to reduce government expenditure particularly during the war period. Secondly, any drastic cut in government expenditure to cure inflation may actually land the economy in a slump.

2. Taxation

The problem during inflation is to reduce the size of disposable income in the hands of the general public in view of the limited supply of goods and services in the market. It is, therefore, necessary to take away the excess purchasing power from the public in the form of taxes. The rates of existing taxes should be steeply increased, while new taxes should be imposed on commodities so as to leave less money supply with the public to spend.

3. Public borrowing

The object of public borrowing is to take away from the public excess purchasing power which, if left free, would surely exert an upward pressure on the price-level in view of the limited supplies of goods and services in the economy. If voluntary borrowing does not yield adequate results, it may become necessary to resort to compulsory borrowing from the public.

4. Debt management

The existing public debt should be managed in such a manner as to reduce the existing money supply and prevent further credit expansion. Anti-disciplinary debt management usually requires the repayment of bank-held debt out of a budgetary surplus. The idea is that the government securities held by commercial banks should be retired by the government out of the budgetary surplus. This would check the power of commercial banks to cash their securities and add to the reserve for the purpose of credit expansion.

5. Overvaluation

An overvaluation of domestic currency in terms of foreign currencies will also serve as an anti-inflationary measure. Firstly, it will discourage exports and thereby increase the availability of goods in the domestic market. Secondly, by encouraging imports from abroad, it will add to the domestic supply of goods in the economy. But, overvaluation as an anti-inflationary weapon suffers from several limitations.

6. A suitable income policy

At a time of inflation, the government must also adopt a suitable price-income policy. It should strictly control wages, salaries and profits to keep spending at a low level to fight inflation.

iii) Other Measures        

These measures can be used to supplement monetary and fiscal measures undertaken to contain inflationary pressures.

1, Expansion of output

Increased production is the best antidote to inflation because inflation arises partly due to inadequacy of output. But it becomes rather difficult to increase output at a time of inflation because of the full utilization of resources. It is suggested that if it is not possible to increase output as a whole, steps should be taken to increase the output of those goods which seem to be extremely sensitive to inflationary pressures by shifting productive resources from the less inflation-sensitive goods. In other words, a reallocation of productive goods, such as food, clothing, housing, etc. Steps may also be taken to increase supply of consumer goods through large-scale imports from other countries to absorb excess money supply.

2. Wage policy

During an inflationary boom, the wages have to be controlled so as to curb the inflationary pressures in the economy. Wage increases may be allowed to workers only if their productivity increases. If this principle is observed, higher wage shall not lead to higher unit costs and hence, it higher unit prices.

3. Price control and rationing

The object of control is to lay down the upper limit beyond which the price of a particular commodity would not be allowed to rise. To ensure the successful functioning of price control, two conditions will have to be satisfied. Firstly, the government should have under its control adequate stocks of the commodities concerned. Secondly, the demand for the concerned commodities should be controlled through rationing, failing which the richer sections shall be able to buy a major portion of the available stocks.

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Inflation and Demand Pull Inflation | Causes of Demand Pull Inflation

Inflation is a fall in the market value or purchasing power of money. It is the opposite of deflation. It refers to a continuous increase in the aggregate price level of goods and services rather than just a one-time increase in it. In other words, inflation means rise in price level or fall in the value of money. Inflation is simply the increase in the general price level in sufficiently a long period. In

some context, the term inflation is used to refer to an increase in the money supply, although this concept is also often referred to as monetary expansion. Due to the causes of inverse relationship between general price level and value of money, inflation is continuous decrease in value or the purchasing power of money.

Inflation results from an increase in the amount of circulating currency beyond the needs of trade; an oversupply of currency is created. In the past, inflation was often due to a large influx of bullion, such as took place in Europe after the discovery of America and at the end of 19th century. In modern times, wars are the most common cause of inflation, as government borrowing, the increase in money supply, and a diminished supply of consumer goods, increase demand relative to supply and thereby cause rising price. The economists have defined inflation in many ways. Some of the definitions have been presented here.

According to Edward Shapiro, “Inflation is a persistent and appreciable rise in the general level of prices.”

 

In the words of Gardner Ackley, “Inflation is defined as a persistent and appreciable rise in the general level of prices. This clearly makes inflation a process rising prices not higher prices.”

 

In the words of Coulbourn, “Inflation is too much money charging too few goods”.

 

According to Sir RG Hawtrey, “Inflation is the issue of too much currency.”

According to Prof. Samuelson, “Inflation occurs when the general level of prices and costs is rising.”

Demand Pull Inflation

Demand pull inflation occurs when there is an excess demand over the available supplies at existing prices. Excess demand means aggregate real demand for output in excess of maximum feasible, or potential, or full employment output. Excess demand is generated by forces operating on the demand side of the commodity market.

As a result of increase in demand, the aggregate demand function shifts upwards to the right (supply function remaining constant). In this case, rise in price is caused exclusively by the increase in demand as could be seen in the figure.

In the figure, OU shows the full-employment level of real output. Beyond OU, rise in prices does not, result in increase in the real output. As the demand for real output increases from D1 to D2 and D3 to D4, the prices level also rises from P1 to P2, P3 and P4 respectively.

Causes of Demand Pull Inflation

Demand-pull inflation is caused by the following factors.

i) Excess demand

Prof. Keynes has explained the effect of excess demand on prices through his notion of ‘inflationary gap’. Inflationary gap may be defined as an excess of aggregate demand for goods over their aggregate supply measured at constant prices.

ii) Increase in money supply

Monetarists held excess increase in the quantity of money responsible for inflation. According to the quantity theory of money, at a given level of national income (potential as well as actual) the general price level (P) rises in the same proportion as increase in the quantity of money (M), the velocity of money being held constant. In a static economy, M is policy-determined; therefore, the rate of inflation also becomes policy-determined.

In a dynamic economy, the real demand for money grows over time and the national income also grows over time. Apparently, the rate of growth of real demand for money will be equal to the rate of growth of the national income. However, excess increase in the stock of money will lead to increase in prices. Excess supply of money is nothing but the excess demand for output that causes inflation.

iii) Disposable income

It refers to the income payments to factors after personal taxes have been paid. An increase in disposable income results in increased purchased power with the people. There is increasing pressure on the demand for goods and services, as a result, prices tend to rise.

iv) Increase in business outlays

During the prosperity phase of business activities, increase in business outlays or capital expansion take on a speculative character. New equipment and plans are often financed by speculative borrowings. Most of business outlay finds their way into the income stream via dividends, wages and other factor of payments. These business outlays are inflationary in character.

v) Increase in foreign demand

Increase in the export demand for domestic goods and services also lead to inflation. This is particularly true for the economies which maintain considerable inflationary pressure on domestic areas of shortages which may be a focal point of spreading inflation.

vi) Increase in government expenditure

There may be an increase in the government expenditure of government revenue. This might have been made possible through government borrowings from banks or through deficit financing, which implies an increase in the money supply.

vii) Reduction of taxation

If government reduces taxes, households are left with more disposable income in their pockets. This leads to increase consumer spending, thus increasing aggregate demand and eventually causing demand pull inflation.

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