Government expenditure refers to government outlays, in terms of recurrent and development expenditure in a given financial year. If resources are less than expenditure requirements the external and internal borrowing may be relied upon to supplement available resource. Whenever long term borrowings only partially cover the excess of state spending over current revenues, a deficit remains to be financed by other means such as short term borrowing from the Central Bank and commercial banks. It is this
borrowing from the domestic banking systems which is known as deficit financing. Such borrowings are then used to balance the budget.
Deficit financing is residual items representing the part of current and capital spending which can not be met by current receipts and long term borrowing. Accurate control of such financing is difficult as it requires accurate predictions of revenues and expenditure which is difficult to do. As an example revenues depend on taxation of imports and exports among other things. Given the volatility of the world markets, it is difficult to forecast reliably export and import revenues. Unpredictability in export
proceeds transmit instability/unpredictability to the ability to import thus making it difficult to estimate receipts from import duties.
Quite often, there is systematic bias in budget estimates – under estimating current spending and over estimating receipts thereby underestimating the financing gap. For this reason many government run financing deficits with total spending exceeding the value of current and long term borrowing from abroad.
Borrowing from abroad is mostly non inflationary as foreign exchange brings command over a large supply of imported goods and services. The same applies to long term borrowing from local residents as it is matched by reductions in the purchasing power of general public.
Short term borrowing from the Central bank and commercial banks has expansionary effects on money supply and total demand. Deficit financing tends to increase the supply of money by the amount of the deficit. It also leads to secondary increases in money supply by increasing the case base of the banking
system and its ability to lend to the private sector.
In view of the above, if the volume of deficit financing can spark off inflation, budget proposals should cut down on short term borrowing from the banking system. This calls for reducing recurrent and development expenditure (in a way not to disorganize government activities and compromise future growth and availability of commodities).
Deficit financing can also be limited through increasing income tax (which may discourage voluntary saving and affect long term investment and growth). Indirect taxes can be used but they may raise prices and worsen inflation.
In conclusion, the economy can be supported by deficit financing to the extent that the expansionary effect of money supply is not necessarily inflationary.