Why is Control of Budget Deficits Argued to be Central to the Control of the Money Supply in LDC's? Is this a Strong Argument?

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Banking & Finance                Tarandeep Baxi

BSc Development Economics                 117514

Why is Control of Budget Deficits Argued to be Central to the Control of the Money Supply in LDC’s?  Is this a Strong Argument?  

A budget deficit is the excess of government expenditure over government taxation and any other receipts, in any one fiscal year.  The operation of a budget deficit is a useful tool of fiscal policy to enable government to influence the level of aggregate demand and employment in the economy.  J.M Keynes advocated this policy in the 1930’s to offset the depression that occurred at the time.  Prior to this, it was often thought that the government should operate a balanced budget policy, allowing the economy to respond in its own way without government intervention.  Keynes argued that government should intervene by deliberately imbalancing its budget in order to inject additional aggregate demand into a depressed economy and vice versa.

The money supply is the amount of money in circulation in an economy.  Money supply can be specified in a variety of ways, and the total value of money in circulation depends on which definition of the money supply is adopted.  ‘Narrow’ definitions of the money supply include only assets possessing ready liquidity, such as notes and coins.  ‘Broad’ definitions include other assets, which are less liquid but still important in strengthening spending, for example, building society deposits must be withdrawn before they are converted into notes and coins.  

The size of the money supply is a vital determinant of the level of spending in the economy and its control is a particular concern of monetary policy.  However, the monetary authorities have a problem because, given the number of possible definitions of the money supply it is difficult for them to decide which is the most appropriate money supply category to target for control purposes.  Moreover, having targeted a particular definition they face the added difficulty of actually controlling it, because of the potential for asset switching from one-category of money to another, for example, if the authorities target M3 (M1 plus UK private sector time bank deposits and UK public sector sterling deposits) for control purposes, this may not be sufficient in itself to reduce spending.  Spenders may simply use their building society deposits (M4 type money) or national savings (M5 type money) to finance current purchases.

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The "deficit" is not an economic sin but an economic necessity.  Its most important function is said to be the means whereby purchasing power, not spent on consumption, nor recycled into income by the private creation of net capital, is recycled into purchasing power by government borrowing and spending.  Purchasing power not so recycled, becomes non-purchase, non-sales, non-production, and unemployment. 

In the case of the Indian economy, liberalisation put the Indian economy on a path of economic progress with a vigorous industrial growth of 12% and accelerated Gross Domestic Product (GDP) growth by 7% in 1996.  The high GDP ...

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