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 growth has been possible mainly to 11.7% growth in industry and construction, with 7% growth in services but a slower, 24% growth in agriculture.
The fiscal deficit as a percentage of GDP has fallen from 8.3% in 1991 and 5.9% in1996. In value terms the fiscal deficit has risen from Rs.577 billion to Rs.640 billion. The Public Sector Undertaking (PSU) programme, which aimed to raise Rs.70 billion, only managed to raise Rs.3.57 billion and therefore, failed to meet the target.
The fiscal deficits, which are financed through borrowings from the Reserve Bank of India (RBI) and banks, had to be mainly funded by the RBI in 1996 as commercial banks which contributed Rs.163 bn to government paper in 1995, could contribute only Rs.147 bn in 1996. Therefore a large part of the government paper devolved on the RBI.
Tight money conditions prevailed in the Indian economy and interest rates rose due to,
i) High level of industrial growth (12%) resulting in increased demand for advances from the banks.
ii) The foreign exchange reserves fell by $3.8 bn. mainly due to a high ($6 bn.) current account deficit arsing from imports (37%) surging ahead of exports (29%) and in spite of strong Foreign Institutional Investments (FII) and Foreign Direct Investments (FDI).
iii) The demand for credit from the Government to finance deficits.
Tight money supply conditions reflected in slower M3 (13.4%) and reserve money growth (5.9%) and consequent slower growth in deposits with the banks. The coupon rates on Government paper went up to exceptionally high levels (14%).
With better administration and lower rates leading to better compliance, the customs collections are expected at 3.3% of GDP for 1996 as against 3.9% in 1991 but the excise collections have come down from 4.6% in 1991 to 3.8% in 1996. The reduction in excise collections can be mainly attributed to extension of Modified Value Added Tax (MODVAT) credit to capital goods. In the revenue tax collections the share of excise duty has come down from 43% in 1991 to 37% in 1996 and that of customs collections has come down from 36% to 32%, while the share of direct taxes has gone up from 18% in 1991 to 29% in 1996.
The ‘Broad’ money supply has increased in first quarter of 1997 mainly due to 20% increase in RBI credit to the government to finance the budget deficits which in turn increases the money reserves.
In the interim credit policy announced by RBI the cash reserve ratio was reduced by 1% to 12%. This along with easing of the tight liquidity situation, led to fall in money rates. As a result of this, RBI credit to the commercial sector fell by 24%.
Though year on year ‘Broad’ money (M3) growth has been 16%, the growth since 31st March’96 has been only 3.5%. Where, reserve money has increased by 7.7%, since 31st March 1996. We expect the ‘Broad’ money to further rise and thus put a downward pressure on interest rates.
1) The budget has largely been anti-inflationary by reducing customs and excise duties across various raw materials and items of daily usage like detergent, toothpaste etc.
2) The budget recognised the need for infrastructure development to facilitate economic growth and have several provisions to encourage investment in infrastructure.
3) Fiscal deficit remained high, at 5% of GDP (Rs.622bn) after taking credit of Rs.50bn from PSU disinvestments as against Rs.640bn in 1996 revised estimates. Interest provision increased to Rs.600 bn from indirect taxes, 7.4% of GDP as against 7.1% in 1996 revised estimates. However, from past experience, we feel that the fiscal deficit figure could go up to the same level (5.9% of GDP) as in 1996 revised estimates. This will result in higher borrowings than the budgeted figure of Rs.557 bn.
The government intends to loosen the money supply by either attracting high foreign investment (monetarisation of US dollar) or domestic monetarisation or a combination of both in order to ensure availability of funds to industry. The attempt is to attain at least 6.6% growth in GDP in 1997 as projected by Central Statistical Organisation (CSO).
However, there have been several delays of decisions by forming committees. Specified areas of concern include expenditure control, rationalisation of subsidies etc.
It is evident from the above examples that the budget deficit is an important determinant of the money supply. This is often said to be due to the ‘dependent’ nature of the LDC’s. LDC’s are characterised as being impoverished and in need of assistance from international organisations. A country that is ‘less developed’ has slow economic growth and a high level of unemployment and illiteracy. The World Bank describes poverty as ‘multi-dimensional, extending from low levels of income and consumption to poor health and lack of education and to other ‘non-material’ dimensions of well-being including gender disparities, insecurities, powerlessness and social exclusion’. These factors contribute to an increase in poverty in most of the least developed nations over time.
If the federal budget deficit decides to maintain the growth rate of the money stock on a predetermined path, considering that by choosing a rate of money growth equal to the long-term growth rate of natural real output and assuming constant velocity, the Fed would hope to maintain price stability and full employment. If the growth rate of the money stock is at zero, even with no change in the money stock, an increase in the deficit results in a once-and-for-all increase in the price level. The rise in the price level is associated with an increase in velocity brought on by the increase in the interest rate.
If the above example was modified to allow for a 3% rate of growth of the money stock and an equal expected growth of natural real output; in this case, the increase in the deficit will still result in a rise in the price level, assuming no change in monetary policy. The effect of the higher interest rate on investment will slow the growth of natural real output. If the original rate of growth of the money stock is maintained, the price level will continue to rise after its initial jump at a rate equal in the long-run to the difference between the rate of growth of the money stock and that of real output.
In order to avoid the inflationary effects of a deficit, the Fed would have to follow a different policy rule. It could target the price level directly or in this case; meet the impact of an increase in the deficit by means of a permanent reduction in the money stock. The decrease in the money stock would offset the rise in velocity associated with deficit-induced increase in the interest rate. The deficit would then have no effect on nominal national income. Consequently, neither real output nor the price level would increase, even in the short-run. To maintain price stability in the long run, the rate of growth of the money stock and nominal income would have to be adjusted to allow for any slowdown in the growth of real output. Theoretically, the appropriate monetary policy could insulate the price level from the impact of the federal deficit.
We see that the effects that the budget deficit has on the money supply are fairly vital and therefore may even be considered as ‘central to the control of the money’. As for the strength of this argument, I believe that from the above examples, the importance of the budget deficit to the control of the money supply is fairly evident.
APPENDIX 1
INITIALS DEFINITION
Narrow’ Money Money held predominantly for spending
Bank notes and coins in circulation
M0 Currency plus banks’ till money & operational balances at Bank Of England
M1 M0 plus UK private sector sight
Bank deposits
M2 M1 plus UK private sector
Deposits in banks & building
Societies
‘Broad’ Money Money held for spending &/or
as a store of value
M3 (formerly sterling M3) M1 plus UK private sector time
Bank deposits & UK public sector sterling deposits
M4 M3 plus net building society
Deposits
M5 (formerly private sector liquidity) M4 plus UK private sector
Holdings of money market
Instruments (e.g. treasury bills)
Plus national savings
BIBLIOGRAPHY
-
Collins Dictionary of Economics, C.Pass, B. Lowes & L.Davies, 3rd edition, 2000, HarperCollins Publishers
- Debt, Deficits & Exchange Rates, H. Reisen, 1994, Edward Elgar Publishing Company
- Money, Banking and Monetary Policy, C. Campbell, R. Campbell & E. Dolan, 1988, The Dryden Press
-
Money, Interest, and Banking in Economic Development, M. Fry, 2nd edition, 1995, John Hopkins University Press
Please see appendix 1 for clearer definitions of the money supply.
