Public Finance

Chapter 9
Public finance
“ The task of economic stabilization requires
keeping the economy from straying too far
above or below the path of steady high
employment. One way lies inflation, and the
other lies recession. Flexible and vigilant
fiscal and monetary policy will allow us to
hold the narrow middle course.” (US
president John F. Kennedy 1962)
The concept of public finance
 Public finance is a study of income and expenditure
of the government at the central, state, and local
levels.
 Government has to perform certain functions in a
country such as to supply certain public or collective
goods which individuals cannot or do not singly
perform. And this is the responsibility of the
government to provide those goods for which it
needs revenue.
The concept of public finance
 In the narrow sense, public finance is defined only
as the study of income and expenditure of the
government.
 But the broader view is that public finance does not
deal only with the income and expenditure of the
government but also the sources of income and the
way of expenditure of various government
corporations, public companies, and quasi
governmental ventures.
The concept of public finance
Public finance is composed of the following
constituents:
1. Public expenditure: wages and salaries; subsidies
and transfers; expenditure on goods and services
such as infrastructures like road, electricity,
telecom, and human capital accumulation like
health and education; interest expenditure etc.
2. Public revenue: Different sources of government
revenue with major focus on tax revenue.
3. Public debt: Often public revenue falls short of
expenditure and government has to borrow from
internal and external sources.
The concept of public finance
Public finance is composed of the following
constituents:
4. Public financial administration: As Walter Bagehot
remarks money cannot manage itself, an efficient,
energetic and scientific management is required to
look after the public expenditure, public revenue
and public debt. What are the authorities,
institutions, agencies to look after the
management, control, and scrutinizing work
created by government? How do they keep check
on the use and misuse of fund? Answer to all
these questions relate public financial
administration.
The concept of public finance

Public finance is composed of the following

constituents:
5. Economic stabilization and economic growth:
Maintaining stability and promoting
balanced sustainable growth through the
functions mentioned above is another
constituent of public policy.
Role of the government
Role of the government
 Promotion of human capital accumulation
 Provision of essential public goods
 Decentralization
 Facilitating and regulating the private sector for
promoting industries, financial institutions, and
building infrastructures.
 Protections of individual liberties
 Private rights to land and capital
 Good courts and legal systems
 Representative political systems
In the absence of the government intervention,
high rates of unemployment can persist for
long periods

Price level
Aggregate Supply

Aggregate Demand
Output (GDP)
Y YF
Markets may tolerate equilibrium output (Y)
less than full employment output (YF)
How does government work?
With policy:

 Macroeconomic policy
 Fiscal policy
 Monetary policy
 Infrastructure investment
 Microeconomic policy
 Social investment and labour policy
 Industrial policy
 Competition policy
Government budgeting

 Derived from Latin word „Bague‟and French word

„Bougette‟. „Bougette‟ means small leather bag.
 Budget provision initially introduced in the UK. In
1733, the then Chancellor of Exchequer Walpole
came with the leather bag in the parliament to
present the annual statement of income and
expenditure, and when he opened bag people
used the term he is opening the budget. Thus, the
term budget became popular.
Government budgeting
 In Nepal, it was on 21 Magh 2008 B.S. budget was
formulated by the cabinet of the then PM Matrika
Prasad Koirala.
 Every year, budget is presented in the parliament.
 Budget is a financial statement of the
government comprising expenditures and
revenues for a year. It is both economic as well
as political document. It is a mirror to look into
development activities undertaken by the
government, which sets a framework for policy
formulation and implementation. Budget document
is a good source of public information on past
activities, current decisions, and future prospects.
Government budgeting

 A good budget document contains: (a)

overall development policy, (b) size and
composition of revenue and expenditure,
and policy, (c) size and composition of
external and internal borrowings, and
policy, (d) whether budget is deficit or
surplus and how is deficit covered and
surplus disposed of? (e) actual of the
previous year, revised estimates of the
current year and estimates for the next
fiscal year.
Government budgeting
 The main components of budget are government
expenditures and government revenues. The
expenditures are classified into: (a) object
classification, (b) functional classification (c)
economic classification.
 The object classification includes expenditure on
personal compensation and benefits; travel and
transportation of persons and things;
communication, utilities and rent; printing and
reproduction; supplies, and materials; equipment;
grant subsidies and contributions; insurance
claims and indemnities, and reimbursable etc.
Government budgeting

 Functional classification is comprised of

expenditures on general public services and
economic services. The general public services
include: expenditure on defense, education,
health, social security and welfare, housing and
community amenities, and other community and
social services. Likewise, economic services
consist of expenditures on agriculture, mining,
manufacturing, electricity roads, water transport,
railways, communications, interest on the public
debt and so on.
Government budgeting

 Economic classification consists of: (a ) current

expenditures, (b) capital expenditure, and (c)
principal repayment. The current expenditures
include expenditures on goods and services such
as wages and salaries, other purchases of goods,
interest payments, subsidies and other current
transfers. Capital expenditures include acquisition
of new and existing fixed assets, purchase of
stocks (inventories), purchase of land and
intangible assets, and capital transfers.
Government budgeting
Revenues are classified into: tax and non-tax
revenues.
 Tax revenues constitute both direct and indirect
taxes. The premier direct taxes are on net income,
property, and capital gains. Major indirect taxes
include taxes on goods and services (VAT, excise
etc), taxes on international trade and transactions
(export and import duties).
 Non tax revenues constitute income from public
enterprises, sales of government property,
administrative fees, fines, penalties and royalties
etc.
Government budgeting

Elements of budget:
 Close to reality: despite being an estimate, it
should be based on reality primarily on the basis
of the experience of the previous year.
 Simple and obvious: Since this is a public
document, all who are interested should easily get
the required information after looking on it.
 Flexibility: Not only income and expenditure
estimates are there but also the policies and
programs of the government. Thus, should have
the quality of flexibility.
Government budgeting

Elements of budget:
 Single fund: A single fund of the
government should be established there for
all revenues and expenditures.
 Extensive: Should be in detail about each
item of revenue and expenditure.
 Publicity: it is made public and all the
stakeholders are free to comment on this.
 Annularity: Prepared for one fiscal year.
Government budgeting

Principles of budget:
 Balanced budget principle: Classical
economists opine that government budget
should be balanced that means expenditure
(G) should be equal to revenue (T). If not
followed, either government has to borrow
internally or externally or has to increase
the tax. Supporters of balanced budget
argue that unbalanced budget creates
disturbances in economy.
Government budgeting
Principles of budget:
 Principle of unbalanced budget: A budget deficit is
incurred when expenditures exceed taxes and
other revenues for a year. And a budget surplus
occurs when all taxes and other revenues exceed
expenditures for a year. Though unbalanced
means both surplus or deficit budget, a number of
economists refer to deficit budget as unbalanced
budget. Keynes has supported this principle
arguing that along with the higher government
expenditure, there will be multiplier effect in the
economy.
Government budgeting

Estimate Enactment or legislation

Budget
cycle
Evaluation Execution

Auditing Accounting
Fiscal policy

 Fiscal policy means setting of the taxes and

public expenditures to help dampen the
swings of business cycle and contribute to
the maintenance of a growing, high
employment economy, free from high or
volatile inflation. Fiscal policy operates
through changes in government
expenditures, taxation, and public
borrowings.
Objectives of fiscal policy
 Optimum allocation of resources: economic
resources such as man, material, money should
be used wisely and productively. Should avoid
wastage of resources and ensure maximum
productive employment of economic resources.
 Price stability: Falling prices (deflation) lead to
decline in economic activity, while steeply rising
prices (inflation) hit hard the fixed income groups.
Fiscal policies should aim at securing price
stability by fighting against inflationary or
deflationary tendencies in the economy.
Objectives of fiscal policy
 Equitable distribution of income and wealth: The
fiscal policies should be designed in such a
manner that inequalities between rich and poor
should be minimum. It should serve to secure
equitable distribution of income and wealth among
various sections of the society and geographical
regions.
 Full employment: This is possible if the economy
attains its economic growth in commensurate with
the growth rate of population. The fiscal policy be
designed in such a manner that the rate of
increase in income, and hence the rate of increase
in employment opportunities is much higher than
the growth rate of population.
Objectives of fiscal policy

 Economic growth: Less developed

countries are caught in the vicious cycle of
poverty because of the low economic
growth primarily caused by low capital
formation, low human capital accumulation,
and lack of technology. Thus, the fiscal
policy should be oriented towards attaining
higher sustainable growth.
Instruments of fiscal policy

 Fiscal policy seeks to achieve national economic

objectives through changes in taxes, or changes in
government expenditure, or a combination of (a)
taxes, (b) government expenditure, and (c) public
debt. These instruments are used to influence
national income, output, employment, and prices.
 Taxes, besides bringing revenue to the
government, can be used to encourage or restrict
private expenditures on consumption and
investment.
Instruments of fiscal policy
 Government expenditure, may take different forms
such as recurrent expenditure, capital expenditure
etc. These expenditures have income creating
effect. Increased government spending raises
income directly, and so indirectly through multiplier
process.
 Management of public debt influences aggregate
spending through changes in the liquid asset
position of the public. Public borrowing leads to
tighter credit by reducing loanable funds otherwise
available, and may have crowding out effect. But
the expenditure of these borrowed funds by the
government eliminates the tightening effect.
Types of fiscal policy
 Usually classified as: expansionary vs.
Contractionary, and discretionary vs. automatic
(built in stabilizers).
 Expansionary fiscal policy: This increases AD
either by increasing government expenditure (G)
or reducing tax. Thus, the impact is either the
budget deficit is increased or surplus budget is
reduced. During the periods of recession or
depression, government follows expansionary
policy to boost income, output and employment.
 Contractionary fiscal policy: Government reduces
expenditure or increases tax particularly to offset
the effect of inflationary gap.
Types of fiscal policy
 Discretionary fiscal policy: Discretionary fiscal policy is the
deliberate and conscious attempt by the government to
promote full employment and price stability by contracyclical
change in public expenditure or taxes or both. Discretionary
fiscal policy change requires specific legislation.
 During depression, the effective discretionary policy may take
four alternative forms: (a) reducing tax rates and leaving
government expenditures unchanged, (b) increasing
government expenditures and leaving tax rates unchanged, (c)
simultaneously increasing government expenditures and
reducing taxes, and (d) Increasing taxes and government
expenditures both.
 During inflation, reverse of the above measures are suggested.
Types of fiscal policy
 Automatic fiscal policy or built-in stabilizers: This
policy operates through the built-in stabilizers to
contract fluctuations in economic activity. Built-in
stabilizers are those factors which automatically
cause government expenditure to rise and tax
receipts to fall during economic contraction and
cause government expenditure to fall and tax
receipts to rise during economic expansion. The
important built in stabilizers are: progressive
income tax, and unemployment compensation.
 During expansion, people pay high income tax and
vice versa. Similarly, during contraction more
people join the queue for unemployment benefit
and vice versa.
More on automatic stabilizers
 Automatic stabilizers are mechanisms that
stabilize real GDP without explicit action by the
government.
 Income taxes and transfer payments are automatic
stabilizers.
 Because income taxes and transfer payments
change with the business cycle, the government‟s
budget deficit also varies with this cycle.
 In a recession, taxes fall, transfer payments rise,
and the deficit grows; in an expansion, taxes rise,
transfers fall, and deficit shrinks.
Taxation policy

 Tax Revenue: Taxes are the most important

source of government income. Taxes can be
defined as "a compulsory contribution imposed by
a public authority, irrespective of the exact amount
of service rendered to the taxpayer in return."
According to Professor Seligman, a tax is "a
compulsory contribution from a person to the
government to defray the expenses incurred in the
common interest of all, without reference to
special benefits conferred."
Taxation policy
 These definitions point following three characteristics
of tax.
 1) It is a Compulsory Contribution: imposed by the
government on the people residing in the country.
Since it is a compulsory payment, a person who
refuses to pay a tax is punished. But a tax is to be paid
only by those who come under its jurisdiction.
Similarly, persons who buy a commodity that is taxable
pay the tax while others do not.
 2) A Tax is a Payment Made by the Taxpayers:
which is used by the government for the benefit of all
the citizens. The state uses the revenue collected from
taxes for providing hospitals, schools, public utility
services, etc.
Taxation policy

 3) A Tax is not Levied in Return for Any

Specific Service: An individual cannot ask
for any special benefit from the state in
return for the tax paid by him. In the words
of Professor Taussig, "The essence of a tax
............ is the absence of a direct quid pro
quo between the taxpayer and the public
authority." It implies that the taxpayer
cannot claim something equivalent to the
tax paid (quid pro quo) from the
government.
Characteristics of a Good Tax
System
Adam Smith’s Canons of taxation
 The Canon of ability: All citizens should contribute
towards the expenses of the government, “as nearly as
possible in proportion to their respective abilities.” The
richer a person, he should pay more.
 The Canon of Certainty: The amount to be paid, the
time and the method of payment should all be clear
and certain for the taxpayer to adjust his income and
expenditure accordingly.
 The Canon of Convenience: In Smith‟s words, every tax
ought to be levied at the time, or in a manner in which
it is most likely to be convenient for the contributor to
pay for it.”
Characteristics of a Good Tax
System
Adam Smith’s Canons of taxation
 The Canon of Economy: Minimization of the cost
of collection.
 The Canon of Productivity: it should produce
adequate revenue. It is not worth to tax unless it
yields adequate.
 The Canon of Elasticity: The tax revenue can be
increased or decreased with the least
inconvenience as the necessity of the sate.
 The Canon of Simplicity : Tax imposed should be
simple and easily understandable by the people.
 The Canon of Diversity: Tax base should be
increased by widening the coverage.
Types of tax
 Direct, and Indirect Tax
 Direct taxes are: (a) income taxes, and (b)
taxes on land, building and other assets.
 Income taxes are further classified into:
corporate tax, and personal tax (tax on
remuneration, tax on investment such as
interest, dividend, capital gains, tax on
windfall gains etc).
 Indirect taxes are : (a) customs, (b) VAT, (c)
excise
Non-tax revenues
Sources of non-tax revenue are:
 Charges, fees, fines and forfeiture (firm
registration, arms registration, vehicle
license, penalty etc)
 Receipts from sales of commodities and
services (drinking water, electricity, postal
service, education, transport etc)
 Dividend (of the government owned
enterprises)
 Royalty and sale of fixed assets
 Principal and interest repayment.
Merits of Direct tax
1. Economy. Cost of collecting these taxes for the
government is relatively low as these taxes are usually
collected at source. And the tax-payers make the
payment of these taxes directly to the state and is
deposited directly in the state's treasury.
2. Equity. Direct taxes can be thoughtfully chosen and
determined according to the ability to pay. In direct
taxes, we can find the degree of progression and
consequently, it is easy to achieve the sufficient level of
social and economic justice through direct taxation. In
other words, these taxes fall more heavily on the richer
persons than those on the poor.
Merits of Direct tax
3. Reduces Inequality. As direct taxes are progressive in
nature, therefore, the person belonging to higher income
groups are imposed a higher rate of tax and the low
income groups are always exempted from such taxes.
Thus, helps to remove disparity among sections of the
society.
4. Certainty. Direct taxes also satisfy the canon of certainty
because of its certain effects on the tax-payer. So, he
makes adequate provision for payment of taxation in
advance. The government collects certain amount
through direct taxes. Thus, it enables the public authority
to estimate the tax collection with greater accuracy and
supports in devising budget accordingly.
Merits of Direct tax
5. Elasticity: Direct taxes also satisfy the canon of
elasticity. Because the income from these taxes can be
increased by increasing the rate of taxation in an
appropriate way in the times of crises. Also, the revenue
from direct taxes will also increase with the increase in
income of the people.
6. Educational Value. Direct taxes have also the
educational value among the common masses. People
are aware about the amount collected from them and
can check the wastage in public expenditure.
8. Easily Understandable. Direct tax is claimed to be
easily understandable even by the layman of the society.
Moreover, it does not cause any distortion in the
resource allocation of the economy.
Demerits of Direct Tax

1. Unpopular. These taxes are directly imposed

on the individual. So people don‟t take it easily
and resist it.
2. Uneconomical. The cost of collection of such a
tax is quite high particularly when the number of
tax-payers is infinite and the amount of tax
collected is small quantity. Requires high
administrative costs in this situation.
3. Possibility or Evasion. A direct tax is
calculated on the basis of honesty of tax-payer.
So, there is always a possibility of tax evasion.
People do not show their correct income to the
tax officials. They adopt fraudulent practices to
save themselves from the tax.
Demerits of Direct Tax

4. Uncertainty. Some critics of direct taxes state

that it is not possible to determine the precise
degree of progression on account of the
difficulty in measuring the ability to pay and the
subjective nature of the marginal utility of
income. Thus, it is highly uncertain which results
in the public authority ends up with either too
much or too little progression.
5.Obstacle to Capital Formation. It is claimed
that if the rate of direct tax is heavy, then it
adversely affects the people's desire, ability to
work, save and investment, therefore, hampers
the capital formation.
Demerits of Direct Tax

6. Narrow in Scope. Generally, direct tax is levied

only on certain group of people which restricts to
raise the civic consciousness among all the
people of the society. In this way, its applicability
is limited.
7. Against the Equity Principle. Since high
earning people have to pay more and low
earning people pay less, it can distort the work
incentive of the former. It is particularly because
of the equal service they take from the state.
Merits of Indirect Tax

1. Convenience. Since taxes are imposed at the

time of the purchase of goods and services,
they don‟t feel the burden of tax directly. And also
the producers and importers think they are not
the ultimate payers of these taxes. Thus,
relatively people take it conveniently.
2. Elastic. Indirect taxes are highly elastic in
nature as the revenue from these taxes can be
increased as and when desired. Therefore, the
tax is imposed on essential commodities which
have inelastic demand e.g. sugar, oil, salt etc. In
fact, it has become a selective tool of financial
policy of the modern governments.
Merits of Indirect Tax

3. Difficult to Evade. It is impossible for an

individual to evade the payment of indirect taxes
because they are already included in the price
of the commodity. Thus, there is very little
possibility for the evasion of such taxes.
4. Equity. Indirect taxes are equitable, because
these taxes are paid by the consumers on the
commodity. So, it will be according to the ability
to any principle. Therefore, it is imposed heavily
on luxuries and other such commodities
consumed by the rich consumers.
Demerits of Indirect Tax

1. No Civic Consciousness. As indirect taxes

are levied on the commodities, consumers do
not feel the burden of tax. This makes
consumers less conscious about the public
expenditure system.
2. Inflationary. This may become inflationary
when the government relies excessively upon
this. Indirect taxes begin by adding to the sales
price of the taxed goods without touching the
purchasing power. So, the indirect taxes lead
to an unending spiral of higher prices, higher
costs, higher wages and again higher prices.
Demerits of Indirect Tax

3. More Uneconomical. Indirect taxes are

uneconomical as they involve more cost of
collection than actual amount of the taxes. In
most of the cases, traders charge more prices
than the actual tax levied by the public
authority.
4. Inequitable. Another weakness of indirect tax is
that it is inequitable and unfair because poor
section of the society have to pay more than the
rich people since poor people purchase
consumables regularly and spend the large
chunk of their earnings on the same. .
Principles of efficient taxation
1) The most efficient tax is the one that influences
people‟s decisions the least. (Except in cases of
market failure).
2) Uniform taxation of taxable goods is not
necessarily most efficient.
3) Charge higher tax rates on complements to
untaxed goods.
4) Tax price-inelastic goods at higher rates than
price-elastic goods, it reduces dead weight
loss (DWL).
5) Don‟t be on the wrong side of the “Laffer
curve”.
These principles affect the decisions of the
investors.
Fiscal-Monetary Mix
 How the IS-LM model determines income and the
interest rate in the short run when P is fixed.
 Remember:
 In the long run
 prices flexible
 output determined by factors of production &
technology
 unemployment equals its natural rate

 In the short run

 prices fixed
 output determined by aggregate demand
 unemployment negatively related to output
Fiscal-Monetary Mix
 We are building our examples confining to the
closed economy assumption where :
AE=C+I+G
 We can use the IS-LM model to see how fiscal
policy (G and T) affects aggregate demand and
output.
Graphing planned expenditure
AE
planned
expenditure
AE =C +I +G

MPC
1

income, output, Y
Graphing the equilibrium
condition
AE
planned AE
expenditure =Y

45º

income, output, Y
The equilibrium value of
income
AE
planned AE
expenditure =Y
AE =C +I +G

income, output, Y
Equilibrium
income
An increase in government
purchases
AE
At Y1, AE =C +I +G2
there is now an
unplanned drop AE =C +I +G1
in inventory…

G
…so firms
increase output,
and income
Y
rises toward a
new equilibrium. AE1 = Y AE2 =
Y1 Y2
The government purchases
multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the govt Y 1
purchases multiplier equals G 
1  MPC

Example: If MPC = 0.8, then

Y 1 An increase in G
  5 causes income to
G 1  0.8
increase 5 times
as much!
 Why the multiplier is greater
than 1
 Initially, the increase in G causes an equal
increase in Y: Y = G.
 But Y  C

 further Y
 further C
 further Y
 So the final impact on income is much bigger
than the initial G.
The IS curve
Def: a graph of all combinations of r and Y that
result in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:
Y  C (Y T )  I (r )  G
Deriving the IS curve
AE AE =Y AE =C +I (r )+G
2

r  I AE =C +I (r1 )+G

 AE I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
Why the IS curve is negatively
sloped
 A fall in the interest rate motivates firms to
increase investment spending, which drives
up total planned spending (AE).

 To restore equilibrium in the goods market,

output (a.k.a. actual expenditure, Y)
must increase.
Shifting the IS curve: G
AE AE =Y AE =C +I (r )+G
At any value of r, 1 2

G  AE  AE =C +I (r1 )+G1

…Ysothe IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals

Y 
1
G Y
1MPC IS1 IS2
Y1 Y2 Y
Money supply
r
The supply of interest M P s
rate
real money
balances
is fixed:
M P  s
M P

M/P
M P real money
balances
Money demand
r
 People interest M P s
either hold: rate
 Money
 Bonds

 Demand for
real money
balances: L (r )

M P  d
 L(r ) M/P
M P real money
balances
The LM curve
Now let‟s put Y back into the money demand
function: M P  d
 L(r ,Y )

Note: In Blanchard:  M 
d
  d 1Y  d2i
   YLi
 P
The LM curve is a graph of all combinations of r and
Y that equate the supply and demand for real money
balances.
The equation for the LM curve is: M P  L(r ,Y )
Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2
L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P
How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r LM2

LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
Why the LM curve is upward
sloping
 An increase in income raises money demand.

 Since the supply of real balances is fixed, there is

now excess demand in the money market at the
initial interest rate.

 The interest rate must rise to restore equilibrium in

the money market.
The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that simultaneously
satisfies the equilibrium
conditions in the goods &
money markets:
IS
Y  C (Y  T )  I ( r )  G
Y
Equilibrium
interest Equilibrium
M P  L ( r ,Y ) rate level of
income
Equilibrium in the IS-LM Model
r
LM

Equilibrium
interest rate

IS
Equilibrium
level of
income
Y
Income and Output
Fiscal Expansion
r
LM

r2 B

r1
A
G IS2
1 c

IS1

Y1 Y2 Y

Income and Output

Monetary Expansion
r LM1

LM2

A
r1

r2 B

IS

Y1 Y2 Y

Income and Output

Fiscal-monetary mix: summary
1. Keynesian cross
 basic model of income determination
 takes fiscal policy & investment as exogenous
 fiscal policy has a multiplier effect on income.
2. IS curve
 comes from Keynesian cross when planned
investment depends negatively on interest rate
 shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services

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Fiscal-monetary mix: summary
3. Theory of Liquidity Preference
 basic model of interest rate determination
 takes money supply & price level as exogenous
 an increase in the money supply lowers the interest
rate
4. LM curve
 comes from liquidity preference theory when
money demand depends positively on income
 shows all combinations of r and Y that equate
demand for real money balances with supply

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Fiscal-monetary mix: summary
5. IS-LM model
 Intersection of IS and LM curves shows the unique
point (Y, r ) that satisfies equilibrium in both the goods
and money markets.

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Deficit financing
 Budget deficit is the annual difference between
government outlays and receipts (G-T).
 The government budget constraint identifies
financing options open to the government:
G= T+∆B +∆MB
Where,
G=Total government expenditure.
T=Total government revenue from taxes, charges, and
sales.
∆B=Change in public debt
∆BM= Change in monetary base (Reserve money)

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Deficit financing
G-T= ∆B +∆MB
 The idea is that if the government spends more than
the revenue either it should borrow or create base
money or do both. If the government is in surplus, it
will either retire debt or contract the monetary
expansion.
 Borrowing from the domestic sector can have also
crowding out, the idea that increase in government
purchases ultimately cause reductions in private
consumption or investment.
 Monetary expansion to finance the government
deficit can have inflationary implications.

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Deficit financing
 Government borrowing can be made raising
through internal debt or external debt.
 Budget deficit financing identity:
Budget deficit=Domestic borrowing+ foreign
borrowing+ printing money + +arrears

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Deficit financing
 In other words, government deficit can be
financed through following sources:
1. Withdrawal of past accumulated cash
balances by the government
2. Borrowing from public
3. Borrowing from central bank and other
banks
4. Issuing new currency
5. External loan
6. Forced savings
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Deficit financing
Why there is the need of deficit financing? (Role of deficit
financing):
 To augment rate of net investment (particularly in
developing countries, private sector is not proactive to
take investment initiative because of the various
constraints, thus there is the large role of the
government and has to )
 Development of economic and social overheads
 To control economic depression
 Reconstruction of the economy
 Augment community savings
 Incentive to private investment
 Utilization of the natural resources
 War financing

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Effects of deficit financing
 Inflation: expansion of money supply and expansion of
credit leads to inflation.
 Crowding out of the private investment: Excessive
reliance on public borrowing creates distortion on
investment of the private sector and may also cause
high interest, additional disincentive for investment.
 Balance of payments difficulties: As monetary income
of the people rise, and also because of the rise in
government expenditure, imports may rise causing an
adverse effect on balance of payments.
 Increases debt servicing: Causing high government
expenditure and pushes country towards vicious circle
of debt and deficit. And also challenges long term debt
sustainability.

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Effects of deficit financing
 Arrears: Past accumulated debt if can
not be repaid because of the increased
deficit, it causes inefficiency and loss of
creditability.
 Rises tax burden to finance debt
service, which creates distortions in the
behavior of economic agents.

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Public debt management
 Public debt management, which is also
called sovereign debt management is the
process of establishing and executing a
strategy for managing the government's
debt in order to raise the required amount of
funding, achieve its risk and cost objectives,
and to meet any other sovereign debt
management goals the government may
have set, such as developing an and
maintaining efficient market for
government securities.
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Public debt management
 Public debt management, which is also
called sovereign debt management is the
process of establishing and executing a
strategy for managing the government's
debt in order to raise the required amount of
funding, achieve its risk and cost objectives,
and to meet any other sovereign debt
management goals the government may
have set, such as developing an and
maintaining efficient market for
government securities.
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Internal debt management
Objectives:
 To influence the size and maturity of debt
 To influence the appropriate pattern of debt
 To affect the type of holders of debt
 To achieve short term stabilization of bond
prices
 To limit debt service cost
 To create capital market
 To give priority to domestic over foreign
issues on domestic market
 To give priority to public sector borrowing

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External debt management
Key elements:
 Policy guidelines on appropriate level, terms
and purpose for foreign borrowing.
 Reorganization of the existing stock of
external debt so as to maintain an optimum
level of debt structure.
 Monitoring the operations relating to loan
commitments, disbursements, and debt
servicing on all loans.
 Accurately recording and maintaining loan
by loan information.

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External debt management
Key elements:
 Preparing projections of debt and debt
service levels to facilitate domestic cost
budgeting and foreign exchange
management.
 Liaison with various creditors, keeping them
informed of macroeconomic developments.
 Regular portfolio review on a sector and/or
creditor basis

slide 87
Note for you
The rest of the slides are additional notes,
therefore, are optional for you. If you are
interested, you can go through them to
widen your understanding. But don’t be
overstressed looking at them and don’t
complain to your parents!
IMF Guidelines for Public debt
management
1. Objectives and coordination
 Objectives: The main objective of public debt
management is to ensure that the government's
financing needs and its payment obligations are
met at the lowest possible cost over the medium to
long run, consistent with a prudent degree of risk.
 Scope: Debt management should encompass the
main financial obligations over which the central
government exercises control.
 Coordination with monetary and fiscal policies

slide 89
IMF Guidelines for Public debt
management
1. Objectives and coordination
 Objectives: The main objective of public debt
management is to ensure that the government's
financing needs and its payment obligations are
met at the lowest possible cost over the medium to
long run, consistent with a prudent degree of risk.
 Scope: Debt management should encompass the
main financial obligations over which the central
government exercises control.
 Coordination with monetary and fiscal policies

slide 90
IMF Guidelines for Public debt
management
2. Transparency and Accountability
 Clarity of roles, responsibilities and
objectives of financial agencies responsible
for debt management
 Open process for formulating and reporting
of debt management policies
 Public availability of information on debt
management policies
 Accountability and assurances of integrity by
agencies responsible for debt management

slide 91
IMF Guidelines for Public debt
management
3. Institutional Framework
 Governance
 Management of internal operations
 Public availability of information on debt
management policies
 Accountability and assurances of integrity by
agencies responsible for debt management

slide 92
IMF Guidelines for Public debt
management
4. Debt Management Strategy
 The risks inherent in the structure of the
government's debt should be carefully monitored
and evaluated. These risks should be mitigated to
the extent feasible by modifying the debt structure,
taking into account the cost of doing so.
 In order to help guide borrowing decisions and
reduce the government's risk, debt managers
should consider the financial and other risk
characteristics of the government's cash flows.
 Debt managers should carefully assess and
manage the risks associated with foreign-currency
and short-term or floating rate debt.

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IMF Guidelines for Public debt
management
5. Risk Management Framework
 A framework should be developed to enable
debt managers to identify and manage the
trade-offs between expected cost and risk in
the government debt portfolio.
 To assess risk, debt managers should
regularly conduct stress tests of the debt
portfolio on the basis of the economic and
financial shocks to which the government--
and the country more generally--are
potentially exposed.

slide 94
IMF Guidelines for Public debt
management
6. Development and Maintenance of an Efficient
Market for Government Securities
 Portfolio diversification and instruments: The
government should strive to achieve a broad
investor base for its domestic and foreign
obligations, with due regard to cost and risk,
and should treat investors equitably.
 Primary market : Debt management operations
in the primary market should be transparent
and predictable. To the extent possible, debt
issuance should use market-based
mechanisms, including competitive auctions
and syndications.
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IMF Guidelines for Public debt
management
6. Development and Maintenance of an
Efficient Market for Government
Securities
 Portfolio diversification and instruments: The
government should Secondary market:
Governments and central banks should
promote the development of resilient secondary
markets that can function effectively under a
wide range of market conditions.
 The systems used to settle and clear financial
market transactions involving government
securities should reflect sound practices.

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