Of budget deficit, money supply and inflation

It has been a matter of debate that countries across the world having persistent budget deficits for a long period of time are prone to high inflation. Before coming to any conclusion, the relation between budget deficit and inflation has to be made clear. Questions remain about whether a budget deficit causes inflation or inflation is the root cause of a budget deficit.  One of the primary causes of budget deficit is that some components of government spending hover higher than the rate of growth in tax receipts.
Theoretically, the budget deficit could be a source of inflation, and its impact on inflation depends on how long it lasts and how it is financed. If the government only suffers from a temporary budget deficit, it could only lead to a temporary increase in the price level, but not inflation, no matter how it is funded. On the other hand, if budget deficits are permanent and are financed by money creation, instead of increasing tax revenue, then inflation occurs. Governments use fiscal policy tools to achieve their desired goals. In that process a deficit budget policy is an important tool of the fiscal policy.
It is interesting to note that we always fail to attain the projected goal of revenue collections, but we are eager to spend funds according to the announced sum of expenditures. Commonly when private and foreign investments become insufficient for optimal production, the government plans to spend available funds in different sectors of the economy.
In the absence of proper distribution of available resources the government has to opt for financing sources to cover the budget deficit. Firstly, the government can finance its deficit by issuing new currency. That will force the central bank to accommodate the budget deficit. A central bank with less economic and instrumental independence tends to monetise the budget deficit through monetary financing (printing more paper money) which leads to a direct increase in the money supply and this in turn increases inflation.
Secondly, the budget deficit can be financed by borrowing from banking and commercial institutions. One lethal upshot of this practice is that this will squeeze the funding source for the private sector, which will create a crowding-out effect. That will also create an obstacle for the domestic bond market. Recently as part of a stabilisation and structural development process the International Monetary Fund (IMF) prohibits the government to relentlessly take loans from the banking sector.
Thirdly, deficit can be financed by borrowing from non-banking financial institutions and general public. When the government is prohibited to borrow from the central bank, then the method of borrowing from general public and commercial institutions come into effect, i.e. the central bank issues bonds, securities or public shares and offers interest as reward for holding those bonds and securities.
This will increase the overall burden of borrowing on the economy alongside the debt-GDP ratio.
Fourthly, the government can also finance deficit by borrowing from international financial institutions like IMF, World Bank etc. However, it is not without any cost. For example, the IMF and World Bank while providing many countries with the funding also set some stringent conditions for the funds from them.
Fifthly, the budget deficit can also be financed by using the foreign exchange reserves. But the use of foreign exchange will weaken the domestic currency and that will increase the cost of import.
Last but not least, the government can meet its deficit by selling public assets through the privatisation process. The budget deficit leads to inflation, when it is financed through money supply. On the other hand, higher inflation leads to higher expenditure compared to the receipts in the form of tax revenue. As a result, high inflation often results in a deficit for a country.
In the event of Bangladesh there exists a unidirectional causal relation between deficit and inflation where the deficit causes inflation. In analysing the relationship between budget deficits and the money supply it is useful to comprehend that the deficit will lead to a direct rise in the money supply, if the government finances the deficit not by borrowing but by drawing down balances it holds with commercial banks or the central bank. The financing of a deficit by drawing down treasury balances may affect commercial banks' reserves as well as the money supply. If treasury deposits with the central banks rather than commercial banks are drawn down, reserves will increase. Unless the increase is offset by the central bank, commercial banks may use the reserves to acquire earning assets. This may lead to a rise in the money supply beyond the direct increase caused by the financing of the deficit. The central bank may, of course, offset the increase in both reserves and the money supply arising out of a deficit financed by drawing down the treasury deposits.
The interest rate also plays a vital role. If the deficit is financed through borrowing, then it will increase the interest rate and induce people to draw down their current balance and transfer the fund to term deposits. Since independence, budget deficit has been a regular feature in Bangladesh. So, fiscal deficits of remain persistent and the common feature of deficit financing is to borrow from abroad and domestic sources (from the central bank, the scheduled banks and the non-bank sector).  Financing budget deficit by money supply can lead to a price spiral. Thus, the extent of inflation depends on how the deficit is financed.
It is suggested that while dealing with deficit the government should either increase the tax or reduce the expenditure. Increasing tax suddenly would not be an effective way to deal with the deficit. So, policymakers can first pinpoint the less important expenditure (pouring money for non-development work) and then assess the possibility of revenue enhancement. Only this can help tame the horse of high inflation of a country.

tanvirhasan_du@yahoo.com