Financing of Fiscal Deficit:
Since the size of balanced budget of the multiplier is small, it is not for all time possible to get the needed demand expansion by raising the expenditures and taxes symmetrically. Thus, the case of the deficit spending and financing should be considered. Here the government expends more than its revenues, and raises debt to the finance excess of expenditures over the revenues. The three borrowing options were mentioned previously:
i. Borrow from the domestic banking system or the general public by the sale of the treasury bills and bonds. Bills are short-term debt instruments (< 1 year) and bonds are the long-term bond instruments (> 2 years).4 The main disadvantage of this type of borrowing is that it can lead to the crowding out of the private sector activity. How is this possible? Consider market for loan able funds. An enlarged demand for the funds by the government will cause interest rates in economy to rise which means making loans more expensive for everybody, including private sector as well squeeze the quantity of credit available for lending to the private sector.
ii. Borrow from central bank by ordering the latter to print the money and lend it to government for onward spending. All governments would adore doing this, except that this type of “apparently free” financing is very highly inflationary. You can simply imagine why. The increased supply of money given the fixed or limited supply of gods will naturally cause the prices of those limited goods to increase.
iii. Borrow from the foreign sources either through the bonds floated on international capital markets or the bilateral, multilateral or the commercial loans. The benefit of this type of borrowing is that it does not lead to the crowding out and is not right away inflationary, particularly if some of the loan helps finance import and expenditure. If all the borrowed money is expended locally given the fixed exchange rate, the monetary effects of the foreign borrowing may become similar to those of borrowing from the central bank.