Public Debt (Public Borrowings) and Inflation (Price Level)

Public Borrowings or Public Debt

Public borrowings/debt refers to government borrowings raised through internal and external sources. During the past few decades, the concept of public debt as a tool of fiscal policy has assumed greater significance. Keynes saw it as an instrument of reviving a depressed economy.

The government borrows either to meet its budgetary obligations or to stimulate the economy. The former implies that the government had little cushion in its cash flow, and falling tax revenue made it necessary to borrow. Government borrowings to stimulate the economy can shorten the period of economic downturn and boost business confidence.

The global economic crisis of 2008-09 witnessed such government activity that a majority of nations had to resort to excessive government borrowing to stimulate their economies. The US budget deficit increased from $318 billion in 2005 to $1300 billion in 2011. Japan, Greece, Italy, Portugal, Singapore and the US are the most indebted nations of the world. As per a recent estimate, India is running a budget deficit of 3.9% of GDP.

This debt has to be serviced, and an excessive amount of it poses severe problems for an already indebted economy. In the case of external debt, payment of interest and principal leads to the transfer of real output to other nations. The implication of debt on an economy depends upon the utilization of funds raised through borrowings.

In case it is used for productive purposes such as capital formation, it could contribute to the real income of present and future generations and add to the repayment capacity of the government as well. However, if borrowings are used to finance only current expenditures, then it poses the risk of rising debt to unsustainable levels.

Public Debt (Public Borrowings) and Inflation (Price Level)

The Keynesian school of thought advocated an active role of the government in economic activities. During The Great Depression of 1930, the government assumed an important role in the revival of the depressed economy. The roots of the government’s role in economic decision-making are found in Keynes’s consumption theory.

According to this, an individual does not consume the entire increase in his income but rather saves a part of it. Since all output is not consumed, unemployment may persist in an economy. Thus, a depressed economy, facing falling aggregate demand and deflation, faces the risk of falling into the problem of prolonged under-employment and depression. When aggregate demand is low, an investment push by the government can help to boost confidence in the economy. An increase in investment will lead to a rise in aggregate demand and price level.

As prices rise, business profits will increase, and profit expectations will cause businesses to increase output. Thus, employment, output and income will increase through the multiplier process. Here, government expenditure financed through debt will be instrumental in curbing deflationary tendencies in the economy.

The above diagram shows the case of an economy facing a liquidity trap (Horizontal portion of the LM curve). A Liquidity trap is a situation where a low/zero level of interest rate fails to stimulate the economy. In this case, a fiscal policy, say through incurring a public deficit, will have a full multiplier effect on the income, output and employment levels.

However, excessive public debt poses real dangers for an economy. It means that substantial resources are required for servicing debt. It creates vulnerabilities, which transmit into macroeconomic shocks and transmit burdens to future generations in the form of high taxes.

The relationship between Public debt and inflation was first examined by Sargent and Wallace (1981) of the Minnesota school. In their article ‘Some Unpleasant Monetarist Arithmetic’, an attempt has been made to analyze the link between fiscal and monetary policy.

Debt financed through increasing liquidity plays a significant role in raising the price level. It is argued that a shift to debt financing from tax financing will result in inflationary tendencies in the economy. They present a model where it is assumed that the monetary base is closely connected to the price level and that the central bank can raise seignorage through the creation of money. They show that exogeneity of the process for the government’s deficit reduces the central bank’s ability to control inflation. Large deficits and increasing government debt may force the central bank to issue money to ensure solvency, ultimately resulting in higher inflation.

Woodford (1996) argues that in the presence of sluggish price adjustment, fiscal shocks disturb real output and real interest rates and cause a rise in the level of prices. Evidences suggest that fiscal instability necessarily results in price level instability, in the sense that there exists no possible monetary policy that results in an equilibrium with stable prices. Fiscal shocks do change households’ intertemporal budget constraints at what would otherwise have been equilibrium prices and interest rates; hence markets fail to clear at those prices.

Let us understand this through the diagram below:

Suppose the economy is at full employment level Y1, and the government engages in debt financing. An expansionary fiscal policy through large public debt will shift the consumption schedule upward, and taxes will alter consumption decisions. This shift in the presence of a vertical aggregate supply curve will be inflationary (In the case of an upward-sloping supply curve, demand for real money stock will get affected). The price level adjusts to guarantee equilibrium. Here, the Price level has risen from P0 to P1. An increase in price will lead to a decrease in real output and real income.

Government bonds constitute a potential backlog of purchasing power which can add to inflationary pressures as they can be traded in for cash without any risk of loss. Thus, any such attempt by consumers to protect their purchasing power will fuel inflation. Thus, The scope for deficit financing is constrained by medium and long-term inflation risks.

The effectiveness of this mechanism depends on the following:

• The nature of the fiscal expansion (transfers to households or increase in public expenditure)
• The public debt-GDP ratio
• The speed of fiscal adjustment.

In addition, economies with high public debt-GDP ratios and slow fiscal adjustment experience larger price fluctuations. Evidence from emerging markets with high public debt levels points out that median inflation more than doubles as debt rises from the low range of 0-30 per cent to above 90 per cent.

Another view held is that the government has the incentive to decrease the real value of its outstanding stock of interest-bearing, nominally-denominated debt through an unanticipated burst of inflation. This could lead to higher inflationary expectations and associated rises in the nominal rate of interest and higher inflation risk premiums. Debt purchasers add their inflation expectations and interest rate premium into the prices they are willing to offer. They do so to compensate for the possibility that inflation may exceed their expectations. Debt purchasers in high-debt countries may then raise their inflation risk premium even before the onset of higher inflation. The more debt issued, the greater the risk of an unanticipated inflation burst and, thus, the greater the risk premium. Unanticipated high inflation is then a compelling method for lessening a country’s debt trouble. Moreover, this will be accompanied by further increases in interest rates.

A balance of payment deficit on the current account can help a nation to avoid such dangers. However, this would mean an external imbalance and a withdrawal of external finance, which could further result in inflation. So when the government runs an excessive budget deficit, the choice is between inflation and a payment deficit.

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment