Models such as the Real Business Cycle assume that the financial system operates smoothly without any frictions. If the system is working well, economic agents can carry out their planned expenditure using money and credit. This report focuses on the intersection between finance and the ‘real economy’. I begin by examining how political economy approaches to money and the wider financialization literature reveal the entangled relationship between finance and broader economic practices. Its institutions, which issue and circulate money, play an important role in the working of the real economy that it would be imprudent to neglect. The allocation of savings, but also the level of activity and the growth rate depend on it. In this book, the authors carefully analyse the close links between money, finance and the real economy.

Let us make in-depth study of the financing of budget deficit through printing money.

Resource Mobilisation through Money Financing of Budget Deficit:

Capital Flows, Asset Prices, and the Real Economy: A 'China Shock' in the U.S. Real Estate Market. Zhimin Li, Leslie Sheng Shen, Calvin Zhang. Abstract: We study the effects of foreign real estate capital flows on local asset prices and employment using detailed housing transactions data. Finance is the answer to that problem. If you think of the economy as a body, finance would be the heart, pumping money from pension funds in Iowa to construction sites in Madrid. In economic terms, the financial system is responsible for a lot of the world’s resource allocation. It decides which investments get funded and which ones do not.

The government can mobilize resources for economic growth by financing its budget deficit through printing high powered money.

This is therefore called money financing of budget deficit. It is important to note that in the old or earlier terminology printing of new money to finance the budget deficit was called deficit financing. It is now called money financing of budget deficit for mobilizing resources by the government. The printing of money to raise revenue by the government is also called seignior-age.

ADVERTISEMENTS:

When government finances its budget deficit through printing money, money supply in the economy increases. There are two views regarding the effect of increase in money supply on inflation. According to the Keynesean view, when money supply is increased in times of depression when both productive capacity and labour are lying idle due to deficiency of aggregate demand, price level is not likely to rise much and the effect of increase in money supply is to raise output or income.

The increase in real income, given the rate of taxation will bring about increase in revenue from taxation, which will tend to reduce budget deficit in the short run. However, if the economy is operating at or near full employment, printing money to finance the deficit will cause inflation.

Printing money to raise revenue for financing the budget deficit which causes inflation is like an inflation tax. This is because the government is able to get resources through printed money which causes inflation and reduces the real value of the holdings of money by the public.

Let us first explain the Keynesian model with a fixed price level when the economy is in recession due to demand deficiency and a lot of unemployment of resources prevails. The tax function can be written as

T = t(Y)

where t is the rate of tax and Y is real income and T is the total tax revenue. If G is government expenditure, then budget deficit (BD) is given by

BD = G – t(Y) …(i)

If G – t(Y) = 0, budget deficit will be zero and therefore the budget will be balanced one. If G – t(Y) > 0 there will be budget deficit.

ADVERTISEMENTS:

If the Government finances its deficit through money creation, then the short-run macro equilibrium can be written as

Y = Y (G, M) … (ii)

The short run equilibrium in simple IS-LM model is shown rated in Fig. 34A. 1 where IS and LM curves intersect at point E and determine equilibrium income Y₀ and equilibrium interest rate r₀. Suppose in this equilibrium the government has a budget deficit so that G – t(Y) > 0. Further, government finances this budget deficit through creating high powered money.

As a result, money supply in the economy increases and LM curve shifts to the right to the new position LM₁With this, as will be seen from the figure, level of equilibrium income increases to Y₁ and rate of interest falls to r,. Since we are assuming an economy with a depression, increase in demand brought about by expansion in money supply will not cause any rise in price level.

In the above model of an economy representing the period of recession price level remains unchanged as more money is created to finance budget deficit. In an important contribution. Fischer and Easterly explain the condition for non-inflationary printing of money.

They write, “the amount of revenue that the government can expect to obtain from the printing of money is determined by the demand for base or high-powered money in the economy, the real rate of growth of the economy and the elasticity of demand for real balances with respect to inflation and income”.

Further, assuming income elasticity of demand equal to unity and currency to GNP ratio equal to 13, they conclude that “for every one percentage point that GNP increases, the government can obtain 0.13 percentage points of GNP in revenue through the printing of money that just meets the increased demand for real balances. With an annual economic growth rate of 6.5 per cent of GNP the government should be able to obtain nearly 0.9 per cent of GNP for financing the budget deficit through the non-inflationary printing of money, increasing the high powered money stock at an annual rate of 6.5 per cent”. If rate of growth of money exceeds this and, given a stable demand function for currency, inflation will result.

Printed Money and the Inflation Tax:

It follows from above that if the economy is operating at full-employment level of GNP or growth rate of money due to persistent budget deficits over time is in excess of rate of growth of GNP, inflation will come about. It has been pointed out by some economists that inflationary financing through the creation of high powered money is an alternative to explicit taxation.

ADVERTISEMENTS:

Though in most of the industrialized economies (including the United States) the creation of high-powered money or inflationary financing of budget deficits is only a minor source of revenue, in other countries (including India), the creation of high-powered money has been a significant source of raising revenue to finance government expenditure.

Before March 1997, in India the creation of money to finance the budget deficit was called ‘deficit financing’ which has been a significant source of revenue for the Central Government in the sixties, seventies and eighties of the last century.

Though, it is not entirely correct that financing government expenditure through creation of high- powered money necessarily leads to inflation, though traditionally every creation of high-powered money or deficit financing has been called inflationary.

Why is the creation of high powered money that causes inflation is called inflation tax and is an alternative to explicit taxation as a source of financing government expenditure. When government uses printed money to finance its deficit year after year, it uses it to pay for the goods and services it buys.

Thus in this process the government get the resources to buy goods and services and as a result, money balances with the people increase a part of which they will save and the rest they will also spend on goods and services.

However, due to inflation real value of money balances held by the people decreases. That is, with their given money balances, people can buy fewer goods and services due to inflation. Thus when the government finances its budget deficit through creation of new high powered money and in the process causes inflation, the purchasing power of old money balances held by the public falls.

Real Economy And Financial Economy

Hence inflation caused by creation of

Money Finance And The Real Economy