Article

Significance of Alternative Concepts of Budget Deficit

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1973
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THE “BUDGET DEFICIT” is among the most widely used concepts in discussions of economic policy. With the preclassical and classical writers of public finance, the importance of budget deficits seems to have stemmed from their concern with prudent finance and with avoiding extravagance by the rulers of rising nation-states.1 The analytical significance of the concept in modern economics arises from its use as a measure to judge the impact of the budget on the economy for short-run fiscal analysis and from the identification of deficit financing with a unique method of mobilizing resources for economic development in less developed countries. In terms of policy, whereas deficit financing in developed countries is advocated as a means of stimulating the economy by raising aggregate demand in conditions of recession, in developing countries it is considered as an instrument by which potential saving can be pre-empted for the public sector, or the rate of investment raised above the level of voluntary saving.

Several concepts of budget deficit are currently in use, and the definition of deficit used in a particular context is often not made clear. It is obvious that alternative formulations of budget balances can give significantly different indications, and there has been considerable discussion in the literature on the appropriateness of the use of various concepts for specified purposes and of the relative merits of different approaches.2 The two main objectives of this paper are (a) to formulate and analyze the major alternative concepts of budget deficit3 and (b) to indicate the considerations necessary to select the best approach for judging the impact of the budget on aggregate demand. In the light of the discussion, the limitations on the use of the size of the budget deficit, however defined, as a measure of the impact of the budget are also discussed briefly. The main ideas discussed in the paper are especially applicable to developing countries. Basically, the paper attempts a clarification of the major issues involved, rather than seeking to present any theoretical innovations.

Apart from its historical connection with ideas of “sound finance,” the budget balance has generally been used as an important summary measure of the impact of the budget on the economy. However, the budget affects the economy in different ways, and the kind of budget balance to be computed obviously depends on the particular effect being studied or measured. The concern here is primarily with the direct budgetary impact on (a) public debt, (b) aggregate demand, and (c) money supply. The concept of budget balance designed to measure saving by the government sector is also considered because of the special interest in this aspect of budgetary performance in developing countries in the long term.

In one sense, the budget is always in balance: incomings equal outgoings, adjusted for changes in cash balances (see Table 1). A deficit or surplus in the budget is arrived at only by designating some items as balancing items, that is, by excluding them from the side of incomings or outgoings so that an inequality is created between expenditure and receipts. The size and sign of the budget balance, therefore, depend on (a) what items are included to make up the budget and, hence, the expenditure total and (b) what items are excluded from incomings to calculate the difference between expenditure and included receipts.

Table 1.The Basic Budget Balance: Incomings and Outgoings
ExpenditureReceipts
A. Current expenditureB. Revenue
Tax revenue
Nontax revenue
C. Net acquisition of real assetsD. Net borrowing (gross borrowing—repayment)
E. Net acquisition of financial assets
F. Increase (+) or decrease (‒) in cash holdings
Total (A+C+E+F)=Total (B+D)

Two categories of questions arise in determining the budget total, that is, concerning the inclusion or exclusion of items of expenditure. The first relates to the comprehensiveness of coverage and includes such questions as what agencies or sections of the public sector are to be covered and whether working expenses of public enterprises should be included. The answers to these questions affect the budget total, and sometimes the size of the budget balance, but do not have a bearing on the conceptual issues concerning the nature of the balance derived. This category of questions is therefore not dealt with in this paper.

The second category of questions is related directly to the size and nature of the budget balance. A good example on the receipts side is the question of the treatment of borrowing from the nonbank private sector and on the expenditure side, the question of including government lending. In the following sections, questions of this type are considered in detail for deriving different kinds of budget balance.

I. Public Debt Concept

A well-known, widely used concept of budget deficit is what may be termed the public debt concept of deficit. This concept most clearly approximates the dictionary meaning of deficit spending, namely, the spending of funds raised by borrowing. This measure of deficit is defined as the difference between the sum of (a) current expenditure, (b) net acquisition of physical assets, and (c) net acquisition of financial assets, on the one hand, and the sum of tax and nontax revenues, on the other hand. In terms of the notations in Table 1,

That is to say, this deficit measures total net borrowing by the government sector adjusted for changes in cash holdings. Since changes in cash holdings as a rule are fairly small, the budget may be said to be balanced, in terms of this concept, if net borrowing is equal to zero, or, in other words, if public debt remains unchanged.4 This measure is, therefore, referred to as the public debt concept of deficit.

The deficit so defined is also often referred to as the overall deficit, and the items on the receipts side that are excluded for computing this deficit are called the financing items. Traditionally, this concept of deficit has been employed in discussions of the impact of budgetary policy on aggregate demand in several Western countries, most notably in the United States.5 It can be seen that if foreign transactions are set aside, the overall deficit would reflect the increase in the claims of the other sectors of the domestic economy against the government. Since foreign receipts have generally been unimportant in the U. S. budget, the overall deficit, which reflects broadly the total of net domestic borrowing, has traditionally been used in the United States as a summary measure of the expansionary impact of the budget. Also, such a use of this concept of deficit fits in well with the premises and techniques of simple Keynesian analysis where the level of private investment in the short run is not related directly to the availability of savings as such. Thus, even if the government were to borrow from the non-bank sector and use the proceeds to finance an increase in expenditure, this would only mean an activation of private savings with no direct effect on the level of autonomous investment.6 This simple system needs to be modified suitably before application to real situations, particularly in developing countries. This question is taken up again when the budget balance and the state of aggregate demand are considered.

Since, as stated earlier, changes in cash balances are usually of minor significance, the overall deficit for any past year indicates the total of government borrowing; likewise, the overall deficit in the budget estimates may be said to give the total borrowing needs of the government for the coming year.7 As such, a measure of the overall deficit is useful for treasury management and is in fact necessary for proper budget planning. Also, it is of interest to know the extent of the increase in public debt or in the gross liabilities of the government, because any such increase has implications for debt servicing in the future. However, wherever the government undertakes, on a significant scale, business and industrial activities and/or borrows on behalf of public enterprises—as in a great number of developing countries—it would be necessary to allow for physical (productive) assets acquired, in order to obtain a balanced picture of the changed financial position of the government. Furthermore, the overall deficit measures the increase in liabilities without netting out the increase in financial assets, since net lending is included in expenditure for deriving the deficit. If the government engages itself in considerable financial mediation, the increase in net public debt—that is, the increase in liabilities minus the increase in financial assets—would give a better indication of the net increase of the debt burden on the general government budget. However, the derivation of the overall deficit may be said to mark a useful starting point for fiscal analysis. As will be shown later, this concept of deficit could also be used as an approximation of the measure of budgetary impact on aggregate demand under certain circumstances.

II. Alternative Budget Balances

As indicated earlier, the overall deficit directly measures the increase in the gross public debt as a result of a given budget. An attempt will now be made to derive three other concepts of budget balance that can be used as summary measures of the impact of the budget on, respectively, net worth of the public sector, aggregate demand, and money supply.8 The classification of budget items in Table 2 is presented both as an aid to theoretical discussion and as a scheme of classification required for deriving the different kinds of budget balance. The hypothetical numbers in the table are used to provide numerical examples.

Table 2.A Statement of Budgetary Items for Fiscal Analysis(Figures shown for illustrative purposes)
OutgoingsIncomings
A. Current Expenditure1,500B. Current Revenue1,800
1. Domestic1,2001. Domestic1,495
(a) expenditure on domestically produced goods and services1,000(a) taxes paid by residents (individuals and juridical entities)990
(b) transfer payments including interest150(b) nontax revenues505
(i) transfer and interest payments to the non-bank private sector(125)(i) rent, interest, and dividends from the domestic economy other than the central bank(310)
(ii) interest payments to the banking system(25)(ii) profits received from the central bank(5)
(c) depreciation on government-owned physical assets50(iii) surpluses of departmental public enterprises (net of depreciation)(50)
(iv) administrative receipts(140)
2. Foreign3002. Foreign305
(a) expenditure on goods and services abroad260(a) taxes paid by nonresidents from abroad100
(b) transfer payments abroad40(b) factor payments received by government from abroad5
(c) grants from abroad200
C. Gross capital formation—acquisition of real or physical assets590D. Capital Receipts440
1. Domestic expenditure on domestically produced goods and services and on land1. Domestic365
(a) depreciation125
500(i) depreciation on government-owned physical assets(50)
2. Foreign expenditure abroad leading to capital formation
90(ii) depreciation provision of departmental public enterprises(75)
E. Net Acquisition of Financial Assets250
(b) net sale of physical assets10
1. Domestic net lending to entities outside the government sector (including purchase of stock)(c) net borrowing230
(i) from the nonbank public(30)
225(ii) from the commercial banks(80)
2. Foreign net lending abroad
25(iii) from the central bank(120)
2. Foreign75
(a) sale of physical assets abroad
(b) net borrowing from abroad75
F. Increase in Cash Balances15G. Decrease in Cash Balances115
1. Domestic1. Domestic115
(a) decrease in domestic balances63
(b) issue of notes by government40
(c) use of counterpart funds12
2. Foreign152. Foreign drawing down of assets abroad
Total (A+C+E+F) = 2,355Total (B+D+G) = 2,355
Definitions of major categories in the table

Current expenditure: (a) all expenditure on goods and services not leading to the acquisition of durable physical assets (as defined herein) and (b) all transfer payments including interest.

Current revenue: all receipts that neither increase liabilitiesn or reduce assets of the government sector.

Gross capital formation: total value of acquisition of durable physical assets (including construction) taken gross of depreciation. Strictly speaking, assets included here should those bewhose normal life extends beyond the accounting period, but to facilitate comparison with national income aggregates, the definition of gross capital formation for the government sector should correspond to that for the economy as a whole. This requirement delimits the types of asset to be included. Depreciation is to be charged only against these items.

Capital receipts: all receipts that either increase the liabilities of the government sector or reduce its assets, that is, all incomings that are not current receipts.

Net acquisition of financial assets: gross lending minus repayment to government plus net purchase of stock. Excludes changesin cash balances and in foreign exchange assets.

Increase in cash balances: includes the same items as enumerated in G.

Definitions of major categories in the table

Current expenditure: (a) all expenditure on goods and services not leading to the acquisition of durable physical assets (as defined herein) and (b) all transfer payments including interest.

Current revenue: all receipts that neither increase liabilitiesn or reduce assets of the government sector.

Gross capital formation: total value of acquisition of durable physical assets (including construction) taken gross of depreciation. Strictly speaking, assets included here should those bewhose normal life extends beyond the accounting period, but to facilitate comparison with national income aggregates, the definition of gross capital formation for the government sector should correspond to that for the economy as a whole. This requirement delimits the types of asset to be included. Depreciation is to be charged only against these items.

Capital receipts: all receipts that either increase the liabilities of the government sector or reduce its assets, that is, all incomings that are not current receipts.

Net acquisition of financial assets: gross lending minus repayment to government plus net purchase of stock. Excludes changesin cash balances and in foreign exchange assets.

Increase in cash balances: includes the same items as enumerated in G.

Budget balance reflecting change in net worth

The net worth concept of deficit, or, in other words, the balance on current account of the budget, is used to indicate the magnitude of savings generated in the government sector. The concept of current account balance is also widely used, but it is not always correctly measured or interpreted. The derivation of the overall deficit necessitates the division of government receipts into current and capital items;9 the derivation of the balance indicating change in net worth requires, in addition, a similar division on the expenditure side. This division of budget items must be based on the accounting principle that capital receipts and expenditure should represent changes in assets and liabilities.10 If total change in the net worth of the public or government sector were to be computed in the same manner as for a private entity, changes in the market value of existing assets owing to price changes would also have to be taken into account. But, for the government sector, the interest is only in what is known in accounting terminology as earned net worth, the main objective being to measure the volume of savings generated in this sector. Therefore, only changes in assets and liabilities resulting from capital transactions need be, and generally are, considered. Thus, savings, or change in net worth, in the government sector can be calculated as the difference between current revenues and current expenditure, which is necessarily equal to the difference between changes in assets and in liabilities.

In Table 2,11 items A and B constitute the current account and items C, D, E, F, and G, the capital account.

This is equal to the difference between changes in assets and in liabilities given by (C+E+F)–(D + G), since by definition, (A+C+E+F) = (B+D+G).12

To obtain a measure of gross savings in the government sector, the depreciation provision of departmental public enterprises should be added to the balance on current account, which is derived without charging depreciation on general government assets.

In calculating government savings, current revenues have been taken to include grants from abroad. Such grants may be a fairly important source of revenue in several developing countries. If it were true that certain current expenditure equivalent to these grants would not have been incurred if the grants had not been received, it would be correct to argue that the receipt of grants made no contribution to government savings and that the savings should be computed by simply deducting current expenditure from current revenues inclusive of grants from abroad. In fact, however, such an assumption about expenditure associated with foreign grants cannot be made as a general rule, and hence the question arises whether savings of the government sector really should be calculated gross of foreign grants. While savings computed in that manner correspond to the accounting definition of change in earned net worth (that is, foreign grants are treated as incomings that do not create liabilities), a misleading picture would result if savings of the government sector gross of foreign grants were added to private savings and the total were used to compute the economy’s propensity to save. Therefore, it may be desirable at least to show the element of foreign grant, if any, that is present in the figure for saving by the government.

It is important to recognize the specific purpose and limitations of deriving a separate balance on current account. In measuring the immediate impact of the budget on aggregate demand or balance of payments, the division of the expenditure side of the budget into current and capital accounts does not have much significance, particularly when a simple (unweighted) budget balance is to be worked out.13 The main purpose of deriving this balance is to estimate savings generated in the government sector, and in this sense it is more a social accounting than a budgetary concept. As indicated earlier, the division of government expenditure into current and capital accounts in practice must be based on national income accounting conventions; hence, the resulting estimates of government savings and capital formation are subject to limitations inherent in the conventional concepts of savings and investment. Thus, for example, government capital formation will exclude all investment in human capital on budget account as well as other expenditure leading to increases in productive capacity but not resulting in the creation of physical assets, such as the promotion of research. This being so, the current-capital division on the expenditure side is sometimes opposed on the grounds that it would disturb the proper allocation of resources and encourage the cement-and-steel concept of economic development.14 If emphasis is placed, without qualification, on maximizing government saving, or if the magnitude of current account surplus is used as a yardstick for judging budgetary performance in developing countries, there is, of course, danger that physical capital formation would be promoted at the expense of more urgently needed categories of current expenditure. But the mere measurement of savings on government account in the conventional sense carries with it no implication, and should not be construed to yield the inference, that making resources available for physical capital formation through the budget should have priority over providing desirable or needed current expenditure for the development of human capital. Nor should the inference be drawn that all current expenditure should always be tax financed. The allocation of resources between material capital formation and investment in human capital is a matter to be decided in the light of the situation in a given country and as part of the planning process. The interest in the measurement of government saving arises more from the requirements of the planning process itself.

In the context of the problems of resource mobilization for economic development, policymakers in developing countries as well as donors of foreign aid would like to have estimates of domestic savings and their distribution among the major sectors. For an exercise of macroeconomic financial planning, measures of sectoral savings are obviously required. Besides, if an imbalance arises between projected investment in the plan and the amount of savings likely to be generated autonomously, one way of bridging the gap would be to restrict private consumption through higher taxation and thus to increase total savings through a generation of increased government savings at the expense of private consumption.15

With the overall shortage of savings and capital in developing countries, the government’s role in saving and capital formation is held to be important, and hence the budget balance indicating the amount of government saving may be said to be a useful concept, especially from the point of view of longer-term assessment, while it is not so relevant for fiscal analysis for developed countries (or, indeed, for any short-run analysis).16

Budget balance reflecting impact on aggregate demand

A stimulus to aggregate demand generally leads to an increase in the demand both for domestically produced goods and services and for imports, that is, an impact on aggregate demand is reducible to an impact on gross national product (GNP) and on the balance of payments. Theoretically, a budget balance that reflects the impact on aggregate demand may be computed by subtracting the sum of receipts that either reduce purchasing power or add to real resources available for spending from total expenditure (all of which would lead to an increase in either GNP or the demand for imports).17 A positive budget balance would denote net expansionary stimulus.18 In practice, however, it is not easy to make categorical, generalized statements about the impact of certain types of receipt and expenditure on private demand, because the results depend so much on institutional arrangements, monetary policy actions, and perhaps also on circumstances peculiar to particular countries. Hence, the approach adopted here is to bring out the considerations relevant to the search for an appropriate definition of a budget deficit reflecting the stimulus to aggregate demand (to be called expansionary deficit) and to suggest two alternative definitions, corresponding to the upper and lower boundaries of the simple measure of budget impact.19

The broadest definition—total domestic borrowing

If it is assumed that (a) all domestic receipts other than borrowing curtail purchasing power and demand, (b) all expenditure adds to aggregate demand, (c) domestic borrowing has no impact either way, and (d) foreign receipts make available additional real resources for the economy, then a budget balance reflecting the stimulatory/contractionary impact on aggregate demand may be derived from the difference between total expenditure, on the one hand, and the sum of domestic “current” receipts and foreign receipts, on the other hand. That is, the expansionary deficit

In a closed economy or in a country where foreign borrowing by the government is nonexistent, negligible, or relatively small, the expansionary deficit as just defined can obviously be equated with the overall deficit, which is often used as a first approximation in attempts at measuring the impact of the budget. However, in countries where government borrowing from abroad forms a significant proportion of total borrowing, the overall deficit will not be an accurate measure of the net impact of the budget on aggregate demand.

The impact of budgetary transactions involving foreign receipts or expenditure varies according to the types of receipt and expenditure that are combined in given transactions. Four different combinations can be envisaged: 20 (a) Foreign receipts, such as grants from abroad, combined with foreign expenditure—net impact is neutral with respect to both GNP and the balance of payments. (b) Foreign receipts combined with domestic expenditure—an expansionary impact on GNP but a countervailing favorable impact on the balance of payments. (c) Domestic receipts other than borrowing combined with foreign expenditure—a contractionary impact on GNP but an adverse impact on the balance of payments, (d) Domestic borrowing combined with foreign expenditure—a nil impact on GNP but an adverse impact on the balance of payments.

As indicated earlier, in the context of the use of the simple (unweighted) budget balance, an expansionary impact is defined in terms of an increase in the demand for domestic goods and of the impact on the balance of payments. Given this definition, the net impact of budgetary transactions can only be obtained by combining the effects on GNP and on the balance of payments. Thus, not only (a) but also (b) and (c) are examples of neutral impact, while (d) is a case of expansionary impact. Since expenditure abroad is added to domestic expenditure in computing the unweighted budget balance, foreign receipts, all of which have a favorable impact on the balance of payments, need to be placed “above the line” in the derivation of the expansionary deficit. As regards the immediate impact on aggregate demand, there is no difference between foreign grants and foreign loans. However, in a longer-term assessment of the overall financial position of the government, a distinction must be made between grants and loans from abroad. For, unlike foreign grants, borrowing from abroad adds to liabilities, giving rise to problems of future interest burden and of transformation of domestic savings involved in repayment of loans in foreign currency. In other words, the favorable impact of borrowing from abroad on the balance of payments may be only temporary, unless the expenditure of the loans were to produce a more lasting effect (in terms of productivity and exports).

Treatment of government lending

In calculating the expansionary deficit (on the basis of the broad definition), domestic lending has been included in expenditure (placed above the line) and government borrowing from the nonbank private sector has been excluded from the receipts side (placed below the line). This procedure implies the assumptions that government lending, or net acquisition of financial assets by the government, increases aggregate demand in the same way as any other expenditure, and that government borrowing from the nonbank private sector has no effect on private consumption or investment. As discussion in the literature has shown, these propositions are subject to a considerable degree of uncertainty, and hence the need to suggest alternatives to the broad definition given earlier as the point of departure for discussion.

The assumption with regard to government lending is taken up first, and the treatment of government borrowing—which is, in a sense, a related question—is discussed next.

The discussion is confined to domestic lending. If lending abroad by a developed country is largely in the form of tied aid, it really should be treated as part of domestic expenditure. Lending abroad is hardly significant in developing countries.

The treatment of domestic lending in the derivation of the budget balance has been the subject of considerable discussion in the literature.21 Only the main arguments are recapitulated here. These revolve around the question whether in lending (or relending) money, the government is merely engaging itself in financial intermediation or whether the intervention of the government in the capital market gives rise to net additional expenditure in the private sector. On the one hand, those who favor the inclusion of lending in expenditure argue that loan programs establish claims on real resources that are hard to distinguish from those that arise from other types of expenditure, such as for grants or subsidies. On the other hand, those who wish to exclude lending argue that payments that affect only liabilities and assets of individuals should not be treated on the same footing as income-creating expenditure, to which indeed they are not additive, and that in any case lending represents mostly financial intermediation, that is, lending of borrowed money. Two different questions seem to be at issue here. First, is financial investment less demand creating than an equivalent amount of direct investment by the government? Second, do not the effects of borrowing neutralize the effects of lending, or, in other words, is there justification for treating lending to and borrowing from the same sector asymmetrically? These two questions may be considered separately to avoid confusing the results of one operation with those of the other.

Acquisition of financial assets by the government can take many forms, ranging from the repurchase of existing government securities to lending money to potential investors who are held back for want of funds (the so-called submarginal borrowers). Some forms of acquisition of financial assets are likely to be much less demand creating than others. A good example is that of buying existing government or private securities. Such expenditure, the direct impact of which is to change the asset portfolio of the private sector, may be considered to create very little additional demand, unlike direct investment by the government.22 There is a good case for excluding that kind of financial investment from expenditure.23 At the other extreme, it could be argued that lending to a submarginal borrower would most likely give rise to a net increase in total demand almost equal to the amount of lending because, in the absence of the government loan, the submarginal borrower without access to the private credit market would have been unable to undertake the investment (now made possible by the loan); it could also be argued that since he is outside the private credit market anyway, others dealing in it are not affected by his actions in either case. In between the two extremes would come loans to supramarginal borrowers whose investment in real assets would probably not increase by the full amount of the loans. For example, if the government lends $100 to a supramarginal borrower who would have obtained $75 from the private credit market in the absence of government action, the net increase in his expenditure would be only $25. However, his withdrawal from the market releases $75 for use by other people. In other words, nonmarginal loans ease conditions in the credit market and put downward pressure on interest rates, thereby enabling some submarginal borrowers to become marginal borrowers.24 Thus, even though the direct increase in real investment is only $25, the total effect flowing from the loan is likely to be much larger, unless the government siphons off the unused credit by some means.

In developing countries, government loans are often given to sub-marginal borrowers, such as small-scale farmers and producers, and to promote investment that would not have taken place otherwise. Typically, the credit market is undeveloped, and large investments would generally be extremely difficult to undertake without the government’s financial support. Furthermore, if the question (of the effects of government lending) is considered not in terms of comparative statics but in the context of growth, it is likely that the market would have adjusted itself to a certain proportional magnitude of government lending in every (annual) period. The stoppage of lending in one period would introduce a deflationary tendency. The continuation of government lending programs may be said to contribute to the growth in aggregate demand. These considerations suggest that there is a strong case for including government lending for new investment as part of expenditure in analyzing the impact of the budget in developing countries. It is true that different lending programs may have greater or smaller demand effects, but since in computing the simple budget balance all items included above the line are to be taken as being equivalent, these differences in impact cannot be taken into account. The only possibility is to include items that are believed to have sufficient effect to warrant inclusion and to exclude others. As already noted, acquisiion of financial assets representing the purchase of existing assets may be excluded. Also, in the French-type treasury system, where the treasury engages in banking activities, lending under these operations should be excluded from expenditure.

In national income accounting and flow-of-funds analysis, real investment is assigned to the sector that undertakes it and not to the one that finances it. Hence, if government lending is added to government expenditure for fiscal analysis, the concerned magnitude should be taken out of the figure of private investment in an overall analysis of the economy in order to avoid double counting.

Treatment of government borrowing

In the broadest definition of expansionary deficit (given earlier), all domestic borrowing has been included in the deficit with the implication that no act of borrowing has a negative impact on demand. It is, of course, granted that such an assumption is not, strictly speaking, equally valid for all types of borrowing, but it is believed by those who adopt this definition that there is a clear difference as regards impact on demand between taxation, on the one hand, and any type of borrowing, on the other hand. However, it seems necessary, at least in respect of the developing countries, that a distinction should be made between borrowing that reduces purchasing power in the hands of the public and that which does not. Let us consider the three major types of borrowing in turn.

Borrowing from the central bank. Borrowing from the central bank may be said to have no direct impact on aggregate demand, because the central bank is not under a compelling necessity to reduce credit elsewhere when it extends credit to the government.25 From this it follows that domestic expenditure combined with central bank borrowing has an expansionary impact on aggregate demand. Demand may be expected to increase not only because of the increase in income but also because of the possible effect of the additional liquidity on consumption through the operation of the Pigou effect. The increase in money supply implicit in this means of financing may turn out to be more than the increase in desired cash balances resulting from the expansion in income that was created by the increase in government expenditure. This is especially likely because part of the newly created cash paid by the government to the public would be deposited with the commercial banks, the credit multiplier would operate, and the increase in aggregate demand would be larger than was originally caused by government expenditure as such. In such a case, the attempt on the part of the public to get rid of the excess cash balances would lead to a rise in the price of income-yielding assets and a downward pressure on interest rates, which in turn might induce additional private investment and/or a balance of payments deficit.

These are the possible results if the problem is viewed in terms of comparative statics. Let us now introduce growth in real income and consider the effects of government expenditure financed by borrowing from the central bank when the economy is growing at a given percentage rate. The borrowing has no negative impact on demand, and hence the domestic expenditure financed by it would have an expansionary effect on aggregate demand as in the comparative static situation. But, whereas in the latter situation if the initial state is one of formal full-employment equilibrium 26 there will be a rise in prices accompanied by an increase in money incomes only, in a situation where growth is allowed for, the additional demand created by credit-financed government expenditure may be met by the increase in real output and hence there need be no inflationary rise in prices. Nevertheless, the effect of credit-financed domestic expenditure is expansionary in both cases in terms of incomes directly generated. But the results are different in terms of the effects of additional liquidity created. Whereas under comparative statics it has been shown that the increase in money supply might produce both the Pigou effect on consumption and the Keynesian effect on the interest rate, in the dynamic situation, with the growth in real income and progressive monetization of the economy, the demand for cash balances will have increased, and the growth in money supply represented by the credit extended by the central bank (if less than the increase in demand) would go toward meeting part of this increase in demand and would not then cause a rise in the price of assets as under comparative statics. The increase in the demand for cash by the public may also be looked upon as the desire to hold a certain proportion of savings in the form of liquid assets, and the government then pre-empts part of these savings for its own use through credit creation by the central bank.27 Insofar as the increase in cash balances resulting from government use of central bank credit is limited to a part of the increase in wealth desired to be held liquid, no Pigou effect could be attributed to government action. Nor will there be an inducement to get rid of cash balances, because there is an increase in demand to which, it is assumed, the increase in supply is limited.

To conclude, domestic expenditure financed by central bank credit is expansionary. In the framework of comparative statics, borrowing from the central bank will not have a negative impact on aggregate demand; instead, it may induce an increase in aggregate demand through the effects of the additional money stock created. In the context of growth in real income, domestic expenditure financed by central bank credit will probably be less expansionary, because the increase in money supply will be counterbalanced, at least in part, by the increase in the demand for cash balances.

If borrowing from the central bank is used to finance government expenditure abroad, the expansionary impact is reflected in the adverse effect on the balance of payments. In this case, there are no additional effects created by a change in liquidity conditions.

Borrowing from commercial banks. Government borrowing from the commercial banks will have no impact on aggregate demand if the banks have excess reserves, and therefore domestic expenditure financed by such borrowing will have a direct expansionary effect in exactly the same way as expenditure financed by central bank credit.28 If the commercial banks do not have excess reserves when the government offers them its bonds, they can lend to the government only by curtailing credit to the private sector. This would exert a contemporary pressure offsetting the expansionary effect of the additional government expenditure.29 However, instead of curtailing credit to the private sector, the banks may turn to the central bank for accommodation. If the central bank extends credit to the commercial banks under such circumstances, the result would tend to be the same as if the government had been granted the credit direct—except that the cost of acquiring credit by the commercial banks would probably result in less expansion. It is possible to adopt a convention by which government borrowing from the commercial banks can be treated as borrowing from the central bank, to the extent that there is extension of credit to the banks at the same time. Even then, whenever the extension of credit by the central bank to the commercial banks is less than the amount of government borrowing from the commercial banks, it would still be necessary to ascertain their excess reserves position. This will not be easy to identify, because, in practice, it is not easy on the basis of ex post data to distinguish between an autonomous fall in the credit extended to the private sector and deliberate curtailment of credit by the banks themselves.

Net borrowing from the commercial banks continuously (in successive periods) will be possible only if the government or the central bank continues to create high-powered money.30 If real income is rising from period to period, the demand for cash balances rises and the creation of high-powered money provides the basis on which bank credit can expand. Thus, in the context of growth, commercial bank credit to the government can also be looked upon as the means by which part of the savings of the public is diverted to the government. This is the part that the public is willing to hold in the form of bank deposits, and the amount that can be diverted without a rise in prices depends both on the proportion of savings that the public wishes to hold as bank deposits and on the rival claims of the private sector for bank credit. But even if government borrowing is limited in every period to this amount, expenditure financed by it acts as an expansionary force. On a balance of considerations, therefore, for practical purposes, commercial bank credit to the government may be treated as having no negative effect on private demand. However, a situation may exist to which this general conclusion does not apply; for example, during a given period the banks might have curtailed credit to the private sector in order to subscribe to government securities in the absence of accommodating action by the central bank.

Expenditure financed by central bank credit may be considered to be potentially more expansionary than that financed by commercial bank credit, insofar as the former adds to the reserves of the banking system. However, we are dealing here only with the direct budgetary impact.

Borrowing from the nonbank private sector. In most developing countries, borrowing from the nonbank private sector, that is, the public, will have a contractionary effect on private demand under several plausible circumstances. Hence, great importance is attached in those countries to efforts at mobilizing private saving for economic development through such means as the establishment of a government savings bank and the issue of savings certificates suited to the small investors. Diversion of funds through these channels is looked upon as the utilization of genuine voluntary savings as opposed to the use of bank credit and is considered, therefore, a noninflationary means of financing economic development. Borrowing from the public, however, will clearly have a less contractionary effect on private demand than taxation, in as much as the taxpayers feel that they are worse off for taxes paid, while bondholders may feel neither worse nor better off since they would have only exchanged one form of asset for another. Nevertheless, borrowing from the public in developing countries may have a significantly more contractionary effect than using bank credit to warrant consideration of excluding it from the measure of expansionary deficit. Again, this question must be considered both in terms of comparative statics and in the context of growth.

Complications in analyzing the effects of government borrowing from the public arise mainly because of the possible countervailing forces emanating from an elastic credit structure and from monetary policy actions. In order to isolate the effects of government borrowing, per se, let us assume a 100 per cent reserve system and no credit creation by the central bank. The analysis under these hypothetical conditions will be carried out only in terms of comparative statics.

(a) If the public were to lend to the government from idle balances (”kept under the mattress”), the borrowing would have no significant impact on aggregate demand. There might have to be a slight increase in the rate of interest to induce “dishoarding,” but unless private investment were to be quite interest elastic, the impact on private demand might be negligible. This source of subscription may not be discounted altogether, but it may not be of much significance except in cases of once-for-all, or infrequent, government borrowing, because the public cannot continuously buy financial assets out of past savings kept as cash.

(b) If the subscription is out of current income, the results will depend on the respective interest elasticities of savings and investment. Government borrowing will lead to a rise in the rate of interest. If savings are interest elastic but investment is not, only consumption will fall. If investment is interest elastic but savings are not, only private investment will fall. If both are interest elastic, both will decline, so that the expenditure financed by borrowing will draw resources from both private consumption and investment. In the realistic case, most of the diversion is likely to be from private investment. Then, if the government sterilized the proceeds of borrowing, a deflationary tendency would be created because private investment would have fallen and money supply would have been reduced.

The government competes with the private entrepreneurs for investible resources, and what the government is able to secure, someone else has to go without.

(c) If the public wishes to subscribe to government securities by selling some of the private securities that it is holding, the market rate of interest will rise and the same reasoning as in (b) applies.

In reality, both a fractional reserve system and the possibility of credit creation by the central bank exist. These must be allowed for. With these realistic assumptions, we shall also consider borrowing in the context of growth. The problem is looked at first in terms of comparative statics.

If no excess reserves exist in the banking system, government borrowing from the public, by itself, reduces aggregate demand (mostly investment demand), reserves of the banking system, and money supply. The effect will be contractionary. The same results would follow even if excess reserves existed, except that the potential private borrower who has been outbidden by the government may be able to obtain credit from the banking system and the effects of government borrowing may be partly neutralized by the expansion of commercial bank credit. If excess reserves do not exist but the central bank extends credit to the commercial banks so that they continue to meet the private demand for credit, government is, in effect, borrowing from the central bank. The result is almost the same if the central bank is required to give price support to government securities through open market operations. Whenever the central bank intervenes in this manner, either the borrowing should be treated as being from the central bank, or the expansionary effect of monetary policy should be set against the contractionary effect of borrowing.

It follows from the reasoning just given that expenditure financed by borrowing from the public may result in a net expansionary impulse if excess reserves exist in the banking system, or if the government follows an expansionary monetary policy.

Let us now introduce growth and government borrowing in successive periods. As stated earlier, with growth in real income and positive savings in every period, the public would wish to hold a part of its savings in the form of cash balances or demand deposits. If opportunities are provided, it would also wish to keep a part in government savings bank deposits and in different types of government securities. Through borrowing from the public, the government may be said to be diverting a part of such savings. In several developing countries, the nonbank contribution to government securities comes mainly from pension funds, social security contributions,31 insurance funds, and government savings institutions. The level of private investment can be expected to adjust itself to the government’s appropriating savings in these forms. And if in one year the government should suddenly sterilize these funds, a deflationary impact would most likely be created. Also, excess reserves cannot be expected to exist in the banking system year after year unless the central bank engages in continuous expansion of credit, or unless a continuing balance of payments surplus exists.

On the other hand, it should not be assumed that the borrowing of the government ex ante would always match the excess of private sector saving over intended private investment. An attempt could be made, in an overall financial plan for the economy, to make the level of government borrowing consistent with the projected level of private investment. But, since fluctuations in private investment (departing from the projected levels) could materialize through the existence of an elastic credit structure, even in the context of growth in income, government borrowing from the public cannot always be said to be a contractionary measure.

In principle, there is not much difference between the way in which monetary conditions and monetary policy modify the effects of borrowing and the way in which they modify the effects of taxation. In computing the unweighted budget balance, it is implicitly assumed that there is a one-to-one relationship between taxation and the reduction in aggregate demand. In fact, however, one dollar of taxation would reduce consumption only by a fraction of the dollar (equal to the marginal propensity to consume); the remainder of it is supposed to come from a reduction in private investment. But this need not happen if commercial banks have excess reserves, or if the central bank is willing to supply additional reserves to the commercial banks on easy terms.32 Again, if there is excess liquidity in the economy, additional taxation may not have the expected full effect even on consumption. Moreover, monetary policy actions, such as relaxing the terms (or reducing the cost) of the hire-purchase system, may partly neutralize the effects of taxation.

An alternative definition

The foregoing discussion of the effects of government lending and of expenditure financed by different types of borrowing seems to lead to the conclusions that in computing an unweighted measure of expansionary deficit (a) borrowing from the entire banking system should be included but (b) borrowing from the nonbank public may be included or excluded depending on circumstances and on the policy assumptions most appropriate to a given situation. A corollary of the inclusion of nonbank borrowing in the deficit is that it would ensure that all net lending is included in expenditure. Exclusion of nonbank borrowing would mean, in effect, that borrowing of that kind is regarded as an offset to lending to the nonbank private sector, where one exists, and that only lending out of bank borrowing is included in expenditure.33 Total net domestic borrowing34 probably indicates the upper range of estimate of expansionary impact, while net borrowing from the banking system gives the lower range of that estimate.

Industrial countries have a highly developed (and integrated) capital market and an elastic credit structure, with a clear dichotomy between savers and users of savings. In these circumstances, short-run levels of private investment are not constrained by the prior availability of savings, and it is possible for investment to be sustained on the basis of increased credit in the face of an increase in the government’s diversion of household sector savings. Given these institutional factors, there is a good case for including borrowing from the nonbank public in the measure of expansionary deficit in fiscal analysis for developed countries.35 However, in regard to a typical developing country, the question may be raised whether borrowing from the banking system alone does not more closely approximate the desired estimate of the expansionary impact of the budget. The following considerations are relevant to the question and seem to support the choice of the lower-range estimate.

(1) Whereas situations of excess ex ante savings over forthcoming investment are common in developed capitalist economies, a shortage of savings in relation to investment is more likely in less developed countries. Thus, it can be said that whereas in the developed countries there exists a situation of closer approximation to the Keynesian framework of investment “determining” the level of income and savings, in the developing countries it is a situation of closer approximation to the classical framework of investment adjusting to changes in available savings. Since, in addition, the credit structure is poorly developed or undeveloped in the less developed countries, and the small farmers and other producers have no easy access to the banking system, if the government should divert a larger part of the savings of the households, it would not be so easy as in developed countries for the level of private investment to be sustained.

(2) It is believed that speculative demand for money is unimportant in most developing countries. If this is so, a rise in the rate of interest induced by the government selling bonds to the public may lead to no change in the demand for money and, hence, to no change in income velocity. In this situation, the monetarist’s argument that since money supply is unchanged when government expenditure is financed by non-bank borrowing there can be no increase in demand or income would acquire validity. Then, as income cannot increase, with a rise in government expenditure financed by nonbank borrowing, there must be a fall in private investment or consumption (or both), depending on their relative interest elasticities.

(3) In a typical developing country, the government undertakes a number of productive activities that are normally left to the private sector in the industrialized private enterprise economies. These activities necessitate the undertaking of industrial and other business investment that often supplants or replaces private investment, especially in view of the limited available foreign exchange that needs to be allocated.

(4) In some of the developing countries that do not have a social security system, there exists a provident fund system that entails compulsory contributions by employers and compulsory savings by employees in both the public and the organized private sectors. Investment in life insurance policies is normally promoted through concessions under the income-tax law, which substantially benefit mainly the taxpayers at the lower end of the taxable income scale. Almost the whole of the provident funds and a good proportion of the life insurance funds are invested in government securities.36 In a developing country, most contributors to provident funds may have little of other savings, so that variations in the laws affecting provident funds, and perhaps in those offering tax concessions for insurance premiums,37 will most likely affect consumption. The contributions by the employers are, of course, akin to taxes. It follows that the utilization of these funds by the government, that is, borrowing from the so-called captive market, may have a significantly contractionary impact.38

In the light of the foregoing considerations, for purposes of fiscal analysis for developing countries, the use of net bank credit may be regarded, conceptually, as the more appropriate summary indicator of budgetary impact on aggregate demand. Thus, the alternative definition of expansionary deficit (giving the lower-range estimate) may be derived as follows:

In practice, however, it is hard to obtain a precise estimate of this magnitude because of the difficulties involved in separating out the amounts borrowed from the bank and nonbank sectors. During the course of the budget year, the public may resell to the banking system bonds taken up during the earlier part of the same year, or, conversely, the banks may resell to the public. Ex post, it is possible to look at the “net absorption” of government bonds by each of the three major nongovernment sectors: the central bank, the commercial banks, and the nonbank private sector. Moreover, the net increase in the combined claims of the three sectors can be expected to equal the net domestic borrowing of the government, if the market value of the “old” securities does not change. However, the net absorption of government securities by any one sector will not be equal to the net borrowing of the government from that sector, because the central bank might have been carrying out open market operations during the year; hence, if these operations have affected the holdings of the nonbank private sector, the estimate of net bank credit or increase in the net claims of the banking system against the government will reflect the impact of not just budget policy but of a mix of budgetary and monetary policy.39 Besides, if the measurement of the increase in the net claims of the government were to be affected by changes in the market value of government bonds, the increase in the net claims would, of course, not equal the net domestic borrowing by the government.

To the extent that the capital market is undeveloped, that open market operations affecting the nonbank public are insignificant or nonexistent, and that the commercial banks do not have much scope for selling securities to the public, the estimate of increase in the net claims of the banking system against the government, derived from banking statistics, will approximate the amount of the government’s net borrowing from the banking system. Insofar as conditions in several less developed countries are like those just described, the government’s use of net bank credit could be employed as the basic measure of the direct expansionary impact of the budget. But wherever the nonbank private sector plays even a moderately important role in the capital market, it will be necessary also to give the total of net domestic borrowing by the government as an alternative upper-range estimate of the expansionary budget balance. For industrialized countries, total net domestic borrowing would be the more adequate basic measure of expansionary deficit; if foreign borrowing is not significant, the overall deficit itself may be used to reflect the impact of the budget.

The weighted budget balance

The use of the simple budget balance, however defined, as a measure of the impact of budget policy on demand is based on a number of simplifying assumptions, which generally are not made explicit. Some of the limitations of the use of this measure arise from these assumptions. First, there is the implicit assumption either that foreign transactions are not significant or that it is not necessary to distinguish between the impact of the budget on GNP and on the balance of payments. Subject to other limitations to be discussed later, a composite measure can be used as a broad measure of the immediate impact of a change in budgetary stance, but further (secondary, tertiary) repercussions on the economy will obviously differ according to the relative weights of the two components of expenditure. Second, it is obvious that the simple budget balance approach is based on an implicit model in which all items of expenditure and receipts that are included to compute the balance have equal (and one-to-one) impact on aggregate demand, negative and positive, respectively, and that those items included in the deficit have no direct impact on demand. In the earlier discussion, it has become apparent that different types of lending and borrowing tend to have an unequal impact on demand. This is also true of various forms of taxation and different kinds of expenditure. That is, quite apart from the differing weight of the impact on the balance of payments in the total demand impact, equivalent amounts of different items of revenue (or of expenditure) are likely to have unequal impact on GNP. For example, expenditure on goods and services and on transfer payments: the impact of the former on GNP plus imports is equal to the amount of expenditure itself, whereas that of the latter is reduced by the savings leakage. On the revenue side, the negative impact on consumption demand of a dollar of a given tax depends on the marginal propensity to consume of the taxpayer, and the way in which it affects his economic position; the impact will rarely be equal to the amount of the tax. From all of this follows the proposition that a balanced budget may exert a positive or negative impact on domestic demand and that consequently an equal increase in revenues and expenditure generally cannot be considered to be “neutral” in its impact.

In order to get a more satisfactory measure of the impact (or first round effect) of the budget, an attempt may be made to construct a weighted budget balance. This balance is derived by assigning a specific weight to each budgetary item and then summing up the items multiplied by their respective weights. The weight assigned to each item would be designed to reflect its impact on GNP or on demand for domestic goods and services,40 as to both magnitude and sign. For example, if expenditure on imports and savings are the only leakages to be taken into account for the personal income tax, the weight for this tax would be — (l-m)c, where m is the marginal propensity to import of the income-tax payers and c is their marginal propensity to consume. A budget item multiplied by its weight may also be called the first-round effect of that item, since its total effect can be obtained by multiplying this product and the general multiplier. The weights for the different budget items are also indicative of (one aspect of) their relative effectiveness for demand management.

A relatively simple way of assigning weights to different budget items would be to use a basic analytical framework for deciding what leakages should be allowed for and then giving them numerical values derived from existing estimates of the relevant propensities, or assigned on the basis of judgment. A more satisfactory way of working out a weighting system would be to construct a somewhat disaggregated fiscal policy model suited to the type of economy that is being studied and to derive the formulas for the weights from the model. This procedure will not only ensure consistency of the weights used but will also make possible, wherever necessary, an econometric estimation of the relevant propensities.41

Even in the absence of a general weighting system, it may be desirable to work out a limited “weighting” exercise designed to show separately the impact on GNP and on the balance of payments. Basically, what is involved is the separation of the total budget balance into domestic and foreign components in such a way that the former will reflect the direct impact on demand for domestic goods and the latter the direct impact on the balance of payments.

Domestic balance. The measure reflecting the impact on GNP equals the total of expenditure on domestic goods and services minus the sum of domestic current revenues, depreciation, and the sale of domestic physical assets. That is,

where G. 1. – F. 1.=net decrease in domestic cash balance
and F.2. – G.2.=net increase in foreign cash balance.

The measure reflecting impact on GNP is thus seen to be equal to the sum of (a) net domestic borrowing, (b) decrease in domestic cash balance, and (c) net sale of foreign exchange to the banking system. Whereas the expansionary deficit (in terms of equation (3)) excludes foreign borrowing and any current receipts from abroad, in the computation of the measure reflecting only domestic impact, foreign receipts are included to the extent that they are used to finance domestic expenditure.43

Direct impact on balance of payments. It is obvious that to the extent that the measure of equation (5) is accurate it excludes the impact of the budget on the balance of payments. An approximate measure of the direct (adverse) impact of budgetary operations on the balance of payments may be said to equal

Most governments do not present, and probably do not maintain, separate accounts of domestic and foreign expenditure.44 Hence, a fiscal analyst can at best make only rough estimates of direct expenditure abroad. (It is probably much easier to obtain a separation of the two components of receipts.) Besides, there are two other limitations to the measures of impact on GNP and on the balance of payments as suggested in equations (5) and (6), respectively. First, equation (6) could give an indication of only the direct impact of the budget on the balance of payments. It could be argued that if a separate measure of the impact on the balance of payments is to be worked out at all it should include both the direct and indirect effects, and that if this is not possible, one summary measure of impact on total demand is to be preferred. Second, it is arbitrary to exclude from the domestic component all expenditure directly incurred abroad but to include domestic purchases straight from an importer. More generally, there is an import content of domestic expenditure as defined and measured in Table 2 that should properly be added to expenditure abroad. The first of these limitations can be overcome only through a proper weighting exercise, but the second can be remedied by estimating the import content of a government’s domestic expenditure and by adding it to the direct expenditure abroad. This in turn would involve the estimation of the marginal or average propensity to import of the government sector or of the economy as a whole, and in that sense would take one farther than the presentation of budget accounts and the derivation of balances, which is the concern of this paper.

Timing or recording of transactions

The whole group of questions relating to the timing of transactions or to the dates to be attached to transactions can be touched upon only briefly. The size of the balances for a given year will differ according to the principle of timing chosen, that is, according to whether the accrual or the cash basis is adopted. For deriving the measure reflecting the impact on money supply, this problem is not relevant, as this can be meaningfully derived only on a cash basis. The accrual basis seems to be the most appropriate one for the balance reflecting government saving, since the figure of government saving is to be generally used within the framework of national accounts, which are (sought to be) kept on an accrual basis. For deriving the balance reflecting the impact on demand, ideally, each budget item should be recorded according to the “reaction-date” of the private sector for each type of budgetary measure. This would mean, in effect, a mixture of cash and accrual recordings, because in some cases the main impact is at the time of accrual (e.g., corporate income tax), while in others it is probably at the time of actual payment or receipt (e.g., personal income tax, transfer payments to households). In practice, the accrual system of keeping accounts poses a number of conceptual and theoretical problems, especially on the expenditure side. At present, accounts on a cash basis only are available in most developing countries. The cash basis statistics are generally considered more useful for macroeconomic analysis, particularly if fiscal and monetary analyses are to be integrated. As progress with accrual accounting is made, the budget balance, with some major items (whose reaction-dates are close to accrual) adjusted on that basis, can be presented as a supplement to the budget statement.

The budget balance as a measure of impact of budget policy

The budget balance approach, whether the weighted or the unweighted balance is used, can give an idea only of the initial impulse imparted to the economy. Since neither the total effects nor the time profile of effects can be determined on the basis of this approach, it can be used only to obtain a broad indication of the size and direction of the budget impact in different years for comparative purposes. That is, the budget balances, or changes therein, can be used only for ordinal comparisons of budgetary impact in different years and not as cardinal measures of the effects of policy in given years.

Apart from the limited use to which the budget balance can be put in demand analysis, a major objection to its use for evaluating budget policy is said to be that the budget outturn for any year partly reflects the impact of the economy on the budget. The reasoning is that if the budget balance itself is partly determined by the level of economic activity, then it would be inappropriate to use the balance for evaluating the impact of budgetary policy. According to this view, a distinction should be made between automatic and discretionary changes, and the evaluation of budget policy should be based more on the discretionary changes. The concept of the full employment budget surplus has been developed mainly to eliminate the effect of changes in income on the budget outcome and to derive a measure or indicator of the strength and direction of discretionary policy. Since even a deficit caused by an exogenous decline in income will serve as a cushion and will act to arrest the decline in income, or to raise it, in the subsequent period, there seems to be a case for employing also a total budget balance to get an idea of the total budgetary stance including the impact of automatic stabilizers. Nevertheless, the limitations of the budget balance approach discussed in this section and the detailed considerations put forward in the discussion of the definition of the expansionary deficit will have pointed up the circumspection with which conclusions about the impact on demand should be drawn on the basis of the simple budget balance.

The budget impact on money supply

The fiscalist approach to the measurement of budget impact concentrates on income effects, that is, the effects of budgetary operations on the generation of income and purchasing power. Per contra, the monetarist approach concentrates on liquidity effects, that is, the effects on money supply.45 According to the latter approach, budget “deficits” are likely to be expansionary because they are often financed in a way that adds to the stock of money. But a budget balance, according to some given definition, may contain elements of financing that do not affect the stock or supply of money. An attempt is made here to identify and to bring together those elements of financing government expenditure that would have an impact on the supply of money.

Money supply may be defined for our purposes as consisting of (a) currency notes and coins with the public and (b) demand deposits held by the public. The public in this connection refers to all holders of money except the government46 and the banking system. According to these definitions, the balance of the government sector in the treasuries and with the central bank and the cash on hand of the commercial banks or their balances with the central bank are not part of money supply, although variations in them will lead to variations in money supply.

Intuitively, it is obvious that the direct (positive) impact of the budget on the money supply will be equal to the excess of government payments to the nonbank private sector over the receipts from that sector. That is, it is equal to

  • (domestic expenditure on goods and services + transfers to the domestic nonbank private sector + domestic net lending)

  • — (domestic tax and nontax revenues including depreciation but excluding profits from the central bank + sale of physical assets within the country + net domestic borrowing from the nonbank private sector)

Given the budget balance equation, this excess has to be financed through (a) borrowing from the banking system, (b) drawing down of the domestic cash balance, (c) profits received from the central bank net of interest payments to the banking system, and (d) the sale of foreign exchange by the government to the banking system (= the excess of foreign receipts including drawing down of the government’s foreign assets over foreign expenditure).47 Hence, the measure of budget impact on money supply may be defined as follows:

Assuming that the profits received from the central bank net of interest payments to the banking system will not be a large (positive or negative) amount, the difference between the measure of the budget impact on money supply and the lower-range estimate of the impact on aggregate demand as given in equation (4) (viz., net borrowing from the banking system including the drawing down of cash balances) will be equal to the net sale of foreign exchange to the banking system by the government. Hence, if the government’s foreign expenditure roughly equaled all receipts from abroad, the measure showing the income effect will also indicate the liquidity effect.

In criticism of the measure of budget impact on money supply presented here, it could be argued that given the reserve ratio to be observed, and in the absence of excess reserves, borrowing from the commercial banks by the government cannot by itself lead to an increase in money supply. There is truth in this argument, as in the corresponding argument, in relation to the demand impact presented earlier,48 that commercial bank lending to the government will lead to a curtailment of credit to the private sector. For more or less similar considerations as put forward in the demand impact analysis, borrowing from the banking system has been included in the measure of impact on money supply. If it is excluded, what is obtained is really the impact on high-powered or reserve money, a change in which alone could be held, strictly speaking, to lead to any change in money supply.

III. Conclusion

The foregoing discussion of alternative concepts of budget deficits leads to two broad conclusions: first, there are several valid concepts of budget balances, and each has meaning in a specific context. Each concept should be used for the purpose for which it is fashioned; in this connection, much confusion has often arisen either because the definitions of the concepts have not been made clear or because a given concept has been employed for a purpose for which it is not fitted. The second broad conclusion is that while the direct impact of the budget on certain economic aggregates, such as the money supply, can be defined with precision, the budget impact on demand cannot be specified with such exactitude, within the confines of the budget balance approach, because the effect on demand depends so much on institutional factors, monetary conditions (policy actions), and the stage of development.

The balance on current account or the net worth concept of budget balance is derived by subtracting current expenditure, that is, expenditure not leading to capital formation or to an increase in financial assets, from current revenues. It indicates simply the saving generated in the government sector. This concept is not so relevant for demand analysis, but it is useful for a longer-term appraisal and for economic planning in developing countries.

The overall deficit, otherwise known as the public debt concept of the deficit, is a widely used concept and clearly indicates the total financing or net borrowing needs of the government, since it is derived by subtracting total expenditure, including the government’s net lending, from the total of receipts other than borrowing. For purposes of stabilization policy, it is best to start with the overall deficit because it gives the most comprehensive picture of the financial position of the government, and also because, ultimately, the reduction of even the amount of borrowing from the banking system for demand management purposes has to be achieved, at least in developing countries, mainly through the narrowing down of the overall deficit, that is, by reducing expenditure relatively to the level of revenues.

The budget deficit as a measure of impact on demand may be called a composite one in the sense that it reflects the unweighted first-round effect on both GNP and the balance of payments. As explained, it is extremely difficult to define one single measure of expansionary deficit as the most appropriate one for all types of economies and under all circumstances. In respect of developing countries in general, it would be desirable to look at two alternative measures: the upper-range estimate given by total domestic (voluntary) borrowing, adjusted for changes in domestic cash balances, and the lower-range estimate given by net borrowing from the banking system.49 As the presumed impact of borrowing from the nonbank public on demand will vary with institutional factors and monetary conditions, a fiscal economist has to interpret and modify the conclusions derived from these estimates on the basis of judgment and knowledge of particular conditions.

While the amount of net borrowing from the banking system (or, in other words, the use of net bank credit) could be used as one measure of the direct income effect of the budget, that is, the impact on demand through the flow of purchasing power, it does not fully reflect the budget impact on the money supply. This measure is obtained by adding to the amount of net borrowing from the banking system (a) the sale of foreign exchange to the banking system and (b), where significant, the profits received from the central bank net of interest payments to the banking system. It is well to remember that whereas it is possible in principle to define precisely the direct impact of budgetary operations on the stock of money, no single measure of impact on demand can be put forward as the most appropriate under all circumstances and for all countries. As long as one is working within the framework of the budget balance approach, it becomes necessary to look at the various components of borrowing and to come to a conclusion on the likely impact on demand, on the basis of special knowledge of conditions in particular countries.

APPENDICES
I. An Alternative Approach to the Definition of Current Account Balance

Musgrave has proposed, with special reference to developing countries, a somewhat different type of balance on current account, which could be said to reflect the contribution of budget policy to capital formation in the economy.50 The current balance, in this sense, must be defined not to show the actual savings in the government sector but to reflect the increase in capital formation in the economy brought about by budget policy. For this purpose, current expenditure would include all public expenditure that provides for current services in the nature of consumption. This would be equivalent to the current expenditure total given in Table 2minus recurring expenditure representing capital formation not resulting in the acquisition of physical assets (such as investment in human capital) minus the portion of government transfer payments saved by the recipients. Current revenue would include shares of different taxes and other receipts that could be said to be drawn from private consumption.51 In other words, current revenue would represent the fall in private consumption brought about through the revenue side of the budget, and current expenditure would represent public consumption (narrowly defined, as above) plus the rise in private consumption arising from government transfer payments. The difference between the two is said to be a measure of the contribution of the budget to total capital formation in the economy.52

The measure of the deficit or surplus under “the capital-formation approach,” which, according to Musgrave, “is of great importance to the fiscal planning of underdeveloped countries,”53 would involve the computation of consumption coefficients of different types of receipt. In principle, this could be handled without much analytical difficulty in respect of taxes. But theoretical problems arise when certain “capital” receipts are considered. Sources of finance, such as borrowing from the central bank and the decumulation of cash balances, do not have a direct impact on private purchasing power and demand, and hence cannot be allocated readily between consumption and capital formation. Under conditions of (formal) full employment,54 expenditure met out of these sources of finance may be held, in terms of comparative statics analysis, to lead to a rise in prices. How the inflation, represented by this rise in prices, will affect private consumption and investment is difficult to say, because much would depend on how relative prices are realigned under the process of inflation. If there is no consequential rise in money wages and if there is a once-for-all increase in prices of products as a result of inflationary financing of public expenditure, it could be argued that the rise in prices would have the same effects as a tax on wages 55 and therefore could be treated in the same way. Since such an assumption cannot be made about the real world, the computation of a simple measure of budgetary contribution to capital formation in terms of the Musgrave approach becomes well-nigh impossible, if budgetary receipts have no contractionary effect on aggregate demand.

II. The Measurement of Budget Impact on Money Supply

The budget impact on money supply could also be measured through a study of changes in the liabilities of the banking system brought about by budgetary changes.

Money supply has been defined for our purposes as the sum of currency and coins in the hands of the public and the demand deposits held by the public. Coins are usually issued by the government, and currency notes by the central bank. In some countries, notes of smaller denomination are issued by the government. The currency notes and coins issued by the government are generally sold to the central bank, through which in due course they pass into the hands of the public. The coins and notes issued by the government may be said to represent the monetary liabilities of the government; the notes issued by the central bank may be said to represent part of its monetary liabilities.56 Similarly, the demand deposits of the public constitute the monetary liabilities of the commercial banks. Therefore, the variations in money supply with the public involve variations in the monetary liabilities of the government and of the banking system. Government budgetary operations can affect money supply directly either by changing the government’s own money liabilities or by affecting the monetary liabilities of the banking system. The first happens when the treasury issues coins and notes. What needs to be discussed now is how budgetary operations lead to variations in the monetary liabilities of the banking system.”57

Since the assets of the banking system are always equal to its liabilities, a change in the monetary liabilities of the banking system can come about if any of its assets (physical and financial) or any of its nonmonetary liabilities changes, without a countervailing change in others. Therefore, any budgetary operation that affects either the assets or the nonmonetary liabilities of the banking system can be said to lead to a change in money supply.58

Variations in the assets of the banking system are affected by the following budgetary operations: (a) borrowing from the central bank (+);59 (b) net borrowing from the commercial banks (+); and (c) net purchase of foreign exchange from the banking system (-).

Variations in the nonmonetary liabilities of the banking system are traceable to the following budgetary operations: (a) payment of interest to the banking system (-); (b) receipt of dividends from the central bank (+); and (c) a fall/rise in the government’s balances with the central bank ( + )/(‒).

Finally, a decrease in the cash balances of the government not kept with the central bank has the same effect as an increase in the monetary liabilities of the banking system that is attributable to government action.

The budgetary balance signifying the direct (positive) impact of the budget on money supply may be formulated in terms of the analysis just given. This balance may be defined as being equal to

(borrowing from the central bank

+ net borrowing from the commercial banks

+ profits received from the central bank

+ decrease in domestic cash balance, if any)

(payment of interest to the banking system

+ net purchase of foreign exchange from the banking system60

+ increase in domestic cash balance, if any).

This gives us the same result as in equation (7).

III. Other Concepts of Budget Deficit

As pointed out earlier, the budget as an accounting document is, in a sense, always in balance. A measure of deficit or surplus is derived by excluding some items of receipts as balancing items and some items of expenditure as being irrelevant. In practice, the principles of exclusion, and hence the nature of the budget balance, have depended on the traditions in given countries and the purposes for which the measures are to be used. This appendix describes concepts of budget balances used by selected member countries that are somewhat different from the ones dealt with in the paper.

France

The French tradition in public sector accounting is somewhat different from the Anglo-Saxon tradition. Under the French system, the Treasury (the Trésor) undertakes a substantial volume of banking operations. In France, the budget balance has traditionally been drawn exclusive of the lending operations of the Trésor. The déficit budgétaire is computed as the difference between expenditure and revenues of the general budget (including annexed budgets). This balance is struck without taking into account some special accounts, such as the earmarked funds and lending by the Trésor to entities other than the Central Government. An additional concept of balance used is that of impasse (or déficit du Trésor), which is derived by adding to the déficit budgétaire the net lending by the Trésor and the repayment of debt. This sum is, of course, equal to the total gross borrowing needs of the Trésor.

In the 1950s and the early 1960s, the budget was said to be in equilibrium if the impasse could be financed without recourse to central bank financing. This was tantamount to saying that a budget would be expansionary only if the total expenditure including amortization was greater than the sum of all receipts other than central bank borrowing. From 1965, according to Hansen, the official concept of budget equilibrium changed to mean a zero déficit budgétaire.61 More recently, a budget balance designated as de couvert has been drawn for purposes of analysis and this, being solde d’exécution des lois de finances, corresponds to the concept of overall deficit.

Australia

Although the fiscal accounts of the Commonwealth Government in Australia give a breakdown of expenditure on goods and services by current and capital accounts and a separate total of transfer payments, no attempt is made to present a balance on current account. In the main financial statement, only the overall deficit is presented. This deficit is measured as the difference between total expenditure, including net advances (net lending), and all receipts other than borrowing except the sale proceeds of previously rented houses; the latter are netted against gross capital formation by the Government. Thus, this concept is very similar to the public debt concept of budget deficit treated in this paper.

However, the overall balance is not really used by the Australian Treasury for purposes of fiscal analysis. In Statement I, attached to the Budget Speech, total outlay is broken down into domestic and overseas outlays and a separate “domestic surplus” is derived, which forms the main basis of analysis. The division into domestic and foreign components is similar to what has been suggested in equations (5) and (6) in the section, The weighted budget balance.62 The direct impact on the balance of payments through overseas outlays and that on private demand through domestic outlays are indicated and discussed separately. In recent years, greater emphasis has been given to the domestic surplus since it was apparently felt that given the strength of Australia’s external reserves, the increase in overseas outlays was not as much a cause for concern as was the pressure on domestic demand caused by the increase in domestic outlays. A reduction in the rate of growth of domestic outlays has been “a prime objective of Government policy.” 63 The domestic surplus has also been used as a measure of withdrawal of liquidity from the economy.64

The estimates of domestic and overseas outlays by the Australian Treasury suffer from the limitation pointed out in the discussion of domestic balance, viz., that the import content of domestic outlays is treated as part of domestic expenditure. However, the Treasury justifies this procedure for Australia in the following words:

  • Although it is not possible to make reliable estimates of the import content of Commonwealth expenditure within Australia the proportion would not be large, and it may be assumed that it is unlikely to change markedly between one year and the next. By contrast, direct payments overseas by the Commonwealth may fluctuate widely between one year and another.65

India

The budget of the Government of India is divided into revenue and capital accounts. A balance is drawn on revenue account, but this does not correspond to a true surplus on current account since the division of expenditure into revenue and capital in the budget does not correspond strictly to the principles of economic classification, as indicated in Table 2.66

An overall deficit on revenue and capital accounts together is drawn, which is often used as the key measure for judging fiscal performance. This overall deficit measure, however, is entirely different from the public debt concept of deficit discussed in Section I of this paper. The “overall deficit” of the Government of India’s budget is measured as the difference between expenditure on revenue and capital accounts and all incomings other than the sale of treasury bills and withdrawals from cash balances. As the Explanatory Memorandum for 1971–72 puts it:

  • Among the principal sources for meeting these requirements [i.e., requirements for expenditure on Capital Account] first, there is the revenue surplus. Secondly, regular loans are floated in the market. Thirdly, funds accrue to Government through small savings, annuity deposits and Provident Funds, and through miscellaneous deposits and advances. Lastly, there are external borrowings. To the extent, [that] receipts from these sources fall short of the capital requirements, the deficit is made good by the issue of treasury bills and drawal from cash balance.67 (Italics added.)

Formally, then, the overall deficit is equated with short-term borrowing and the use of domestic cash balances. In practice, however, since treasury bills are largely taken up by the banking system, a good part of the net sales being absorbed by the Reserve Bank of India itself, the deficit may be defined to equal short-term borrowing from the banking system plus the drawing down of cash balances. The implication is that only expenditure financed by short-term borrowing has an expansionary effect on demand, being drawn mostly from the banking system, and that long-term borrowing even if effected through the banking system ultimately represents the transfer of savings from the private sector. Such reasoning, however, has not been offered explicitly as a justification for the use of this measure of deficit.

In addition to the purchase of treasury bills, the Reserve Bank also from time to time absorbs a portion of the increase in the outstanding long-term securities issued by the Government of India.68 Total net credit to the Government by the Reserve Bank would therefore be given by the sum of net purchase of treasury bills and net absorption of long-term securities by the Reserve Bank minus the increase in the deposits of the Government with the Bank. This could be taken to represent the portion of financing that leads to an increase in base money or high-powered money. Since 1961, the Indian Planning Commission has defined deficit financing to equal borrowing from the Reserve Bank as just measured. In the search for a suitable definition of deficit or of deficit financing, the criterion adopted seems to have been the question of impact on money supply. Thus, the Second Plan document stated that “in defining what type of financing constitutes deficit financing, the criterion should, by and large, be whether or not the transaction in question tends to increase money supply.” 69 It was then argued that because the normal practice in India was not to rely on the central bank for subscription to long-term securities and because the short-term debt of the Government was held largely by the central bank, “a deficit measured in terms of withdrawals of cash balances and net increase in floating debt gives on the whole, a reasonably reliable indication of the impact of the budget on money supply.” 70 As pointed out earlier, the measurement of deficit was modified at the beginning of the Third Five Year Plan (1961–62). Recognizing that “whatever support the Reserve Bank may have to give to the loan programme has of course to figure in deficit financing,” the Indian Planning Commission modified the definition to include total net borrowing from the Reserve Bank.

Two inferences may be drawn from the use of this definition of deficit for planning purposes. First, what is intended to be measured is the impact of the budget on money supply—not the net direct impact on aggregate demand through the income effect, in which the fiscal analysts are normally interested. Second, borrowing from the commercial banks is not included in the measure of deficit on the grounds, presumably, that such borrowing cannot lead to an increase in money supply unless excess reserves existed in the banking system. This point was discussed in Section II.71 Since it often occurs that the commercial banks are enabled to absorb government securities through accommodation from the central bank, it may be more realistic and useful to include borrowing also from the commercial banks in the measure reflecting the impact on money supply resulting from budgetary actions. The measure used by the Indian Planning Commission, however, is a good approximation of the increase in high-powered money caused by government financing.72 It is only an approximation because it does not take into account (a) the net sale of foreign exchange to the banking system and (b) the profits received from the central bank net of interest payments to the banking system.

Sweden

The Ministry of Finance of Sweden uses two different concepts of budget balance. It presents an overall balance representing the net borrowing needs of the Government. This is the same as the public debt concept of deficit. However, for estimating the impact of the budget on aggregate demand, the Ministry uses another concept of balance called “financial savings,” which is defined as the difference between revenues, on the one hand, and expenditure on goods, services, and transfers, on the other hand. Net lending other than government support to the housing sector is excluded from expenditure. Financial savings are therefore equal to the difference between government savings and government capital formation.73 In the analysis developed by the Ministry of Finance, a change in financial savings is held to affect the level of total demand by bringing about a change in disposable income.

In social accounting, it is customary to separate purely financial transactions on capital account from transactions relating to income flows. If this is done, the income account of a sector, either government, household, or corporate, will yield an “income deficit” (surplus) that measures the excess (shortfall) of its own savings over its capital formation.74 This is to be matched by a deficit (surplus) on financial accounts, that is, a shortfall (excess) of borrowing over lending. It is obvious that, ex post, the financial deficits of some sectors will be exactly matched by financial savings of other sectors, including that of the rest of the world, since total savings equal total investment. It could be argued, ex ante, in the context of the traditional Keynesian model, that a government’s fiscal policy should have the objective of offsetting the difference between the anticipated savings and investment of the private sector at full employment. Given this objective, it becomes important to focus attention on the financial savings of the government sector. It is presumably on this ground that the Swedish Ministry of Finance uses a change in the financial savings of the Government as a key variable in its analysis of the impact on demand.

In this approach, government borrowing and lending transactions with the private sector are treated largely as acts of financial intermediation. If any additional investment is induced by government lending, it will be counted as private investment and therefore as part of the demand arising from the private sector. Generally speaking, in assessing the impact of fiscal policy on the economy, it is not at all clear why any additional investments induced by government action should not be treated as part of the total effects of that policy. If this is not done, even lending financed by central bank borrowing will be left out of the measure of the impact of fiscal policy. However, in the particular context of Sweden, it might be appropriate to assume that lending other than support to the government sector does not lead to any net additional demand.

Mr. Chelliah, Chief of the Fiscal Analysis Division of the Fiscal Affairs Department, is a graduate of Madras University and of the University of Pittsburgh. He was formerly Professor of Economics at the University of Rajasthan and at the Osmania University, Hyderabad. He served as Consultant to the UN Economic Commission for Asia and the Far East, in Bangkok, and for some time was its Regional Fiscal Advisor. He is the author of Fiscal Policy in Underdeveloped Countries and a number of articles in economic journals.

See, in this connection, the review of the evolution of economists’ views on the subject in Jesse Burkhead, “The Balanced Budget,” The Quarterly Journal of Economics, Vol. LXVIII (1954), pp. 191–216.

For an excellent example, see Staff Papers and Other Materials Reviewed by the President’s Commission, President’s Commission on Budget Concepts (Washington, 1967).

The more general term “budget balance” will be used in the ensuing discussion.

Economic Commission for Asia and the Far East, “Economic Concepts of Budget Deficits,” Economic Bulletin for Asia and the Far East, Vol. VI (May 1956), p. 12. The term “public debt concept” is taken from this paper.

Slightly different concepts are employed in some of the European countries. In France, for example, the déficit budgétaire is computed as the difference between total expenditure (excluding net lending by the Trésor) and revenues. In the United Kingdom, until the recent budget reform, the budget balance “above the line” has generally been thought of as the operationally significant factor for purposes of demand management; see Sir Herbert Brittain, The British Budgetary System (London, 1959), pp. 49–58. Appendix III of this paper, “Other Concepts of Budget Deficit,” analyzes the definition of budget balances adopted by a few countries with different traditions.

“The most familiar version of Keynesian economics … is the elementary simplification of Keynes in which the only determinants of the level of national income are the consumption function and a given volume of investment (including government) spending,” Lawrence S. Ritter, “The Role of Money in Keynesian Theory,” in Readings in Macroeconomics, ed. by M. G. Mueller (New York, 1966), p. 161. It would follow from this simple formulation that taxes that affect disposable income (and, hence, consumption via the consumption function) and government expenditure are the only budgetary factors that enter into the determination of national income.

This is not, strictly speaking, always true for developing countries. Often the amount of foreign borrowing (with the corresponding amount of developmental expenditure) included in the budget estimate represents the amount of foreign loans expected to be negotiated with the donors rather than the “needed” amount of borrowing.

Variants of these concepts are used in government documents and in public discussion in different countries. One approach would be to take the major concepts actually employed and to analyze their significance and shortcomings, if any. The alternative approach of indicating the most appropriate definitions is adopted here.

Only one item of a capital nature, namely, sale of physical assets, is normally included in revenues for measuring the overall deficit.

Assets here include both real and financial assets. In practice, difficult problems arise in defining real assets. In principle, one could agree that “In terms of cost accounting, real assets can be defined to include ‘goods’ which serve the government in the implementation of its various tasks beyond the accounting period in which they are acquired…,” Economic Commission for Asia and the Far East, “Economic Concepts of Budget Deficits” (cited in footnote 4), p. 13. However, it would be almost impossible to apply this principle strictly, considering that even such objects as writing pens have a “useful life” beyond one year, which is the normal accounting period, and remembering that depreciation is to be charged on all assets. Besides, the basic objective of the classification here is the derivation of the measures of government saving and capital formation. Therefore, it is desirable that national income accounting conventions be adopted in this matter.

Notations used in the whole of this section refer to those in Table 2.

The balance on current account has been computed net of depreciation on assets owned by general government (A.l.(c)). It is not the practice in most developing countries (indeed, in most countries in the world) to provide depreciation against assets owned by general government agencies. In practice, therefore, the surplus on current account obtainable in most countries would be gross of depreciation on general government assets but would exclude depreciation on the assets of government enterprises.

If a weighted budget balance is to be worked out for measuring the impact on aggregate demand, a distinction between public consumption and investment may have to be made if the propensity to import is not the same with respect to the two categories of expenditure. For this approach, see the section, The weighted budget balance.

Richard A. Musgrave, The Theory of Public Finance: A Study in Public Economy (New York, 1959), p. 562.

“Public finance, in particular, has the twofold task of providing social overhead capital and of mobilizing saving by restricting consumption … Savings which are not derived from the private sector or from abroad through capital inflow, must be provided by government …,” R. A. Musgrave, Revenue Policy for Korea’s Economic Development, Nathan Economic Advisory Group (Washington, September 27, 1965), p. 1. See also Bent Hansen, “A Short-Term Model for Planning Monetary and Fiscal Policy,” in Theory of Economic Policy and Planning, Institute of National Planning (Cairo, 1964).

As indicated earlier, the limitations applicable to the concepts of private (and national) saving and capital formation are equally applicable to those of public saving and investment. If the concepts of saving and capital formation are redefined in economic analysis, saving, public as well as private, would no longer be equal to the change in “earned net worth.” For an alternative approach to the definition of current account balance suggested by Musgrave, see Appendix I.

Giving the same or differential impact weights to different items considered to be appropriate or feasible.

In a closed economy, by definition, such a budget balance would show the net impact on GNP.

Whether the level of the budget deficit itself or a change in it should be used as the indicator of impact is partly a question of semantics; the answer depends partly on the purpose of the analysis and on whether the monetary repercussions of the deficit are to be considered. These questions are not discussed in this paper.

It is assumed for the sake of simplicity that the receipt and expenditure are equal in each case.

A comprehensive discussion of the subject is found in the President’s Commission on Budget Concepts, op. cit.; see, in particular, the paper by Professor George F. Break on “The Treatment of Government Lending and Borrowing in the Federal Budget” and comments on the paper by a number of discussants (pp. 380–414).

Reference here is to direct impact on expenditure. The purchase of existing securities, while not creating additional income, increases liquidity and may thus have indirect effects on demand.

The necessary adjustment would have to be made in item E.l. in Table 2.

Break thinks that nonmarginal loans should be treated as monetary transactions, because the effect resembles those flowing from monetary policy tools (Break, op. cit., p. 386). The classification of the actions is largely a matter of taste.

William H. White points out correctly that use of the budget deficit to judge the inflationary impact of the budget carries the implication that the central bank is not obliged to vary credits to others, as a result of extending credit to the government. See his “Measuring the Inflationary Significance of a Government Budget,” Staff Papers, Vol. I (1950–51), p. 359.

That is, conditions under which an increase in aggregate demand would lead to a rise in prices rather than to a rise in output.

Part of the savings desired to be kept in liquid assets is appropriated by private entrepreneurs through extension of commercial bank credit. Since the creation of high-powered money by the central bank for the benefit of the government will increase the reserves of the commercial banks, and since they may be expected to expand credit on the basis of the increase in reserves, the government cannot normally hope to divert to itself the entire portion of savings desired to be held as liquid assets. What part of them it can try to pre-empt can be determined as part of an overall financial plan for the economy. See R. J. Chelliah, “Public Sector Investment and the Financial Plan—A General Framework and Some Policy Issues,” Economic Commission for Asia and the Far East, Bulletin for Asia and the Far East, Vol. XIX (September 1968), pp. 29–47.

However, the important difference is that when central bank credit is used, additional bank reserves are created, leading to the possibility of increased lending by the banks.

Similar results would follow if the banks are in an “equilibrium” position with excess reserves, as legally defined.

Commercial bank borrowing from the central bank, central bank notes, and government coins and currency. Banks can obtain reserves also when there is a continuous balance of payments surplus.

Social security contributions would, of course, be shown as taxes in the presentation under discussion.

Indeed, the balanced budget multiplier theorem assumes this and proceeds on the basis that private investment after the imposition of additional taxation will be sustained at the same level by the extension of bank credit.

The budget balance obtained by excluding all net lending is discussed in Appendix III, Sweden.

Borrowing is taken to be adjusted for changes in domestic cash balances.

This is, of course, in line with the assumptions of a simple Keynesian-type model that investment is autonomous, that savings are interest inelastic, and that only taxes curtail private (consumption) demand.

Often, there are statutes requiring life insurance funds to be so invested.

The latter possibility is doubted by several experts.

In most developing countries, the greater part of borrowing from the public consists of diverting provident funds, insurance funds, and deposits in government savings banks.

There could also have been transfers of “old” securities between the commercial banks and the nonbank public.

The weighted budget balance is usually constructed to reflect the impact on GNP and not on total demand; a separate measure is worked out to reflect the impact on the balance of payments.

See Jitendra G. Borpujari and Teresa Ter-Minassian, “The Weighted Budget Balance Approach to Fiscal Analysis: A Methodology and Some Case Studies,” Staff Papers, Vol. XX (1973), pp 801–31.

42

Follows from the basic budgetary balance equation.

As in defining the expansionary deficit, it is possible to think of a narrower definition of the domestic balance as excluding part or all of domestic nonbank borrowing. The considerations relating to this issue have already been elaborated in discussing the former concept.

Australia is an exception; for details of the Australian exercise, see Appendix III.

Strictly speaking, liquidity effects must be defined to mean the change in the structure of claims brought about by the change in both the money supply and the level of bonds held outside the central bank. As an approximation, attention is often concentrated on the effect on money supply.

The government sector may be defined more or less narrowly. For practical purposes as well as for relevance for formulation of policy, the local authorities may be taken to be part of the public. Again, the working balances of public enterprises would not be used as policy instruments, and hence these entities should also be treated as outside the government for this purpose.

A more technical method of obtaining the same result is given in Appendix II.

See the section, Borrowing from commercial banks.

In respect of industrialized countries in general, total net domestic borrowing would more truly reflect the impact on demand. If foreign receipts are not relatively important, the overall deficit itself may be used.

Musgrave, The Theory of Public Finance (cited in footnote 14), p. 570.

That is, instead of including the total yield of a tax, one would include the yield multiplied by its relevant consumption coefficient, which may be defined as the (marginal) proportion of the item of revenue drawn from resources that would have gone into private consumption.

Musgrave defines capital formation in a broader sense than is done in national accounting. This broader definition is not an essential part of the scheme. If the national accounting definition is used, the resulting current surplus would represent the contribution of the budget to saving (and capital formation) in the conventional sense.

Ibid.

That is, conditions under which an increase in aggregate demand would lead to a rise in prices rather than to a rise in output.

Assuming that people’s reaction to this kind of reduction in real income will be the same as to a corresponding reduction in disposable income.

This usage is taken from S. L. N. Simha and others, “Analysis of Money Supply in India,” Part I, Reserve Bank of India Bulletin (Bombay), July 1961, pp. 1045–49.

Although notes and coins issued by the government are taken as (nominal) liabilities here, they have not been counted as liabilities for computing the net worth of the government sector, since they really represent fiat money and will not be “redeemed.”

The monetary liabilities of the central bank consist of notes held not only by the public and by government treasuries but also by the commercial banks in their tills. When monetary liabilities of the banking system as a whole are considered, interbank claims get cancelled out.

Since central bank notes held in government treasuries are not part of money supply, this statement is, strictly speaking, true only on the assumption that there is no offsetting change in government holdings of central bank notes. This qualification is introduced later.

The ( +) and (–) signs in this subsection indicate an increase and decrease, respectively, in money supply.

Net purchase of foreign exchange from the banking system by the government equals the difference between the sum of expenditure abroad on goods, services, and transfers plus net lending abroad plus increase in cash balances abroad (if any) and the sum of revenue receipts from abroad plus net borrowing from abroad plus sale of physical assets abroad plus decrease in cash balances abroad (if any).

Bent Hansen, Fiscal Policy in Seven Countries, 1955–1965, Organization for Economic Cooperation and Development (Paris, 1969), p. 161.

However, all revenues are taken to be domestic revenues, and wages and salaries paid overseas are included in domestic outlays to be in accord with national accounts.

Commonwealth of Australia, Budget Speech, 1971–72, Statement No. 1, p. 3.

Ibid.

Ibid., p. 8, footnote 1.

An economic classification of the budget, provided separately, derives the true current account balance.

Ministry of Finance, Explanatory Memorandum on the Budget of the Central Government for 1971–72, Part II, p. 49.

This happens either through the “funding” of ad hoc treasury bills issued to the Bank or through the straightforward taking up of a portion of new issues of long-term securities not absorbed by the other sectors of the economy.

Government of India, Planning Commission, Second Five Year Plan (New Delhi), pp. 83–84. The period of the Second Five Year Plan was 1956–57 through 1960–61.

Ibid., p. 84.

Considering that expenditure financed by borrowing from the central bank leads to an increase in the reserves of commercial banks that may in turn be used for subscription to government securities, it is not clear in any case how the impact on money supply should be confined to central bank borrowing.

The measure reflecting the increase in high-powered money is, of course, useful in drawing up a financial plan providing for a desirable amount of increase in total money supply in the economy during the period of the plan.

Including investment in housing controlled directly by the Government.

This is referred to as financial savings in the Swedish exercise and as “net lending” (meaning lending net of net borrowing) in the system of national accounts used by the Organization for Economic Cooperation and Development.

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