Chapter 9- public finance for BBA


Published on

Published in: Education

Chapter 9- public finance for BBA

  1. 1. Public Finance Chapter 9
  2. 2. Public finance “ The task of economic stabilization requires keeping the economy from straying too far above or below the path of steady high employment. One way lies inflation, and the other lies recession. Flexible and vigilant fiscal and monetary policy will allow us to hold the narrow middle course.” (US president John F. Kennedy 1962)
  3. 3. The concept of public finance  Public finance is a study of income and expenditure of the government at the central, state, and local levels.  Government has to perform certain functions in a country such as to supply certain public or collective goods which individuals cannot or do not singly perform. And this is the responsibility of the government to provide those goods for which it needs revenue.
  4. 4. The concept of public finance  In the narrow sense, public finance is defined only as the study of income and expenditure of the government.  But the broader view is that public finance does not deal only with the income and expenditure of the government but also the sources of income and the way of expenditure of various government corporations, public companies, and quasi governmental ventures.
  5. 5. The concept of public finance Public finance is composed of the following constituents: 1. Public expenditure: wages and salaries; subsidies and transfers; expenditure on goods and services such as infrastructures like road, electricity, telecom, and human capital accumulation like health and education; interest expenditure etc. 2. Public revenue: Different sources of government revenue with major focus on tax revenue. 3. Public debt: Often public revenue falls short of expenditure and government has to borrow from internal and external sources.
  6. 6. The concept of public finance Public finance is composed of the following constituents: 4. Public financial administration: As Walter Bagehot remarks money cannot manage itself, an efficient, energetic and scientific management is required to look after the public expenditure, public revenue and public debt. What are the authorities, institutions, agencies to look after the management, control, and scrutinizing work created by government? How do they keep check on the use and misuse of fund? Answer to all these questions relate public financial administration.
  7. 7. The concept of public finance Public finance is composed of the following constituents: 5. Economic stabilization and economic growth: Maintaining stability and promoting balanced sustainable growth through the functions mentioned above is another constituent of public policy.
  8. 8. Role of the government Role of the government  Promotion of human capital accumulation  Provision of essential public goods  Decentralization  Facilitating and regulating the private sector for promoting industries, financial institutions, and building infrastructures.  Protections of individual liberties  Private rights to land and capital  Good courts and legal systems  Representative political systems
  9. 9. In the absence of the government intervention, high rates of unemployment can persist for long periods Price level Output (GDP) Aggregate Supply Markets may tolerate equilibrium output (Y) less than full employment output (YF) Aggregate Demand Y YF
  10. 10. How does government work? With policy:  Macroeconomic policy  Fiscal policy  Monetary policy  Infrastructure investment  Microeconomic policy  Social investment and labour policy  Industrial policy  Competition policy
  11. 11. Government budgeting  Derived from Latin word „Bague‟ and French word „Bougette‟. „Bougette‟ means small leather bag.  Budget provision initially introduced in the UK. In 1733, the then Chancellor of Exchequer Walpole came with the leather bag in the parliament to present the annual statement of income and expenditure, and when he opened bag people used the term he is opening the budget. Thus, the term budget became popular.
  12. 12. Government budgeting  In Nepal, it was on 21 Magh 2008 B.S. budget was formulated by the cabinet of the then PM Matrika Prasad Koirala.  Every year, budget is presented in the parliament.  Budget is a financial statement of the government comprising expenditures and revenues for a year. It is both economic as well as political document. It is a mirror to look into development activities undertaken by the government, which sets a framework for policy formulation and implementation. Budget document is a good source of public information on past activities, current decisions, and future prospects.
  13. 13. Government budgeting  A good budget document contains: (a) overall development policy, (b) size and composition of revenue and expenditure, and policy, (c) size and composition of external and internal borrowings, and policy, (d) whether budget is deficit or surplus and how is deficit covered and surplus disposed of? (e) actual of the previous year, revised estimates of the current year and estimates for the next fiscal year.
  14. 14. Government budgeting  The main components of budget are government expenditures and government revenues. The expenditures are classified into: (a) object classification, (b) functional classification (c) economic classification.  The object classification includes expenditure on personal compensation and benefits; travel and transportation of persons and things; communication, utilities and rent; printing and reproduction; supplies, and materials; equipment; grant subsidies and contributions; insurance claims and indemnities, and reimbursable etc.
  15. 15. Government budgeting  Functional classification is comprised of expenditures on general public services and economic services. The general public services include: expenditure on defense, education, health, social security and welfare, housing and community amenities, and other community and social services. Likewise, economic services consist of expenditures on agriculture, mining, manufacturing, electricity roads, water transport, railways, communications, interest on the public debt and so on.
  16. 16. Government budgeting  Economic classification consists of: (a ) current expenditures, (b) capital expenditure, and (c) principal repayment. The current expenditures include expenditures on goods and services such as wages and salaries, other purchases of goods, interest payments, subsidies and other current transfers. Capital expenditures include acquisition of new and existing fixed assets, purchase of stocks (inventories), purchase of land and intangible assets, and capital transfers.
  17. 17. Government budgeting Revenues are classified into: tax and non-tax revenues.  Tax revenues constitute both direct and indirect taxes. The premier direct taxes are on net income, property, and capital gains. Major indirect taxes include taxes on goods and services (VAT, excise etc), taxes on international trade and transactions (export and import duties).  Non tax revenues constitute income from public enterprises, sales of government property, administrative fees, fines, penalties and royalties etc.
  18. 18. Government budgeting Elements of budget:  Close to reality: despite being an estimate, it should be based on reality primarily on the basis of the experience of the previous year.  Simple and obvious: Since this is a public document, all who are interested should easily get the required information after looking on it.  Flexibility: Not only income and expenditure estimates are there but also the policies and programs of the government. Thus, should have the quality of flexibility.
  19. 19. Government budgeting Elements of budget:  Single fund: A single fund of the government should be established there for all revenues and expenditures.  Extensive: Should be in detail about each item of revenue and expenditure.  Publicity: it is made public and all the stakeholders are free to comment on this.  Annularity: Prepared for one fiscal year.
  20. 20. Government budgeting Principles of budget:  Balanced budget principle: Classical economists opine that government budget should be balanced that means expenditure (G) should be equal to revenue (T). If not followed, either government has to borrow internally or externally or has to increase the tax. Supporters of balanced budget argue that unbalanced budget creates disturbances in economy.
  21. 21. Government budgeting Principles of budget:  Principle of unbalanced budget: A budget deficit is incurred when expenditures exceed taxes and other revenues for a year. And a budget surplus occurs when all taxes and other revenues exceed expenditures for a year. Though unbalanced means both surplus or deficit budget, a number of economists refer to deficit budget as unbalanced budget. Keynes has supported this principle arguing that along with the higher government expenditure, there will be multiplier effect in the economy.
  22. 22. Government budgeting Budget cycle Enactment or legislation Execution AccountingAuditing Evaluation Estimate
  23. 23. Fiscal policy  Fiscal policy means setting of the taxes and public expenditures to help dampen the swings of business cycle and contribute to the maintenance of a growing, high employment economy, free from high or volatile inflation. Fiscal policy operates through changes in government expenditures, taxation, and public borrowings.
  24. 24. Objectives of fiscal policy  Optimum allocation of resources: economic resources such as man, material, money should be used wisely and productively. Should avoid wastage of resources and ensure maximum productive employment of economic resources.  Price stability: Falling prices (deflation) lead to decline in economic activity, while steeply rising prices (inflation) hit hard the fixed income groups. Fiscal policies should aim at securing price stability by fighting against inflationary or deflationary tendencies in the economy.
  25. 25. Objectives of fiscal policy  Equitable distribution of income and wealth: The fiscal policies should be designed in such a manner that inequalities between rich and poor should be minimum. It should serve to secure equitable distribution of income and wealth among various sections of the society and geographical regions.  Full employment: This is possible if the economy attains its economic growth in commensurate with the growth rate of population. The fiscal policy be designed in such a manner that the rate of increase in income, and hence the rate of increase in employment opportunities is much higher than the growth rate of population.
  26. 26. Objectives of fiscal policy  Economic growth: Less developed countries are caught in the vicious cycle of poverty because of the low economic growth primarily caused by low capital formation, low human capital accumulation, and lack of technology. Thus, the fiscal policy should be oriented towards attaining higher sustainable growth.
  27. 27. Instruments of fiscal policy  Fiscal policy seeks to achieve national economic objectives through changes in taxes, or changes in government expenditure, or a combination of (a) taxes, (b) government expenditure, and (c) public debt. These instruments are used to influence national income, output, employment, and prices.  Taxes, besides bringing revenue to the government, can be used to encourage or restrict private expenditures on consumption and investment.
  28. 28. Instruments of fiscal policy  Government expenditure, may take different forms such as recurrent expenditure, capital expenditure etc. These expenditures have income creating effect. Increased government spending raises income directly, and so indirectly through multiplier process.  Management of public debt influences aggregate spending through changes in the liquid asset position of the public. Public borrowing leads to tighter credit by reducing loanable funds otherwise available, and may have crowding out effect. But the expenditure of these borrowed funds by the government eliminates the tightening effect.
  29. 29. Types of fiscal policy  Usually classified as: expansionary vs. Contractionary, and discretionary vs. automatic (built in stabilizers).  Expansionary fiscal policy: This increases AD either by increasing government expenditure (G) or reducing tax. Thus, the impact is either the budget deficit is increased or surplus budget is reduced. During the periods of recession or depression, government follows expansionary policy to boost income, output and employment.  Contractionary fiscal policy: Government reduces expenditure or increases tax particularly to offset the effect of inflationary gap.
  30. 30. Types of fiscal policy  Discretionary fiscal policy: Discretionary fiscal policy is the deliberate and conscious attempt by the government to promote full employment and price stability by contracyclical change in public expenditure or taxes or both. Discretionary fiscal policy change requires specific legislation.  During depression, the effective discretionary policy may take four alternative forms: (a) reducing tax rates and leaving government expenditures unchanged, (b) increasing government expenditures and leaving tax rates unchanged, (c) simultaneously increasing government expenditures and reducing taxes, and (d) Increasing taxes and government expenditures both.  During inflation, reverse of the above measures are suggested.
  31. 31. Types of fiscal policy  Automatic fiscal policy or built-in stabilizers: This policy operates through the built-in stabilizers to contract fluctuations in economic activity. Built-in stabilizers are those factors which automatically cause government expenditure to rise and tax receipts to fall during economic contraction and cause government expenditure to fall and tax receipts to rise during economic expansion. The important built in stabilizers are: progressive income tax, and unemployment compensation.  During expansion, people pay high income tax and vice versa. Similarly, during contraction more people join the queue for unemployment benefit and vice versa.
  32. 32. More on automatic stabilizers  Automatic stabilizers are mechanisms that stabilize real GDP without explicit action by the government.  Income taxes and transfer payments are automatic stabilizers.  Because income taxes and transfer payments change with the business cycle, the government‟s budget deficit also varies with this cycle.  In a recession, taxes fall, transfer payments rise, and the deficit grows; in an expansion, taxes rise, transfers fall, and deficit shrinks.
  33. 33. Taxation policy  Tax Revenue: Taxes are the most important source of government income. Taxes can be defined as "a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to the taxpayer in return." According to Professor Seligman, a tax is "a compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all, without reference to special benefits conferred."
  34. 34. Taxation policy  These definitions point following three characteristics of tax.  1) It is a Compulsory Contribution: imposed by the government on the people residing in the country. Since it is a compulsory payment, a person who refuses to pay a tax is punished. But a tax is to be paid only by those who come under its jurisdiction. Similarly, persons who buy a commodity that is taxable pay the tax while others do not.  2) A Tax is a Payment Made by the Taxpayers: which is used by the government for the benefit of all the citizens. The state uses the revenue collected from taxes for providing hospitals, schools, public utility services, etc.
  35. 35. Taxation policy  3) A Tax is not Levied in Return for Any Specific Service: An individual cannot ask for any special benefit from the state in return for the tax paid by him. In the words of Professor Taussig, "The essence of a tax ............ is the absence of a direct quid pro quo between the taxpayer and the public authority." It implies that the taxpayer cannot claim something equivalent to the tax paid (quid pro quo) from the government.
  36. 36. Characteristics of a Good Tax System Adam Smith’s Canons of taxation  The Canon of ability: All citizens should contribute towards the expenses of the government, “as nearly as possible in proportion to their respective abilities.” The richer a person, he should pay more.  The Canon of Certainty: The amount to be paid, the time and the method of payment should all be clear and certain for the taxpayer to adjust his income and expenditure accordingly.  The Canon of Convenience: In Smith‟s words, every tax ought to be levied at the time, or in a manner in which it is most likely to be convenient for the contributor to pay for it.”
  37. 37. Characteristics of a Good Tax System Adam Smith’s Canons of taxation  The Canon of Economy: Minimization of the cost of collection.  The Canon of Productivity: it should produce adequate revenue. It is not worth to tax unless it yields adequate.  The Canon of Elasticity: The tax revenue can be increased or decreased with the least inconvenience as the necessity of the sate.  The Canon of Simplicity : Tax imposed should be simple and easily understandable by the people.  The Canon of Diversity: Tax base should be increased by widening the coverage.
  38. 38. Types of tax  Direct, and Indirect Tax  Direct taxes are: (a) income taxes, and (b) taxes on land, building and other assets.  Income taxes are further classified into: corporate tax, and personal tax (tax on remuneration, tax on investment such as interest, dividend, capital gains, tax on windfall gains etc).  Indirect taxes are : (a) customs, (b) VAT, (c) excise
  39. 39. Non-tax revenues Sources of non-tax revenue are:  Charges, fees, fines and forfeiture (firm registration, arms registration, vehicle license, penalty etc)  Receipts from sales of commodities and services (drinking water, electricity, postal service, education, transport etc)  Dividend (of the government owned enterprises)  Royalty and sale of fixed assets  Principal and interest repayment.
  40. 40. Merits of Direct tax 1. Economy. Cost of collecting these taxes for the government is relatively low as these taxes are usually collected at source. And the tax-payers make the payment of these taxes directly to the state and is deposited directly in the state's treasury. 2. Equity. Direct taxes can be thoughtfully chosen and determined according to the ability to pay. In direct taxes, we can find the degree of progression and consequently, it is easy to achieve the sufficient level of social and economic justice through direct taxation. In other words, these taxes fall more heavily on the richer persons than those on the poor.
  41. 41. Merits of Direct tax 3. Reduces Inequality. As direct taxes are progressive in nature, therefore, the person belonging to higher income groups are imposed a higher rate of tax and the low income groups are always exempted from such taxes. Thus, helps to remove disparity among sections of the society. 4. Certainty. Direct taxes also satisfy the canon of certainty because of its certain effects on the tax-payer. So, he makes adequate provision for payment of taxation in advance. The government collects certain amount through direct taxes. Thus, it enables the public authority to estimate the tax collection with greater accuracy and supports in devising budget accordingly.
  42. 42. Merits of Direct tax 5. Elasticity: Direct taxes also satisfy the canon of elasticity. Because the income from these taxes can be increased by increasing the rate of taxation in an appropriate way in the times of crises. Also, the revenue from direct taxes will also increase with the increase in income of the people. 6. Educational Value. Direct taxes have also the educational value among the common masses. People are aware about the amount collected from them and can check the wastage in public expenditure. 8. Easily Understandable. Direct tax is claimed to be easily understandable even by the layman of the society. Moreover, it does not cause any distortion in the resource allocation of the economy.
  43. 43. Demerits of Direct Tax 1. Unpopular. These taxes are directly imposed on the individual. So people don‟t take it easily and resist it. 2. Uneconomical. The cost of collection of such a tax is quite high particularly when the number of tax-payers is infinite and the amount of tax collected is small quantity. Requires high administrative costs in this situation. 3. Possibility or Evasion. A direct tax is calculated on the basis of honesty of tax-payer. So, there is always a possibility of tax evasion. People do not show their correct income to the tax officials. They adopt fraudulent practices to save themselves from the tax.
  44. 44. Demerits of Direct Tax 4. Uncertainty. Some critics of direct taxes state that it is not possible to determine the precise degree of progression on account of the difficulty in measuring the ability to pay and the subjective nature of the marginal utility of income. Thus, it is highly uncertain which results in the public authority ends up with either too much or too little progression. 5. Obstacle to Capital Formation. It is claimed that if the rate of direct tax is heavy, then it adversely affects the people's desire, ability to work, save and investment, therefore, hampers the capital formation.
  45. 45. Demerits of Direct Tax 6. Narrow in Scope. Generally, direct tax is levied only on certain group of people which restricts to raise the civic consciousness among all the people of the society. In this way, its applicability is limited. 7. Against the Equity Principle. Since high earning people have to pay more and low earning people pay less, it can distort the work incentive of the former. It is particularly because of the equal service they take from the state.
  46. 46. Merits of Indirect Tax 1. Convenience. Since taxes are imposed at the time of the purchase of goods and services, they don‟t feel the burden of tax directly. And also the producers and importers think they are not the ultimate payers of these taxes. Thus, relatively people take it conveniently. 2. Elastic. Indirect taxes are highly elastic in nature as the revenue from these taxes can be increased as and when desired. Therefore, the tax is imposed on essential commodities which have inelastic demand e.g. sugar, oil, salt etc. In fact, it has become a selective tool of financial policy of the modern governments.
  47. 47. Merits of Indirect Tax 3. Difficult to Evade. It is impossible for an individual to evade the payment of indirect taxes because they are already included in the price of the commodity. Thus, there is very little possibility for the evasion of such taxes. 4. Equity. Indirect taxes are equitable, because these taxes are paid by the consumers on the commodity. So, it will be according to the ability to any principle. Therefore, it is imposed heavily on luxuries and other such commodities consumed by the rich consumers.
  48. 48. Demerits of Indirect Tax 1. No Civic Consciousness. As indirect taxes are levied on the commodities, consumers do not feel the burden of tax. This makes consumers less conscious about the public expenditure system. 2. Inflationary. This may become inflationary when the government relies excessively upon this. Indirect taxes begin by adding to the sales price of the taxed goods without touching the purchasing power. So, the indirect taxes lead to an unending spiral of higher prices, higher costs, higher wages and again higher prices.
  49. 49. Demerits of Indirect Tax 3. More Uneconomical. Indirect taxes are uneconomical as they involve more cost of collection than actual amount of the taxes. In most of the cases, traders charge more prices than the actual tax levied by the public authority. 4. Inequitable. Another weakness of indirect tax is that it is inequitable and unfair because poor section of the society have to pay more than the rich people since poor people purchase consumables regularly and spend the large chunk of their earnings on the same. .
  50. 50. Principles of efficient taxation 1) The most efficient tax is the one that influences people‟s decisions the least. (Except in cases of market failure). 2) Uniform taxation of taxable goods is not necessarily most efficient. 3) Charge higher tax rates on complements to untaxed goods. 4) Tax price-inelastic goods at higher rates than price-elastic goods, it reduces dead weight loss (DWL). 5) Don‟t be on the wrong side of the “Laffer curve”. These principles affect the decisions of the investors.
  51. 51. Fiscal-Monetary Mix  How the IS-LM model determines income and the interest rate in the short run when P is fixed.  Remember:  In the long run  prices flexible  output determined by factors of production & technology  unemployment equals its natural rate  In the short run  prices fixed  output determined by aggregate demand  unemployment negatively related to output
  52. 52. Fiscal-Monetary Mix  We are building our examples confining to the closed economy assumption where : AE=C+I+G  We can use the IS-LM model to see how fiscal policy (G and T) affects aggregate demand and output.
  53. 53. Graphing planned expenditure income, output, Y AE planned expenditure AE =C +I +G MPC 1
  54. 54. Graphing the equilibrium condition income, output, Y AE planned expenditure AE =Y 45º
  55. 55. The equilibrium value of income income, output, Y AE planned expenditure AE =Y AE =C +I +G Equilibrium income
  56. 56. An increase in government purchases Y AE AE =C +I +G1 AE1 = Y1 AE =C +I +G2 AE2 = Y2 Y At Y1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. G
  57. 57. The government purchases multiplier Example: If MPC = 0.8, then Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals 1 1 MPC     Y G 1 5 1 0.8      Y G An increase in G causes income to increase 5 times as much!
  58. 58. Why the multiplier is greater than 1  Initially, the increase in G causes an equal increase in Y: Y = G.  But Y  C  further Y  further C  further Y  So the final impact on income is much bigger than the initial G.
  59. 59. The IS curve Def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: ( ) ( )Y C Y T I r G   
  60. 60. Y2Y1 Y2Y1 Deriving the IS curve r  I Y AE r Y AE =C +I(r1 )+G AE =C +I(r2 )+G r1 r2 AE =Y IS I AE  Y
  61. 61. Why the IS curve is negatively sloped  A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (AE).  To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y) must increase.
  62. 62. Y2Y1 Y2Y1 Shifting the IS curve: G At any value of r, G  AE  Y Y AE r Y AE =C +I(r1 )+G1 AE =C +I(r1 )+G2 r1 AE =Y IS1 The horizontal distance of the IS shift equals IS2 …so the IS curve shifts to the right. 1 1 MPC     Y G Y
  63. 63. Money supply The supply of real money balances is fixed:   s M P M P M/P real money balances r interest rate   s M P M P
  64. 64. Money demand  People either hold:  Money  Bonds  Demand for real money balances: M/P real money balances r interest rate   s M P M P  ( ) d M P L r L(r)
  65. 65. The LM curve Now let‟s put Y back into the money demand function: ( , )M P L r Y Note: In Blanchard: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is:   d M P L r Y ( , )   idYdiYL P M d 21      
  66. 66. Deriving the LM curve M/P r 1M P L(r,Y1 ) r1 r2 r YY1 r1 L(r,Y2 ) r2 Y2 LM (a) The market for real money balances (b) The LM curve
  67. 67. How M shifts the LM curve M/P r 1M P L(r,Y1 ) r1 r2 r YY1 r1 r2 LM1 (a) The market for real money balances (b) The LM curve 2M P LM2
  68. 68. Why the LM curve is upward sloping  An increase in income raises money demand.  Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.  The interest rate must rise to restore equilibrium in the money market.
  69. 69. The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: ( ) ( )Y C Y T I r G    Y r ( , )M P L r Y IS LM Equilibrium interest rate Equilibrium level of income
  70. 70. Equilibrium in the IS-LM Model Income and Output r Y LM IS Equilibrium interest rate Equilibrium level of income
  71. 71. Fiscal Expansion IS2  Y2 Income and Output r Y LM IS1 Y1 r1 r2  c G   1 A B
  72. 72. Monetary Expansion LM2 r2 LM1 Income and Output r Y IS r1 Y1 Y2 A B
  73. 73. Fiscal-monetary mix: summary 1. Keynesian cross  basic model of income determination  takes fiscal policy & investment as exogenous  fiscal policy has a multiplier effect on income. 2. IS curve  comes from Keynesian cross when planned investment depends negatively on interest rate  shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services slide 73
  74. 74. Fiscal-monetary mix: summary 3. Theory of Liquidity Preference  basic model of interest rate determination  takes money supply & price level as exogenous  an increase in the money supply lowers the interest rate 4. LM curve  comes from liquidity preference theory when money demand depends positively on income  shows all combinations of r and Y that equate demand for real money balances with supply slide 74
  75. 75. Fiscal-monetary mix: summary 5. IS-LM model  Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. slide 75
  76. 76. Deficit financing  Budget deficit is the annual difference between government outlays and receipts (G-T).  The government budget constraint identifies financing options open to the government: G= T+∆B +∆MB Where, G=Total government expenditure. T=Total government revenue from taxes, charges, and sales. ∆B=Change in public debt ∆BM= Change in monetary base (Reserve money) slide 76
  77. 77. Deficit financing G-T= ∆B +∆MB  The idea is that if the government spends more than the revenue either it should borrow or create base money or do both. If the government is in surplus, it will either retire debt or contract the monetary expansion.  Borrowing from the domestic sector can have also crowding out, the idea that increase in government purchases ultimately cause reductions in private consumption or investment.  Monetary expansion to finance the government deficit can have inflationary implications. slide 77
  78. 78. Deficit financing  Government borrowing can be made raising through internal debt or external debt.  Budget deficit financing identity: Budget deficit=Domestic borrowing+ foreign borrowing+ printing money + +arrears slide 78
  79. 79. Deficit financing  In other words, government deficit can be financed through following sources: 1. Withdrawal of past accumulated cash balances by the government 2. Borrowing from public 3. Borrowing from central bank and other banks 4. Issuing new currency 5. External loan 6. Forced savings slide 79
  80. 80. Deficit financing Why there is the need of deficit financing? (Role of deficit financing):  To augment rate of net investment (particularly in developing countries, private sector is not proactive to take investment initiative because of the various constraints, thus there is the large role of the government and has to )  Development of economic and social overheads  To control economic depression  Reconstruction of the economy  Augment community savings  Incentive to private investment  Utilization of the natural resources  War financing slide 80
  81. 81. Effects of deficit financing  Inflation: expansion of money supply and expansion of credit leads to inflation.  Crowding out of the private investment: Excessive reliance on public borrowing creates distortion on investment of the private sector and may also cause high interest, additional disincentive for investment.  Balance of payments difficulties: As monetary income of the people rise, and also because of the rise in government expenditure, imports may rise causing an adverse effect on balance of payments.  Increases debt servicing: Causing high government expenditure and pushes country towards vicious circle of debt and deficit. And also challenges long term debt sustainability. slide 81
  82. 82. Effects of deficit financing  Arrears: Past accumulated debt if can not be repaid because of the increased deficit, it causes inefficiency and loss of creditability.  Rises tax burden to finance debt service, which creates distortions in the behavior of economic agents. slide 82
  83. 83. Public debt management  Public debt management, which is also called sovereign debt management is the process of establishing and executing a strategy for managing the government's debt in order to raise the required amount of funding, achieve its risk and cost objectives, and to meet any other sovereign debt management goals the government may have set, such as developing and maintaining an efficient market for government securities. slide 83
  84. 84. Public debt management  Public debt management, which is also called sovereign debt management is the process of establishing and executing a strategy for managing the government's debt in order to raise the required amount of funding, achieve its risk and cost objectives, and to meet any other sovereign debt management goals the government may have set, such as developing and maintaining an efficient market for government securities. slide 84
  85. 85. Internal debt management Objectives:  To influence the size and maturity of debt  To influence the appropriate pattern of debt  To affect the type of holders of debt  To achieve short term stabilization of bond prices  To limit debt service cost  To create capital market  To give priority to domestic over foreign issues on domestic market  To give priority to public sector borrowing slide 85
  86. 86. External debt management Key elements:  Policy guidelines on appropriate level, terms and purpose for foreign borrowing.  Reorganization of the existing stock of external debt so as to maintain an optimum level of debt structure.  Monitoring the operations relating to loan commitments, disbursements, and debt servicing on all loans.  Accurately recording and maintaining loan by loan information. slide 86
  87. 87. External debt management Key elements:  Preparing projections of debt and debt service levels to facilitate domestic cost budgeting and foreign exchange management.  Liaison with various creditors, keeping them informed of macroeconomic developments.  Regular portfolio review on a sector and/or creditor basis slide 87
  88. 88. Note for you The rest of the slides are additional notes, therefore, are optional for you. If you are interested, you can go through them to widen your understanding. But don’t be overstressed looking at them and don’t complain to your parents!
  89. 89. IMF Guidelines for Public debt management 1. Objectives and coordination  Objectives: The main objective of public debt management is to ensure that the government's financing needs and its payment obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk.  Scope: Debt management should encompass the main financial obligations over which the central government exercises control.  Coordination with monetary and fiscal policies slide 89
  90. 90. IMF Guidelines for Public debt management 1. Objectives and coordination  Objectives: The main objective of public debt management is to ensure that the government's financing needs and its payment obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk.  Scope: Debt management should encompass the main financial obligations over which the central government exercises control.  Coordination with monetary and fiscal policies slide 90
  91. 91. IMF Guidelines for Public debt management 2. Transparency and Accountability  Clarity of roles, responsibilities and objectives of financial agencies responsible for debt management  Open process for formulating and reporting of debt management policies  Public availability of information on debt management policies  Accountability and assurances of integrity by agencies responsible for debt management slide 91
  92. 92. IMF Guidelines for Public debt management 3. Institutional Framework  Governance  Management of internal operations  Public availability of information on debt management policies  Accountability and assurances of integrity by agencies responsible for debt management slide 92
  93. 93. IMF Guidelines for Public debt management 4. Debt Management Strategy  The risks inherent in the structure of the government's debt should be carefully monitored and evaluated. These risks should be mitigated to the extent feasible by modifying the debt structure, taking into account the cost of doing so.  In order to help guide borrowing decisions and reduce the government's risk, debt managers should consider the financial and other risk characteristics of the government's cash flows.  Debt managers should carefully assess and manage the risks associated with foreign-currency and short-term or floating rate debt. slide 93
  94. 94. IMF Guidelines for Public debt management 5. Risk Management Framework  A framework should be developed to enable debt managers to identify and manage the trade-offs between expected cost and risk in the government debt portfolio.  To assess risk, debt managers should regularly conduct stress tests of the debt portfolio on the basis of the economic and financial shocks to which the government-- and the country more generally--are potentially exposed. slide 94
  95. 95. IMF Guidelines for Public debt management 6. Development and Maintenance of an Efficient Market for Government Securities  Portfolio diversification and instruments: The government should strive to achieve a broad investor base for its domestic and foreign obligations, with due regard to cost and risk, and should treat investors equitably.  Primary market : Debt management operations in the primary market should be transparent and predictable. To the extent possible, debt issuance should use market-based mechanisms, including competitive auctions and syndications. slide 95
  96. 96. IMF Guidelines for Public debt management 6. Development and Maintenance of an Efficient Market for Government Securities  Portfolio diversification and instruments: The government should Secondary market: Governments and central banks should promote the development of resilient secondary markets that can function effectively under a wide range of market conditions.  The systems used to settle and clear financial market transactions involving government securities should reflect sound practices. slide 96