In his book on general theory of employment interest and money, John Maynard Keynes, mentioned that effective demand can be raised by increasing the rate of investment with the help of deficit financing. Deficit financing occurs when Government expenditure exceeds Government revenue. Deficit financing takes place when the Government obtains the cash balances of past fiscal years, or borrows from the Central Bank leaving Government security as on insurance or ever when the Government prints more money, thus expenditure is met over receipts.

Generally deficit financing takes place during the period of depression or for the purpose of economic growth. We shall discuss them separately.

We know that unemployment can take place in developed countries due to the deficiency of the effective demand. Through the role of Government to stimulate private consumption and investment to overcome depression, it can lower the tax rates whilst maintaining level of expenditure in public as well as private sector. Thus, here the Government actually spends more than it can collect taxes, deficit financing takes place. If this method does not work, the Government may then increase its expenditure above taxes, it is also deficit financing. As a result of increase in Government Investment, income and employment also rises due to the multiplier. Thus, during a depression period deficit financing can be administered to expand income output and employment without adversely causing inflation. In a depression phase it is better to finance the Government expenditure through deficit financing rather than taxation as the latter has an adverse effect on the private consumption and investments and thus effective demand will be hampered with.

Generally unlike developed countries whose problem of unemployment is due to effective demand, LDCs problem attribute to deficiency of capital. The only possible method of increasing the growth rate is by increasing investment, but how? Being LDCs foreign aid is almost out of the question. One method may be to increase domestic saving which can only be obtained through savings of the people. However, since the people in general are already living at subsistence level, difference between consumption and income is almost nil making it quite impossible to let alone save! Another attempt by the Government is to increase taxes. Once again due to extreme poverty such a method of financing means creation of new money. Increase in money supply raises the prices of goods and services, supply cannot be increased in the short run, loans are given to the people to increase their purchasing power. The money comes back to the government, reducing money supply and thus decreasing price level of commodities. On the other hand, as a result of rise in prices, entrepreneurs profits go up and they are further induced to investments in the public sector i.e. developmental expenditures e.g. on roads, railways, bridges etc. Thus, deficit financing can develop an underdeveloped country provided there is an efficient body of administration, controlling and allocating the resources accordingly.

There are a few major effects of deficit financing interalia increase in money supply with the public, rise in income level and a rise in the general price level. The main controversy between classical economists and Keynes regarding deficit financing was that it is likely to cause inflation. However, Keynes theory proved that no inflation would take place in the case of a developed country; however, once again, inflation may take place in underdeveloped countries as a result of deficit financing. This is due to the fact that there is a time lag in production of goods; between the moments expenditure is incurred right up until goods are finally produced. Shorter the time lag, lesser the pressure of inflation and if people were to just save the newly created money, there will be no inflation. Inflationary pressure as a result of deficit financing can be reduced by the following policies:

Government should promote exports and local goods, give subsidies to entrepreneurs etc. and demote import of foreign goods through heavy duty.

Resources should be properly allocated by the Government, no extravagance should occur, supply of commodities and prices should be controlled through fiscal policy.

Inflation can be controlled through fiscal policy and through monetary policy. The government is in a position to avoid extravagance.