Deficit financing is similar to debt financing, but refers to specific practices used by governments in order to increase the number of debt instruments they have currently in the market. Most people assume the government does not want to increase its deficit, but governments can have several different reasons for using deficit financing, including the ways in which it affects the economy.
Deficit financing occurs when a government funds expenditures, such as new government programs or government construction projects, by using debt instead of income. Governments receive a large amount of income through taxes, but they also get funds by selling debt instruments like bonds. Typically, government bonds are very popular in the debt market if the government is stable, and it is easy for the government to raise money in this manner.
Governments use deficit financing for serveral purposes. One of the most common is to increase the money supply and the number of bonds it has in the economic system, thus influencing the economic activity of investors. Other governments may have a choice between using debt and raising taxes. Issuing more bonds is usually more politically favorable than raising taxes.
When used correctly, deficit financing increases the amount of spending in the debt market and has a favorable effect on economic conditions, making people more willing to spend money on a variety of businesses. In the end, this activity will raise greater amounts of income, from which the government draws greater amounts of taxes to cover the deficit. In the meantime, the government can use the funds it receives to immediately pay pressing expenses.
If used incorrectly, deficit spending can put governments in a dangerous and unstable position. Eventually, the bonds the government uses will come due and the government must be prepared to pay them off when this occurs. Also, increasing the number of government bonds in the market can increase competition over bonds, which raises interest rates. Interest rates across the economy will tend to follow suit, making it difficult for many people to afford loans.
Deficit financing may also apply to businesss on a smaller scale, where a nation's economy is not affected but the business still needs extra funds to pay off important expenses. Like the government, the business sells bonds to raise funds beyond the capacity of its profits to pay off. The business must make sure it remains successful enough to pay back the bonds in the future.