What are the Effects of Debt Financing ?

What are the Effects of Debt Financing ?

Mainly there are two effects –

(a) Crowding Out Effect of Debt Financing

(b) Wealth Effect of Debt Financing

(a) Crowding Out Effect of Debt Financing –

In economics, crowding out effect states that rising government spending drives down or even eliminates the private sector spending.

Debt financed government expenditure is largely offset by the crowding out effect of debt financing on private investment.

The crowding out effect on private investment takes place in many ways.

First, government borrowing funds to finance budget deficit leads to the increase in demand for lendable funds which will cause the rate of interest to rise. The rise in the rate of interest will cause private investment to decline. In this way, debt financed government expenditure crowds out private investment.

Second, due to crowding out effect on private investment net expansionary effect of increase in government expenditure is negligible.

While the society will have to bear the burden of increase in public debt as a result of debt financed expansion in government expenditure. If the budget deficit arises due to reduction in taxes, keeping the government expenditure constant, this will also lead to rise in interest rate and therefore will cause crowding out effect on the private investment. This happens because reduction in taxes stimulates consumption expenditure of the people which in turn reduces savings. The reduction in savings causes interest rate to rise resulting in fall in private investment.

(b) Wealth Effect of Debt Financing –

When the government issues bonds to finance the budget deficit, it creates wealth. This happens because bonds are considered as wealth by the people.

According to Patinkin and Friedman, demand for money depends on the real value of wealth, apart from other factors. When this wealth effect of bond financing of budget deficit is recognised, then it greatly influences the dynamic behaviour of the economy. When through debt financing of budget deficit, more bonds are issued and sold by the government, the wealth of the people increases which will raise the demand for money.

(Patinkin and Friedman have included wealth in the models of their money demand function.)