CHAPTER- FIVE

Public Debt
 Meaning of Public debt
Modern governments need to borrow from d/t sources when
current revenue falls short of public expenditures.
Thus, public debt refers to loans incurred by the gov’t to
finance its activities when other sources of income fail to
meet the requirements.
It is the obligation of government particularly those
evidenced by securities, to pay certain sums to the holders at
some future date.
In simple words, Public Debt is the amount of debt taken
by gov’t from internal as well as external sources to meet
out its deficit.
Gov’t needs to borrow when current revenue falls short of
public expenditure.
 Meaning of Public debt

Rather, it constitutes public expenditure.

Public debt is incurred when the government floats loans
and borrows either internally or externally from banks,
individuals or countries.
What is true about public borrowing is that, like taxes,
public borrowing is not a compulsory source of public
income.
The word ‘compulsion’ is not applied to public borrowing
except in certain exceptional cases of borrowing.
 Types of Public debt
Gov’t loans are of d/t kinds, they may differ in respect of time of
repayment, the purpose, conditions of repayment, method of
covering liability.
Thus the debt may be classified into the following types.
1. Productive and unproductive debts
2. Voluntary and compulsory debts
3. Internal and external debt
4. Short term, long term and medium term debt
5. Redeemable and Irredeemable Debts
6. Funded and unfunded debts
 Types of Public debt
1. Productive and unproductive debts
Productive debt
Public debt is said to be productive when it is raised for productive
purposes & is used to add to the productive capacity of the economy.
As Dalton puts, productive debts are those which are fully covered by
assets of equal or greater value.
Ex. borrowed money is invested in the construction of railways,
irrigation projects, power generations.
It adds to the productive capacity of the economy and also provides a
continuous flow of income to the government.
The interest and principal amount is generally paid out of income
earned by the government from these projects.
Productive loans are self-liquidating.
Generally, such loans should be repaid within the lifetime of property.
Thus, such loans does not cause any net burden on the community.
 Types of Public debt
Unproductive debt
They are those which do not add to the productive capacity of
the economy.
Unproductive debts are not necessarily self-liquidating.
The interest & the principal amount may have to be paid from
other sources of revenue, generally from taxation.
Public debt used for war, famine relief, social services, etc.
However, such expenditures are not always bad because they
may lead to wellbeing of the community.
But such loans are a net burden on the community since they are
repaid generally through additional taxes.
 Types of Public debt
2. Voluntary and Compulsory debts
Voluntary debt
These loans are provided by the members of the public on voluntary
basis.
Most of the loans obtained by the government are voluntary in nature.
They are obtained in the form of market loans, bonds, etc.
The gov’t makes an announcement in the media to obtain such loans.
The rate of interest is normally higher than that of compulsory debt, in
order to induce the people to provide loans to the gov’t.
Compulsory debt
It is a rare phenomenon in modern public finance unless there are some
special circumstances like war or crisis.
The rate of interest on such loans may be low.
Considering the compulsion aspect; these loans are similar to tax, the
only difference is that loans are repaid but tax is not.
 Types of Public debt
3. Internal and External debts
Internal debt
It refers to the funds borrowed by the gov’t from various
sources within the country.
The various internal sources from which the government
borrows include individuals, banks, business firms, &
others.
The various instruments of internal debt include market
loans, bonds, treasury bills, etc.
Internal debt is repayable only in domestic currency.
It implies a redistribution of income & wealth within the
country & therefore it has no direct money burden.
 Cont’d
External debts
External loans are raised from foreign countries or
international institutions.
These loans are repayable in foreign currencies.
External loans help to take up various developmental
programs in developing and underdeveloped countries.
These loans are usually voluntary.
An external loan involves, initially a transfer of resources
from foreign countries to the domestic country
But when interest and principal amount are being repaid a
transfer of resources takes place in the reverse direction.
 Cont’d
4. Short-term, Medium term & Long term debt
Short term debts (Floating debt)
Short term debt matures within duration of less 1 year.
Generally, rate of interest is low.
Company refinances continuously.
Long-Term debt
Long term debt has a maturity period of five years or more.
Generally the rate of interest is high.
Such loans are raised for developmental programs and to meet other long
term needs of public authorities.
Medium-Term debt
The Government may borrow funds for medium term needs.
These funds can be used for development and non-development activities.
The period of medium term debt is normally for a period above 1year & up
to 5 years.
One of the main forms of medium term debt is by way of market loans.
 Cont’d
5. Redeemable and Irredeemable Debts
Redeemable debts
The debts which the government promises to pay off at some
future date are called redeemable debts.
Most of the debt is redeemable in nature.
There is certain maturity period of the debt.
The government has to make arrangement to repay the principal
& the interest on the due date.
Irredeemable debts (Perpetual debt)
Such debt has no maturity period.
In this case, the government may pay the interest regularly, but
the repayment date of the principal amount is not fixed.
Normally, the government does not resort to such borrowings.
 Cont’d
5. Funded and Unfunded Debts
Funded debts
Funded debt is repayable after a long period of time.
The period may be 30 years or more.
Funded debt has an obligation to pay fixed sum of interest
subject to an option to the government to repay the principal.
The government may repay it even before the maturity if market
conditions are favorable.
Funded debt is undertaken for meeting more permanent needs,
say building up economic & industrial infrastructure.
The government usually establishes a separate fund to repay this
debt.
Money is credited by the government into this fund & debt is
repaid on maturity out of this fund.
 Cont’d
Unfunded debts
Unfunded debts are incurred to meet temporary needs of the
governments.
In such debts duration is comparatively short say a year.
The rate of interest on unfunded debt is very low.
Unfunded debt has an obligation to pay at due date with
interest.
 Effects of public debt
Public borrowing involves transfer of purchasing power
from individual to government and a vise visa.
Thus, public debt, in one sense, has the ‘revenue effect’,
and, in another sense, has the ‘expenditure effect’.
This means that public borrowing produces different effects
on the economy.
However, the exact effects of borrowing will greatly depend
on the sources of borrowed amounts.
Effect on National Income and Distribution
Effect on Price Level
 Justification for public debt
Today, no one believes that public borrowing is wasteful and undesirable.
Public borrowing is an important tool of the government to affect
economic activities.
Even governments of rich countries do not hesitate in raising loans; it
does not, reflect financial weakness of the government.
To carry out its ever-increasing expenditure, a government often incurs
debt both internally and externally.
Public debt is justified on the following grounds:
Unforeseen Emergencies
The government often resorts to public borrowing to meet unforeseen
emergencies, like war, flood, drought, etc.
Huge expenditures on these national emergencies can never be met by
taxation alone, particularly in poor countries.
That is why a short run emergency borrowing is made to tackle these
emergencies
 Cont’d
For Economic Development
Public borrowing is considered to be an important source of development
finance.
The state is required to build up industries, economic & social
infrastructures.
The inadequacy of tax revenue has led the government to adopt the
borrowing policy to finance these activities.
To Curb Inflation
Underdeveloped countries are inflation sensitive countries.
By resorting to public borrowing, gov’t can siphon off the excessive
purchasing power of the public.
In an inflationary situation, since people’s disposable income tends to rise,
their purchasing potential also rises.
Under the circumstance, purchasing power of the people can be curbed by
resorting to borrowing by the gov’t.
However, some economists argue that, as an anti-inflationary method,
taxation works better.
 Cont’d

To Control Depression
During depression, economic activity remains at a low level.
To stimulate the economy, what is required is the increase in
public spending.
Public works programs are one such example of government
investment spending.
Under depressionary condition, financing of an economic
activity through taxation is not advisable.
By increasing the volume of gov’t spending an economy can be
stimulated.
Gov’t spending has the multiplier effect on income &
employment.
Thus, additional gov’t spending financed through public
borrowing may revive the economy from a state of depression.
 Cont’d
Thus, public borrowing is not necessarily dangerous.
On the contrary, public borrowing is unavoidable in certain
circumstances.
That is why modern gov’ts borrow money from different
sources.
But, one thing that is certain is that if volume of public
borrowing grows to an abnormal extent, it will then
destabilize the economy.
Benefits of borrowing or objectives of borrowing will then be
defeated.
Thus, public borrowing has to be made carefully and
judiciously.
 Cont’d
When public debt is good
In the short run, public debt is a good way for countries to get extra
funds to invest in their economic growth.
Public debt is a safe way for foreigners to invest in a country's growth
by buying government bonds.
This is much safer than foreign direct investment.
It is also less risky than investing in the country's public companies via
its stock market.
Public debt is attractive to risk-averse investors since it is backed by
the government itself.
When used correctly, public debt improves the standard of living in a
country.
It allows the government to build new roads and bridges, improve
education and job training, and provide pensions.
This spurs citizens to spend more now instead of saving for retirement.
Cont’d
 Cont’d
When public debt is bad
Gov’ts tend to take on too much debt because the benefits make them
popular with voters.
Increasing the debt allows gov’t leaders to increase spending without
raising taxes.
Investors usually measure the level of risk by comparing debt to a
country's total economic output.
Investors usually don't become concerned until the debt-to-GDP ratio
reaches a critical level.
When debt approaches a critical level, investors usually start demanding
a higher interest rate.
They want more return for the greater risk.
As interest rates rise, it becomes more expensive for a country to
refinance its existing debt.
In time, income has to go toward debt repayment, and less toward
government services.
 Cont’d
In the long run, public debt that's too large is like driving
with the emergency brake on.
Investors drive up interest rates in return for the increased
risk of default.
That makes the components of economic expansion, such as
housing, business growth, and auto loans, more expensive.
To avoid this burden, gov’ts need to carefully find that
sweet spot of public debt.
It must be large enough to drive economic growth but small
enough to keep interest rates low.
Thank You so
Much!!!