UNIT- 4

PUBLIC DEBT
 Concept of Public Debt
Public debt is also sometimes referred to as
government debt.
 It is a term for all of the money owed at any
given time by any branch of the government.
It encompasses public debt owed by the
federal government, the state government, and
even the municipal and local government.
 Cont’
Public debt is a debt or loan taken by the
govt. from its own people as well as from
foreign countries or both.
Govt. needs to borrow when current revenue
falls short of public expenditure.
Since current public revenue is usually
insufficient to meet the current and
development expenditure of the modern
govt., the govt. has no alternative except to
borrow money.
The instruments of public borrowings are in
the form of various types of govt. bonds and
securities.
 Causes of Increase in PD

 To cover the budget deficits on current account.

 War or war-preparedness, including nuclear
programmes.
 Natural Calamities :- so as to provide relief to the
victims, PD is increased.
 To undertake public welfare schemes.
 Urge for economic growth.
 Economic stability:- government borrows to control
inflationary conditions.
 Objectives/ Importance of PD
 Bridging gap between revenue and
expenditure through temporary loans from
National bank.
 To reduce depression in the economy and
financing public works programme.
 To curb inflation by withdrawing the
purchasing power from the public.
 Cont’
 Financing economic development esp. in
under-developed countries.
 For the development of social welfare schemes
like education, health, general insurance.
 Financing the public sector for expanding and
strengthening the public enterprises.
 A lot of money has to be spent by the govt. at
the time of wars, floods, epidemics, famines.
 Classification of public debt
 Internal and external debt
 Productive and unproductive debt
 Compulsory and voluntary debt
 Redeemable and irredeemable debt
 Funded and unfunded debt
 Marketable and non-marketable debt
 According to source: Internal and
external debt
Public loans floated within the country
are called internal debt.
When a state finds that it is not possible
to obtain further money by taxation, it
resorts to borrowing from citizens and
financial institutions within the country.
 Cont’
If the state is passing through a very critical
period, then it can borrow all the money
which the nation saves.
In that case trade and industry will suffer a
lot because no money is left to finance
them.
In the normal period, however, the state can
borrow only surplus funds which are left
with the businessmen after meeting all the
needs of the business.
 Cont’
External debt, is always in terms of foreign
currency.
The govt. borrows from friendly foreign
countries or international financial
institutions.
When a state is in need of money, it tries to
get as much loan as it can from other states.
The foreign governments do not advance
loans without a limit.
 Cont’
They intensively study the budgetary
position of the borrowing country, the tax-
bearing capacity of the nation, the per-capita
income of the people and the purpose for
which the loan is desired.
If the position of the budget is sound and
the taxable capacity of the nation is high,
then a foreign government may advance
sizable loan to the borrowing country.
 According to use: Productive and unproductive
debt
Public debt may be productive or unproductive
depending on the use of public loans.
Productive debts are those which are used for
those projects which yield income to the
government.
Thus, when the govt. borrows for developmental
expenditure, the debt is productive.
When the govt. borrows for non-developmental
purposes such as war finance or wastefulness in
public administration, the debt becomes
unproductive.
 According to nature: Compulsory and
voluntary debt
When the govt. borrows from public by
using forceful method, i.e., by virtue of its
sovereign powers, we may call it
compulsory debt.
For example, the loans raised during an
emergency e.g. war.
When the govt. borrows money from the
public, individuals and institutions by
issuing securities like bonds etc., it is called
voluntary debt.
 According to Period: 1. Redeemable and
irredeemable debt
Redeemable loans are those loans which the
govt. promises to pay off at some future
date.
Irredeemable debts are those which are
raised without any intention to repay the
principal, though the govt. continues to pay
interest on such debts.
 According to period: 2. Funded and
unfunded debt
Funded debt is a long-term debt,
exceeding the duration of at least a year.
These are permanent debts in the sense
that new securities are issued every time
the debt matures.
A debt fund is created in which some
money is deposited every year so as to
repay this type of debt.
 Cont’
Thus, the permanent debt covers loan raised in
the open market by sale of securities.
Unfunded or floating debt is a relatively short-
period debt, meant to meet current need.
They are generally redeemable within a year.
The government does not create any separate
fund to repay the debt. Such a debt is repaid out
of current receipts, by floating additional bonds
in the market.
 Marketable and non-marketable debt
Generally, securities issued by the govt. at
the time of borrowing are bought and sold in
the open market are called marketable
public debt.
For example, treasury bills and promissory
notes.
Certain forms of public debt, such as
savings under various saving schemes,
postal savings, national defense certificates
etc., are not marketable debt.
 Discussion

How the government repays its public debt?

 Effects of PD
Effects on Production
Effects on Consumption
Effects on Distribution
Effects on the Level of Income and
Employment
Effects on Liquidity
Effects on Money Market
 Effects on Production
If public debts are raised to finance
productive purpose, over all production is
positively affected.
But if it is used for wasteful or non-
productive purpose, total production is
affected negatively.
 Effects on Consumption
The effect of public debt on consumption
depends upon how it is financed by
individuals.
If they lend to the government out of their
idle savings, consumption is not affected.
But if they lend by cutting present savings, it
may make them feel less secure and so they
may reduce their consumption.
 Effects on Distribution
 Public loans transfer money from rich to
government.
 The fiscal operations of the government
are to benefit the poor primarily.
 The income of the poor increase directly
through increased employment or it
benefits them in directly through the
enlargement of social services.
 Effects on the Level of Income and
Employment
 In modern times, public borrowing is
resorted to in order to raise funds for
financing agriculture, industry, mining,
transportation, communication, etc.
 It increases employment opportunities, the
level of income and standard of living.
 Effects on Liquidity
Effect of public debt on liquidity is
favorable because the governments bonds
are liquid assets which can be sold in the
market whenever the bondholders need
money.
So, public debt increases the volume of
liquid assets in the country.
 Effects on Money Market
The government has to compete with the
private sector for fund.
 Usually if the rate of interest paid by
private sector on borrowing is high, the
government also will have to rise its
interest rate to attract public funds.
 Burden of Public Debt
 Public borrowings are to be paid along with
interests.
 Govt. imposes new taxes upon the people to
repay the loans and meet the annual interests
on such loans.
 The sacrifice of the people in the form of tax
payment is the burden of public debt.
 Cont’
 If the debt is taken for productive purposes,
for e.g., for irrigation, transportation, roads,
information technology, human skill
development, etc., it will not mean any
burden.
 But if the debt is unproductive it will impose
both money burden and real burden on the
economy.
 The burden of public debt into:
i. Burden of internal debt
ii. Burden of external debt
i. Burden of internal debt
 Internal debt involves a series of transfers
of wealth within the country, i.e., from
lender to government and then later on at
the time of redemption from government to
lender.
 Money is thus transferred from one section
of the community to other sections.
 In this case the money burden on the
economy is zero.
 But there may be real burden on the
community.
 Cont’
In order to repay the interest and the
principal amount of the debt, the
government has to levy taxes.
What the taxpayers pay the lenders receive.
The lenders are generally rich people and
tax burden is fall on poor especially in the
case of indirect taxes.
The net result may be that the wealth is
transferred from poor to rich.
This is the loss of economic welfare.
ii. Burden of external debt
 External debt also involves a series of transfer
of wealth from the foreign lender to the
borrowing country, and when it is repaid the
transfer is in the opposite direction.
 As the borrowing country paid interest to the
foreign lenders, a direct money burden is fall on
the whole community.
 This burden depends on the rate of interest. If
the rate of interest is high, the money burden, is
also high and vice-versa.
 The community is also suffered from real
burden of external debts.
 Cont’
The real burden of the external debts depends on
the nature and use of these debts.
If it is used for productive purpose, the real
burden of these debts will be less.
If external debts to be used for non-productive
purposes, much real burden will have to be borne
in order to repay such a debt.
As a result the production, consumption and
distribution of income is badly affected.
Moreover, the foreign lender has direct
involvement in the economic activities of the
country.
 Measurement of the burden of public
debt
 The burden of public debt can be measured by
any of the following methods.
Income-Debt Ratio
Debt Service Ratio
Interest Revenue Ratio
Interest- Public Expenditure Ratio
Interest Export Earning Ratio
 Income-Debt Ratio
 The burden of the public debt can be measured as
a ratio of the size of the public debt and national
income at current prices.

PD
 i.e., PDB = Y

If ΔPD > ΔY → Real burden Increases

If ΔPD < ΔY → Real burden Decreases
 Debt Service Ratio
 The burden of the public debt can also be
measured as a ratio of annual interest payment
on public debt and the national income.
It is known as Debt service ratio

 i.e., PDB =
i
Y
 Cont’
It indicates that a developed economy with a
high rate of growth of national income can
afford a large amount of public debt.
An underdeveloped country, with a low rate
of growth of national income cannot afford a
large amount of public debt.
In an underdeveloped country, most of the
government’s annual revenue will have to be
paid as interest on public debt and less
amount will be available for welfare and
developmental purposes.
 Interest Revenue Ratio
The burden of public debt can also be measured a
the ratio of annual interest payment and
aggregate tax revenue.

 i.e., PDB = i
R
 Cont’
The interest revenue ratio indicates the
fiscal burden of the public debt.
If this ratio is more, it will mean less
resources will be available for
developmental purposes and thus the burden
will be high.
 Interest- Public Expenditure Ratio
 The burden of the public debt can also be
measured by the ratio of annual interest payment
on public debt and total revenue expenditure.

 i.e., PDB =
i
E
This method measures the proportion of public
expenditure required to meet annual rate of
interest.
 Interest Export Earning Ratio
 This method is used to measure the burden of
external debt.
 It calculates the ratio of interest payments and
export earnings.

 i.e., PDEB = i
Ex

This ratio shows the proportion of export earnings

required to pay annual interest on external debts.
 Redemption of Public Debt
 Redemption is a way of escape from the
burden of a public debt.
 Redemption means repayment of loans.
 Methods of debt redemption
Utilisation of surplus revenue
Purchase of government bonds
Terminable annuities
Conversion of high-interest-rated loans to
low-interest-rated loans
Sinking fund
 Utilisation of surplus revenue
 This is an old method and badly out of
tune with the modern conditions.
 Even when there is a surplus, it cannot
be used for making any substantial
reduction in the public debt.
 Purchase of government bonds
 The government may buy its own
stocks in the market, thus wiping off its
obligation to that extent.
 This may be done by the application of
surplus revenues or by borrowing at
low rates, if the conditions are
favourable.
 Terminable annuities
 When it is intended completely to wipe off a
permanent debt, it may be arranged to pay
the creditors a certain fixed amount for a
number of years.
 These annual payments are called
‘annuities’.
 It will appear that, during the time these
annuities are being paid, there will be much
greater strain on the government finances
than when only interest has to be paid.
 Conversion of high-interest-rated
loans to low-interest-rated loans
 A government may have borrowed
when the rate of interest was high.
 Now, if the rate of interest falls, it can
convert a high-rated loan into a low-
rated one.
 Sinking fund
 This is the most important method.
 A fund is created for the repayment of
every loan by setting aside a certain
amount every year out of the current
revenue.
 The sum to be set aside is so calculated
that over a certain period, the total sum
accumulated, together with the interest
thereon, is enough to pay off the loan.
 Discussion

• Difficulties of public borrowings in UDCs

 Difficulties of public borrowings in
UDCs
 In UDCs there are no or very small organised
capital and money markets. The resources are too
inadequate to fulfil the capital needs of the
economy.
 Resources are hoarded in non-productive sections
of the economy, for e.g., real estate, jewellery.
 The savings in rural areas cannot be mobilised
effectively because rural incomes do not move
through monetary channels.
 The response to government securities is also poor
because of rising prices.