Identify sources of public borrowing

Borrowing from Individuals
When individuals purchase government bonds, they are diverting funds from private use to
government use. Individuals may be able to subscribe to government bonds either through
curtailment of current consumption needs (this may be very rare) or through diversion of
funds from their own business or diverting funds into government bonds from corporate
securities. Normally, the sale of government bonds to individuals should not curtail either
consumption or business expansion. To a large measure, the bonds will be absorbed out of
funds that would have been lying idle or would have been used to buy other securities.

Borrowing from Non-banking Financial Institutions
More important than individual subscribers to government bonds are the financial institutions
such as insurance companies, trusts, mutual savings banks, etc. These non-banking financial
institutions prefer government bonds because of the security provided by the latter and also
due to their high negotiability and liquidity. But the rate of interest is low and hence in many
cases financial institutions may prefer high-risk high-return securities particularly equities.
When non-banking financial institutions fake up government bonds, they do so to reduce
their cash holdings.

Borrowing from Commercial Banks
While individuals and non-banking financial institutions take up government bonds out of
their own funds, commercial banks can do so by creating additional purchasing power known
as credit creation. The banking system as a whole can make additional loans up to an amount
several times as great as the excess cash reserves. This is possible because the loans the
bankers make are typically book entries in the names of borrowers who pay in the form of
cheques to others who have also bank accounts. The result is that so long as cash is not
withdrawn from the banks, it serves as the basis for the expansion of loans. Commercial banks can subscribe to government loans through creation of credit. They need not contract their other loans and advances. Whenever the banking system has excess cash reserves, it can absorb an amount of government bonds considerably greater than the excess cash reserves. It is important to note that the power to buy bonds is essentially created rather than merely transferred. So if commercial banks create additional purchasing power and place it at the disposal of the government to finance the latter's expenditures, inflationary
pressures will be generated (if previously, the economy has been working at full
employment).

Borrowing from the Central Bank
The central Bank of the country also subscribes to government loans. The action is exactly
similar to the system of creation of additional purchasing power by the commercial banking system. By purchasing government bonds, the central bank credits the account of the government. The latter pays to its creditors out of its account with the central Bank. Those who have received cheques from the government on the central bank deposit the amount with their banks. These banks find themselves with large cash reserves which become the basis for additional loans and advances. It will be seen that borrowing from the central bank is the most expansionary of all the sources for not only the government secures funds for its
expenditure but the commercial banking system gets additional cash which can be used as the basis for further credit expansion. While the borrowings from individuals and financial institutions are simply transfer of funds from private to government use and, therefore, will not be expansionary in their effect on the economy (unless the funds were previously lying idle and are being activised through
government borrowing), borrowing from the commercial banking system and the central
bank will have expansionary effect.

Borrowing from External Sources
Government may borrow from other countries too. These borrowings can be used to finance
war expenditure, or to produce defence equipment, or to pay for development projects, or to
pay off adverse balance of payments. Formerly, the floating of loans for any specific
development projects, like railway construction, was taken up by individuals and banking and
other financial institutions. However, in recent years, apart from this source, two important
sources have become prominent. They are:
a) International financial institutions, viz., I.M.F., the I.B.R.D., the I.D.A. and the I.F.C., which give loans for short-term for overcoming temporary balance of payments difficulties and for the long-term for development purposes; and
b) Government assistance generally for development projects. For developing countries like Kenya, external sources of borrowing are becoming considerably important in recent

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NatalieR answered the question on June 22, 2022 at 10:13