Functional Finance: Concept and Roles

After reading this article you will learn about:- 1. Concept of Functional Finance 2. Rules of Functional Finance 3. Roles.

The Concept of Functional Finance:

The chief exponent of functional finance was Prof. Abba P. Lemer who believed that fiscal measures should be judged only by their effects. The way fiscal measures function in an economy is called functional finance.


Prof. Lemer asserted that fiscal policy is an effec­tive instrument in the hands of the government for maintaining full employment and controlling economic fluctuations.

Prof. A. P. Lemer states the central idea is that government fiscal policy, its spending and taxing its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound.

The principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science as opposed to scholasticism.

The principle of Judging fiscal measures by the way they work or function in the economy we may call Functional Finance. Functional Finance entrust the government the meritorious re­sponsibility of keeping a watch over the movements of the economy as a whole.

Whenever and where ever employment sags, income decreases, profitability declines and the economy suffers a severe setback the public authorities are advised to counteract these ten­dencies by un-leasing the opposite force which would rise up the dropping nerves of the system and bring the situation back normally.

The government cannot remain a silent spectator of the dislocations and disturbance in the economy in tune with the non-intervention list policy of the captains of Laissez-fairism. The object of a stable economy is as much in the interest of the capitalists as in the rest of the society.


Hence maintenance of a high level of demand reason­able prices, a high level of employment and income ought to be the supreme objective of functional finance through the instrument of budgetary manipulations.

Functional Finance is a positive policy in the sense that it advocates a vigorous policy of intense activity on behalf of the community undertaken by the public authority.

Rules of Functional Finance:

Concept of functional finance insists on the elimination of the basic causes of inflation and deflation and thereby to maintain economic stability.

To achieve this objective, Lemer suggests the following rules for government activity under functional finance:


1. The first financial responsibility of the government is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current price would buy all goods that it is possible to produce.

If total spending is allowed to go above this, there will be inflation. If it is allowed to go below this there will be unemployment. The government can increase total spending by spending more itself or by reducing taxes so that the tax payers have more money left to spend.

It can reduce spending by spending less itself or by raising taxes so that tax payers have less money left to spend. By these means total spending can also be kept at the required level, where it will be enough to buy the goods produced.

2. The second law of functional finance is that the government should borrow money only if it is desirable that the public should have less money and more government bonds.


This might be desirable if otherwise the rate of interest would be reduced too low and induce too much investment, thus bringing about inflation. Conversely the government should lend money only if it is desirable to increase the money or to reduce the quantity of government bonds in the hands of the public.

3. Taxing is never to be undertaken merely because the government needs to make money payments. According to the principle of functional finance, taxation must be judged only by its effect. Taxation should be framed to regulate the spending habit of the people. If private spending is desirable government should reduce the volume of taxation and vice versa.

4. Lerner was of the view that printing of money (deficit finance) should take place only when it is needed to implement functional finance in spending or lending (repayment of public debt). That is deficit financing should be used when current revenue falls short of expenditure during depression under inflation hoarding or destruction of money should be done.

Functional finance thus rejects completely the traditional doc­trines of “sound finance” and the principle of trying to balance the budget. Lerner observes “no budget balancing principle can be used for maintaining full employment and preventing inflation”. Thus functional finance has come to stay, whatever the reactions of the ortho­dox school. It has demolished the basis of the fiscal policy based on sound finance.

Roles of Functional Finance:

Role of Functional Finance under Inflation:

Functional finance can be used as an effective instrument to fight inflation and depression.

The various instruments of the fiscal sys­tem functions in the following way under inflation:

1. Budgetary Policy:

According to the policy of functional finance, government should not adopt a balanced budget during inflation; government should follow a surplus budget.

By resorting to heavy taxation and extensive bor­rowing, the excess purchasing power in the economy should be neutralized. Government should apply drastic cut in expenditure programmes to deal with inflationary force. All these measures should result in surplus budget, which act as an anti-dot during inflation.

2. Government Expenditure Policy:

Inflation is a situation in which aggregate effective demand increases too much due to unregulated private expenditure. To counter increased private spending government at such a time, should reduce its ex­penditure to the possible extend. All unproductive and wasteful ex­penditure should be minimized.

3. Taxation Policy:

As an anti-inflationary weapon taxation policy has much significance. During inflation, the problem is to reduce the size of the disposable income. Hence taxation must be resorted to take away the excess purchasing power from the people. For this the rate of existing taxes should be increased steeply. Moreover if needed new taxes should be imposed.

4. Public Borrowing: 

The object of public borrowing should be to take away from the pub­lic excess purchasing power. Government can resort to voluntary and if needed compulsory methods to raise loans. Coupled with this the existing public debt should be managed in such a manner as to reduce the existing money supply and to prevent credit expansion.

Anti-inflationary debt management required the payment of bank held debt out of a budget surplus. That is during inflation government securities should be repaid through a budgetary surplus. Thus by resorting to a surplus budget, increasing the volume of taxation, reducing the rate of expenditure and by resorting to public borrowing, the inflationary forces can be controlled under inflation.

Role of Functional Finance under Deflation:

Deflation or unemployment is the result of deficiency in private spend­ing. Hence fiscal policy under deflation should be fine-tuned to in­creasing consumption and investment expenditure.

For achieving this various instruments of functional finance should be adjusted in the following way:

1. Budgetary Policy:

Budgetary policy of the government is geared to fight depression and unemployment. The need of depression is an increased flow of income. This according to Keynes can only be realized through a deficit budget.

Government should spend more than its ordinary rev­enue collection. The deficit so incurred should be met either by bor­rowing from the bank or through printing of currency. The injection of more money into circulation will stimulate private spending and eco­nomic recovery. In this context prof.

Gunnar Myrdal remarked “Un­der balancing the budget during depression is not primarily a deliber­ate policy but a practical necessity.” Hence as an anti-inflationary tool deficit budget is a virtue.

2. Taxation Policy:

As an anti-depression policy fiscal policy, should aim at increasing both consumption and investment expenditure. For realizing this ob­jective taxation policy can render valuable help to the government. Taxation policy in depression, according to Keynes should be de­signed to stimulate both consumption and investment. This can be achieved by reducing the burden of taxation on the community.

Com­modity taxation should be reduced to the possible extend, to stimu­late consumption. Moreover reduction in excise duty, sales tax etc. will also help to increase the propensity to consume of the commu­nity. Coupled with this to boost investment, business and corporate tax should be slashed down to increase consumption during defla­tion.

3. Expenditure Policy:

The deficiency in effective demand during depression can be miti­gated through increased public expenditure. Public expenditure ac­cording to Keynes is a best anti-depression tool to recover eco­nomic activity.

Government should increase the volume of development expen­diture on public works programmes and social security measures. The expenditure incurred on public works programme and social security measures are together called compensatory spending.

Keynes opines that government should always keep at hands cer­tain well planned schemes of public works such as road construc­tion, building, parks, schools, canals, hospitals etc. to be enforced during depression.

This type of development works will generate em­ployment not only directly but also indirectly. Increased employment leads to additional income and increased effective demand. This will help to enhance productive capacity and remove the evils of depres­sion

4. Public Debt Policy:

During depression government should resort to a deficit budget. The deficit caused in the government budget should be met particularly or wholly by borrowed money. That is public borrowing should be re­sorted during deflation to meet the budget deficit.

However in order to keep the burden of public debt low, the government should aim at a policy of low interest rate during depression. Government should also try to borrow from those sections of population with whom the funds are laying idle.

“Thus the role of fiscal policy can be linked to the driving of a car. While driving up a gradient, what is needed is an increase in power. On the other hand, when it moves against the national interest it is necessary to control the supply of power and also to apply breaks judiciously to ensure that the vehicle does not slip out of control but keeps a moving all the same. The national exchequer could see that the breaks are not pressed so much as to bring the vehicle to a stop.”

What is imperative is a continuous and judicious use of fiscal policy, in tune to the existing circumstances.

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