Previous Year Question

The inflationary effect of different methods of financing a Budget Deficit depends upon whether they create additional Money Supply or merely transfer existing purchasing power from one sector to another.

Option (d) is the most inflationary

When the Central Bank creates new money to finance the Government’s deficit, the process is called Monetisation of Deficit.

In this process:

The Government may issue securities to the Central Bank.

The Central Bank provides newly created money in exchange.

Government expenditure introduces this money into the economy.

The Banking Multiplier may produce an additional effect on Broad Money.

If the real production of goods and services does not increase proportionately, a larger amount of money pursues limited output and the general price level may rise.

This can be understood through the Quantity Equation:

MV = PY

Where:

M = Money Supply

V = Velocity of Money

P = Price Level

Y = Real Output

If V remains relatively stable and M increases faster than Y, a significant part of the adjustment may occur through an increase in P.

Thus, creating new money provides the most direct inflationary form of deficit financing.

Option (a): Repayment of public debt

When the Government repays the principal on public debt, liquidity in the hands of households or institutions increases. Aggregate demand may rise if the recipients spend the money.

However, debt repayment does not necessarily create new money. It may be financed through:

Tax Revenue;

Fresh market borrowing; or

Existing cash balances.

Its inflationary effect therefore depends upon the source used for repayment.

Option (b): Borrowing from the public

When the Government sells bonds or securities to the public, purchasing power is transferred from the public to the Government.

Ordinarily:

No immediate new Money Supply is created.

Private consumption or investment capacity may decline.

Government borrowing may exert upward pressure on market interest rates.

This may produce a Crowding Out effect. It is therefore less inflationary than creating new money.

Option (c): Borrowing from banks

The impact of Government borrowing from banks depends upon whether banks use:

Existing deposits and liquidity; or

Additional Central Bank liquidity to support credit creation.

Bank borrowing may affect liquidity and Money Supply, but it is generally less direct than creating fresh High-Powered Money specifically to finance the deficit.

Conclusion

Among the four alternatives, creating new money to finance the Budget Deficit most directly expands nominal purchasing power. Option (d) is therefore the most inflationary.