Previous Year Question

The correct answer is an increase in money supply.

In this question, Deficit Financing is used in its traditional sense, where the Government finances the gap between its expenditure and receipts through a mechanism that results in the creation of new money/reserve money. Consequently, the money supply in the economy increases.

In simple terms, when Government expenditure exceeds its receipts and the deficit is financed through the creation of additional monetary liabilities by the Central Bank, additional reserve money enters the banking system. Through the money multiplier, this can also expand the broader money supply.

Therefore, a reduction in taxes is not a necessary consequence of deficit financing. Similarly, an increase in wages is not its direct and inevitable effect. An increase in money supply, however, is the direct effect associated with the traditional monetised-deficit mechanism.

If the increase in money supply exceeds the growth of production of goods and services, it can generate inflationary pressure. India's historical experience also shows the inflationary implications associated with monetised fiscal deficits and monetary expansion.

Current Status

An important modern distinction is necessary. Not every Fiscal Deficit today is financed by “printing new money.” When a Government finances its deficit through market borrowing, its immediate effects differ from direct Central Bank monetisation and may operate through interest rates, Government borrowing and private investment.

India discontinued automatic monetisation through ad hoc Treasury Bills from 1 April 1997 and replaced it with the limited Ways and Means Advances (WMA) mechanism. The subsequent fiscal framework also placed general restrictions on direct Central Government borrowing from the RBI.

Thus, for this remember—

Traditional Deficit Financing → Creation of money → Increase in Money Supply → Inflationary tendency