Question map
Which one of the following is likely to be the most inflationary in its effects?
Explanation
The correct answer is Option 4: Creation of new money to finance a budget deficit.
Inflations occurs when the money supply grows faster than the economy's output of goods and services. Here is why the options differ in their impact:
- Option 4 (Correct): Also known as "deficit financing" or "monetizing the debt," this involves the central bank printing new currency. This directly increases the total money supply in the economy without reducing purchasing power elsewhere, leading to "too much money chasing too few goods," which is highly inflationary.
- Options 2 and 3: Borrowing from the public or commercial banks merely transfers existing money from private hands to the government. Since the total money supply remains relatively constant, the inflationary pressure is significantly lower.
- Option 1: Repayment of debt puts money back into the hands of the public, but it is generally less inflationary than the creation of entirely new currency.
Therefore, Option 4 is the most inflationary as it results in a net increase in the high-powered money base of the economy.
PROVENANCE & STUDY PATTERN
Guest previewThis is a fundamental static concept from NCERT Macroeconomics (Class XII). It tests the hierarchy of money supply expansion mechanisms. If you understand the difference between 'transferring' existing purchasing power (borrowing) and 'creating' new purchasing power (printing), this is a 10-second sitter.
This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.
- Statement 1: Is repayment of public debt inflationary in its effects in the context of government fiscal operations?
- Statement 2: Does borrowing from the public to finance a government budget deficit tend to be inflationary?
- Statement 3: Does borrowing from commercial banks to finance a government budget deficit tend to be inflationary?
- Statement 4: Does creation (monetization) of new money to finance a government budget deficit tend to be inflationary?
Gives the general rule that fiscal deficits are inflationary because higher government spending raises aggregate demand, but notes inflationary effects depend on resource utilisation (idle resources reduce inflationary pressure).
A student could extend this by asking whether debt repayment (which reduces future deficit or withdraws demand) would lower aggregate demand and thus be less or nonâinflationary, especially when resources are fully utilised.
States that borrowings from the RBI raise the money supply and cause rising price levels (an inflationary channel).
One can infer the reverse: if repayment reduces RBI/central bank financing, it may contract money supply and thus be disinflationary â testable by checking financing source during repayment.
Breaks down gross fiscal deficit into net borrowing at home, borrowing from RBI and abroad, highlighting different instruments/sources of government finance.
A student could use this to examine which component is being repaid (e.g., RBI vs public) since repaying centralâbank debt has different monetary effects than repaying debt held by the public.
Presents a standard exam question listing repayment of public debt among options about what is most inflationary, implying conventional comparisons among repayment, public borrowing, bank borrowing and money creation.
A student could use typical answer logic (money creation most inflationary) to infer repayment is generally not viewed as the most inflationary and thus may be neutral or deflationary relative to those alternatives.
Notes that policy withdrawal speed matters: slow withdrawal of stimulus may be inflationary and push up yields, linking fiscal stance changes to inflation and debt costs.
Extend by considering repayment as a form of fiscal withdrawal; examine whether rapid vs slow repayment would differently affect inflation and yields in practice.
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