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Q40 (IAS/2021) Economy › Money, Banking & Inflation › Inflation and policy Official Key

Which one of the following is likely to be the most inflationary in its effects?

Result
Your answer: —  ·  Correct: D
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.

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Out of everyone who attempted this question.
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got it right
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Don’t just practise – reverse-engineer the question. This panel shows where this PYQ came from (books / web), how the examiner broke it into hidden statements, and which nearby micro-concepts you were supposed to learn from it. Treat it like an autopsy of the question: what might have triggered it, which exact lines in the book matter, and what linked ideas you should carry forward to future questions.
Q. Which one of the following is likely to be the most inflationary in its effects? [A] Repayment of public debt [B] Borrowing from the pu…
At a glance
Origin: Mixed / unclear origin Fairness: Moderate fairness Books / CA: 7.5/10 · 0/10

This 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.

How this question is built

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?
Origin: Weak / unclear Fairness: Borderline / guessy
Indirect textbook clues
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > 4.8 Perspectives on Deficit and Debt > p. 158
Strength: 5/5
“One of the main criticisms of deficits is that they are inflationary. This is because when government increases spending or cut taxes, aggregate demand increases. Firms may not be able to supply/produce higher quantities that are being demanded at the ongoing prices, resulting in an increase in price. However, if there are unutilised resources in the economy and the output is held back by lack of demand then a higher fiscal deficit will be accompanied by higher demand and higher supply/output and therefore it may not be inflationary. If the economy is in boom phase and the economic resources are fully utilized then if government incurs fiscal deficit, there is a decrease in private investment due to reduction in the amount of savings available to the private sector.”
Why relevant

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).

How to extend

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 non‑inflationary, especially when resources are fully utilised.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 5: Indian Tax Structure and Public Finance > IMPLICATIONS OF FISCAL DEFICIT > p. 111
Strength: 5/5
“• It implies greater borrowings by the Central Government. Borrowings from RBI raise the money supply in the economy, which results in rise in the general price level over a period of time. This leads to inflationary spiral.• Its affects GDP growth as a significant amount of budgeted revenue is spent on the payment of interest on borrowings by the Central Government, thus resulting in reduced investment.”
Why relevant

States that borrowings from the RBI raise the money supply and cause rising price levels (an inflationary channel).

How to extend

One can infer the reverse: if repayment reduces RBI/central bank financing, it may contract money supply and thus be disinflationary — testable by checking financing source during repayment.

Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad > p. 72
Strength: 4/5
“Net borrowing at home includes that directly borrowed from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR). The gross fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the economy. From the way gross fiscal deficit is measured as given above, it can be seen that revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital Expenditure - non-debt creating capital receipts). A large share of revenue deficit in fiscal deficit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.”
Why relevant

Breaks down gross fiscal deficit into net borrowing at home, borrowing from RBI and abroad, highlighting different instruments/sources of government finance.

How to extend

A student could use this to examine which component is being repaid (e.g., RBI vs public) since repaying central‑bank debt has different monetary effects than repaying debt held by the public.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 4: Inflation > begin{array}{|c|c|c|c|c|c|c|c|c|c|c|c|c|c|c|c|c} > p. 79
Strength: 3/5
“• 6. Which one of the following is likely to be the most inflationary in its effect? • (a) Repayment of public debt • (b) Borrowing from the public to finance a budget deficit • (c) Borrowings from banks to finance a budget deficit • (d) Creating new money to finance a budget deficit • 7. Economic growth is usually coupled with • (a) Deflation (b) Inflation• (c) Stagflation (d) Hyperinflation.• 8. A rapid increase in inflation is sometimes attributed to the 'base effect'.”
Why relevant

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.

How to extend

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.

Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 15: Budget and Economic Survey > Indirect Taxes > p. 452
Strength: 3/5
“In combination with the still-existing supply disruptions and constraints, the overheating of the economy led to inflationary pressures. While a sudden withdrawal may have costs for medium-term growth, a slow withdrawal may be inflationary and hence put upward pressure on yields, making the debt costly.• 13. Major reforms in the Union budget over the last few years: • Improved fiscal transparency and realistic revenue assumptions in the Budget (No Extra Budgetary Resources were estimated for FY 23 in the Budget)• Discontinuation of Plan and Non-plan classification• Merger of railway budget with the main budget• Shifting the date of budget to 1 February”
Why relevant

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.

How to extend

Extend by considering repayment as a form of fiscal withdrawal; examine whether rapid vs slow repayment would differently affect inflation and yields in practice.

Statement 2
Does borrowing from the public to finance a government budget deficit tend to be inflationary?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > 4.8 Perspectives on Deficit and Debt > p. 158
Presence: 5/5
“One of the main criticisms of deficits is that they are inflationary. This is because when government increases spending or cut taxes, aggregate demand increases. Firms may not be able to supply/produce higher quantities that are being demanded at the ongoing prices, resulting in an increase in price. However, if there are unutilised resources in the economy and the output is held back by lack of demand then a higher fiscal deficit will be accompanied by higher demand and higher supply/output and therefore it may not be inflationary. If the economy is in boom phase and the economic resources are fully utilized then if government incurs fiscal deficit, there is a decrease in private investment due to reduction in the amount of savings available to the private sector.”
Why this source?
  • Explicitly identifies a main criticism of deficits as being inflationary and explains the mechanism: higher government spending (or tax cuts) raises aggregate demand leading to higher prices.
  • Notes the important conditional: if resources are underutilised the deficit may not be inflationary, implying inflationary tendency depends on economic capacity.
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Debt > p. 79
Presence: 4/5
“When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today. It has often been argued that 'debt does not matter because we owe it to ourselves'. This is because although there is a transfer of resources between generations, purchasing power remains within the nation. However, any debt that is owed to foreigners involves a burden since we have to send goods abroad corresponding to the interest payments. Other Perspectives on Deficits and Debt : One of the main criticisms of deficits is that they are inflationary.”
Why this source?
  • States that one of the main criticisms of deficits is that they are inflationary, supporting the general link between government deficits and inflationary pressure.
  • Positions government borrowing as equivalent in effect to present spending financed by future taxes, reinforcing the demand-side channel.
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad > p. 72
Presence: 3/5
“Net borrowing at home includes that directly borrowed from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR). The gross fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the economy. From the way gross fiscal deficit is measured as given above, it can be seen that revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital Expenditure - non-debt creating capital receipts). A large share of revenue deficit in fiscal deficit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.”
Why this source?
  • Defines net borrowing at home as borrowing directly from the public through debt instruments, connecting 'borrowing from the public' to the fiscal deficit concept.
  • Allows inference that the inflationary critique of deficits (from other passages) applies to deficits financed via public borrowing as part of net domestic borrowing.
Statement 3
Does borrowing from commercial banks to finance a government budget deficit tend to be inflationary?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 4: Inflation > a) Demand Side Factors/Causes for Inflation > p. 70
Presence: 5/5
“(a) Demand Side Factors/Causes for Inflation • Due to rise in non-developmental Government expenditure. • Due to increase in deficit financing, i.e. financing the deficits by borrowing funds from ğ. the banking system.”
Why this source?
  • Explicitly lists financing deficits by borrowing from the banking system as a demand-side cause of inflation.
  • Directly links bank-financed deficit financing to upward pressure on the general price level.
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad > p. 72
Presence: 4/5
“Net borrowing at home includes that directly borrowed from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR). The gross fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the economy. From the way gross fiscal deficit is measured as given above, it can be seen that revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital Expenditure - non-debt creating capital receipts). A large share of revenue deficit in fiscal deficit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.”
Why this source?
  • Describes commercial banks purchasing government securities (including via SLR), showing how banks finance the fiscal deficit.
  • Identifies the banking channel through which government borrowing at home can alter domestic liquidity and affect price stability.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > 4.8 Perspectives on Deficit and Debt > p. 158
Presence: 4/5
“One of the main criticisms of deficits is that they are inflationary. This is because when government increases spending or cut taxes, aggregate demand increases. Firms may not be able to supply/produce higher quantities that are being demanded at the ongoing prices, resulting in an increase in price. However, if there are unutilised resources in the economy and the output is held back by lack of demand then a higher fiscal deficit will be accompanied by higher demand and higher supply/output and therefore it may not be inflationary. If the economy is in boom phase and the economic resources are fully utilized then if government incurs fiscal deficit, there is a decrease in private investment due to reduction in the amount of savings available to the private sector.”
Why this source?
  • Explains the general mechanism: fiscal deficits raise aggregate demand, which tends to be inflationary when resources are fully utilised.
  • Provides the important conditional qualification that deficits need not be inflationary if there are idle resources — clarifying when bank-financed deficits cause inflation.
Statement 4
Does creation (monetization) of new money to finance a government budget deficit tend to be inflationary?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > Impact of "Monetization of Deficit" > p. 165
Presence: 5/5
“• Helps in increasing aggregate demand in the economy thereby resulting in economic growth• Results in increase in debt on Government thereby impacting overall macro-economic stability and may result in ratings downgrade• Increases inflation due to increased money supply• Increased money supply may result in depreciation of rupee which can lead to flight of capital from the country• RBI can be seen as losing control over its monetary policy• As such there is no issue if it is done once in exceptional circumstances but in India the problem is once it is done, then it will lure future governments of an easy route of financing their deficit "Deficit Financing": It generally means that Govt. is having deficit (as expenses are more than receipts) which can be financed from different sources like from market borrowing or borrowing from abroad or there can also be the case that Govt may ask RBI to finance its deficit by printing more money. (So, in deficit financing there can be various options to finance Govt.'s deficit and one of the options could be from RBI by printing cash)”
Why this source?
  • Explicitly links monetization/deficit financing by printing money to an increase in money supply.
  • Directly asserts that increased money supply from monetization increases inflation and can depreciate the currency.
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 101
Presence: 5/5
“Deficit financing through central bank borrowing Financing of budget deficit by the government through borrowing money from the central bank. Leads to increase in money supply in an economy and may result in inflation. Depreciation A decrease in the price of the domestic currency in terms of the foreign currency under floating exchange rates. It corresponds to an increase in the exchange rate. Depreciation Wear and tear or depletion which capital stock undergoes over a period of time. Devaluation The decrease in the price of domestic currency under pegged exchange rates through official action. Double coincidence of wants A situation where two economic agents have complementary demand for each others' surplus production.”
Why this source?
  • Defines central bank borrowing/deficit financing as increasing money supply.
  • States that such an increase in money supply may result in inflation.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 5: Indian Tax Structure and Public Finance > IMPLICATIONS OF FISCAL DEFICIT > p. 111
Presence: 5/5
“• It implies greater borrowings by the Central Government. Borrowings from RBI raise the money supply in the economy, which results in rise in the general price level over a period of time. This leads to inflationary spiral.• Its affects GDP growth as a significant amount of budgeted revenue is spent on the payment of interest on borrowings by the Central Government, thus resulting in reduced investment.”
Why this source?
  • Explains that borrowings from the central bank raise money supply in the economy.
  • Links the rise in money supply to a subsequent rise in the general price level (inflationary spiral).
Pattern takeaway: UPSC loves 'Degree of Impact' questions (e.g., 'Most inflationary', 'Best measure'). They test if you understand the transmission mechanism. The pattern is to compare Fiscal tools (Taxes/Spending) vs Monetary tools (Printing/Interest Rates).
How you should have studied
  1. [THE VERDICT]: Sitter. Directly solvable from NCERT Class XII Macroeconomics (Chapter 5: Government Budget and the Economy).
  2. [THE CONCEPTUAL TRIGGER]: Deficit Financing methods and their impact on High-Powered Money (Reserve Money).
  3. [THE HORIZONTAL EXPANSION]: 1. Crowding Out Effect: Borrowing from public increases interest rates, hurting private investment. 2. Money Multiplier: Printing money increases Base Money (H), which expands Money Supply (M3) by a multiple. 3. Seigniorage: The profit govt makes by printing currency. 4. Inflation Tax: The penalty on holders of cash when govt prints money. 5. Sterilization: RBI selling bonds to neutralize inflationary impact of forex inflows.
  4. [THE STRATEGIC METACOGNITION]: Don't just memorize definitions. Rank policy tools by their 'Liquidity Impact'. Borrowing = Transfer of liquidity (Neutral/Low Inflation). Printing = Injection of new liquidity (High Inflation). Always look for the option that changes the 'Base Money'.
Concept hooks from this question
📌 Adjacent topic to master
S1
👉 Fiscal deficits and inflationary pressure
💡 The insight

A fiscal deficit raises aggregate demand and can produce inflationary pressure when resources are fully utilised.

High-yield concept for UPSC: it explains why questions ask whether government borrowing or spending causes inflation, links budget policy to aggregate demand and price level, and helps evaluate trade-offs between growth and price stability. Mastering this enables answers on when deficits are inflationary and when they are not (output gap, utilisation of resources).

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > 4.8 Perspectives on Deficit and Debt > p. 158
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Debt > p. 79
🔗 Anchor: "Is repayment of public debt inflationary in its effects in the context of govern..."
📌 Adjacent topic to master
S1
👉 Methods of deficit financing (RBI monetisation vs market borrowing)
💡 The insight

The channel of financing matters: borrowing from the central bank increases money supply and is inflationary compared with non-monetary market borrowing.

Essential for UPSC answers distinguishing sources of public finance and their macro effects; it connects fiscal operations to monetary outcomes (money supply, inflation, interest rates) and helps handle questions on policy instruments and implications of monetising debt.

📚 Reading List :
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 5: Indian Tax Structure and Public Finance > IMPLICATIONS OF FISCAL DEFICIT > p. 111
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad > p. 72
🔗 Anchor: "Is repayment of public debt inflationary in its effects in the context of govern..."
📌 Adjacent topic to master
S1
👉 Debt sustainability and the interest–growth differential (IRGD)
💡 The insight

Repayment burden and policy choices depend on the difference between interest rates and economic growth; a favourable IRGD makes debt manageable without inflationary financing.

Important for essays and economic policy questions: links public debt dynamics to growth strategy, explains why growth-oriented fiscal policy can lower debt-to-GDP, and helps assess whether repayment pressures force inflationary measures.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > Findings from previous years Economic Surveys > p. 159
🔗 Anchor: "Is repayment of public debt inflationary in its effects in the context of govern..."
📌 Adjacent topic to master
S2
👉 Deficit financing methods
💡 The insight

Financing a budget deficit can be done via taxation, borrowing from the public, borrowing from the central bank, or printing money, and the method affects macro outcomes.

High-yield for UPSC because questions often ask how financing choices alter money supply, inflation and fiscal sustainability; links public finance to monetary policy and debt metrics. Mastery enables comparison-type answers and policy evaluation.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Debt > p. 78
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad > p. 72
🔗 Anchor: "Does borrowing from the public to finance a government budget deficit tend to be..."
📌 Adjacent topic to master
S2
👉 Fiscal deficits and inflationary pressure
💡 The insight

A fiscal deficit can raise aggregate demand and thereby exert upward pressure on prices, making deficits a common source of inflationary concern.

Essential for explaining macroeconomic trade-offs in answers on inflation, fiscal policy and growth; helps frame conditional answers (when deficits are inflationary vs not).

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > 4.8 Perspectives on Deficit and Debt > p. 158
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Debt > p. 79
🔗 Anchor: "Does borrowing from the public to finance a government budget deficit tend to be..."
📌 Adjacent topic to master
S2
👉 Money creation vs. market borrowing
💡 The insight

Borrowing from the central bank (money creation) increases money supply and is directly inflationary, whereas borrowing from the public is a non-monetary financing route with different effects.

Clarifies a frequent UPSC distinction between inflationary mechanisms; important for questions on deficit financing tools, monetary financing bans, and crowding-out. Enables precise policy prescriptions.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 101
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 5: Government Budget and the Economy > Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad > p. 72
🔗 Anchor: "Does borrowing from the public to finance a government budget deficit tend to be..."
📌 Adjacent topic to master
S3
👉 Deficit financing increases money supply (monetization)
💡 The insight

Monetizing a fiscal deficit (borrowing from the central bank) raises money supply and tends to be inflationary.

High-yield for UPSC because it links fiscal operations to monetary outcomes and inflation. It connects fiscal policy, RBI actions, and price-level dynamics, enabling answers on causes of inflation and policy trade-offs.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 101
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 5: Indian Tax Structure and Public Finance > IMPLICATIONS OF FISCAL DEFICIT > p. 111
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > Impact of "Monetization of Deficit" > p. 165
🔗 Anchor: "Does borrowing from commercial banks to finance a government budget deficit tend..."
🌑 The Hidden Trap

The 'Crowding Out' Effect. Since borrowing from the public (Option B) is NOT the most inflationary, its primary negative externality is 'Crowding Out'—it soaks up loanable funds, spikes interest rates, and reduces private investment. Expect a question asking which method 'hurts private investment the most'.

⚡ Elimination Cheat Code

Use the 'Conservation of Money' logic. Options A, B, and C involve moving *existing* money from one pocket (public/banks) to another (government). The total pool of money remains roughly constant. Option D involves 'Creation'. Creation > Transfer. The option introducing a *new* variable (New Money) is mathematically the outlier.

🔗 Mains Connection

Mains GS-3 (Fiscal Policy): Link this to the FRBM Act and the N.K. Singh Committee recommendations. The committee strictly prohibited direct monetization of deficit (Option D) except in 'Escape Clause' scenarios (War, Calamity, Structural Collapse) precisely because of this inflationary risk.

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SIMILAR QUESTIONS

IAS · 2013 · Q59 Relevance score: 8.54

Which one of the following is likely to be the most inflationary in its effect?

CDS-I · 2023 · Q103 Relevance score: 0.78

Which one of the following situations can lead to inflation?

CDS-II · 2016 · Q90 Relevance score: -0.67

Which of the following will be the outcome if an economy is under the inflationary pressure? 1. Domestic currency heads for depreciation. 2. Exports become less competitive with imports getting costlier. 3. Cost of borrowing decreases. 4. Bondholders get benefitted. Select the correct answer using the code given below.

CDS-I · 2023 · Q31 Relevance score: -1.47

Which one of the following is a measure that can be used by the Government for combatting inflation?