Civil Services Prep

Prelims 2021 · Economy · Question 10

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

  1. Repayment of public debt
  2. Borrowing from the public to finance a budget deficit
  3. Borrowing from the banks to finance a budget deficit
  4. Creation of new money to finance a budget deficit

Answer

Creation of new money to finance a budget deficit

  • (a) Repayment of public debt: This generally transfers purchasing power back to debt holders; by itself it is not the most inflationary. Verdict: Not correct.
  • (b) Borrowing from the public to finance a budget deficit: This mobilizes existing savings, so no new money is created directly. Verdict: Less inflationary.
  • (c) Borrowing from the banks to finance a budget deficit: Bank credit can expand money supply, so it is inflationary, but usually less than direct monetization. Verdict: Inflationary, but not the most.
  • (d) Creation of new money to finance a budget deficit: This directly increases money supply without a matching rise in output, making it the most inflationary. Verdict: Correct.
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