UPSC Prelims 2013 Q84: Indian Economy – Fiscal Policy & Budget
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) Borrowing from banks to finance a budget deficit
- (d) Creating new money to finance a budget deficit
Answer: (d) Creating new money to finance a budget deficit
Explanation
Which is most inflationary?
| Option | Effect on money supply | Inflationary? |
|---|---|---|
| (a) Repayment of public debt | Returns money to lenders; no new money | Mild |
| (b) Borrowing from the public | Only shifts existing money from people to the Government | Least |
| (c) Borrowing from banks | Banks may create some new credit | Moderate |
| (d) Creating new money | Adds brand-new money with no new goods | Most |
Why new money is the worst:
| Step | Result |
|---|---|
| RBI prints money for the Government | Money supply rises |
| Goods stay the same | Too much money chases too few goods |
| Prices rise | Inflation |
This is called monetisation of the deficit.
India stopped automatic monetisation by ending ad hoc treasury bills in 1997; the FRBM Act, 2003 bars the RBI from buying Government bonds in the primary market.
Answer: (d) Creating new money to finance a budget deficit.
Why each option is right or wrong
- (a) Incorrect. Repayment of public debt does not create new money.
- (b) Incorrect. Borrowing from the public only moves existing money around.
- (c) Incorrect. Borrowing from banks is less inflationary than printing money.
- (d) CORRECT. Creating new money is the most inflationary way to finance a deficit.
Key point
Most to least inflationary: printing money (monetisation), borrowing from banks, borrowing from the public. Ad hoc treasury bills ended in 1997.
Remember
Printing money is the most inflationary.
Common mistakes
- Thinking all borrowing is equally inflationary.
- Not knowing the term monetised deficit.
- Forgetting the 1997 reform that ended automatic money creation.
Exam tip
New money with no new goods = pure inflation.
Sources
- NCERT Class XII — Introductory Macroeconomics, Ch 5 (Government Budget and the Economy)
- Fiscal Responsibility and Budget Management Act, 2003