UPSC Prelims 2021 Q10: Indian Economy – Human Development, Poverty & Employment Schemes
- (a) Repayment of public debt
- (b) Borrowing from the public to finance a budget deficit
- (c) Borrowing from the banks to finance a budget deficit
- (d) Creation of new money to finance a budget deficit
Answer: (d) Creation of new money to finance a budget deficit
Explanation
Which Deficit Financing Option Is Most Inflationary?
| Option | Money Supply Impact | Inflationary Effect |
|---|---|---|
| Repayment of public debt | Neutral or contractionary | Not inflationary |
| Borrowing from public (bonds) | No new money created; only transfers existing money | Low - crowds out private investment |
| Borrowing from banks | Some money creation via bank credit multiplier | Moderate |
| Creation of new money (monetisation) | Direct expansion of money supply (M0) | HIGHEST inflation |
Deficit monetisation (RBI printing new money to buy government bonds) directly expands the monetary base and, via the money multiplier, causes broad money (M3) to expand. Since output is fixed in the short run, this raises prices. Zimbabwe, Weimar Germany, Venezuela are classic hyperinflation cases from monetisation.
Answer: (d) Creation of new money to finance a budget deficit.
Why each option is right or wrong
- (a) Incorrect. Repayment of public debt is anti-inflationary - it withdraws money from circulation.
- (b) Incorrect. Public borrowing transfers existing money to government, does not expand money supply.
- (c) Incorrect. Bank borrowing creates some money but less than direct monetisation.
- (d) CORRECT. Creation of new money (monetary financing/monetisation of deficit) directly expands the monetary base, triggers the money multiplier, and causes broad money to rise faster than output - the most inflationary route.
Key point
Most inflationary = creating new money to finance deficit (monetisation). Directly expands M0, then M3 via multiplier, chasing fixed output = inflation. This is why FRBM Act 2003 banned RBI from primary G-Sec purchases (except in emergencies).
Remember
Creation of new money to finance a budget deficit (deficit monetisation) is the most inflationary. It directly expands the monetary base, triggers the money multiplier, and pushes broad money growth beyond output growth - causing sustained inflation. FRBM Act 2003 restricted this practice in India.
Common mistakes
- Confusing public borrowing (transfer of existing money) with money creation (new money).
- Not knowing FRBM Act 2003 prohibits automatic monetisation of deficit. RBI can only buy G-Secs in the secondary market.
- Missing that OMOs and QE are indirect monetisation. During COVID, RBI's G-SAP was a form of controlled monetisation.
Exam tip
Deficit financing ranking (least to most inflationary): Tax > External aid > Public borrowing > Bank borrowing > Money creation. FRBM Act 2003 restricted deficit monetisation to preserve macro stability. Look up Zimbabwe hyperinflation - textbook monetisation case.
Sources
- NCERT Class XII Macroeconomics - Chapter on Money and Banking
- Fiscal Responsibility and Budget Management (FRBM) Act, 2003