Question 85 from UPSC CSE 2021 - Economics

Question

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

Accepted Answer

Correct Option: D. Creation of new money to finance a budget deficit

Strategy: Focus on identifying the action that directly increases the overall money supply. Borrowing from the public or banks merely shifts existing money and does not expand the total supply. Repayment of public debt is neutral or temporarily reduces public money holdings. In contrast, the creation of new money directly injects fresh currency, increasing the monetary base and purchasing power, making it the most inflationary action.

Key Info: Inflation occurs when there is an excess of money pursuing a limited supply of goods, often resulting from an increased money supply without a corresponding rise in economic output.

**How New Money Creation Drives Inflation**
The creation of new money, also known as deficit monetization or 'printing money', involves a central bank issuing new currency, typically by purchasing government securities directly. This action expands the monetary base and can cause demand-pull inflation.

**Less Inflationary Financing Methods**
* **Borrowing:** When the government borrows from the public or banks, it merely shifts existing money from the private sector to the government. This does not increase the total money supply and is therefore less inflationary.
* **Debt Repayment:** Repaying public debt generally does not increase the money supply and can even be deflationary if the funds are drawn from budget surpluses.

**Global and Historical Examples**
To mitigate inflation risk, institutions like India's Reserve Bank of India (RBI) have historically avoided deficit monetization, particularly under the Ways and Means Advances (WMA) system. Internationally, direct money creation has been linked to periods of high inflation, as seen in historical cases like Zimbabwe and Weimar Germany.

Answer

Option A: Repayment of public debt

Answer

Option B: Borrowing from the public to finance a budget deficit

Answer

Option C: Borrowing from the banks to finance a budget deficit