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

• Repayment of public debt
• Borrowing from the public to finance a budget deficit
• Borrowing from the banks to finance a budget deficit
• Creation of new money to finance a budget deficit

Answer: d) Creation of new money to finance a budget deficit

Notes:

• Deficit financing means generating funds to finance the deficit which results from excess of expenditure over revenue. The gap being covered by borrowing from the public by the sale of bonds or by printing new money.
• There are three ways to finance a budget:
  • ​Creating new currency
  • Borrowing from internal sources like RBI, issuing bonds, etc.
  • Borrowing from External sources like WB, IMF, etc.
• Government expenditure by printing money boosts incomes and raises private demand in the economy. Thus, it fuels inflation. A little increase in inflation is healthy as it encourages business activity. But if the government doesn’t stop in time, more and more money floods the market and creates high inflation.
  • And since inflation is revealed with a lag, it is often too late before governments realise, they have over-borrowed. Higher inflation and higher government debt provide grounds for macroeconomic instability. 
• Borrowing from the public by issuing bonds at a lower interest rate will not create inflation. Similarly, borrowings from banks will not generate inflation.