UPSC Prelims 2021 Q10: Deficit Financing and Inflation — Explained
Which one of the following is likely to be 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
Statement-wise explanation
- a: incorrect — Repaying public debt returns money to bondholders. That money usually comes from tax revenue or fresh borrowing, so the government is passing on purchasing power it has already taken from the economy. The net addition to money supply is small. Repayment out of a revenue surplus is usually counted as neutral or mildly deflationary.
- b: incorrect — When the government borrows from the public by selling bonds to households and firms, savings that already exist move from private hands to the government. The total money supply does not change. Spending power moves from one group to another and is not added. Among the ways of financing a deficit, this is the least inflationary.
- c: incorrect — Commercial banks that use spare reserves to buy government securities can add to the money supply. Net bank credit to government is one of the sources of broad money (M3) that the RBI tracks. The expansion is limited by banks' reserves, and lending to the government can reduce credit to private borrowers (crowding out). The inflationary effect is moderate, not the highest.
- d: correct — Creating new money means the RBI issues fresh reserve money (M0, high-powered money) to pay for the deficit. As banks lend this money on, it grows through the money multiplier into a much larger increase in broad money. The economy gains purchasing power without producing more goods. In India this was done through ad hoc Treasury Bills until they were discontinued from 1 April 1997.
How to eliminate
Ask one question of each option: does it add new money, or does it only move existing money around? Borrowing from the public only moves existing savings to the government, so it can be ruled out quickly. Repaying debt is the opposite of running a deficit, and it is paid for out of money the government has already collected, so it is a weak candidate. That leaves bank borrowing and new money. Bank borrowing adds money only as far as banks' reserves allow. New money adds reserve money, which then multiplies across the whole banking system. The words 'most inflationary' point to the option with no ceiling on new purchasing power. The fact to remember: deficit financing in its strict sense, meaning money creation by the central bank, is the most inflationary way to fund a deficit, and borrowing from the public is the least.
Know more
Ways of financing a budget deficit and how inflationary each one is
A government that spends more than it earns has to close the gap. The source of the money decides how much new purchasing power enters the economy.
| Method | What happens to money supply | Inflationary effect |
|---|---|---|
| Borrowing from the public (bonds, small savings) | Existing savings move to the government; no new money | Lowest |
| Borrowing from commercial banks | Can rise if banks lend out spare reserves; may crowd out private credit | Moderate |
| Borrowing from the central bank / printing money | Reserve money (M0) rises and multiplies into broad money (M3) | Highest |
| External borrowing | Brings in foreign exchange; the effect depends on how it is used | Variable |
Why money creation tops the list. Money issued by the RBI is high-powered money. Banks keep part of it as reserves and lend out the rest, and each loan creates new deposits. One rupee of reserve money can therefore support several rupees of broad money. This ratio is the money multiplier. If output does not grow as fast as the money, prices rise.
The Indian record.
- Until March 1997, the Centre's deficit was automatically monetised through ad hoc Treasury Bills. The RBI–Government agreement of March 1997 discontinued them from 1 April 1997. Ways and Means Advances (WMA) replaced them. WMA covers only temporary gaps between receipts and payments and is not a source of deficit financing.
- The FRBM Act, 2003 barred the RBI from subscribing to primary issues of Central Government securities from 2006-07. The Act allows exceptions only on the grounds it lists.
- Monetised deficit is the part of the fiscal deficit that the RBI pays for. It is the closest measure of new money created for the government.
The term deficit financing is used loosely for any way of covering a deficit. In the strict Indian usage it means money creation.
In the news
In 2020-21 the pandemic pushed the Centre's fiscal deficit to about 9.5% of GDP (revised estimate, Budget 2021-22). Economists and banks publicly debated whether the RBI should directly monetise the deficit, and this debate brought the inflation risk of money creation back into the news before the 2021 Prelims.
NCERT Concepts to Revise
- Deficit financing: The four options are different ways of covering a budget gap; this term has a specific meaning in Indian usage that matches one of them.
- Monetised deficit: This measures how much of the fiscal deficit the RBI pays for, which separates central-bank financing from other borrowing.
- Money multiplier: Explains why an increase in reserve money can expand total money far more than borrowing existing savings does.
- Money supply: The question turns on which method changes the total stock of money held by the public, not just who holds it.