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

(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 ✓ UPSC's answer

Why the answer is (d)

• Financing a deficit by creating new money (deficit monetisation, i.e. the RBI printing money to buy government bonds) directly expands the monetary base without any offsetting reduction in private spending, so it is the most inflationary — option (d).

• Borrowing from the public (b) transfers existing money from savers to the government and is least inflationary; borrowing from banks (c) creates some deposit money but is constrained by bank reserves.

• Repaying public debt (a) returns money to the public and can be mildly expansionary but is not deficit financing.

• India ended automatic monetisation through ad hoc treasury bills in 1997.

• Hence option (d).

Why the other options are wrong

(a) Repayment of public debt: Debt repayment is not deficit financing and is only mildly expansionary.
(b) Borrowing from the public to finance a budget deficit: Borrowing from the public recycles existing money and is least inflationary.
(c) Borrowing from the banks to finance a budget deficit: Bank borrowing is less inflationary than printing new money.

Asked in the GS Paper I of the UPSC Civil Services Preliminary Examination 2021, held on 10 October 2021. Question and answer key: Union Public Service Commission. Explanation: UPSC Answer Check.