Which is most inflationary? UPSC Prelims PYQ 2021

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

Explanation

Option (d) is correct

Deficit financing involves raising funds to cover a deficit resulting from expenditures exceeding revenues. This shortfall is typically filled by borrowing from the public through bond sales or by issuing new currency. Monetising the fiscal deficit means the RBI buys government bonds directly, instead of the government borrowing from the financial markets. To finance this, the central bank prints more currency, which increases the overall money supply in the economy.
Inflationary Impact: This increase in money supply can lead to higher inflation because more money in the economy can drive up prices if not matched by an equivalent increase in goods and services.
Historical Context in India:
- Previous Practice: Historically, India used to monetise deficits by issuing short-term treasury bills to the RBI. These practices led to an increase in reserve money and contributed to inflationary pressures.
- Shift Away from Monetisation: Since the late 1980s and early 1990s, India made efforts to phase out monetisation. Agreements in 1994 and 1997 aimed to reduce and eventually stop this practice.
- By 2003, the Fiscal Responsibility and Budget Management (FRBM) Act was enacted to prohibit the RBI from participating in the primary issuance of government securities.
FRBM Act and Its Provisions:
- Act’s Stipulations: The Act barred the RBI from participating in primary issuances of government securities from 1 April 2006. This was to ensure that fiscal policy did not unduly influence monetary policy.
- Escape Clause: The Act includes an escape clause allowing the RBI to subscribe to government securities under exceptional circumstances, like national emergencies or significant economic disruptions. For instance, the Act allows a deviation from the fiscal deficit target in the event of severe national calamities or substantial economic disruptions.