A government finances its budget deficit by borrowing from the central bank. What is the likely result?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Money supply in the economy rises, which may result in inflation.
Borrowing from the central bank puts new money into the economy. Money supply rises, and this may cause inflation.
Option (1) Money supply rises, which leads to a fall in the general price level. — Incorrect. More money tends to raise prices, not lower them.
Option (2) Money supply in the economy falls, as the central bank absorbs reserves. — Incorrect. The central bank gives money to the government, so money supply rises.
Option (3) Money supply in the economy rises, which may result in inflation. — Correct. This is deficit financing through central bank borrowing: the central bank creates new money to lend to the government.
Option (4) Money supply is unchanged, as the borrowing is only a transfer within the government sector. — Incorrect. The central bank’s loan is new money in the economy.
This question uses Money and Banking and Government Budget and the Economy together.
NCERT (2026-27): Glossary: “Deficit financing through central bank borrowing - Financing of budget deficit by the government through borrowing money from the central bank. Leads to increase in money supply in an economy and may result in inflation.” Government Budget and the Economy: “Budgetary deficits must be financed by either taxation, borrowing or printing money. Governments have mostly relied on borrowing, giving rise to what is called government debt. The concepts of deficits and debt are closely related. Deficits can be thought of as a flow which add to the stock of debt.” |