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

Explanation : 

Inflationary Impact of Budget Deficit Financing

Among the options provided, the creation of new money to finance a budget deficit is likely to be the most inflationary in its effect. Here’s why:

Repayment of Public Debt

When a government repays its debt, it is essentially transferring money from itself to the creditors (which could be the public, banks, or foreign entities). This does not increase the total amount of money in circulation and therefore does not have an inherently inflationary effect.

Borrowing from the Public to Finance a Budget Deficit

When the government borrows from the public, it issues bonds or other securities. The public purchases these securities with existing money, so the total money supply does not increase. This action is not directly inflationary, although it could lead to higher interest rates if it crowds out private borrowing.

Borrowing from the Banks to Finance a Budget Deficit

If the government borrows from banks, the banks may lend from their reserves, which can lead to a slight increase in the money supply through the money multiplier effect in the banking system. However, this is still not as directly inflationary as creating new money, because the banks are limited by their reserve requirements and the existing money supply.

Creation of New Money to Finance a Budget Deficit

This option is directly inflationary because it increases the total money supply in the economy without a corresponding increase in goods and services. When more money chases the same amount of goods and services, prices tend to rise, which is the definition of inflation. Central banks can create new money through various means, such as open market operations or quantitative easing. This new money can then be used by the government to finance its spending, leading to an immediate increase in the money supply and potential inflationary pressures.