Effect of deficit financing by the government

What is the likely effect of deficit financing by the government?

  1. Increase in employment without inflation
  2. Decrease in money supply and price levels
  3.  Increase in aggregate demand and rise in prices
  4. Reduction in government expenditure

EXPLANATION

What is Deficit Financing?

  • Deficit financing means the government spends more than it earns through revenues (like taxes).

  • To cover this gap (the fiscal deficit), the government borrows from the Reserve Bank of India (RBI) or prints new currency.

  • This leads to an increase in money supply in the economy.

🔹 Likely Effects:

  1. Increase in Money Supply:

    • When the government borrows from the RBI or prints new money, additional currency enters circulation.

    • More money → people have higher purchasing power.

  2. Increase in Aggregate Demand:

    • With more money in hand, consumption and investment increase.

    • This raises the aggregate demand for goods and services.

  3. Rise in Prices (Inflation):

    • If production doesn’t increase in proportion to the demand, prices start rising.

    • This leads to demand-pull inflation.

🔹 Short-term vs Long-term Effects:

  • Short-term: Can boost employment and economic growth (useful during recession).

  • Long-term: May cause inflation and currency devaluation if overused.

❌ Why Other Options Are Wrong:

Option Explanation
Increase in employment without inflation Not likely — deficit financing usually causes inflation if not matched by production.
Decrease in money supply and price levels Opposite effect — deficit financing increases money supply.
Reduction in government expenditure Deficit financing means more expenditure, not less.

✅ Final Answer:
Increase in aggregate demand and rise in prices

Effect of deficit financing by the government