Question

Is deficit financing inflationary? Give reasons for your answer.

Answer 1

1. Increase in Money Supply: Deficit financing often involves printing new money or borrowing from the central bank. This increases the total money supply in the economy without a corresponding increase in goods and services.
2. Rise in Aggregate Demand: Government spending raises overall demand for goods and services. If supply doesn’t increase quickly, excess demand leads to higher prices, causing inflation.
3. Pressure on Resources: More money chases limited resources (raw materials, labour, goods). This pushes up production costs and consumer prices.
4. Excess Demand Over Supply: If the supply of goods and services does not rise proportionately, the excess demand leads to a price rise, i.e., inflation.