Correct Option
Creation of new money to finance a budget deficit directly increases the money supply in the economy. This method, often referred to as monetizing the deficit, injects additional purchasing power without a corresponding increase in the production of goods and services. Such an imbalance between money supply and available goods and services is a primary cause of demand-pull inflation, and in severe cases, can lead to hyperinflation. Therefore, it is considered the most inflationary method of deficit financing.
Incorrect Options
Repayment of public debt generally involves the government returning funds to bondholders. This process, if financed through taxation or non-inflationary means, can be neutral or even deflationary as it reduces the money in circulation or redistributes existing funds, rather than creating new money.
Borrowing from the public involves the government issuing bonds to individuals, households, and institutions. This action primarily mobilizes existing savings from the private sector to the government. It represents a transfer of purchasing power rather than an increase in the overall money supply, thus having a less inflationary impact compared to creating new money.
Borrowing from banks, particularly commercial banks, can lead to an increase in the money supply through the credit creation multiplier effect. When banks lend to the government, they may create new deposits, thereby expanding the money supply. However, this effect is typically less direct and potent than the outright creation of new money by the central bank or government, which directly adds to the monetary base.