SSC Selection Post 2025 PYQ — Question 15

Correct Answer

The central bank directly finances the government by purchasing its debt

Explanation

Debt monetization, also commonly known as deficit financing or printing money, occurs when a country's central bank directly purchases government bonds or treasury bills. Under normal circumstances, when a government runs a fiscal deficit, it borrows money from the public or commercial banks by issuing bonds in the open market.

However, during debt monetization, the central bank steps in to buy these newly issued government securities directly. To pay for these bonds, the central bank creates new money electronically. This newly created money goes directly into the government's account, allowing the state to finance its expenditures without drawing from existing tax revenues or public savings.

The other choices represent completely different monetary or economic actions. Raising interest rates and reducing the money supply are contractionary monetary policies used to cool down an overheating economy. Borrowing from foreign countries represents external commercial borrowing, which does not involve domestic money creation by the central bank.

Key Points

Debt monetization results in a direct expansion of the monetary base, meaning it increases the total supply of money circulating within the economy.

This mechanism is often used as a last resort during severe economic crises or wars when a government needs immediate funding and cannot easily borrow from traditional financial markets.

While it provides immediate liquidity to the government, a sustained period of debt monetization carries a high risk of fueling high inflation or hyperinflation because too much money begins chasing too few goods and services.

This practice is often restricted or banned in many modern economies to protect the independence of the central bank and maintain fiscal discipline.

Additional Facts

In modern financial systems, central banks usually perform Open Market Operations (OMO), where they buy or sell existing government bonds in the secondary market to regulate liquidity. This is legally distinct from direct debt monetization, which occurs in the primary market.

In India, automatic monetization of budget deficits through the issuance of ad-hoc Treasury Bills was permanently discontinued following an agreement between the Government of India and the Reserve Bank of India (RBI) in 1997.

Important Questions and Answers

Question: What is the primary macroeconomic risk associated with a central bank continuously engaging in debt monetization?

Answer: The primary risk is a sharp rise in inflation or hyperinflation, along with the potential devaluation of the national currency.

Question: How does debt monetization differ from standard Open Market Operations (OMO)?

Answer: Debt monetization involves the central bank buying new bonds directly from the government (primary market) to create new money for state spending, whereas OMOs involve buying or selling older, existing bonds from commercial banks and investors (secondary market) purely to adjust interest rates and market liquidity.