What is the effect of deficit financing on economy?

Deficit financing means the government spends more than it earns and covers the gap by borrowing, largely from the central bank through new money creation. The direct effect is an increase in money supply, so C is correct.

• A) Reduction in taxes: Tax cuts are a separate fiscal choice that may widen the deficit. They are not what deficit financing itself does, which is a money-side mechanism.
• B) Increase in wages: Wages depend on labour markets and demand. Extra money can push up prices and erode real wages, so this is an indirect and unreliable outcome, not the intended effect.
• D) Decrease in money supply: This is the opposite of what happens. Money supply contracts when the government retires debt or the central bank sells securities through open market operations.

Core concept: the fiscal deficit and its monetisation. Deficit financing is a Keynesian tool that injects purchasing power, but it risks inflation if output does not keep pace. For Mains, link it to fiscal consolidation under the FRBM framework and to the restrictions on direct central bank financing of government.

Trap: candidates pick A because the word "deficit" suggests tax policy, but financing the deficit is a money-supply question.