Current Challenges Facing the Indian Economy
Topic 3: Inflation
Multiple Choice Questions (MCQs)
1.Inflation is best defined as:
a) A decrease in the general price level of goods and services.
b) A sustained increase in the general price level of goods and services.
c) A sudden drop in the value of a single commodity.
d) An increase in the money supply without a change in prices.
Correct Answer: b) A sustained increase in the general price level of goods and services.
2.When aggregate demand in the economy outpaces aggregate supply, leading to price increases, it is known as:
a) Cost-push inflation
b) Stagflation
c) Demand-pull inflation
d) Hyperinflation
Correct Answer: c) Demand-pull inflation
3.An increase in the cost of raw materials and wages leading to higher prices is characteristic of:
a) Demand-pull inflation
b) Cost-push inflation
c) Suppressed inflation
d) Deflation
Correct Answer: b) Cost-push inflation
4.Which of the following is an anti-inflationary measure primarily used by the Reserve Bank of India (RBI)?
a) Increasing government expenditure
b) Reducing direct taxes
c) Increasing the Repo Rate
d) Providing subsidies on essential goods
Correct Answer: c) Increasing the Repo Rate
5.If the RBI wants to reduce the money supply to control inflation, it would:
a) Decrease the Cash Reserve Ratio (CRR).
b) Buy government securities in the open market.
c) Increase the Reverse Repo Rate.
d) Encourage more bank lending.
Correct Answer: c) Increase the Reverse Repo Rate
6.Which of these is a fiscal policy measure to control inflation?
a) Decreasing the Statutory Liquidity Ratio (SLR).
b) Increasing government spending on infrastructure.
c) Raising direct and indirect taxes.
d) Selling government bonds to commercial banks.
Correct Answer: c) Raising direct and indirect taxes.
7.A sudden surge in crude oil prices globally would most likely lead to what type of inflation in India?
a) Demand-pull inflation
b) Core inflation
c) Cost-push inflation
d) Hyperinflation
Correct Answer: c) Cost-push inflation
8.Inflation generally benefits:
a) Lenders
b) Savers
c) Fixed-income earners
d) Borrowers
Correct Answer: d) Borrowers (as the real value of their debt decreases)
9.What is the primary objective of maintaining buffer stocks of food grains in India?
a) To export surplus food grains.
b) To ensure food security and stabilize food prices.
c) To encourage farmers to grow more crops.
d) To provide fodder for livestock.
Correct Answer: b) To ensure food security and stabilize food prices.
10.The term 'headline inflation' typically refers to inflation measured by:
a) Wholesale Price Index (WPI) only.
b) Consumer Price Index (CPI) only.
c) The overall inflation rate, including volatile components like food and fuel.
d) Inflation excluding food and fuel components.
Correct Answer: c) The overall inflation rate, including volatile components like food and fuel.
Short Questions
1.Define inflation.
Answer: Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time, leading to a fall in the purchasing power of money.
2.What is the difference between demand-pull and cost-push inflation?
Answer: Demand-pull inflation occurs when aggregate demand exceeds aggregate supply, pulling prices up. Cost-push inflation occurs when production costs (like raw materials, wages) increase, pushing prices up.
3.Name two causes of demand-pull inflation in India.
Answer: Two causes of demand-pull inflation in India are: excessive money supply in the economy and high government expenditure without a corresponding increase in production.
4.Mention two causes of cost-push inflation in India.
Answer: Two causes of cost-push inflation in India are: increase in the price of essential raw materials (e.g., crude oil) and supply chain disruptions (e.g., due to natural calamities affecting agricultural produce).
5.How does increasing the Repo Rate help in controlling inflation?
Answer: Increasing the Repo Rate (the rate at which RBI lends to commercial banks) makes borrowing more expensive for banks. This leads to higher lending rates for consumers and businesses, reducing credit demand and hence overall aggregate demand, which helps curb inflation.
6.What role does the Cash Reserve Ratio (CRR) play in anti-inflationary measures?
Answer: Increasing the CRR requires commercial banks to hold a larger percentage of their deposits with the RBI. This reduces the amount of money available with banks for lending, thereby tightening liquidity and curbing aggregate demand, which helps control inflation.
7.Why is maintaining buffer stocks of food grains important for managing food inflation in India?
Answer: Maintaining buffer stocks allows the government to release food grains into the market during times of shortage or price spikes, thereby increasing supply and stabilizing food prices, which are a significant component of overall inflation in India.
8.Who is likely to be negatively affected by high inflation: a fixed-income pensioner or a borrower with a floating-rate loan?
Answer: A fixed-income pensioner is likely to be negatively affected by high inflation because the purchasing power of their fixed income decreases, meaning they can buy fewer goods and services.
9.Briefly explain the impact of inflation on savings.
Answer: Inflation erodes the purchasing power of money. Therefore, for savers, high inflation means that the real value of their savings decreases over time, unless the interest earned on their savings is higher than the inflation rate.
10.Give two fiscal policy measures the government can use to control inflation.
Answer: Two fiscal policy measures are: reducing government expenditure (to lower aggregate demand) and increasing direct/indirect taxes (to reduce disposable income and curb spending).
Long Questions (5 Marks each)
1.Explain the concept of inflation, differentiate between demand-pull and cost-push inflation, and discuss their primary causes in the Indian context.
Answer:
Inflation is defined as a sustained and general increase in the price level of goods and services in an economy over a period of time. This results in a decrease in the purchasing power of money; in simpler terms, your money buys less than it did before. It is not just about the price rise of a single commodity, but a broad-based increase across the economy.
Differentiation and Primary Causes in Indian Context:
1. Demand-Pull Inflation:
Concept: This type of inflation occurs when aggregate demand for goods and services in an economy grows faster than the economy's productive capacity to supply those goods and services. Essentially, "too much money chasing too few goods."
Primary Causes in India:
Excessive Money Supply and Credit Growth: If the Reserve Bank of India (RBI) adopts an overly expansionary monetary policy (e.g., lower interest rates, less stringent reserve requirements), or if there is a large inflow of foreign capital, it can lead to too much money in circulation, boosting demand.
High Government Expenditure: Significant increases in government spending (e.g., on infrastructure projects, welfare schemes) without a corresponding increase in production can inject more money into the economy, fueling demand.
Rising Disposable Incomes: General wage increases or higher transfer payments can lead to higher purchasing power among consumers, increasing their demand for goods and services.
Population Growth: A consistently growing population naturally increases the overall demand for essential goods and services.
Black Money/Unaccounted Money: The circulation of unaccounted money can lead to increased demand, especially for certain assets like real estate or gold, driving up their prices.
2. Cost-Push Inflation:
Concept: This type of inflation arises from increases in the cost of producing goods and services. Producers pass these higher costs onto consumers in the form of higher prices, even if demand has not necessarily increased.
Primary Causes in India:
Rising Raw Material Prices: India is a net importer of crude oil. Global increases in oil prices directly impact transportation, manufacturing costs, and subsequently, the prices of almost all goods and services. Similarly, price hikes in other key raw materials (e.g., minerals, metals) contribute to this.
Wage Hikes: If wages increase significantly without a corresponding increase in labor productivity, businesses face higher labor costs, which they often pass on to consumers.
Supply Shocks/Agricultural Shortfalls: India's dependence on agriculture means that poor monsoons, natural calamities (floods, droughts), or pest attacks can lead to significant shortfalls in food production (e.g., vegetables, pulses, onions). This creates a demand-supply mismatch for essential food items, leading to sharp price increases.
Infrastructure Bottlenecks: Inefficiencies in transportation, storage, and logistics (e.g., cold chains for perishables) lead to wastage and higher costs, contributing to higher final prices for consumers.
Higher Indirect Taxes: An increase in indirect taxes (like GST rates on certain goods) can directly lead to higher consumer prices.
Global Supply Chain Disruptions: Events like pandemics or geopolitical conflicts can disrupt global supply chains, increasing the cost of imported components and finished goods.
In India, inflation often has elements of both demand-pull (e.g., due to government spending or easy credit) and significant cost-push factors, particularly driven by volatile food and fuel prices due to supply-side constraints and global commodity price fluctuations.
2. Elaborate on the various anti-inflationary measures employed by the Reserve Bank of India (RBI) and the Government of India, explaining how each measure aims to control price levels.
Answer:
Controlling inflation is a key macroeconomic objective, and both the monetary authority (RBI) and the fiscal authority (Government of India) employ a range of measures:
A. Monetary Policy Measures (by Reserve Bank of India - RBI):
The RBI primarily uses its tools to regulate the money supply and credit in the economy, thereby influencing aggregate demand.
Interest Rate Adjustments (Policy Rates):
Repo Rate: This is the rate at which commercial banks borrow money from the RBI. To control inflation, RBI increases the Repo Rate. This makes borrowing more expensive for commercial banks, which in turn leads to higher lending rates for businesses and consumers. Higher interest rates discourage borrowing and investment, reducing overall demand in the economy and thus cooling inflationary pressures.
Reverse Repo Rate: This is the rate at which commercial banks lend money to the RBI. To control inflation, RBI increases the Reverse Repo Rate. This encourages banks to deposit their surplus funds with the RBI, effectively withdrawing liquidity from the banking system and reducing the money available for lending.
Cash Reserve Ratio (CRR):
Concept: CRR is the percentage of a bank's total deposits that it must hold as reserves with the RBI. To control inflation, RBI increases the CRR. This means banks have less money to lend out, which tightens credit availability, reduces money supply, and curbs aggregate demand.
Statutory Liquidity Ratio (SLR):
Concept: SLR is the percentage of a bank's deposits that it must hold in liquid assets like government securities, gold, or cash. To control inflation, RBI increases the SLR. This forces banks to hold more of their funds in these approved assets, reducing their capacity to extend credit to the public.
Open Market Operations (OMOs):
Concept: OMOs involve the buying and selling of government securities by the RBI in the open market. To control inflation, RBI sells government securities. When RBI sells securities, commercial banks buy them, transferring money from the banks to the RBI. This reduces the liquidity (money supply) in the banking system, thereby curbing inflationary pressures.
B. Fiscal Policy Measures (by Government of India):
The government uses its taxation and expenditure policies to manage aggregate demand and supply.
Reduction in Government Expenditure:
Mechanism: When the government reduces its spending on public works, welfare schemes, or subsidies, it directly lowers aggregate demand in the economy. This helps cool down demand-pull inflation.
Increase in Taxes:
Mechanism: The government can increase direct taxes (like income tax, corporate tax) or indirect taxes (like GST). Higher direct taxes reduce the disposable income of individuals, leading to less spending. Higher indirect taxes increase the price of goods and services, which can initially contribute to inflation but eventually reduce demand if purchasing power declines. The aim is to curb consumption and investment.
Public Borrowing:
Mechanism: When the government borrows from the public (e.g., through bonds), it draws money out of circulation, reducing the liquidity in the economy and curtailing aggregate demand.
Supply-Side Management Measures:
Improving Supply Chain and Infrastructure: Investing in better roads, cold storage facilities, and efficient logistics can reduce wastage and ensure timely availability of goods, especially agricultural produce. This helps mitigate cost-push inflation.
Maintaining Buffer Stocks: The government maintains buffer stocks of essential commodities (like food grains through the Food Corporation of India - FCI). During periods of shortage or price spikes, these stocks are released into the market, increasing supply and stabilizing prices.
Import Liberalization: To address shortages and reduce import-driven cost-push inflation, the government can reduce import duties or allow increased imports of essential goods (e.g., pulses, edible oils) to augment domestic supply.
Control on Speculation and Hoarding: Taking strict action against hoarding and speculative activities can prevent artificial shortages and price manipulations.
By coordinating these monetary and fiscal measures, the RBI and the Government of India aim to strike a balance between controlling inflation and fostering sustainable economic growth.
