Inflation is an important part of Economy and its syllabus. Previous Year Question (PYQ) papers are invaluable resources for aspirants preparing for competitive exams like the Union Public Service Commission (UPSC) examinations. In this article we present important PYQ on inflation.
PYQ on Inflation
Q- With reference to the Indian economy, consider the following statements: (2022)
- If the inflation is too high, Reserve Bank of India (RBI) is likely to buy government securities.
- If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.
- If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.
Which of the statements given above are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer- Option B
EXPLANATION
Statement 1 is inaccurate: If inflation rises significantly, the Reserve Bank of India (RBI) typically aims to mitigate it by tightening the money supply within the economy. This can be achieved by selling government securities, thereby absorbing excess liquidity and helping to control inflationary pressures.
Statement 2 accurately states: The Reserve Bank of India intervenes in the currency market to bolster the rupee’s value, especially when it weakens. Various methods, such as direct intervention through buying and selling dollars, are employed by the RBI to stabilize the rupee. Selling dollars helps to support the rupee’s value, while buying dollars can be utilized to bring down the rupee’s value if necessary.
Statement 3 is also accurate: When the United States raises its domestic interest rates, India may become less appealing for currency traders, potentially leading to capital outflows from Indian markets back to the US. This movement of capital can result in a depreciation of the Indian rupee against the US dollar. Conversely, if interest rates in the US or European Union decline, the rupee’s value against the dollar may increase, prompting the RBI to engage in dollar purchases.
Q- With reference to the India economy, what are the advantages of “Inflation-Indexed Bonds (IIBs)”? (2022)
- Government can reduce the coupon rates on its borrowing by way of IIBs.
- IIGs provide protection to the investors from uncertainty regarding inflation.
- The interest received as well as capital gains on IIBs are not taxable.
Which of the statements given above are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer- Option A
EXPLANATION
Statement 1 accurately states that Inflation-Indexed Bonds (IIBs), being part of Government Securities (G-Secs), can be traded in the secondary market similar to other G-Secs. This tradability assists the government in lowering coupon rates on its borrowing. Like traditional G-Secs, interest on IIBs is paid semi-annually, and the fixed coupon rate is applied to the adjusted principal.
Statement 2 is also correct in highlighting that IIBs serve as a hedge against inflation, with the Reserve Bank of India (RBI) choosing the Wholesale Price Index (WPI) for determining inflation protection in these bonds.
Statement 3, however, contains an error. The correct statement should reflect that existing tax regulations apply to interest payments and capital gains on IIBs, without any special tax treatment for these bonds.
Q- The money multiplier in an economy increases with which one of the following? (2021)
a) Increase in the Cash Reserve Ratio in the banks.
b) Increase in the Statutory Liquidity Ratio in the banks
c) Increase in the banking habit of the people
d) Increase in the population of the country
Answer- Option C
EXPLANATION
The multiplier effect is an economic concept that measures the proportional increase or decrease in final income resulting from an injection or withdrawal of capital. It assesses the impact of changes in economic activity, such as investment or spending, on overall economic output.
An increase in people’s banking habits can lead to a rise in the money multiplier in an economy. When individuals deposit funds into short-term deposit accounts, banks can lend out a portion of those funds, known as the reserve requirement. Subsequent deposits by borrowers further increase the money supply, even though no additional physical currency is created.
Q- With reference to the Indian economy, demand-pull inflation can be caused/increased by which of the following? (2021)
1. Expansionary policies
2. Fiscal stimulus
3. Inflation-indexing wages
4. Higher purchasing power
5. Rising interest rates
Select the correct answer using the code given below.
a) 1, 2 and 4 only
b) 3, 4 and 5 only
c) 1, 2, 3 and 5 only
d) 1, 2, 3, 4 and 5
Answer– Option A
EXPLANATION
Demand-pull inflation occurs when prices rise due to increased demand relative to supply, resulting in a situation where there are “too much money chasing too few goods,” according to economists.
Expansionary policies, such as increased government spending, inject more money into the market, leading to heightened demand for goods and contributing to demand-pull inflation.
Similarly, fiscal stimulus measures also boost money in the market, leading to increased demand for goods and fueling demand-pull inflation.
Additionally, when consumers have higher purchasing power due to increased income, they tend to spend more confidently, leading to increased demand for goods and further contributing to demand-pull inflation.
Q- Which among the following steps is most likely to be taken at the time of an economic recession? (2021)
a) Cut in tax rates accompanied by increase in interest rate
b) Increase in expenditure on public projects
c) Increase in tax rates accompanied by reduction of interest rate
d) Reduction of expenditure on public projects
Answer- Option B
EXPLANATION
An economic recession is characterized by a substantial decrease in overall economic activity within a specified area. Increased spending on public projects can have a multiplier effect on the rate of economic growth in the country.
Public expenditure stimulates the growth of national income and creates employment opportunities. Private investors lack the capacity to undertake large-scale investments in infrastructure projects such as road, bridge, dam construction, power plants, and transportation and communication systems.
Therefore, it is essential for the government to take on these projects. The level of economic development is directly correlated with the magnitude of public expenditure.
Q- Which one of the following is likely to be one of the most inflationary in its effects? (2021)
a) Repayment of public debt
b) Borrowing from the public to finance a budget deficit
c) Borrowing from the banks to finance a budget deficit
d) Creation of new money to finance a budget deficit
Answer- Option D
EXPLANATION
Deficit financing refers to the practice of raising funds to cover the deficit resulting from expenditure surpassing revenue. This shortfall is typically addressed by borrowing from the public through the sale of bonds or by resorting to the printing of new money.
Government spending financed through the printing of money stimulates incomes and increases private demand within the economy, leading to inflation. While a moderate level of inflation can be beneficial by encouraging business activity, prolonged unchecked printing of money can exacerbate inflationary pressures. Unfortunately, governments often realize the consequences of over-borrowing only after the fact, as inflation tends to manifest with a delay. Elevated inflation levels and escalating government debt can contribute to macroeconomic instability.
Q- Consider the following statements : (2020)
(1) The weightage of food in Consumer Price Index (CPI) is higher than that in Wholesale Price Index (WPI).
(2) The WPI does not capture changes in the prices of services, which CPI does.
(3) The Reserve Bank of India has now adopted WPI as its key measure of inflation and to decide on changing the key policy rates.
Which of the statements given above is/are correct?
(a) 1 and 2 only
(b) 2 only
(c) 3 only
(d) 1, 2 and 3
Answer- Option A
EXPLANATION
Statement 3 is inaccurate because in 2014, it was not Raghuram Rajan who announced the adoption of the new Consumer Price Index (CPI) (combined) as the key measure of inflation by the Reserve Bank of India (RBI).
Q- Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)? (2017)
(1) It decides the RBI’s benchmark interest rates.
(2) It is a 12-member body including the Governor of RBI and is reconstituted every year.
(3) It functions under the chairmanship of the Union Finance Minister.
Select the correct answer using the code given below :
(a) 1 only
(b) 1 and 2 only
(c) 3 only
(d) 2 and 3 only
Answer- Option A
EXPLANATION
The Monetary Policy Committee (MPC) is responsible for determining the benchmark interest rates set by the RBI, which include the MSF, Repo Rate, Reverse Repo Rate, and Liquidity Adjustment Facility, making Statement 1 accurate.
Contrary to Statement 2, the committee comprises six members, with three members nominated by the government and the remaining three by the RBI. Additionally, the Governor of the RBI serves as the ex-officio Chairperson of the MPC, which refutes Statement 3. Members of the MPC are appointed for a fixed term of four years and are not eligible for reappointment.
Q- With reference to inflation in India, which of the following statements is correct? (2015)
(a) Controlling the inflation in India is the responsibility of the Government of India only
(b) The Reserve Bank of India has no role in controlling the inflation
(c) Decreased money circulation helps in controlling the inflation
(d) Increased money circulation helps in controlling the inflation
Answer- Option C
EXPLANATION
Inflation denotes the overall upward trend in prices of goods and services within an economy over time. When the money supply surpasses the economy’s capacity to produce goods and services, inflation tends to rise accordingly. During periods of heightened inflation, the government can mitigate the issue by reducing its spending, thereby diminishing the circulation of money within the country. Consequently, reducing money circulation aids in managing inflation. Sterilization refers to the process by which the RBI absorbs surplus liquidity within the economy.
Q- Consider the following statements : (2013)
(1) Inflation benefits the debtors.
(2) Inflation benefits the bond-holders.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer- Option A
EXPLANATION
Inflation leads to a redistribution of wealth from creditors to debtors, as lenders experience losses while borrowers gain from inflation. Bondholders, who have loaned funds and received bonds in return, fall into the category of lenders and therefore suffer from inflation, benefiting debtors. Thus, statement 1 is accurate. However, statement 2 does not explicitly mention “inflation-indexed bonds,” making it unclear whether bondholders benefit from inflation. Therefore, statement 2 is deemed incorrect.
Q- A rise in general level of prices may be caused by (2013)
(1) an increase in the money supply
(2) a decrease in the aggregate level of output
(3) an increase in the effective demand
Select the correct answer using the codes given below.
(a) 1 only
(b) 1 and 2 only
(c) 2 and 3 only
(d) 1, 2 and 3
Answer- Option D
EXPLANATION
The rise in the general price level can be attributed to various factors such as an increase in the money supply, a decrease in aggregate output, a surge in effective demand, an upsurge in income, and rapid population growth.
- Increase in the money supply: A boost in the money supply leads to inflation and stimulates consumer spending, consequently lowering the interest rates. Thus, statement 1 is accurate.
- Decrease in aggregate output: A decline in aggregate output occurs when input prices rise, leading to cost-push inflation. However, changes in price levels do not directly influence aggregate supply.
- Increase in effective demand: Effective demand reflects consumers’ willingness and ability to purchase goods and services at various price levels. A rise in effective demand results in increased employment opportunities along with a surge in prices.
Q- Supply of money remaining the same when there is an increase in demand for money, there will be (2013)
(a) a fall in the level of prices
(b) an increase in the rate of interest
(c) a decrease in the rate of interest
(d) an increase in the level of income and employment
Answer- Option B
EXPLANATION
When the demand for money increases while the money supply remains constant, the interest rate tends to rise. This adjustment aims to incentivize customers to deposit funds in banks. Similarly, in a scenario where the demand for a commodity like onions surges while the supply remains unchanged, prices typically increase to stabilize the market. Consequently, this situation may lead to a decline in aggregate demand.