Test: Economy - 1 - UPSC MCQ

Legal tender

• It is any official medium of payment recognized by law. Hence statement 1 is correct.

• It is used for monetary transactions, ulfils the financial obligation or to repay public or private debt. The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items.

• They do not have intrinsic value like gold or silver coin. Hence statement 2 is not correct,

• They cannot be refused by any citizen of the country for settlement of any kind of transaction,Coins and currency notes are recognized as legal tenders.

• While the currency notes are issued by RBI, coins are issued by the central government. Hence statement 3 is not correct.

• New stocks and bonds are created and sold to investors in the primary capital market, while securities are traded by investors on the secondary capital market.

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  When a company publicly sells new stocks and bonds for the first time, it does so in the primary capital market. This market is also called the new issues market. In many cases, the new issue takes the form of an initial public offering (IPO). When investors purchase securities on the primary capital market, the company that offers the securities hires an underwriting firm to review it and create a prospectus outlining the price and other details of the securities to be issued. Hence statement 1 is not correct.

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  As per Section 15 (1) (a) of the SEBI FII Regulations, 1995, a Foreign Institutional Investor (FII) could invest in the securities in the primary and secondary markets including shares, debentures and warrants of companies unlisted, listed or to be listed on a recognized stock exchange in India. In factFils are very active in the over the counter (OTC) markets and in the IPO market in India. However, subsequent to SEBI (FPI) regulations, FIIs are allowed to invest only in listed or to-be listed entities and only through stock exchanges. The Reserve Bank of India monitors the ceilings on FII/NRI/PIO investments in Indian companies on a daily basis. Hence statement 2 is not correct.

• Traditionally, when a government cuts taxes and runs a budget deficit, consumers respond to their after­tax income by spending more. A counter argument is that consumers are forward-looking and will base their spending not only on their current income but also on their expected future income.

• They will understand that borrowing by the government today means higher taxes in the future. Further, the consumer will be concerned about future generations because they are the children and grandchildren of the present generation and the family which is the relevant decision making unit, continues living. They would increase savings now, which will fully offset the increased government dissaving so that national savings do notchange. This view is called Ricardian equivalence after one of the greatest nineteenth century economists, David Ricardo, who first argued that in the face of high deficits, people save more.

• It is called ‘equivalence’ because it argues that taxation and borrowing are equivalent means of financing expenditure. When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.

Reserve Bank of India

o It was established on April 1, 1935, in accordance with the provisions of the Reserve Bank of India Act, 1934.

O Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India.

• The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as to: o Regulate the issue of Banknotes

• Keeping of reserves with a view to securing monetary stability in India o Operate the currency and credit system of the country to its advantage

• Have a modern monetary policy framework to meet the challenge of an increasingly complex economy

• To maintain price stability while keeping in mind the objective of growth.

• When commercial banks need more funds in order to be able to create more credit, they may go to market for such funds or go to the Central Bank.

• The central bank provides them funds through various instruments. This role of RBI, that of being ready to lend to banks at all times is an important function of the central bank, and due to this central bank is said to be the lender of last resort. Hence only statement 1 is correct.

• In pursuance of the announcement made in the Union Budget 2010-11 and with a view to strengthen and institutionalize the mechanism for maintaining financial stability and enhancing inter-regulatory coordination, Indian Government has setup an apex-level Financial Stability and Development Council (FSDC), vide its notification dated 30^th December, 2010. The first meeting of the Council was held on 31^st December, 2010.

• FSDC has replaced the High Level Coordination Committee on Financial Markets (HLCCFM), which was facilitating regulatory coordination, though informally, prior to the setting up of FSDC.

• Composition:

o The Chairman of the FSDC is the Finance Minister of India and its members include the heads of the financial sector regulatory authorities (i.e., SEBI, IRDA, RBI, PFRDA and FMC) , Finance Secretary and/or Secretary, Department of Economic Affairs (Ministry of Finance), Secretary, (Department of Financial Services, Ministry of Finance) and the Chief Economic Adviser. Hence, statement 2 is not correct.

O The commodities markets regulator, Forward Markets Commission (FMC) was added to the FSDC in December 2013 subsequent to shifting of administrative jurisdiction of commodities market regulation from Ministry of consumer Affairs to Ministry of Finance. The Joint Secretary (Capital Markets Division, Department of Economic Affairs, Ministry of Finance) was the Secretary of the Council till August 2013. Now this post is being held by the Additional Secretary in the Ministry of Finance.

O A sub-committee of FSDC has also been set up under the chairmanship of Governor RBI. The Sub­Committee discusses and decides on a range of issues relating to financial sector development and stability including substantive issues relating to inter-regulatory coordination.

Mandate: Without prejudice to the autonomy of regulators, this Council would monitor macro prudential supervision of the economy, including the functioning of large financial conglomerates. It will address inter-regulatory coordination issues and thus spur financial sector development. It will also focus on financial literacy and financial inclusion. What distinguishes FSDC from other such similarly situated organizations across the globe is the additional mandate given for development of financial sector. Hence, statement 1 is correct.

• Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing. Fiscal deficit is bridged by market borrowing and Central Bank printing fresh currency (monetization) if necessary. Fiscal deficit may cause macroeconomic instability by inflating the economy as money supply and thus inflation increases. Hence curtailing Fiscal Deficit is necessary to fight inflationary pressures. Curtailing government expenditure would lead to decrease in fiscal deficit.

• If government expenditure decreases, inflation might also decrease.

• When interest rates are low, individuals and businesses tend to demand more loans. Each bank loan increases the money supply in a fractional reserve banking system. A growing money supply increases inflation. Thus, a low interest rate tends to result in more inflation. So to fight inflation, loans have to be made costly.

• Decreasing taxation rates and giving tax exemptions will increase the money supply in markets and will lead to demand-pull inflation. Hence the increase in tax rates is necessary to fight inflation.

• Hence option (a) is the correct answer.

• Before the 1991 economic reforms, the Private sector was not allowed in many industries. Also, some goods could be produced only in small-scale industries. Post the economic reforms of 1991, the only industries which are now reserved for the public sector are a part of defense equipment, atomic energy generation, and railway transport. Hence options 1 and 3 are correct.

• Many goods produced by small-scale industries have now been deserved. In many industries, the market has been allowed to determine prices.

• In coal-based energy generation, private players are also allowed. Hence option 2 is not correct.

• Statement 1 is correct- Core Inflation, also known as underlying inflation, is a measure of inflation which excludes items that face volatile price movement, notably food and energy. It is nothing but Headline Inflation minus inflation that is contributed by food and energy commodities.

• Statement 2 is not correct- Unlike core inflation, headline inflation also takes into account changes in the price of food and energy. Since food and energy prices are highly volatile, headline inflation fluctuates more and may not give an accurate picture of how an economy is behaving.

Whenever core inflation rises, RBI increases policy rates to suck excess liquidity from the market and vice versa.

• Statement 1 is correct: ‘Invest India’ is India’s official agency dedicated to investment promotion and facilitation.

• It is a not-for-profit, single-window facilitator for prospective overseas investors and to those aspiring Indian investors desiring to invest in foreign locations, and acts as a structured mechanism to attract investment. Invest India is essentially an Investment Promotion Agency in India.

• Statement 2 is not correct: Invest India, an investment promotion agency in which the government has 49% equity, the rest is equally divided among three industry bodies — CII, FICCI and NASSCOM — thereby technically making it a private entity. While Department for Promotion of Industry and Internal Trade (DPIIT) has a 43.5% stake in the agency, 5.5% has been transferred to 19 states, including Maharashtra, Madhya Pradesh, Telangana and Kerala; this makes the state’s stakeholders in the mission of Invest India.

• Flows: Flows are defined over a period of time. Income, or output, or profits of a company are concepts that make sense only when a time period is specified. These are called flows because they occur in a period of time. Therefore we need to delineate a time period to get a quantitative measure of these. Saving is measured per unit time and is a flow variable. Hence, options 1 and 2 are correct.

• Stocks: Stocks are defined at a particular point of time. In contrast, capital goods or consumer durables once produced do not wear out or get consumed in a delineated time period. In fact, capital goods continue to serve us through different cycles of production. The buildings, machines, inventories in a factory are there irrespective of the specific time period. There can be an addition to or deduction from, these if a new machine is added or a machine falls in disuse and is not replaced. These are called stocks. Wealth is measured at a point in time and is, therefore, a stock variable. Hence, option 3 is not correct.

• However, we can measure a change in stock over a specific period of time like how many machines were added this year. Such changes in stocks are thus flows, which can be measured over specific time periods.

• Managed floating exchange rate system is a system in which the central bank allows the exchange rate to be determined by market forces but intervene at times to influence the rate. Hence statement 1 is correct.

• India follows a managed floating exchange rate system. RBI acts as a controller in the exchange rate market. Hence statement 2 is correct.

• In India, the farming community uses the mixed crop-livestock farming system — cattle, goats, fowl are the widely held species. Livestock production provides increased stability in income, food security, transport, fuel and nutrition for the family without disrupting other food-producing activities.

• The distribution of livestock in India: Poultry accounts for the largest share with 58 percent followed by cattle and buffaloes (24 percent), goats and sheep (16 percent), pigs (1 percent). Other animals which include camels, asses, horses, ponies, and mules are in the lowest rung. Hence statement 1 is not correct.

• In the fisheries sector, presently, fish production from inland sources contributes about 64 percent to the total value of fish production and the balance 36 percent comes from the marine sector (sea and oceans). Today total fish production accounts for 0.8 percent of the total GDP. In India, West Bengal, Andhra Pradesh, Kerala, Gujarat, Maharashtra, and Tamil Nadu are major fish producing states. Hence statement 2 is not correct.

• Escrow Account

o An escrow account in simple terms is a third party account.

O It is a separate bank account to hold money which belongs to others and where the money parked will be released only under the ulfilment of certain conditions of a contract. O An escrow account is an arrangement for safeguarding the seller against its buyer from the payment risk for the goods or services sold by the former to the latter. Hence option c is the correct answer.

The Hindu rate of growth was a term used disparagingly to indicate the low growth rate of the Indian economy for more than 3 decades, between the 50s to the 80s. The average growth of GDP during thisperiod was around 3.5% while per capita income grew by a mere 1.3%.

The term was coined by Prof Raj Krishna who argued at one of his lectures in the late 70s that —..no matter what happens to the economy the trend growth rate in India will be 3.5%”. It was later used by a few economists to link the low growth rate of the 50s-80s period to Hindu beliefs of —Karma” & —Bhagya”.

• The industrial policy that we adopted was closely related to the trade policy. In the first seven five year plans, trade was characterized by what is commonly called an inward-looking trade strategy. Technically, this strategy is called import substitution.

• This policy aimed at replacing or substituting imports with domestic production. For example, instead of importing vehicles made in a foreign country, industries would be encouraged to produce them in India itself. Hence option 2 is correct.

• In this policy, the government protected the domestic industries from foreign competition. Protection from imports took two forms: tariffs and quotas.

• Tariffs are a tax on imported goods; they make imported goods more expensive and discourage their use. Quotas specify the quantity of goods which can be imported. The effect of tariffs and quotas is that they restrict imports and, therefore, protect domestic firms from foreign competition. Hence option 1 is correct.

• Increasing the proportion of Indian goods in the export market was not the aim of the Import Substitution policy. Hence option 3 is not correct.

• Economic reforms after 1991 have not been able to benefit agriculture, where the growth rate has been decelerating. The agriculture sector achieved a growth rate of 3.3% in 1992-2001 compared to 3.6% in 1980-91. For 2002-07 and 2007-12, the growth rate was 2.3% and 3.2% respectively. Hence statement 1 is not correct.

• Agriculture accounted for 24.02% of the GDP in the year 1991-92, while 23.83% in 1993-94, 19.61% in 1999-00 while 12.35% in 2009-10. Hence statement 2 is not correct.

• Statement 1 is correct: Balance of Payments is the record of all economic transactions between the residents of the country and the rest of the world in a particular period of time. These transactions include the transactions in goods, services and assets (like financial capital, etc).

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  Statement 2 is correct: The balance of payments (BoP) is not independent on the currency of the transaction. For e.g. the transaction of India buying Oil from Iran is under the balance of payments even if the payment is made in Indian rupees (INR).

• Structural inflation is the one prevailing in most developing countries. The situation is due to the operation of the structural weakness (supply bottleneck, lack of infrastructure, etc.) existing in a developing economy. Lack of adequate supply responses or production to increase in demand is the cause of structural inflation. Hence option (c) is the correct answer.

• A complete change in economic policy would be needed to address it. Below examples illustrate structural inflation.

O To keep farmers happy, Government keeps increasing Minimum Support Price for wheat and rice but MSP for pulses remain stagnant. It disincentivises farmers to grow pulses thus decrease its supply and increases pulse prices.

O Due to APMC acts of states, artelization and hoarding is rampant in the agricultural market. It leads to supply and demand mismatch and increases inflation.

• Financial Market Infrastructure (FMI) is defined as a multilateral system among participating institutions, including the operator of the system, used for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions.

• The term FMI generally refers to systemically important payment systems, Central Securities Depositories (CSDs), Securities Settlement Systems (SSSs), Central Counter Parties (CCPs), and Trade Repositories (TRs) that facilitate the clearing, settlement, and recording of financial transactions.

• FMIs play a critical role in the financial system and the broader economy and contribute to maintaining and promoting financial stability and economic growth.

• RTGS system is owned and operated by the RBI. It is a Systemically Important Payment System (SIPS) where the inter-bank payments settle on a ’real’ time and on a gross basis in the books of the RBI. It is designated as an FMI which is regulated by the RBI. Hence both the statements are correct.

• Sterilization is intervention by the monetary authority of a country in the money market to keep the money supply stable against exogenous or sometimes external shocks such as an increase in foreign exchange inflow. It is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply. Hence option (c) is the correct answer.

• Sterilization most frequently involves the purchase or sale of financial assets by a central bank, and is designed to offset the effect of foreign exchange intervention. It refers to the process by which the RBI takes away money from the banking system to neutralise the fresh money that enters the system

Through its tax and expenditure policy, the government attempts to bring about a distribution of income that is considered fair’ by society. The government affects the personal disposable incomeof households by making transfer payments and collecting taxes and, therefore, can alter the income distribution. This is the distribution function.

• Transfer Payment is a payment made or income received in which no goods or services are being paid for, such as a benefit payment or subsidy. Unlike the exchange transaction which mutually benefits all the parties involved in it, the transfer payment consists of a donor and a recipient, with the donor giving up something of value without receiving anything in return.

• In any period, the level of expenditures may not be sufficient for full utilisation of labour and other resources of the economy. Since wages and prices are generally rigid downwards (they do not fall below a level), employment cannot be restored automatically. Hence, policy measures are needed to raise aggregate demand. On the other hand, there may be times when expenditures exceed the available output under conditions of high employment and thus may cause inflation. In such situations, restrictive conditions are needed to reduce demand. These constitute the tabilization requirements of the domestic economy.

• To understand the need for governmental provision of public goods, we must consider what distinguishes them from private goods. There are two major differences.

  • One, the benefits of public goods are not limited to one particular consumer, as in the case of private goods, but become available to all. For instance, if a person consumes a chocolate or wears a shirt, these will not be available to other individuals. This person’s consumption stands in a rival relationship to the consumption of others. However, if we consider a public park or measures to reduce air pollution, the benefits will be available to all. The consumption of such products by several individuals is not ‘rivalrous’ in the sense that a person can enjoy the benefits without reducing their availability to others.

  • Two, in case of private goods anyone who does not pay for the good can be excluded from enjoying its benefits. If you do not buy a ticket, you are excluded from watching a film at a local theatre. However, in case of public goods, there is no feasible way of excluding anyone from enjoying the benefits of the good (they are non-excludable). Since non-paying users usually cannot be excluded, it becomes difficult or impossible to collect fees for the public good. This is what is cal led the ‘free­rider’ problem.

• Consumers will not voluntarily pay for what they can get for free and for which there is no exclusive title to the property being enjoyed. The link between the producer and the consumer is broken and the government must step in to provide for such goods. Public provision, however, is not the same as public production. Public provision means that they are financed through the budget and made available free of any direct payment. Hence the train journey will not be counted as a public provision, however the public park will be considered so. These goods may be produced directly under government management or by the private sector.

The Gross Domestic Product (GDP) deflator is a measure of general price inflation. It is calculated by dividing nominal GDP by real GDP and then multiplying by 100. Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation (It is the GDP measured at current prices). Real GDP is nominal GDP, adjusted for inflation to reflect changes in real output (It is the GDP measured at constant prices). Hence, statement 1 is correct.

GDP Deflator = ( Nominal GDP/ Real GDP) x 100

The weights of goods and services in GDP deflator are not constant and differ according to the production level of each good and services in the country. Due to these changes in consumption patterns or the introduction of new goods and services or structural transformation are automatically reflected in the deflator which is not the case with other inflation measures. Hence, statement 2 is correct.

Disinflation is a temporary slowing of the pace of price inflation. It is used to describe instances when the inflation rate has reduced marginally over the short term. Unlike inflation and deflation, which refer tothe direction of prices, disinflation refers to the rate of change in the rate of inflation. Hence option a is the correct answer.

• It should not be confused with deflation. Deflation is a decrease in general price levels of throughout an economy, while disinflation is what happens when price inflation slows down temporarily. Deflation, which is the opposite of inflation, is mainly caused by shifts in supply and demand. Disinflation, on the other hand, shows the rate of change of inflation over time. The inflation rate is declining over time, but it remains positive.

• In the Product method or Gross Value Added (GVA) method, the Gross Domestic Product (GDP) is calculated by adding the gross value added (GVA) of all firms in the economy. The GVA of a firm is calculated in the following ways:

• Gross value added of firm = Gross value of the output produced by the firm - Value of intermediate goods used by the firm

• GVA = Value of sales by the firm + Value of change in inventories - Value of intermediate goods used by the firm

• This equation has been derived by using: Change in inventories of a firm during a year = Production of the firm during the year - Sale of the firm during the year.

• It is worth noting that the sales by the firm include sales not only to domestic buyers but also to buyers abroad (the latter is termed as exports). It is also to be noted that all the above-mentioned variables are flow variables. Generally, these are measured on an annual basis. Hence they measure the value of the flows per year.

• Net value added of the firm = GVA - Depreciation of the firm