Ramesh Singh Test: Inflation & Business Cycle- 1 - UPSC MCQ

These are some of the most common academic definitions of inflation.

• A rise in the general level of prices;

• a sustained rise in the general level of prices;

• persistent increases in the general level of prices;

• an increase in the general level of prices in an economy that is sustained over time;

• rising prices across the boards—is inflation.

• When the general level of prices is falling over some time this is deflation, the opposite situation of inflation.

• It is also known as disinflation. But in contemporary economics deflation or disinflation not used to indicate fall in prices.

• In policy terms, deflation or disinflation means a reduction in the level of national income and output, usually accompanied by a fall in the general price level.

• A mismatch between demand and supply pulls up prices.

• Either the demand increases over the same level of supply, or the supply decreases with the same level of demand and thus the situation of demand-pull inflation arises.

• This was a Keynesian idea. The Keynesian School suggests cuts in spending as the way of tackling excess demand mainly by increasing taxes and reducing government expenditure.

• Monetarists view Demand-pull inflation as the creation of extra purchasing power to the consumer over the same level of production.

• This is the type of creating extra money (either by the printing or public borrowing) without equivalent creation in production/supply i.e. too much money chasing too little output.

• For the monetarists, a particular level of money supply for a particular level of production is healthy for an economy.

• Extra creation of money over the same level of production causes inflation.

• They suggested proper monetary policy (money supply, interest rates, the printing of currencies, public borrowing etc.), to check situations of inflationary pressure on the economy.

• Monetarists rejected the Keynesian theory of inflation.

Statement 1 is correct, while statement 2 is incorrect.

Explanation:

1. Tighter monetary policy is used by governments to reduce inflation, whether it is demand-pull or cost-push inflation. It involves increasing interest rates or reducing the money supply in the economy, making borrowing more expensive and discouraging excessive spending. This helps to reduce aggregate demand, thus cooling down inflationary pressures.

2. The statement is incorrect because tighter monetary policy is not intended to increase the money supply in the economy; rather, it is aimed at reducing the money supply. An increase in the money supply is associated with looser monetary policy, which is used to stimulate economic growth during periods of slow economic activity or recession.

• The governments may take recourse to tighter monetary policy to cool down either the demand-pull or the cost-push inflations.

• This is intended to cut down the money supply in the economy by siphoning out the extra money (as RBI increases the Cash Reserve Ratio of banks in India) from the economy and by making money costlier (as RBI increases the Bank Rate or Repo Rate in India) This is a short-term measure.

• In the long-run, the best way is to increase production with the help of the best production practices.

Gallopin Inflation is a type of inflation that occurs when the prices of goods and services increase at two-digit or three-digit rate per annum. Galloping inflation is also known as jumping inflation.

• This is the ratio between GDP at Current Price and GDP at Constant Prices.

• If GDP at Current Prices is equal to the GDP at Constant Prices, GDP deflator will be 1, implying no change in the price level. If GDP deflator is found to be 2, it implies a rise in price level by a factor of 2.

• GDP deflator is acclaimed as a better measure of price behaviour because it covers all goods and services produced in the country (because the weight of services has not been equitably accounted in the Indian "headline inflation', i.e., inflation at WPI).

• The first statement says that rising inflation indicates rising aggregate demand, which suggests a comparatively lower supply and higher purchasing capacity among consumers. This is False. Rising inflation could indicate rising demand, but it doesn't necessarily mean there is a higher purchasing capacity among consumers. Inflation can erode purchasing power if wages do not increase at the same rate as prices. Additionally, inflation can also be caused by factors other than aggregate demand, such as increased costs of production or supply chain disruptions.
• The second statement suggests that higher inflation prompts producers to increase their production level as it is generally considered a sign of higher demand. This is false; producers might increase production if they perceive inflation as a sign of increased demand. However, if inflation is caused by supply-side factors (like increased costs of raw materials), higher production levels may not be feasible or profitable. Furthermore, inflation could also be a result of too much money chasing too few goods, which doesn't necessarily mean that demand has increased in real terms — it could just mean that the money supply has increased.

Both statements are correct.

1. Higher inflation indicates higher demand and suggests entrepreneurs expand their production level: This is generally true. When prices rise due to increased demand, it signals to businesses that there's a market for their products, encouraging them to expand production.

2. Higher the inflation, the higher the cost of the loan: This is also accurate. When inflation is high, the value of money decreases. Lenders adjust interest rates upward to compensate for the decreasing value of money, making loans more expensive.

Therefore, both statements are correct reflections of the relationship between inflation and economic activity.