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IAS Prelims Exam 2016: GS Economy Questions: Inflation and Business Cycle Set III

Jul 11, 2016 03:50 IST

    From UPSC IAS Examination point of view, the Questions based on Indian Economy are very important. The UPSC IAS Exam aspirants must be aware of the every perspective of Indian Economy either it is historical perspective or current perspective.


    For the Civil Services aspirants, here, we have developed Multiple Choice Questions for the UPSC IAS Prelims Exam based on Ramesh Singh’s Indian Economy book, one of the most important books available for UPSC IAS Exam.
    1.    Consider the following statements regarding the Phillip Curve:
    I.    It is a graphic curve which advocates a relationship between inflation and unemployment in an economy.
    II.    As per the curve there is a ‘trade off’ between inflation and unemployment i.e. an inverse relationship between them.
    III.    The curve suggests that lower the inflation, higher the unemployment and higher the inflation, lower the unemployment.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    II and III
    d.    All of the above

    Answer: d

    Explanation:


    It is a graphic curve which advocates a relationship between inflation and unemployment in an economy. As per the curve there is a ‘trade off’ between inflation and unemployment i.e. an inverse relationship between them. The curve suggests that lower the inflation, higher the unemployment and higher the inflation, lower the unemployment.

    During 1960s, this idea was among the most important theories of the modern economists. This concept is known after the economists who developed it— Alban William Housego Phillips (1914–75). Bill Phillips (popular name) was an electrical engineer from New Zealand and was an economist at the London School of Economics when propounded the idea.

    In ‘The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957’ (published in Economica in 1958), he provided empirical evidence to support his ideas.

    2.    Consider the following statements regarding NAIRU?
    I.    The NAIRU is that rate of unemployment which is consistent with a constant rate of inflation.
    II.    At NAIRU, the upward and downward forces on price (inflation) and wage (unemployment) neutralise each other and there is no tendency of change in the rate of inflation.
    III.    The NAIRU is the lowest unemployment rate that an economy can sustain without any upward pressure on inflation rate.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    II and III
    d.    All of the above

    Answer: d

    Explanation:


    By the early 1970s, two American economists, Milton Friedman (Nobel Laureate, 1976) and Edmund Phelps challenged the idea of the Phillips Curve. According to them the trade-off between inflation and unemployment was only short-term, because once people came to expect higher inflation they started demanding higher wages and thus unemployment will rise back to its ‘natural rate’ (the unemployment rate that occurs at full employment when the economy is producing at potential output, it is usually called the natural rate of unemployment).

    They advocated that there was no long-term trade-off between inflation and unemployment. In the long run, monetary policy can influence inflation. They suggested that if monetary policy tried to hold unemployment below its natural rate, inflation will be rising to higher level—which is known as the non-accelerating inflation rate of unemployment (NAIRU) also.

    The NAIRU is that rate of unemployment which is consistent with a constant rate of inflation. It means at NAIRU, the upward and downward forces on price (inflation) and wage (unemployment) neutralise each other and there is no tendency of change in the rate of inflation. We may say that the NAIRU is the lowest unemployment rate that an economy can sustain without any upward pressure on inflation rate.

    IAS Prelims Exam 2016: GS Economy Questions: Inflation and Business Cycle Set II

    3.    Consider the following statements regarding 'reflation':

    I.    It is a situation often deliberately brought by the government to reduce unemployment and increase demand by going for higher levels of economic growth.
    II.    Reflation can also be understood from a different angle—when the economy is crossing a cycle of recession and government takes some economic policy decisions to revive the economy from recession.
    III.    It is a situation in an economy when inflation and unemployment both are at higher levels, contrary to conventional belief.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    II and III
    d.    All of the above

    Answer: b

    Explanation:


    Reflation is situation often deliberately brought by the government to reduce unemployment and increase demand by going for higher levels of economic growth. Governments go for higher public expenditures, tax cuts, interest rate cuts, etc. Fiscal deficit rises, extra money is generally printed at higher level of growth, wages increase and there is almost no improvement in unemployment.

    Reflation can also be understood from a different angle—when the economy is crossing a cycle of recession (low inflation, high unemployment, low demand, etc.) and government takes some economic policy decisions to revive the economy from recession, certain goods see sudden and temporary increase in their prices, such price rise is also known as reflation.

    4.    With reference to the stagflation which of the following statements is correct:
    a.    It is a situation often deliberately brought by the government to reduce unemployment and increase demand by going for higher levels of economic growth.
    b.    It can also be understood from a different angle—when the economy is crossing a cycle of recession and government takes some economic policy decisions to revive the economy from recession.
    c.    It is a situation in an economy when inflation and unemployment both are at higher levels, contrary to conventional belief.
    d.    All of the above

    Answer: c

    Explanation:


    A situation in an economy when inflation and unemployment both are at higher levels, contrary to conventional belief. Such a situation first arose in 1970s in the US economy (average unemployment rate above 6 per cent and the average rate of inflation above 7 per cent) and in many Euro-American economies. This took place as a result of oil price increases of 1973 and 1979 and anticipation of higher inflation.

    The stagflationary situation continued till the early 1980s. Conventional thinking that a trade-off existed between inflation and unemployment (i.e. Phillips curve) was falsified and several economies switched over to alternative ways of economic policies such as monetaristic and supply-side economics.

    When the economy is passing through the cycle of stagnation (i.e. long period of low aggregate demand in relation to its productive capacity) and the government shuffles with the economic policy, a sudden and temporary price rise is seen in some of the goods—such inflation is also known as stagflation. Stagflation is basically a combination of high inflation and low growth.

    5.    Consider the following statements regarding the inflation targeting:
    I.    The announcement of an official target range for inflation is known as inflation targeting.
    II.    The inflation targeting is done by the Central Bank in an economy as a part of their monetary policy to realise the objective of a stable rate of inflation.
    III.    New Zealand was the first economy to go for inflation targeting in 1989 which has been followed by almost all economies since then.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    II and III
    d.    All of the above

    Answer: d

    Explanation:


    The announcement of an official target range for inflation is known as inflation targeting. It is done by the Central Bank in an economy as a part of their monetary policy to realise the objective of a stable rate of inflation (the Government of India asked the RBI to perform this function in the early 1970s).

    New Zealand was the first economy to go for inflation targeting in 1989 which has been followed by almost all economies since then. In the Indian case, the target ranges between 4 to 5 per cent which is also popular as the comfort zone of inflation in India.

    6.    Consider the following statements regarding the GDP Deflator:
    I.    This is the ratio between GDP at Current Prices and GDP at Constant Prices.
    II.    If GDP at Current Prices is equal to the GDP at Constant Prices, GDP deflator will be 0, implying no change in price level.
    III.    If GDP at Current Prices is equal to the GDP at Constant Prices, GDP deflator will be 1, implying no change in price level.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    I and III
    d.    All of the above

    Answer: c

    Explanation:


    This is the ratio between GDP at Current Prices 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 price level. If GDP deflator is found to be 2, it implies rise in price level by a factor of 2, and if GDP deflator is found to be 4, it implies a rise in price level by a factor of 4.

    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 the WPI).

    7.    Consider the following statements regarding the ‘base effect’:
    I.    The base rate refers to the impact of the rise in price level (i.e. last year’s inflation) in the previous year over the corresponding rise in price levels in the current year (i.e., current inflation).
    II.    If the price index had risen at a high rate in the corresponding period of the previous year, leading to a high inflation rate then the similar absolute increase in the Price index in the current year will lead to a relatively lower inflation rates.
    III.    If the inflation rate was too low in the corresponding period of the previous year, even a relatively smaller rise in the Price Index will arithmetically give a high rate of current inflation.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    I and III
    d.    All of the above

    Answer: d

    Explanation:



    It refers to the impact of the rise in price level (i.e. last year’s inflation) in the previous year over the corresponding rise in price levels in the current year (i.e., current inflation).

    If the price index had risen at a high rate in the corresponding period of the previous year, leading to a high inflation rate, some of the potential rise is already factored in, therefore, a similar absolute increase in the Price index in the current year will lead to a relatively lower inflation rates. On the other hand, if the inflation rate was too low in the corresponding period of the previous year, even a relatively smaller rise in the Price Index will arithmetically give a high rate of current inflation.

    8.    Consider the following statements regarding the effects of inflation on an economy:
    I.    There are multi-dimensional effects of inflation on an economy both at the micro and macro levels.
    II.    Inflation redistributes wealth from creditors to debtors i.e. lenders suffer and borrowers benefit out of inflation.
    III.    Rising inflation indicates rising aggregate demand and indicates comparatively lower supply and higher purchasing capacity among the consumers.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    I and II
    c.    I and III
    d.    All of the above

    Answer: d

    Explanation:

    There are multi-dimensional effects of inflation on an economy both at the micro and macro levels. Inflation redistributes wealth from creditors to debtors i.e. lenders suffer and borrowers benefit out of inflation. The opposite effect takes place when inflation falls (i.e. deflation).

    Rising inflation indicates rising aggregate demand and indicates comparatively lower supply and higher purchasing capacity among the consumers. Usually, higher inflation suggests the producers to increase their production level as it is generally considered as an indication of higher demand in the economy. Higher inflation indicates higher demand and suggests entrepreneurs to expand their production level and Higher the inflation, lower the cost of loan.

    9.    With reference to the effects of inflation on savings which of the following statements is correct?
    I.    In the long-run, higher inflation depletes the saving rate in an economy.
    II.    In the short run higher inflation means that saving rate increases.
    III.    In cases the opposite situation arises when inflation falls or shows falling traits with decreasing saving, in the short-run and increasing saving in the long-run, respectively.

    Codes:
    a.    Only I
    b.    I and II
    c.    I and III
    d.    All of the above

    Answer: d

    Explanation:

    Holding money does not remain an intelligent economic decision (because money loses value with every increase in inflation) that is why people visit banks more frequently and try to hold least money with themselves and put maximum with the banks in their saving accounts. This is also known as the shoe leather cost of inflation (as it consumes the precious time of the people visiting the bank frequently tagging their shoe!).

    It means that saving rate increases. But this happens as a short-term effect of inflation. In the long-run, higher inflation depletes the saving rate in an economy. Just the opposite situation arises when inflation falls or shows falling traits with decreasing saving, in the short-run and increasing saving in the long-run, respectively.

    10.    Consider the following statements regarding the effects of inflation on tax structure of the economy:
    I.    Due to inflation, direct tax (income tax, interest tax, etc.) burden of the tax-payers also increases as tax-payer’s gross income moves to the upward slabs of official tax brackets
    II.    Inflation increases the nominal value of the gross tax revenue while real value of the tax collection does not compare with the current pace of inflation as there is a lag (delay) in the tax collection in all economies.

    Which of the following statement(s) is/are correct?
    a.    Only I
    b.    Only II
    c.    Both I and II
    d.    Neither I nor II

    Answer: d

    Explanation:

    On tax structure of the economy, inflation creates two distortions:

    (a) Tax-payers suffer while paying their direct and indirect taxes. As indirect taxes are imposed ad valorem (on value), increased prices of goods make tax-payers to pay increased indirect taxes (like cenvat, vat, etc. in India).
    Similarly, due to inflation, direct tax (income tax, interest tax, etc.) burden of the tax-payers also increases as tax-payer’s gross income moves to the upward slabs of official tax brackets
    (but the real value of money does not increase due to inflation; in fact, it falls). This problem is also known as bracket creep — i.e. inflation-induced tax increases. Some economies (as in the US and many European countries) have indexed their tax provisions to neutralise this distortion on the direct tax payers.

    (b) The extent to which tax collections of the government are concerned, inflation increases the nominal value of the gross tax revenue while real value of the tax collection does not compare with the current pace of inflation as there is a lag (delay) in the tax collection in all economies.

     

    It is necessary for the UPSC IAS aspirants to understand the concepts of Inflation and other aggregates of Macroeconomics which affects an economy as a whole. Such macroeconomic concepts have greater influence on day to day economic activities performed by the common people. So, being an administrator or as a Civil Servant, must posses with the knowledge of such concepts and it is one of most important section of GS Economy of UPSC IAS Prelims Exam Syllabus.

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