Indian Economy: UPSC Previous Year Questions (Prelims)

Explanation

Statement 1 is correct: When a company uses its funds to acquire or upgrade physical assets, it is called Capital Expenditure (CapEx). These assets can include property, plants, buildings, technology, or equipment. CapEx is intended to provide long-term benefits to the organization.

Statement 2 is incorrect: When a company borrows money to be paid back at a future date with interestit is known as debt financing. It is not a capital expenditure. Equity financingis the process of raising capital through the sale of shares.It is an example of non-debt capital receipts, not revenue expenditure.

Explanation

Statement 1 is correct: In India, people save through various financial options, including bank deposits, pension funds, insurance schemes, and government securities. Some of these savings are invested in government bonds and securities, helping the government fund its expenditures and manage its budget shortfall. Thus a portion of household financial savings is used to support government borrowing.

Statement 2 is correct: The Indian government raises money by issuing dated securities, which are long-term bonds with a fixed maturity date. Their interest rates are decided by market demand and supply. The government sells these securities through auctions, where banks, financial institutions, and investors place bids. These bonds make up a large part of the government’s internal debt, which is the money it owes to lenders with-in the country. The share of marketable securities in internal debt is at 76.4 per cent at end-March 2023 which is slightly moderate relative to 76.9 per cent at end-March 2022. The share of dated securities in public debt stood at 66.3 per cent at end-March 2023.

Outstanding Marketable Dated Securities (₹ crore, actuals at end-March)

Explanation

Rapid Financing Instrument (RFI) and Rapid Credit Facility (RCF) are instruments of the International Monetary Fund (IMF) which provides financial assistance to the countries in need. Rapid Financing Instrument (RFI): The Rapid Financing Instrument (RFI) provides rapid financial assistance, which is available to any IMF member countries facing an urgent balance of payment needs. The RFI was created as part of a broader reform to make the IMF’s financial support more flexible to address the diverse needs of member countries. It is one of the facilities under the General Resources Account (GRA) that provide financial support to countries, including in times of crisis. Rapid Credit Facility (RCF): The Rapid Credit Facility (RCF) provides rapid concessional financial assistance to low-income countries (LICs) facing an urgent Balance of Payments (BoP) need with no ex post conditionality where a full-fledged economic program is neither necessary nor feasible. The RCF was created under the Poverty Reduction and Growth Trust (PRGT) as part of a broader reform to make the Fund’s financial support more flexible and better tailored to the diverse needs of LICs, including in times of crisis.

Explanation

Statement 1 is correct: The Nominal Effective Ex-change Rate (NEER) is an unadjusted weighted average rate at which a country’s currency exchanges for a basket of multiple foreign currencies. An increase in NEER signifies that the domestic currency has strengthened or appreciated relative to the selected basket of foreign currencies. An increase in NEER means that, on average, the rupee has become more valuable relative to those other currencies. It takes more of the foreign currencies to buy one unit of the rupee.

Statement 2 is incorrect: Real Effective Exchange Rate (REER) is a measure of a country’s currency value relative to a basket of other currencies adjusted for inflation differentials. An increase in REER implies that the domestic currency has appreciated in real terms, making exports more expensive and im-ports cheaper. Consequently, a higher REER indicates a loss in trade competitiveness, not an improvement.

Statement 3 is correct: If domestic inflation is higher than inflation in other countries, the REER will appreciate (be-come more expensive) even if the NEER remains constant or depreciates. This divergence occurs because the REER calculation accounts for inflation differentials. The higher domestic inflation makes a country’s goods less competitive, even if nominal exchange rates don’t reflect that.

Explanation

Statement 1 is correct: A tight monetary policy by the US Federal Reserve typically involves increasing interest rates to control inflation. Higher US interest rates can attract investors seeking better returns which can lead to capital outflows from emerging markets as investors move their funds to the US. This phenomenon is known as capital flight.

Statement 2 is correct: Capital flight can lead to the depreciation of the domestic currency as investors sell off local assets. For firms with ECBs(loans in foreign currency) denominated in foreign currencies, a weaker domestic currency means that more local currency is required to service the same amount of foreign debt, effectively increasing the interest cost and principal repayments in domestic currency terms.

Statement 3 is incorrect: Devaluation increases(not decreases) the currency risk associated with ECBs. If a firm has borrowed in a foreign currency and the domestic currency is devalued, the firm will have to pay more in domestic currency terms to repay the loan. This increases the burden of the debt and the currency risk for the borrower.

Explanation

Statements 1 and 2 are correct: Inflation-Indexed Bonds is a debt market securities offered by the government to protect the savings from inflation and offer positive real rates of returns. Since Inflation-Indexed Bonds (IIBs) provide inflation protection to investors, the government can offer these bonds with lower coupon rates compared to traditional bonds. The inflation adjustment compensates for the lower fixed interest.

Statement 3 is incorrect: The existing tax provisions will be applicable on interest payment and capital gains on IIBs. There will be no special tax treatment for these bonds.

Explanation

The real sector refers to the segment of the economy that is involved in the production and consumption of tangible goods and services. It includes industries such as agriculture, manufacturing, construction, mining, and services like health-care, education, and transportation. Statements 1 and 2 are correct:

Farmers harvesting their crops: This is a primary sector activity directly contributing to the production of goods (agricultural produce). Textile mills converting raw cotton into fabrics: This is a manufacturing activity, part of the secondary sector, which also belongs to the real sector. Statements 3 and 4 are incorrect:

A commercial bank lending money to a trading company:

This is a financial sector activity, involving monetary transactions rather than the production of tangible goods or services. A corporate body issuing Rupee Denominated Bonds overseas: This relates to the financial sector and capital markets, as it involves raising funds rather than producing goods or services.

Explanation

Statement 1 is correct: A convertible bond is a fixed-in-come corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. Convertible bonds generally offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature.

Statement 2 is correct: Equity (stock) prices tend to rise with inflation. Companies’ earnings and assets often appreciate during inflationary periods. Therefore, the option to convert a bond into equity provides a hedge against inflation. If inflation rises and the company performs well, its stock price is likely to increase. The bondholder can then convert the bond into equity at a more favorable price, thus benefiting from the rising prices and protecting their investment’s real value (purchasing power). This acts as a form of indexation (linking to a price index) against inflation.

Explanation

Inflation is the general rise in prices of goods and services within an economy wherein, the purchasing power of consumers decreases, and the value of the cash holdings erode. The creation of new money to finance a Budget Deficit is highly inflationary. The government prints new money or borrows directly from the central bank (RBI in India) to fund its deficit. This directly increases the money supply in the economy without a corresponding increase in goods and services. It leads to excess liquidity in the economy causing demand-pull inflation.

Explanation

A fall in the gross domestic product (GDP) for two or more consecutive quarters is often regarded as an economic recession. Recessions are brought on by high interest rates because they reduce liquidity, or the quantity of money available for investment.

Option (b) is correct: An increase in expenditure on public projects will lead to an increase in investments, leading to an increase in GDP and income in the economy and in turn increase in demand, completing the virtuous cycle of investment.

Option (a), (c) and (d) is incorrect:

Cutting taxes can increase disposable income, encouraging consumption and investment, which helps in a recession. However, raising interest rates makes borrowing more expensive, discouraging investment and consumption, which contradicts the objective of stimulating the economy during a recession. When income is falling in the economy then an increase in tax rates accompanied by a reduction of interest rate is not desirable at the moment. Reduction of expenditure on public projects in the time of recession will not be favourable as it will reduce the output of the economy.