Indian Economy: UPSC Previous Year Questions (Prelims)

Explanation

Demand-pull inflation is caused by an increase in demand and wherein the demand in the economy outgrows the supply in the economy. It can be summed up as a condition of ‘too much money chasing too few goods’. With reference to the Indian economy, demand-pull inflation can be caused/increased by the following:

1. Expansionary policies: Money in the market rises when the government spends more freely. It leads to an increase in demand for the goods and fuels demand-pull inflation.

2. Fiscal Stimulus: Fiscal stimulus is a government-driven strategy that involves adjusting government spending and taxes to stimulate the economy. It also increases the money in the market which leads to an increase in demand for the goods and fuels demand-pull inflation

3. Higher Purchasing Power: Consumers feel more confident and spend more when they have a better income. As a result, demand increases, driving up inflation. Rising interest rates will reduce the money supply in the market. Borrowing money will become costlier, creating a credit crunch in the economy. So, it can not cause demand to pull inflation in the economy. Inflation-indexing wages means wages are linked to the inflation which means wages move as inflation changes in the economy. Such indexing is provided to reduce the effect of inflation on wages. It can not lead to demand pull inflation in the economy. Effective change in the wages is zero and it does not increase/ decrease purchasing power. So it cannot lead to demand-pull inflation in the economy.

Explanation

Statement 1 is correct: The Reserve Bank’’s affairs are governed by a central board of directors. The board is appointed by the Government of India in keeping with the Reserve Bank of India Act,1934.

Statement 2 is incorrect: The Constitution of India does not contain provisions granting the Central Government the authority to issue directions to the RBI. However, such authority is provided under Section 7 of the Reserve Bank of India Act, 1934. This section allows the Central Government to issue directions to the RBI in matters of public interest.Accordingly the Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider it necessary in the public interest.

Statement 3 is correct: The powers and functions of the RBI Governor are derived from the Reserve Bank of India Act, 1934. The Act outlines the roles, responsibilities, and authority of the Governor in managing the affairs of the RBI.

Explanation

A Co-operative bank belongs to its members, who are at the same time the owners and the customers of their bank. Co-operative banks are under dual control of the RBI and Registrar of Cooperative Societies. Agriculture, some small-scale businesses, and independent contractors primarily receive funding from cooperative banks. These banks are cooperative credit institutions that are registered under the Cooperative Societies Act 1912. These banks work according to the cooperative principles of mutual assistance. Co-operative banks have a three-tier structure:

Primary Credit Societies-PCSs (agriculture or urban). District Central Co-Operative Banks-DCCBs. State Co-Operative Banks-SCBs (at the apex level).

Statement 1 is incorrect: After Banking Regulation(Amendment) Act 2020 was passed, Most of the powers were transferred to RBI from the Registrars of the cooperative societies. Urban Cooperative Banks are subject to dual regulation by both the Re-serve Bank of India (RBI) and the respective State Governments. The RBI oversees their banking operations, while the State Governments handle their incorporation, registration, management, and audit aspects through the Registrar of Cooperative Societies.

Statement 2 is correct: RBI has issued guidelines to allow UCBs to raise capital by issuing equity shares and preference shares, similar to other banking institutions. This allows them to diversify their funding sources and strengthen their capital base.

Statement 3 is correct: Urban Cooperative Banks (UCBs) were brought under the regulatory framework of the Banking Regulation Act, 1949 through the Banking Laws (Application to Cooperative Societies) Act, 1965, which came into effect in 1966. This amendment extended the provisions of the Banking Regulation Act, 1949, to cooperative banks, including UCBs, bringing them under the supervision of the RBI.

Explanation

Statement 2 is correct: A "lender of last resort" means that the RBI (also called banker of banks) offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse. By doing so, it helps stabilize the financial system and prevents bank runs and thereby safeguarding public confidence in the banking sector. Statements 1 and 3 are incorrect:

Trade and industry bodies typically borrow from commercial banks or financial markets and not directly from the central bank. The RBI’s role as a lender of last resort is limited to the banking sector to ensure financial stability. Providing funds to cover government budgetary deficits is not part of the lender-of-last-resort function. The RBI’s support in such cases would fall under separate monetary management activities rather than emergency banking support.

Explanation

Option (a) is incorrect: An increase in the CRR means banks have to keep a larger portion of their deposits with the Re-serve Bank of India (RBI), reducing the funds available for lending. This leads to a decrease in the money multiplier.

Option (b) is incorrect: An increase in the SLR requires banks to hold a higher percentage of their deposits in the form of liquid assets like government securities, reducing their ability to lend. This also leads to a decrease in the money multiplier.

Option (c) is correct: When more people prefer banking and keep their money in banks instead of holding cash, it increases deposits in the banking system. This boosts banking activities like lending, which leads to a higher money multiplier as the deposits circulate through the system.

Option (d) is incorrect: While an increase in population may lead to more economic activity, it does not directly affect the money multiplier unless it translates into higher banking habits or changes in monetary policy.

Explanation

Black money refers to income or wealth that is generated through illegal means or through legitimate activities that are not reported to the authorities for the purpose of avoiding taxes. It typically exists in the form of undeclared or unaccounted money, which is not taxed by the government.

Option (a) is incorrect: While this is a consequence of black money, it is not the primary concern. The real estate market may become inflated due to investments made with black money, but this diversion of funds does not directly impact the government’s ability to generate revenue through taxation. However, it can lead to inefficient allocation of resources.

Option (b) is incorrect: Black money often gets invested in unproductive assets like gold, precious stones, and luxury items. Al-though this can lead to economic inefficiencies, it does not directly cause a loss of government’s ability to generate revenue. The main problem lies in the undocumented nature of these transactions, leading to tax evasion.

Option (c) is incorrect: Black money can be funneled into undocumented political donations and may contribute to regional political growth. However, the core issue remains the loss of tax revenue rather than the political consequences.

Option (d) is correct: The main issue with black money is tax evasion, resulting in a significant loss of revenue for the government. Without the full collection of taxes, the government faces challenges in funding essential public services and development projects, which is the biggest concern for India’s economic health.

Explanation

Statement 1 is correct: Devaluation is a decrease in the value of a country’s currency relative to other currencies. It means it takes more of the domestic currency to buy one unit of a foreign currency. For example, if the exchange rate changes from 70 to 80 per dollar, the rupee has been devalued. Devaluation makes a country’s exports cheaper for foreign buyers. This can increase demand for exports, leading to higher export volumes and potentially improving the trade balance (ex-ports minus imports).

Statement 2 is incorrect: Devaluation means a decrease(not increase) in the value of the domestic currency relative to foreign currencies. It takes more of the domestic currency to buy one unit of a foreign currency.

Statement 3 is incorrect: Devaluation can potentially improve the trade balance over time by boosting exports and reducing imports, but it is not guaranteed. The trade balance may deteriorate because import costs rise immediately, while export volumes may take time to increase. This phenomenon is called the J-curve effect. If a country devalues its currency, it still has to pay higher prices for imported oil, machinery, and technology. Over time, as foreign buyers demand more of its cheaper exports, the trade balance may improve.

Explanation

Foreign Direct Investment (FDI) refers to an investment made by an entity (typically a company or individual) from one country into a business or asset in another country, with the intent of establishing a lasting interest and exerting a degree of influence over the enterprise’s management and operations. It’s not just about a financial transaction but more about substantial and enduring involvement. Foreign currency convertible bonds (FCCBs) are debt instruments issued by a company in a foreign currency, which can be converted into equity shares at a future date. Because FCCBs can be converted into equity, and thus represent a potential ownership stake so They are considered a component of FDI. Foreign Institutional Investment (FII) are investments made by foreign institutions in the financial markets of another country. In India, if an FII’s investment exceeds 10% of the post-issue paid-up equity capital of a company, it is reclassified as FD Global Depository Receipts (GDRs) are financial instruments used by companies to raise capital from international markets. They represent shares of a foreign company and are traded on international stock exchanges. Investments through GDRs are treated as FDI since they result in foreign equity participation in the issuing company. Non-Resident External (NRE) Deposits are deposits held by non-resident Indians (NRIs) in Indian banks in Indian rupees. They are primarily a means for NRIs to invest their savings in India. While they represent a flow of foreign funds into India, they are not considered FDI. They are more akin to portfolio investments or remittance as they don’t involve a direct stake in a business or substantial management influence.

Explanation

Bond yield is the return an investor gets on that bond or on a particular government security. It depends on the price of the bond which is impacted by its demand.

Statement 1, 2 and 3 are correct:

Factor Scenario Impact Effect on Bond Yields

1. US Federal Reserve Actions Raises Inter-est Rates Capital outflows from In-dia as US bonds become more attractive. Yields rise due to lower demand for Indian bonds. Lowers Interest Rates Capital inflows to India as Indian bonds offer better returns. Yields fall due to higher demand for Indian bonds.

2. RBI Actions Increases Repo Rates (Tightening Policy) Higher borrowing costs slow down credit growth and economic activity. Yields rise as new bonds offer higher interest. Cuts Repo Rates (Easing Policy) Cheaper borrowing encourages economic activity and credit flow. Yields fall as new bonds are issued at lower rates.

3. Inflation and Short-Term Interest Rates Rising Inflation Reduces the real value of bond interest payments. Yields rise to compensate for inflation. Falling Inflation Improves real returns on bonds, making them more attractive. Yields fall due to increased bond demand.

Explanation

Statement 1 is correct: Retail investors can participate in government securities (G-Secs) like Treasury Bills (T-Bills) and Government of India Bonds through schemes such as Retail Direct Scheme facilitated by the Reserve Bank of India (RBI). This allows them to invest directly in the primary market using Demat accounts.

Statement 2 is correct: The NDS-OM platform, is an electronic trading platform, operated by the RBI, is an anonymous order-matching system for secondary market trading in government securities (G-Secs)

Statement 3 is incorrect: CDSL is promoted by the Bombay Stock Exchange (BSE) but not by the Reserve Bank of India. It is promoted by BSE Ltd. jointly with leading banks such as State Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank and Union Bank of India.