DETAILED

TEST-8 EXPLANATION PDF

October 6th, 2019

Lesson 5
Inflation
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

Inflation .................................................................... 2 Advantages of Inflation ................................... 13

Understanding Inflation ....................................... 2 Disadvantages of Inflation .............................. 13
Why Study Inflation?............................................ 2 Inflation Management in India ........................... 14
Uncertainty ....................................................... 3 Reasons for Periodic Spurt in Inflation in India
Haphazard Redistribution ................................. 3 ......................................................................... 14

Causes of Inflation ............................................... 3 Inflation Targeting in India .............................. 15

Demand-Pull Inflation ....................................... 4 How to Control Inflation? ................................... 16
Cost-Push Inflation ........................................... 4 Interest Rate.................................................... 16

Types of Inflation Indexes .................................... 4 Reserve Ratios ................................................. 16

Wholesale Price Index ...................................... 4 Open Market Operations ................................ 16
Consumer Price Index ....................................... 5 Reducing the Money Supply ........................... 16
Wholesale Price Index Vs Consumer Price Index MCQs for Practice................................................... 18
.......................................................................... 6 MCQs with Answer and Explanation ...................... 19
Headline Inflation ............................................. 6
Core Inflation .................................................... 6
Consumer Food Price Index .............................. 7
WPI Food Index ................................................. 7
Producer Price Index......................................... 8
PPI vs Wholesale Price Index ............................... 8
PPI vs Consumer Price Index ................................ 8
Application of Inflation in Economic Analysis ...... 9
Inflation and Nominal & Real GDP ................... 9
Nominal GDP ........................................................ 9
Real GDP.............................................................10
Inflation and Value of Money ......................... 10
Inflation and Nominal & Real Interest Rate ... 10
Inflation and Base Effect ................................. 11
Bonds, Interest Rates and the Impact of
Inflation........................................................... 11
The price-yield seesaw and interest rates .........11
What moves the seesaw? ..................................11
If inflation means higher prices, why do bond
prices drop? .......................................................12
Inflation, Interest Rate and Bonds .....................12
Pros and Cons of Inflation .................................. 13

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
1
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

the domestic economy at a range of price levels,

INFLATION during a given time period.

Money Supply: The quantity of money balances

UNDERSTANDING INFLATION that exists in the economy. The money supply is
controlled by the Reserve Bank of India through its
monetary policy.
Inflation occurs when the average price level (that
is, prices in general) increases over time. This does Purchasing Power: In general, the quantities of
not mean that all prices increase the same, nor that goods and services that can be bought with a given
all prices necessarily increase. Some prices might amount of money. The notable feature of
increase a lot, others a little, and still other prices purchasing power is that it declines as prices rise.
decrease or remain unchanged. Inflation results In particular, inflation is the number one nemesis
when the average of these assorted prices follows of purchasing power. When inflation gives higher
an upward trend. prices, purchasing power falls.
While short-term bouts of inflation can be triggered Inflation: A persistent increase in the average
by anything that would cause aggregate demand to price level in the economy. It is measured by the
increase more than aggregate supply, long-term inflation rate, the annual percentage change in a
inflation can be sustained only through increases in price index such as the Consumer Price Index (CPI)
the money supply. The price level, and any or GDP price deflator. Inflation is the most
"inflation" of the price level, depends directly on the common phenomenon associated with the price
amount of money in circulation. On the flip side of level. Two related phenomena are deflation, a
this relationship, inflation leads to a continual decrease in the price level, and disinflation, a
erosion in the purchasing power of money. decrease in the inflation rate. Inflation is one of
two key macroeconomic problems.
KEY DEFINITION

Price Level: The average of the prices of goods and QUESTION 1

services produced in the aggregate economy. In a Q. Which one of the following statements is an
theoretical sense, the price level is the price of appropriate description of deflation? [2010]
aggregate production. In a practical sense, the (a) It is a sudden fall in the value of a currency
price level is measured by either of two price against other currencies
indexes, the Consumer Price Index (CPI) or the (b) It is a persistent recession in both the financial
GDP price deflator. and real sectors of economy
(c) It is a persistent fall in the general price level
Aggregate Demand: The total (or aggregate) real of goods and services
expenditures on final goods and services produced (d) It is a fall in the rate of inflation over a period
in the domestic economy that buyers would be of time
willing and able to make at different price levels, Answer: C
during a given time period (usually a year). The
aggregate expenditures are consumption,
investment, government purchases, and net WHY STUDY INFLATION?
exports made by the four macroeconomic sectors
Inflation attracts the interest of economists, policy
(household, business, government, and foreign).
makers, and regular everyday ambling folks for a
couple of reasons: uncertainty and haphazard
Aggregate Supply: The total (or aggregate) real
redistribution.
production of final goods and services available in
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
2
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

UNCERTAINTY While inflation is an increase in the average price

level, all prices do not increase at the same rate.
First, inflation creates uncertainty, especially when When prices change at different rates, the owners of
inflation catches people unexpectedly off guard or resource used in the production of goods with
fluctuates widely from month to month or year to above-average price increases receive more real
year. income. Resource owners involved in the
production of goods with below-average price
The reason that most people, consumers and increases (even declining prices) get relatively less
producers alike, do not like unexpected inflation is real income. The end result is the income and wealth
that they are risk averse; they prefer a knowable, are redistributed from some resource owners to
stable, predictable life. Known, constant, or others.
expected inflation can be integrated into the fabric
of the economy. If people know that prices will be One of the most noted areas of inflation-induced
increasing by 10 percent, then they can adjust plans redistribution is between borrowers and lenders.
accordingly. However, unexpected or changing When borrowers and lenders correctly anticipate
inflation creates uncertainty, making long-range inflation over the life of a loan, they adjust the
planning exceedingly difficult. interest rate to ensure that the purchasing power of
the money loaned is equal to the purchasing power
For example, a significant amount of household, of the money repaid.
business, and government activity involves long-
term commitments--such as borrowing to purchase However, income and wealth are redistributed
cars and homes, investing in multi-year capital between borrowers and lenders when inflation is
construction projects, anticipating tax or revenue not correctly anticipated.
collections, and planning expenditure budgets.
If inflation is more than expected, then the
Not knowing, or not correctly anticipating, inflation purchasing power of the repayment is less than the
makes such commitments difficult at best and might original loan, so income and wealth are
even be financial disastrous. Households and redistributed from lenders to borrowers.
businesses can be forced into bankruptcy.
Governments can encounter serious fiscal If inflation is less than expected, then the
problems. purchasing power of the repayment is more than
the original loan, so income and wealth are
A worker might not know whether to accept a multi- redistributed from borrowers to lenders.
year employee contract with automatic wage
increases of 2 percent or 12 percent. A business
might not know whether to plan for a 3 percent or CAUSES OF INFLATION
13 percent increase in raw material prices.
The causes of inflation are conveniently analysed
within the framework of a simple market. In general,
HAPHAZARD REDISTRIBUTION prices increase as a result of market shortages,
which occur when quantity demanded exceeds
Second, inflation can haphazardly redistribute quantity supplied.
income and wealth. The redistribution of income
and wealth has always been an inherent part of the Market shortages can be created by either increases
economy. However, inflation can redistribute in demand or decreases in supply. Translating this
income in ways that society might not want. to the macroeconomy suggests that inflation occurs
when aggregate demand exceeds aggregate supply.
Inflation-inducing, economy-wide shortages can be
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
3
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

created by either increases in aggregate demand or While any of the factors of production "could"
decreases in aggregate supply. trigger cost-push inflation, labour and land are the
two factors most likely to do so--especially wages
This analysis suggests the two basic types of and energy prices.
inflation: demand-pull inflation and cost-push
inflation.
QUESTION 2
DEMAND-PULL INFLATION Q. A rise in general level of prices may be caused
by [2013 - I]
Demand-pull inflation places responsibility for 1. an increase in the money supply
inflation squarely on the shoulders of increases in 2. a decrease in the aggregate level of output
aggregate demand. This type of inflation results 3. an increase in the effective demand
when the four macroeconomic sectors (household, Select the correct answer using the codes given
business, government, and foreign) collectively try below:
to purchase more output than the economy is (a) 1 only
capable of producing. (b) 1 and 2 only
(c) 2 and 3 only
In general, if aggregate demand increases beyond (d) 1, 2 and 3
aggregate supply, buyers seek to buy more Answer: D
production than the economy can provide. The
buyers bid up the price. This extra demand "pulls"
the price level higher.
TYPES OF INFLATION INDEXES
Any increase in aggregate demand resulting from
changes in any of the aggregate demand WHOLESALE PRICE INDEX
determinants can trigger demand-pull inflation.
However, the only way to sustain demand-pull ▪ Wholesale Price Index (WPI) measures the
inflation is with an increase in the money supply. average change in the prices of commodities for
Inflation simply cannot persist for any extended bulk sale at the level of early stage of
period of time (that is, a year or more) without transactions.
increases in the amount of money available to the ▪ The index basket of the WPI covers commodities
economy. falling under the three major groups namely
Primary Articles, Fuel and Power and
COST-PUSH INFLATION Manufactured products.
▪ The prices tracked are ex-factory price for
Cost-push inflation places responsibility for inflation manufactured products, mandi price for
directly on the shoulders of decreases in aggregate agricultural commodities and ex-mines price for
supply that result from increases in production minerals.
cost. This type of inflation occurs when the cost of ▪ Weights given to each commodity covered in the
using any of the four factors of production (labour, WPI basket is based on the value of production
capital, land, or entrepreneurship) increases. adjusted for net imports.
▪ WPI basket does not cover services.
In general, higher production cost means the ▪ In India, Office of Economic Advisor (OEA),
economy simply cannot continue to supply the Department for Promotion of Industry and
same production at the same price level. If buyers Internal Trade, Ministry of Commerce and
want the production, they must pay higher prices. Industry calculates the WPI.
The higher cost "pushes" the price level higher. ▪ The main uses of WPI are the following:

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
4
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

1. It provides estimates of inflation at the across the major groups to ensure

wholesale transaction level for the economy comprehensive coverage and
as a whole. This helps in timely intervention representativeness.
by the Government to check inflation in ▪ Wholesale price index calculated with 2011-12
particular, in essential commodities, before base year does not include taxes in order to
the price increase spill over to retail prices. remove the impact of fiscal policy. This also
2. WPI is used as deflator for many sectors of brings the present WPI series closer to Producer
the economy including for estimating GDP by Price Index, as is practised globally. A Producer
Central Statistical Organisation (CSO). Price Index reflects the change in average prices
3. WPI is also used for indexation by users in that producers get.
business contracts.
4. Global investors also track WPI as one of the
key macro indicators for their investment
decisions.
▪ The Government periodically reviews and
revises the base year of the WPI as a regular
exercise to capture structural changes in the
economy and improve the quality, coverage and
representativeness of the indices. The
Wholesale Price Index (WPI) series in India has
undergone six revisions in 1952-53, 1961-62, CONSUMER PRICE INDEX
1970-71, 1981-82, 1993-94 and 2004-05 so far.
▪ The base year of All-India WPI has been revised ▪ Consumer Price Index (CPI) is a measure of
from 2004-05 to 2011-12 on 12 May 2017 to change in retail prices of goods and services
align it with the base year of other consumed by defined population group in a
macroeconomic indicators like the Gross given area with reference to a base year. This
Domestic Product (GDP) and Index of Industrial basket of goods and services represents the level
Production (IIP). The current series is the seventh of living or the utility derived by the consumers
revision. at given levels of their income, prices and tastes.
▪ The revision entails not just shifting the base ▪ The CPI number measures changes only in one
year to 2011-12 from 2004-05, but also changing of the factors: prices. This index is an important
the basket of commodities and assigning new economic indicator and is widely considered as a
weights to the commodities. barometer of inflation, a tool for monitoring
▪ The weight of an item in the WPI basket is based price stability and as a deflator in national
on the net traded value of the item in the base accounts.
year i.e. 2011-12. The net traded value is the ▪ The dearness allowance of Government
value of output of the item in the year 2011-12 employees and wage contracts between labour
adjusted for net imports. Thus, net traded value and employer is based on this index.
represents the total transactions of each ▪ The formula for calculating CPI is Laspeyre’s
product in the economy during the base year. index which is measured as follows: [Total cost
▪ In the updated WPI basket, the number of items of a fixed basket of goods and services in the
has been increased from 676 to 697. In all 199 current period * 100] divided by Total cost of
new items have been added and 146 old items the same basket in the base period.
have been dropped. Efforts have been made to ▪ Presently the consumer price indices compiled in
enhance the number of quotations from 5482 to India are CPI for Industrial workers CPI(IW), CPI
8331, an increase by 2849 quotations (52%). The for Agricultural Labourers CPI(AL) and; Rural
increase in number of quotations has been done Labourers CPI(RL) and (Urban) and CPI(Rural).

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
5
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

▪ The CPI(IW) and CPI (AL & RL) compiled are are not part of WPI basket. A significant
occupation specific and centre specific and are proportion of WPI item basket represents
compiled by Labour Bureau. This means that manufacturing inputs and intermediate goods
these index numbers measure changes in the like minerals, basic metals, machinery etc. whose
retail price of the basket of goods and services prices are influenced by global factors but these
consumed by the specific occupational groups in are not directly consumed by the households and
the specific centres. are not part of the CPI item basket.
▪ CPI (Urban) and CPI (Rural) are new indices in ▪ Thus, even significant price movements in items
the group of CPI and has a wider coverage of included in WPI basket need not necessarily
population. This index compiled by Central translate into movements in CPI in the short run.
Statistical Organisation, Ministry of Statistics The rise or fall in prices at wholesale level spill
and Programme Implementation, tries to over to the retail level after a lag.
encompass the entire population and is likely to
replace all the other indices presently compiled. HEADLINE INFLATION
▪ The Reserve Bank of India (RBI) has started
▪ In general, headline inflation reflects the rate of
using CPI-combined (both Urban & Rural) as the
change in prices of all goods and services in an
sole inflation measure for the purpose of
economy over a period of time. Every country
monetary policy. As per the agreement on
has its own set of commodity basket to track
Monetary Policy Framework between the
inflation. While some countries use Wholesale
Government and the RBI dated February 20,
Price Index (WPI) as their official measure of
2015 the sole of objective of RBI is price stability
inflation, most others use the Consumer Price
and a target is set for inflation as measured by
Index (CPI).
the Consumer Price Index-Combined.
▪ Up until March 2014, Reserve Bank of India (RBI)
WHOLESALE PRICE INDEX VS had given more weightage to Wholesale Price
CONSUMER PRICE INDEX Index (WPI) than CPI as the key measure of
inflation for all policy purposes.
▪ WPI reflects the change in average prices for ▪ Since April 2014, RBI has adopted the new
bulk sale of commodities at the first stage of Consumer Price Index (CPI) (combined) as the
transaction while CPI reflects the average key measure of inflation.
change in prices at retail level paid by the ▪ Therefore CPI-combined is the measure of
consumer. headline inflation in India now.
▪ The prices used for compilation of WPI are
collected at ex-factory level for manufactured CORE INFLATION
products, at ex-mine level for mineral products
and mandi level for agricultural products. In ▪ Core Inflation is also known as underlying
contrast, retail prices applicable to consumers inflation, is a measure of inflation which
and collected from various markets are used to excludes items that face volatile price
compile CPI. movement, notably food and energy. In other
▪ The reasons for the divergence between the words, Core Inflation is nothing but Headline
two indices can also be partly attributed to the Inflation minus inflation that is contributed by
difference in the weight of food group in the food and energy commodities.
two baskets. CPI Food group has a weight of 39.1 ▪ To understand the concept in a better way we
per cent as compared to the combined weight of can say that food and fuel prices may go up in
24.4 per cent (Food articles and Manufactured the short run due to some disturbance in the
Food products) in WPI basket. agriculture sector or oil economy. However,
▪ The CPI basket consists of services like housing, over the long term they tend to revert back to
education, medical care, recreation etc. which their normal trend growth. On the other hand,

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
6
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

prices of other commodities do not fluctuate as separately on an all India basis with effect from
regularly as food and fuel – as such increase in May, 2014.
their prices could be taken relatively to be much ▪ Like CPI, the CFPI is also calculated on a monthly
more of a permanent nature. basis and methodology remains the same as CPI.
▪ If this is so, then it follows logically for Central The base year presently used is 2012. The CSO
Banks to target only core inflation, as it reflects revised the Base Year of the CPI and CFPI from
the demand side pressure in the economy. In 2010=100 to 2012=100 with effect from the
practice too, the Reserve Bank of India (RBI) and release of indices for the month of January 2015.
Central Banks around the World always keep an ▪ CFPI (Rural/ Urban/ Combined) is compiled as
eye on the core inflation. the weighted average of the Cereals and
▪ Whenever core inflation rises, Central Banks Products sub group of CPI for each of those
increase their key policy rates to suck excess categories - Rural/ Urban/ Combined. Modified
liquidity from the market and vice versa. It is, weights of these Sub-groups within CFPI are as
therefore, a preferred tool for framing long- follows:
term policy.
▪ Here it needs to be mentioned that, 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 may not give an accurate
picture of how an economy is behaving.
▪ Responding to headline inflation might
therefore sometimes be inappropriate as it
generates excessive variability in the monetary
policy – variability that would be much more ▪ Inflation rates (on point to point basis i.e.
subdued when policy responds to core inflation. August, 2014 over August, 2013), based on
▪ This is because, it is important to distinguish general Indices and CFPIs, are issued by CSO.
between temporary (like seasonal variation in ▪ Price data are collected from selected towns by
fruits and vegetable prices) and permanent the Field Operations Division of NSSO and from
changes in prices. While temporary changes selected villages by the Department of Posts.
would reverse and might not warrant attention, Price data are received through web portals
permanent changes would require standard being maintained by the National Informatics
remedies involving monetary and fiscal policies. Centre.
▪ Research has shown that headline inflation ▪ Globally, food price index is being released by
tends to revert strongly towards core inflation Food and Agriculture Organization of the United
once the temporary fluctuation in food and Nations. The FAO Food Price Index is a measure
energy sector stabilizes. of the monthly change in international prices of
a basket of food commodities. It consists of the
CONSUMER FOOD PRICE INDEX average of five commodity group price indices
(Cereal, Vegetable Oil, Dairy, Meat and Sugar)
▪ Consumer Food Price Index (CFPI) is a measure weighted with the average export shares of each
of change in retail prices of food products of the groups.
consumed by a defined population group in a
given area with reference to a base year. WPI FOOD INDEX
▪ The Central Statistics Office (CSO), Ministry of
Statistics and Programme Implementation ▪ After the revision of WPI with the new base year
(MOSPI) started releasing CFPI for three 2011-12, a new “WPI Food Index” is being
categories - rural, urban and combined - compiled by combining the “Food Articles”
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
7
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

under “Primary Articles” in WPI and “Food various factor such as taxes, trade and transport
Products” under “Manufactured Products” in margin, distribution cost etc.
WPI. ▪ Weights of items in CPI are derived from
▪ WPI food index is a new Food price Index Consumer Expenditure Surveys whereas for PPI
launched on 12 May 2017 as part of revised WPI it is calculated on the basis of Supply Use tables.
series with base year 2011-12.
▪ WPI food index measures the changes in prices Supply and use tables or in short supply use tables
of food items at the level of producers. are in the form of matrices that record how supplies
▪ Together with the Consumer Food Price Index of different kinds of goods and services originate
released by Central Statistics Office, this would from domestic industries and imports and how those
help monitor the price situation of food items supplies are allocated between various intermediate
better. or final uses, including exports.

PRODUCER PRICE INDEX KEY DEFINITION

▪ Producer Price Index (PPI) measures the average
Consumer Price Index: The Consumer Price Index
change in the price of goods and services either
(CPI) is a measure that examines the weighted
as they leave the place of production, called
average of prices of a basket of consumer goods
output PPI or as they enter the production
and services, such as transportation, food, and
process, called input PPI.
medical care. It is calculated by taking price
▪ PPI estimates the change in average prices that
changes for each item in the predetermined
a producer receives.
basket of goods and averaging them. Changes in
PPI VS WHOLESALE PRICE INDEX the CPI are used to assess price changes
associated with the cost of living; the CPI is one of
PPI is different from WPI on following grounds: the most frequently used statistics for identifying
▪ WPI captures the price changes at the point of periods of inflation or deflation.
bulk transactions and may include some taxes
levied and distribution costs up to the stage of Wholesale Price Index: A wholesale price index
wholesale transactions. PPI measures the (WPI) is an index that measures and tracks the
average change in prices received by the changes in the price of goods in the stages before
producer and excludes indirect taxes. the retail level – that is, goods that are sold in bulk
▪ Weight of an item in WPI is based on net traded and traded between entities or businesses instead
value whereas in PPI weights are derived from of consumers. Usually expressed as a ratio or
Supply Use Table. percentage, the WPI shows the included goods'
▪ PPI removes the multiple counting bias inherent average price change and is often seen as one
in WPI. indicator of a country's level of inflation.
▪ WPI does not cover services and whereas PPI
includes services. Headline Inflation: Headline inflation is a measure
of the total inflation within an economy, including
PPI VS CONSUMER PRICE INDEX commodities such as food and energy prices (e.g.,
oil and gas), which tend to be much more volatile
PPI is different from CPI on following grounds: and prone to inflationary spikes.
▪ PPI estimates the change in average prices that
a producer receives while CPI measures the Core Inflation: Core inflation is the change in the
change in average prices that consumer pays. costs of goods and services but does not include
The prices received by the producers differ from those from the food and energy sectors. This
the prices paid by the consumers on account of measure of inflation excludes these items because

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
8
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

their prices are much more volatile. It is most (d) The labour Bureau brings out consumer price
often calculated using the consumer price index index numbers.
(CPI), which is a measure of prices for goods and Answer: C
services.

Producer Price Index: The producer price index, or

PPI, is a group of indexes that calculates and APPLICATION OF INFLATION IN
represents the average movement in selling prices ECONOMIC ANALYSIS
from domestic production over time. The PPI
measures price movements from the seller's point When we examine economic statistics, it's crucial to
of view. distinguish between nominal and real
measurements so we know whether or not inflation
has distorted a given statistic.
QUESTION 3
Q. In India, inflation is measured by the: [1997] Looking at economic statistics without considering
(a) Wholesale Price Index number* inflation is like looking through a pair of binoculars
(b) Consumers Price Index for urban non-manual and trying to guess how close something is—unless
workers you know how strong the lenses are, you cannot
(c) Consumers Price Index for agricultural guess the distance very accurately.
workers
(d) National Income Deflation Similarly, if you do not know the rate of inflation, it
Answer: A is difficult to figure out if a rise in gross domestic
* Note that this is a 1997 question. At that time product, or GDP, is due mainly to a rise in the overall
WPI was the measure of inflation in India. If a level of prices or to a rise in quantities of goods
similar question is asked today, the answer will be produced.
CPI-Combined.
The nominal value of any economic statistic means
QUESTION 4 the statistic is measured in terms of actual prices
Q. The new series of Wholesale Price Index (WPI) that exist at the time. The real value refers to the
released by the Government of India is with same statistic after it has been adjusted for
reference to the base prices of: [2001] inflation. Generally, it is the real value that is more
(a) 1981-82 important.
(b) 1990-91
INFLATION AND NOMINAL & REAL GDP
(c) 1993-94*
(d) 1994-95 NOMINAL GDP
Answer: C
* Note that this is a 2001 question. At that time The nominal GDP is the value of all the final goods
WPI’s base year was 1993-94. If a similar question and services that an economy produced during a
is asked today, the answer will be 2011-12. given year. It is calculated by using the prices that
are current in the year in which the output is
QUESTION 5
produced. In economics, a nominal value is
Q. Which of the following brings out the expressed in monetary terms. For example, a
'Consumer Price Index Number for Industrial nominal value can change due to shifts in quantity
Workers'? [2015-I] and price. The nominal GDP takes into account all of
(a) The Reserve Bank of India the changes that occurred for all goods and services
(b) The Department of Economic Affairs produced during a given year. If prices change from
(c) The Labour Bureau one period to the next and the output does not
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
9
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

change, the nominal GDP would change even To mitigate this decrease in the time value of money,
though the output remained constant. you can invest the money available to you today at
a rate equal to or higher than the rate of inflation.
REAL GDP
INFLATION AND NOMINAL & REAL
The real GDP is the total value of all of the final INTEREST RATE
goods and services that an economy produces
during a given year, accounting for inflation. It is When you borrow or lend, you normally do so in
calculated using the prices of a selected base year. rupee terms. If you take out a loan, the loan is
To calculate Real GDP, you must determine how denominated in rupees, and your promised
much GDP has been changed by inflation since the payments are denominated in rupees. These rupee
base year, and divide out the inflation each year. flows must be corrected for inflation to calculate the
Real GDP, therefore, accounts for the fact that if repayment in real terms. A similar point holds if you
prices change but output doesn’t, nominal GDP are a lender: you need to calculate the interest you
would change. earn on saving by correcting for inflation.

INFLATION AND VALUE OF MONEY The Fisher equation provides the link between
nominal and real interest rates. To convert from
The impact inflation has on the time value of money nominal interest rates to real interest rates, we use
is that it decreases the value of a rupee over time. the following formula:
The time value of money is a concept that describes
how the money available to you today is worth Real Interest Rate = Nominal Interest Rate −
more than the same amount of money at a future inflation rate.
date.
To find the real interest rate, we take the nominal
This also assumes you do not invest the money interest rate and subtract the inflation rate. For
available to you today in an equity security, a debt example, if a loan has a 12 percent interest rate and
instrument, or an interest-bearing bank account. the inflation rate is 8 percent, then the real return on
Essentially, if you have a rupee in your pocket today, that loan is 4 percent.
that rupee’s worth, or value, will be lower one year
from today if you keep it in your pocket. In calculating the real interest rate, we used the
actual inflation rate. This is appropriate when you
Inflation increases the price of goods and services wish to understand the real interest rate actually
over time, effectively decreasing the number of paid under a loan contract. But at the time a loan
goods and services you can buy with a rupee in the agreement is made, the inflation rate that will occur
future as opposed to a rupee today. If wages remain in the future is not known with certainty. Instead,
the same but inflation causes the prices of goods the borrower and lender use their expectations of
and services to increase over time, it will take a future inflation to determine the interest rate on a
larger percentage of your income to purchase the loan. From that perspective, we use the following
same good or service in the future. formula:

So, for example, if a candy costs Rs 1 today, it's Contracted Nominal Interest Rate = Real Interest
possible that it could cost Rs 2 for the same candy Rate + Expected Inflation Rate.
one year from today. This effectively decreases the
time value of money, since it will cost twice as much We use the term contracted nominal interest rate to
to purchase the same product in the future. make clear that this is the rate set at the time of a
loan agreement, not the realized real interest rate.

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
10
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

INFLATION AND BASE EFFECT same. Remember, year-on-year inflation is

calculated as:
The base effect is the distortion in a monthly
inflation figure that results from abnormally high or Current Inflation Rate =
low levels of inflation in the year-ago month. A base (Current Price Index – Last year’s Price Index)
( ) ∗ 100
effect can make it difficult to accurately assess Last year ′ s price index
inflation levels over time. It diminishes over time if
inflation levels are relatively constant.
BONDS, INTEREST RATES AND THE
IMPACT OF INFLATION
Inflation is often expressed as a month-over-month
figure or a year-over-year figure. Typically, There are two fundamental ways that you can profit
economists and consumers want to know how much from owning bonds: from the interest that bonds
higher or lower prices are today than they were one pay, or from any increase in the bond’s price. Many
year ago. people who invest in bonds because they want a
steady stream of income are surprised to learn that
But a month in which inflation spikes may produce bond prices can fluctuate, just as they do with any
the opposite effect a year later, essentially creating security traded in the secondary market. If you sell a
the impression that inflation has slowed. bond before its maturity date, you may get more
than its face value; you could also receive less if you
Inflation is calculated based on price levels that are must sell when bond prices are down. The closer the
summarized in an index. The index may spike in bond is to its maturity date, the closer to its face
June, for example, perhaps due to a surge in oil value the price is likely to be.
prices. Over the following 11 months, the month-
over-month changes may return to normal, but THE PRICE-YIELD SEESAW AND INTEREST
when June arrives again its price level will be RATES
compared to those of a year earlier in which the
index reflected a spike in oil prices. In that case, Just as a bond’s price can fluctuate, so can its yield–
because the index for that month was high, the its overall percentage rate of return on your
price change this June will be less, implying that investment at any given time. A typical bond’s
inflation has become subdued when, in fact, the coupon rate–the annual interest rate it pays–is
small change in the index is just a reflection of the fixed. However, the yield isn’t, because the yield
base effect—the result of the higher index value a percentage depends not only on a bond’s coupon
year earlier. rate but also on changes in its price.

Consider another example: Both bond prices and yields go up and down, but
there’s an important rule to remember about the
Price Index Inflation relationship between the two: They move in
Year 2007 2008 2009 2010 2008 2009 2010 opposite directions, much like a seesaw. When a
April 100 120 140 160 20 16.67 14.29 bond’s price goes up, its yield goes down, even
though the coupon rate hasn’t changed. The
The index has increased by 20 points in all the three opposite is true as well: When a bond’s price drops,
years – 2008, 2009, 2010. However, the inflation rate its yield goes up.
(calculated on year-on-year basis) tends to decline
over the three years from 20% in 2008 to 14.29% in WHAT MOVES THE SEESAW?
2010. This is because the absolute increase of 20
points in the price index in each year increases the In some cases, a bond’s price is affected by
base year price index by an equivalent amount, while something that is unique to its issuer–for example, a
the absolute increase in price index remains the change in the bond’s rating. However, other factors

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
11
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

have an impact on all bonds. The twin factors that ▪ To control inflation, the RBI may raise interest
affect a bond’s price are inflation and changing rates to get investors to purchase bonds.
interest rates. A rise in either interest rates or the ▪ When interest rates go up, borrowing costs rise.
inflation rate will tend to cause bond prices to drop. Economic growth and spending tend to slow.
Inflation and interest rates behave similarly to bond ▪ With less demand for goods and services,
yields, moving in the opposite direction from bond inflation levels off or falls. Bond investors worry
prices. less about the buying power of future interest
payments. They may accept lower interest rates
on bonds, and prices of older bonds with higher
IF INFLATION MEANS HIGHER PRICES, WHY interest rates tend to rise.
DO BOND PRICES DROP?
▪ Interest rates in general fall, fuelling economic
growth and potentially new inflation.
The answer has to do with the relative value of the
interest that a specific bond pays. Rising prices over
Key Definition
time reduce the purchasing power of each interest
payment a bond makes. Let’s say a five-year bond
Nominal: The actual rupee price of stuff when it's
pays Rs 10,000 every six months. Inflation means
bought or sold. The contrast is with the term real,
that Rs 10,000 will buy less five years from now.
which is actual value adjusted for price changes
When investors worry that a bond’s yield won’t keep
or inflation.
up with the rising costs of inflation, the price of the
bond drops because there is less investor demand
Real: The value after adjusting for inflation.
for it.
Economist are frequently interested in comparing
INFLATION, INTEREST RATE AND BONDS stuff (production, income, or whatever) in one
year with similar stuff in another year. However,
When the RBI raises its target interest rate to in that inflation can distort such a comparison, it's
control high inflation, other interest rates and bond best made using a fixed set of prices that eliminate
yields typically rise as well. That’s because bond inflationary changes. In practice, this is
issuers must pay a competitive interest rate to get accomplished by using the prices in an arbitrary
people to buy their bonds. New bonds paying "base year." Once the price differences have been
higher interest rates mean existing bonds with eliminated, the numbers are said to be measured
lower rates are less valuable. Prices of existing in real dollars.
bonds fall.
Nominal Gross Domestic Product: The total
Just the opposite happens when interest rates are market value, measured in current prices, of all
falling. When rates are dropping, bonds issued goods and services produced within the political
today will typically pay a lower interest rate than boundaries of an economy during a given period
similar bonds issued when rates were higher. Those of time, usually one year. The key is that nominal
older bonds with higher yields become more gross domestic product is measured in current, or
valuable to investors, who are willing to pay a actual prices; the prices buyers actually pay for
higher price to get that greater income stream. As a goods and services purchased.
result, prices for existing bonds with higher interest
rates tend to rise. Real Gross Domestic Product: The total market
value, measured in constant prices, of all goods
The inflation/interest rate cycle at a glance: and services produced within the political
boundaries of an economy during a given period
▪ When prices rise, bondholders worry that the of time, usually one year. The key is that real gross
interest they’re paid won’t buy as much. domestic product is measured in constant prices,

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
12
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

the prices for a specific base year. Real gross 4% +/- 2%), suggesting that low inflation can have
domestic product, also termed constant gross various advantages to the economy. Some
domestic product, adjusts gross domestic product economists even argue we should target a higher
for inflation. inflation rate during periods of economic stagnation.

Time Value of Money: It is the concept that

money available at the present time is worth more ADVANTAGES OF INFLATION
than the identical sum in the future due to its
▪ Deflation (a fall in prices – negative inflation) is
potential earning capacity.
very harmful: When prices are falling, people
are reluctant to spend money because they feel
Real Interest Rate (RIR): The market, or nominal
that goods will be cheaper in the future;
interest rate (NIR), after adjusting for inflation.
therefore, they keep delaying purchases. Also,
This is the interest rate lenders receive and
deflation increases the real value of debt and
borrowers pay expressed in real terms.
reduces the disposable income of individuals
who are struggling to pay off their debt.
Base Effect: The base effect is the distortion in a
o Assume Inflation is – 1%; RIR = NIR –
monthly inflation figure that results from
Inflation; Assume NIR = 10%; therefore,
abnormally high or low levels of inflation in the
RIR = 10 – ( – 1%) = 11%.
year-ago month. A base effect can make it difficult
▪ Moderate inflation enables adjustment of
to accurately assess inflation levels over time.
wages: It is argued a moderate rate of inflation
makes it easier to adjust relative wages. For
QUESTION 6 example, it may be difficult to cut nominal wages
Q. A rapid increase in the rate of inflation is (workers resent and resist a nominal wage cut).
sometimes attributed to the “base effect”. What But, if average wages are rising due to moderate
is “base effect”? [2011 - I] inflation, it is easier to increase the wages of
(a) It is the impact of drastic deficiency in supply productive workers; unproductive workers can
due to failure of crops have their wages frozen – which is effectively a
(b) It is the impact of the surge in demand due to real wage cut.
rapid economic growth ▪ Inflation can boost growth: At times of very low
(c) It is the impact of the price levels of previous inflation, the economy may be stuck in a
year on the calculation of inflation rate recession. Arguably targeting a higher rate of
(d) None of the statements (a), (b) and (c) given inflation can enable a boost in economic
above is correct in this context growth. This view is controversial. Not all
Answer: C economists would support targeting a higher
inflation rate. However, some would target
higher inflation, if the economy was stuck in a
PROS AND CONS OF INFLATION prolonged recession.

DISADVANTAGES OF INFLATION
Inflation occurs when there is a sustained increase in
the general price level. Traditionally high inflation Inflation is usually considered to be a problem when
rates are considered to be damaging to an economy. the inflation rate rises above tolerance levels. The
High inflation creates uncertainty and can wipe away higher the inflation, the more serious the problem
the value of savings. However, most Central Banks in is. In extreme circumstances, hyperinflation can
developed economies target an inflation rate of 2% wipe away people’s savings and cause great
(Reserve Bank of India seeks to keep inflation instability, e.g. Germany 1920s, Hungary 1940s,
measured by Consumer Price Index within a band of Zimbabwe 2000s. However, in a modern economy,

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
13
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

this kind of hyperinflation is rare. However, inflation (a) Deflation

can still cause problems. (b) Inflation
▪ Inflationary growth tends to be unsustainable (c) Stagflation
leading to a damaging period of boom and bust (d) Hyperinflation
economic cycles. Answer: B
▪ Inflation tends to discourage investment and
long-term economic growth: This is because of
QUESTION 8
the uncertainty and confusion that is more likely
to occur during periods of high inflation. Low Q. Consider the following statements: [2013 - I]
inflation is said to encourage greater stability 1. Inflation benefits the debtors.
and encourage firms to take risks and invest. 2. Inflation benefits the bondholders.
▪ Inflation can make an economy uncompetitive: Which of the statements given above is/are
For example, a relatively higher rate of inflation correct?
in India can make Indian exports uncompetitive, (a) 1 only
leading to lower Aggregate Demand, a current (b) 2 only
account deficit and lower economic growth. (c) Both 1 and 2
▪ Reduce the value of savings: Inflation leads to a (d) Neither 1 nor 2
fall in the value of money. This makes savers Answer: A
worse off – if inflation is higher than interest
rates. High inflation can lead to a redistribution
of income in society. Often it is pensioners who
INFLATION MANAGEMENT IN
lose out most from inflation. This is particularly INDIA
a problem if inflation is high and interest rates
low. REASONS FOR PERIODIC SPURT IN
▪ Fall in real wages: In some circumstances, high INFLATION IN INDIA
inflation can lead to a fall in real wages. If rate
of inflation is higher than rate of increase of ▪ Impact of Global Economy: Maybe inflation can
nominal wages, then real incomes fall. intrude from outside since India is now
integrated with the world economy. Further, a
KEY DEFINTION spurt in world crude oil prices will increase the
cost of energy in India and consequently raise the
Hyperinflation: Exceptionally high inflation rates. prices of most goods and services in India. Rise in
While there are no hard and fast guidelines, an global food prices (example: protein inflation)
annual inflation rate of 20 percent or more is likely will also have a bearing on inflation in India.
to get you the hyperinflation title. Some countries ▪ Minimum Support Price (MSP) linked Inflation:
in the past have been quite good at creating Key driver of inflation in India is food inflation
hyperinflation. An annual inflation rate of 1,000 (food accounts for 50 per cent of the CPI) and the
percent has not been uncommon. On occasion, key driver of food inflation is the MSP set by the
the trillion percent inflation rate mark has been government.
achieved. (That is, something with a one dollar ▪ Demand-Supply Mismatch: High demand and
price tag in early January would have a one trillion low production or supply of multiple
dollar price in late December. We're talking commodities create a demand-supply gap, which
serious hyperinflation.) leads to a hike in prices. This happens when
consumer preferences and buying habits have
changed and supply is yet to catch up.
QUESTION 7 ▪ Rising income/credit: With people having more
Q. Economic growth is usually coupled with [2011 money, they also tend to spend more, which
- I] causes increased demand.
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
14
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

▪ Structural Factors: The supply side inflation is a less than 2 per cent for three consecutive quarters
key ingredient for the rising inflation in India. The from 2016-17. If this happens, RBI will have to
agricultural scarcity or the damage in transit explain the reason for its failure to meet as well as
creates a scarcity causing high inflationary give a timeframe within which it will achieve it.
pressures. Similarly, the high cost of labour
eventually increases the production cost and The RBI will also be required to bring a document
leads to a high price for the commodity. every six months to explain the sources of inflation
and forecast for inflation for next 6-18 months.
INFLATION TARGETING IN INDIA
RBI has been using headline CPI (Combined)
Inflation targeting is a monetary policy strategy
inflation as the nominal anchor for monetary policy
used by Central Banks for maintaining price level at
stance from April 2014 onwards.
a certain level or within a range. It indicates the
primacy of price stability as the key objective of
Management of monetary policy and the express
monetary policy.
objective of inflation targeting has been enshrined
as the responsibility of RBI by amending the
The argument for price stability stems from the fact
preamble of the RBI Act, 1934 through the Finance
that rising prices create uncertainties in decision
Act 2016 (Chapter XII). Thus, ensuring price stability
making, adversely affecting savings and encouraging
through inflation targeting is a legal responsibility
speculative investments. Inflation targeting brings
of RBI since 2016. A new Chapter (Chapter IIIF,
in more predictability and transparency in deciding
Section 45Z) was introduced in the RBI Act, through
monetary policy. If the central banks could ensure
this Finance Bill, 2016, for detailing the operation of
price stability, households and companies can plan
a Monetary Policy Committee (MPC), which would
ahead, negotiating wages on the basis of expecting
be the institutional arrangement at the disposal of
low and stable inflation.
RBI for targeting inflation.
Various advanced economies including United
Under Section 45ZA(1) of the RBI Act, 1934, the
States, Canada and Australia have been using
Central Government determines the inflation
inflation targeting as a strategy in their monetary
target in terms of the Consumer Price Index, once in
policy framework. The case for inflation targeting
every five years in consultation with the RBI. This
has been made in India as the country has been
target would be notified in the Official Gazette.
experiencing a high level of inflation till recently.
Amongst other measures, RBI targets inflation
primarily by changing the "Policy Rate” which
The Reserve Bank of India and Government of India
means the rate for repo-transactions as defined
signed a Monetary Policy Framework Agreement on
under sub-section (12AB) of section 17 of the RBI
20th February 2015. As per terms of the agreement,
Act.
the objective of monetary policy framework would
be primarily to maintain price stability, while
keeping in mind the objective of growth. The QUESTION 9
monetary policy framework would be operated by Q. India has experienced persistent and high food
the RBI. RBI would aim to contain consumer price inflation in the recent past. What could be the
inflation within 6 percent by January 2016 and reasons? [2011 - I]
within 4 percent with a band of (+/-) 2 percent for 1. Due to a gradual switchover to the cultivation of
all subsequent years. commercial crops, the area under the cultivation
of food grains has steadily decreased in the last
The central bank would be seen as failing to meet five years by about 30%.
the targets, if retail inflation is more than 6 per cent
for three consecutive quarters from 2015-16 and
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
15
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

2. As a consequence of increasing incomes, the ▪ Increase in these interest rates means that the
consumption patterns of the people have RBI is making it expensive for the commercial
undergone a significant change. banks to borrow money (in case of reverse repo
3. The food supply chain has structural constraints. rate, lucrative to keep the deposits in RBI), thus
Which of the statements given above are limiting the injection of money the market. RBI
correct? does this to decrease the liquidity in the market.
(a) 1 and 2 only
(b) 2 and 3 only RESERVE RATIOS
(c) 1 and 3 only
▪ Cash Reserve Ratio: Banks are required to keep
(d) 1, 2 and 3
a fraction of deposit liabilities in the form of
Answer: B
liquid cash, CRR, with the RBI to ensure safety
and liquidity of the deposits.
HOW TO CONTROL INFLATION? ▪ Statutory Liquidity Ratio: Every bank in India has
to maintain a minimum proportion of their net
Inflation occurs when an economy grows due to demand and time deposits as liquid assets in the
increased spending. When this happens, prices rise. form of cash, gold, precious and semiprecious
stones.
The popular method of controlling inflation is ▪ If there is increase in the reserve ratios, the total
through a contractionary monetary policy. The goal amount of deposits left with commercial banks
of a contractionary policy is to reduce the money which it can give as commercial loans decreases
supply within an economy by decreasing bond and hence there is reduction in the loan granting
prices and increasing interest rates. This helps capacity of the banks. RBI uses this instrument
reduce spending because when there is less money for credit control in the market.
to go around, those who have money want to keep
it and save it, instead of spending it. It also means OPEN MARKET OPERATIONS
that there is less available credit, which can also
▪ The RBI can purchase or sell Government
reduce spending. Reducing spending is important
securities from or to the public. To control
during inflation because it helps halt economic
inflation, the RBI sells the securities in the
growth and, in turn, the rate of inflation.
money market which sucks out excess liquidity
from the market. As the amount of liquid cash
INTEREST RATE decreases, demand goes down. This part of
monetary policy is called the open market
▪ Repo Rate: Repo rate (Repurchase or operation.
Repossession) is the rate at which RBI buys
government securities with an agreement of REDUCING THE MONEY SUPPLY
repossession, from the commercial banks. It is a
▪ Another method is to directly or indirectly
short term borrowing from the central bank,
reduce the money supply by enacting policies
against securities, to inject money to meet the
that encourage reduction of the money supply.
gap between the demand for money (loans) and
▪ Two examples of this include calling in debts that
deposits in the bank.
are owed to the government and increasing the
▪ Reverse Repo rate: It is the rate at which the RBI
interest paid on bonds so that more investors
borrows money from the commercial banks.
will buy them. The latter policy raises the
Banks deposit money in RBI when there is no
exchange rate of the currency due to higher
other profitable option to invest the short-term
demand and, in turn, increases imports and
excess liquidity or when there is uncertainty in
decreases exports.
the market for a significant period of time.

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
16
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

▪ Both of these policies will reduce the amount of

money in circulation because the money will be
going from banks, companies and investors
pockets and into the government’s pocket where
it can control what happens to it.

There are many methods used to control inflation;

some work well while others may have damaging
effects. For example, controlling inflation through
wage and price controls can cause a recession and
cause job losses.

QUESTION 10
Q. Which one of the following is likely to be the
most inflationary in its effect? [2013 - I]
(a) Repayment of public debt
(b) Borrowing from the public to finance a budget
deficit
(c) Borrowing from banks to finance a budget
deficit
(d) Creating new money to finance a budget
deficit
Answer: D

QUESTION 11
Q. With reference to inflation in India, which of
the following statements is correct? [2015-I]
(a) Controlling the inflation in India is the
responsibility of the Government of India only
(b) The Reserve Bank of India has no role in
controlling the inflation
(c) Decreased money circulation helps in
controlling the inflation
(d) Increased money circulation helps in
controlling the inflation
Answer: C

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
17
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

(b) 3>1>2
MCQS FOR PRACTICE (c) 2>1>3
(d) 1>3>2
Q.1 With reference to the recently launched WPI
Food Index, consider the following statements: Q. 5 Consider the following statements with
1. It measures the changes in prices at the level of reference to Consumer Price Index (CPI):
producers. 1. It accounts for all goods and services produced
2. It considers 2011-12 as the base year. in an economy.
Which of the statements given above is/are 2. It includes prices of imported goods.
correct? 3. Weights in CPI differ according to production
(a) 1 only level of each good.
(b) 2 only Which of the statements given above is/are
(c) Both 1 and 2 correct?
(d) Neither 1 nor 2 (a) 1 and 2 only
(b) 2 only
Q.2 With respect to economy, which of the (c) 1 and 3 only
following correctly describes the term skewflation? (d) 1, 2 and 3
(a) It is a rise in the price of one or a small group of
commodities over a sustained period of time.
(b) It means declining rate of inflation over the last
four economic quarters of a financial year.
(c) It means declining inflation due to huge imports
over a period of time.
(d) It is a measure of increasing prices particularly for
the service sector.

Q. 3 Which of the following rates can be increased

to decrease inflation in the economy?
1. Statutory Liquidity Ratio
2. Repo rate
3. Bank rates
Select the correct answer using the code given
below:
(a) 1 only
(b) 1 and 2 only
(c) 2 and 3 only
(d) 1, 2 and 3

Q. 4 Arrange the following items of the Wholesale

Price Index (WPI) in the decreasing order of their
weights:
1. Primary Articles
2. Fuel and Power
3. Manufactured Products
Select the correct answer using the code given
below:
(a) 1>2>3

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
18
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

Answer: A
MCQS WITH ANSWER AND
EXPLANATION Explanation:
▪ Skewflation is an episodic price rise pertaining to
one or a small group of commodities. It is an
Q.1 With reference to the recently launched WPI unusual inflation, with inflation in one particular
Food Index, consider the following statements: sector for a particular period of time, while the
1. It measures the changes in prices at the level of other sector is experiencing no changes at all or
producers. facing deflation. (Hence option A is correct)
2. It considers 2011-12 as the base year. ▪ As food commodities are regularly affected by
Which of the statements given above is/are market forces (i.e. Demand-Supply), such
correct? commodities are most vulnerable to skewflation.
(a) 1 only
(b) 2 only Q. 3 Which of the following rates can be increased
(c) Both 1 and 2 to decrease inflation in the economy?
(d) Neither 1 nor 2 1. Statutory Liquidity Ratio
Answer: C 2. Repo rate
3. Bank rates
Explanation: Select the correct answer using the code given
▪ WPI food index is a new Food price Index below:
launched on 12 May 2017 as part of revised WPI (a) 1 only
series with base year 2011-12. WPI food index (b) 1 and 2 only
measures the changes in prices of food items at (c) 2 and 3 only
the level of producers. (Hence both statements 1 (d) 1, 2 and 3
and 2 are correct) Answer: D
▪ The WPI Food index is compiled by taking the
aggregate of WPI for 'Food Products' under Explanation:
'Manufacture Products' and 'Food Articles' under ▪ When RBI increases Statutory Liquidity Ratio
'Primary Article' using weighted arithmetic (SLR) and Cash Reserve Ratio (CRR), banks are
mean. (Indices for Food Articles and Food left with low reserves hence liquidity in the
Products were being released separately in WPI market get reduced.
(2004-05) also. But no separate estimate like WPI ▪ RBI uses Cheap money policy to counter
food index was being generated then). deflationary trends. To reduce inflation the RBI
▪ Together with the Consumer Food Price Index adopts Dear money policy wherein it increases
released by Central Statistics Office, this would SLR, CRR, Repo rate and Bank rates. (Hence
help monitor the price situation of food items option D is correct)
better. ▪ Repo rate is the rate at which the central bank of
a country (Reserve Bank of India in case of India)
Q.2 With respect to economy, which of the lends money to commercial banks in the event of
following correctly describes the term skewflation? any shortfall of funds. Repo rate is used by
(a) It is a rise in the price of one or a small group of monetary authorities to control inflation.
commodities over a sustained period of time.
(b) It means declining rate of inflation over the last Q. 4 Arrange the following items of the Wholesale
four economic quarters of a financial year. Price Index (WPI) in the decreasing order of their
(c) It means declining inflation due to huge imports weights:
over a period of time. 1. Primary Articles
(d) It is a measure of increasing prices particularly for 2. Fuel and Power
the service sector.
Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
19
 Subscribe to our YouTube Channel – CivilsTap by EduTap for free, quality and regular content

3. Manufactured Products to production levels. Hence, statement 3 is not

Select the correct answer using the code given correct.
below:
(a) 1>2>3
(b) 3>1>2
(c) 2>1>3
(d) 1>3>2
Answer: B

Explanation:
▪ In India, headline inflation is measured through
the WPI (latest base year 2011-12) – which
consists of 697 commodities (services are not
included in WPI in India).
▪ Weight of components in WPI – Primary Articles
(weight: 22.62%), Fuel & Power (weight: 13.15%)
and Manufactured Products (weight: 64.23).
Hence, the correct answer is 3>1>2. (Hence
option B is correct)

Q. 5 Consider the following statements with

reference to Consumer Price Index (CPI):
4. It accounts for all goods and services produced
in an economy.
5. It includes prices of imported goods.
6. Weights in CPI differ according to production
level of each good.
Which of the statements given above is/are
correct?
(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: B.

Explanation:
▪ Consumer Price Index (CPI) does not account for
all goods and services produced in an economy
because goods purchased by consumers does
not represent all the goods which are produced
in a country. Hence, statement 1 is not correct.
▪ CPI includes prices of goods consumed by the
representative consumer; hence it includes
prices of imported goods. Hence, statement 2 is
correct.
▪ The weights in CPI differ according to purchase
pattern of consumers. It does not vary according

Visit: [Link]
For Any Query Mail us: hello@[Link] or call us at - (+91)-8146207241
20