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APPROACH - ANSWER: GENERAL STUDIES MAINS MOCK TEST - 1394 (2020)

1. Explain the value-added, income and expenditure methods of estimating national

income.
Approach:
 Briefly explain the concept of national income.
 Explain the value added, income and expenditure methods of estimating national income.
 Conclude with a brief note on the methods employed in India.
Answer:
National Income refers to the money value of all the goods and services produced in a country
during a financial year. It is generally calculated in terms of GDP or GNP at factor cost (i.e. costs of
all the factors of production) or at market price (which includes cost of production, indirect taxes
and subsidies for the producers). The national income can be estimated by various methods like
value-added method, income method and expenditure method.
Value-added method: Also known as product method or inventory method, it consists of finding
out the market value of all the goods and services produced in a country during a given
period. The value of intermediate products consumed for production of final goods is deducted so
that doubling of values is eliminated. The value of depreciation of equipments during the process of
production and indirect taxes is also deducted. The total of the estimates gives us net domestic
product at factor cost classified by industrial origin. The addition of net income from abroad to this
gives us net national income at factor cost.
NNPFC = GDPMP - consumption of fixed capital (Depreciation) + Net Factor Income from
Abroad - Net indirect Tax
where, NNPFC = Net National Product at Factor Cost, GDPMP = Gross Domestic Product at
Market Prices
Income method: This method consists of adding together all the income that accrues to the factors
of production i.e. human labour, capital, fixed natural resources (land) and entrepreneurship by
way of wages, interest, rents, and profits respectively during a given period. National income is net
domestic factor income added with net factor income from abroad.
NNPFC = NDPFC + Net Factor Income from Abroad.
Where, NDPFC = Net Domestic Product at Factor Cost
Expenditure method: In this method, the total sum of expenditure on the purchase of final goods
and services produced during an accounting year within an economy is estimated to obtain the
values of national income. The expenditure may be classified into four categories viz. Private final
consumption expenditure, Government final consumption expenditure, Investment expenditure or
gross domestic capital formation, and Net exports (exports – imports).
GDPMP = Private final consumption expenditure + Government final consumption
expenditure + Investment expenditure + Net exports (exports – imports).
NNPFC= GDPMP – Depreciation + Net Factor Income from Abroad-Net Indirect Tax

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 In India, there is varied use of these methods to calculate the national income. The CSO calculates
value addition done through activities like agriculture, forestry, fishing, mining & manufacturing,
construction etc. using the value-added method. Under expenditure method, the CSO adds up
various components of expenditure i.e. Private Final Consumption, Government Final Consumption,
Gross Fixed Capital Formation, Net of Exports and Imports.

2. Explain why Micro, Small and Medium Enterprises (MSME) sector is regarded as the ‘growth
engine’ of the Indian economy. Suggest key reforms that are required for improving the overall
business climate for MSMEs in India.
Approach:
 Highlight the reasons as to why MSME sector is considered as the growth engine of Indian
economy.
 Briefly mention the issues facing this sector.
 Suggest reform measures for improving the overall business climate for MSME sector in India.
Answer:
With a vast network of about 63.38 million enterprises, MSME sector contributes to about 45% of
manufacturing output, more than 40% of exports and over 28% of GDP. Besides, MSMEs create
employment for about 111 million people. The sector produces a wide range of products, from
simple consumer goods to high-precision, sophisticated finished products. It has also been
contributing significantly to the expansion of entrepreneurial base through business innovations.
Due to its tremendous multiplier impact on economic growth, and its forward and backward
linkages with industry, it is rightly considered the growth engine of Indian economy.
However, MSMEs in India face a lot of constraints such as high cost of credit; low access to new
technology and marketing; poor access to international markets; lack of skilled manpower;
inadequate infrastructure and regulatory issues related to taxation, labour laws and environment.
In this regard, the following key reforms, as discussed in the UK Sinha Committee report, are
needed to improve the business climate for MSMEs:
 Addressing the cumbersome registration process and promote use of Unique Enterprise
Identifier (UEI) like PAN for purposes like procurement, availing government sponsored
benefits, etc.
 Establishing Enterprise Development Centers (EDCs) in each district for capacity building of
entrepreneurs.
 MSME clusters should collaborate with companies having innovation infrastructure, R&D
institutions and universities.
 Considering their vulnerability and size, insolvency code / delegated legislation should provide
for out-of-court assistance such as mediation, debt counseling etc. to MSMEs.
 Creation of a Digital Public Infrastructure to reduce loan-operating costs significantly and also
address information asymmetry that improves credit access.
 Creation of a National Council for MSMEs to facilitate coherent policy outlook and uniform
monitoring.
 The MSMED Act, 2006 should be amended and its focus should be towards market facilitation
and ease of doing business.
It must be ensured that MSMEs come to terms with the ongoing structural changes in the economy
(like GST) and fully benefit from advances in digitization. This shall also substantially reduce the
cost and time for this sector and enhance its ease of doing business.

3. The average size of holdings has shown a steady declining trend over the last three decades.
What are the challenges faced by farmers due to fragmentation of land? What needs to be done
in this regard?
Approach:
 Introduce briefly declining trend of land holding size as well as current scenario in this regards.
 Mention the challenges faced by farmers due to fragmentation of land.

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  Provide some suggestions to resolve the given challenges.
 Discuss some steps taken by government in conclusion.
Answer:
As per Agriculture Census 2015-16, the average size of operational holding has declined to 1.08
hectare in 2015-16 as compared to 1.15 hectare in 2010-11. The small and marginal holdings (<2
ha) now constitute 86%, while the large holdings (>10 ha) are merely 0.57% of the total land
holdings.
High population pressure, decline of joint family
system, increasing indebtedness and conversion of
agricultural land to other uses are some of the reasons
behind this fragmentation.
 Challenges faced by farmers due to
fragmentation of land:Low productivity: Small
and fragmented landholdings are suitable for
subsistence agriculture, where farmers are forced
to use age-old labour-intensive techniques. This
decreases the productivity of land and in turn lack
of investment for increasing productivity.
 Difficulties in modernisation: Use of improved
agricultural practices e.g. use of tractors, micro-irrigation techniques, etc. becomes
uneconomical in small landholdings.
 Wastage of land: There is wastage of land in boundaries and fencing.
 Indebtedness: As per Economic Survey-2016-17, there is an inverse relationship between
indebtedness and the size of land holding. In Bihar and West Bengal, more than 80% of
agricultural households with marginal landholdings are indebted.
 Disputes over boundaries: Small fragmented lands become one of the major cause of
complaints related to boundary disputes.
Overall, it makes farmers prone to all sort of agricultural risks including Production risks, Climatic
risks, Price risks, Credit risks, Market risks, and Policy risks.Measures to resolve these issues:
 Consolidation of land holdings: Land holdings can be consolidated by promoting land leasing
(to ensure security of tenure to tenants), land pooling of smaller lands.
 Promoting collective farming: Small farmers can be nudged to undertake cooperative farming,
form Farmer Producer Organizations (FPOs) etc.
 Economic viability of farms: The economic viability of smaller landholdings can be improved
by promoting mixed farming, cooperative farming and crop diversification through high value
crops.
 Delineation of farms: To bring more clarity on farm boundaries and titles, digitization and
modernization of land records should be promoted.
 Easing pressure on farmland: The land-man ratio of the landholdings can be improved by
providing alternate economic opportunities through urban growth to attract rural migrants,
promotion of non-farm activities etc.
Few steps like Model Contract Framing Act 2018, promotion of food processing industries, adoption
of low-cost farm technologies etc. have been taken keeping an eye on problems due to small land
holdings in India.

4. Distinguishing between a flexible and fixed exchange rate system, explain how exchange rate is
determined under a flexible exchange rate system.
Approach:
 Introduce by defining exchange rate.
 Highlight the difference between flexible and fixed exchange rate system.
 Explain how exchange rate is determined in a flexible exchange rate system.
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Answer:
The price of one currency in terms of the other currencies is known as the exchange rate. There are
generally two types of regimes that determine exchange rates – fixed exchange rate system and
flexible exchange rate system.
The differences between the two are as follows:
 A Fixed exchange rate is an exchange rate of the currency that is fixed at some level with
respect to some benchmarks like US dollar or gold and adjusted only infrequently. Whereas,
Flexible/floating exchange rate is an exchange rate which is determined by the forces of
demand and supply in the foreign exchange market.
 A fixed rate is set by the government or Central Bank and is also maintained at that level. But,
in flexible system, the central banks do nothing to directly affect the level of the exchange
rate.
 Fixed exchange rate regime is less susceptible to volatility and fluctuations and generally
depends on change in government policy, whereas currencies under flexible exchange rate
regime are susceptible to volatility and high fluctuations as it depends on day to day scenario
and market conditions.
 Change in exchange rate in fixed regime is termed as devaluation or revaluation whereas in
flexible regime it is termed as depreciation or appreciation.
Determination of exchange rate under a flexible exchange rate system:
Let us understand how exchange rate is determined in a flexible exchange rate system, by taking a
two country model of say, India and USA:
 Under a Flexible Exchange Rate system, the
equilibrium rate of exchange is determined by
forces of demand and supply of foreign exchange.
The demand of foreign currency arises to
import goods & services; to purchase financial
assets abroad; send gifts/grants etc. It varies
inversely with the exchange rate. This because,
at a high exchange rate, the amount of rupees
required per unit dollar would be high and vice
versa. The demand curve plotted against
exchange rate is therefore downward sloping.
 Similarly, the supply of foreign currency arises
because of export of domestic goods; arrival of
foreign tourists; foreigners undertaking direct
investment; remittances etc. The supply of foreign currency varies directly with the exchange
rate. This is because a higher exchange rate gets more rupees per unit currency. This increases
the profitability of the exporters. The supply curve plotted against exchange rate is therefore
forward sloping.
 The flexible exchange rate system autocorrects any disequilibrium in the balance of
payments. This means that any deficit or surplus in the BoP automatically triggers movement
in the exchange rate to an equilibrium value where the demand and supply of foreign exchange
becomes equal again.
 For instance, if a deficit occurs in an economy i.e. increase in imports, there will be excess
demand of foreign currency. Such a demand will lead to the appreciation of the foreign
currency & depreciation of the domestic currency. Imports will become expensive and
exports more profitable. The quantity demanded of the foreign exchange will fall and quantity
supplied rise till the deficit is eliminated. This will be the new higher equilibrium value of the
exchange rate. Similarly, a surplus in the balance of payments leads to an appreciation of the
domestic currency. Hence, exports will fall while imports increase till the surplus is eliminated
at the new lower equilibrium value of the exchange rate.

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  In the graph, the excess demand of foreign exchange curve shifts from DD to D 1D1 due to
increase in demand for foreign exchange. At present equilibrium rate r 0, excess demand of
foreign exchange to the extent of E0K will lead to the depreciation of the domestic currency i.e.
rupee. Indians demand larger amount of dollars which Americans now supply at a higher price.
The exchange rate market autocorrects itself to a higher new equilibrium value E 1,
corresponding to which r1 is the new exchange rate.
 An increase in supply of foreign exchange will cause the supply curve to shift from SS to S 1S1. At
r0, excess supply of foreign exchange to the extent of E0L will lead to the appreciation of the
Indian rupee i.e. fall in exchange rate. The exchange rate market will autocorrect itself to a lower
new equilibrium value E2, corresponding to which r2 will be the new exchange rate.

5. Discuss why enacting appropriate land leasing laws should be given priority in India.
Approach:
 Introduce by giving a brief background on the objectives of land reform in India.
 Mention the fallouts in terms of meeting these objectives.
 Discuss the benefits of an appropriate land leasing framework.
 On the basis of aforementioned points, make a brief conclusion.
Answer:
Land reforms in India had aimed to eliminate all forms of exploitation and social injustice
within the agrarian system; to provide security for the tiller and remove impediments to
agricultural production. However, the land reforms have only been partially successful in achieving
these objectives.
One of the major weak links has been restrictive land leasing laws that forced tenancy to be
informal, insecure and inefficient. With the rising levels of income, the prices of agricultural lands
are going up and, therefore, landless agri-labourers and small/marginal farmers cannot buy land.
This has adversely impacted the growth of agriculture in India.
There is a need for appropriate land leasing laws which would help in the following ways:
 Security of tenure to tenant: It would incentivize tenant cultivators to invest in and conserve
agricultural land resources, which in turn, leads to increased land productivity and profitability.
 Benefits of different schemes to the tenants: Legal documents can facilitate access to
institutional credit. Besides, it makes it possible to extend the benefits of various schemes such
as DBT for fertilizer subsidy, crop insurance, disaster relief etc. to the real cultivators.
 Security to the land-owner: Legal backing provides a greater sense of security to the owner. It
will also help contain the problem of fallow land due to fear of losing ownership rights.
 Dispute Resolution: A legal framework would provide owners as well as tenants with a safe
legal route for conflict resolution.
 Land consolidation: It will open doors for the consolidation of the operational land holdings
which is essential to exploit scale economies and increase farm incomes.
 Attract private investment in agriculture: Long-term leasing can facilitate contract farming
and lead to crop diversification; introduction new farming techniques and technologies;
investment in post-harvest management and processing etc.
Therefore, appropriate land leasing laws are much needed for agricultural efficiency, equity and
occupational diversification. In this context, a model land leasing law has also been proposed by
NITI Aayog.

6. Gross Domestic Product (GDP) of a country can not be taken as an index of the welfare of the
people of that country. Analyse.
Approach:
 Explain the concept of GDP.
 Discuss the view that GDP is not an index of welfare in a country.
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  Conclude briefly by using examples of some other indicators used to depict the level of social
well-being in a country.
Answer:
Gross Domestic Product (GDP) is the total monetary or market value of all finished goods and
services produced within a country's borders in a specific time period. As a broad measure of
overall domestic production, it functions as a comprehensive scorecard of the country’s economic
health.
It is a good indicator to depict the living conditions of people in a country, as it includes a number of
factors such as consumption and investment. However, it can not be taken as an index of the welfare
of the people of a country. The reasons include:
 It doesn’t measure equity in income distribution: If the GDP of a country is rising, its social
indicators may not rise as a consequence. This is because rise in GDP may be concentrated in
the hands of a few individuals or firms. For the rest, the income may, in fact, have fallen.
 Non-monetary exchanges: Many activities in an economy are not evaluated in monetary
terms. For example, the domestic services that women perform at home are not paid for. Since
there is no transaction of money, their contribution is generally not counted in the GDP, leading
to underestimation of GDP.
 Externalities: Externalities refer to the benefits (or harms) a firm or an individual causes to
another for which they are not paid (or penalised). For instance, while calculating GDP,
pollution caused by industries is not accounted for. Therefore, if we take GDP as a measure of
welfare of the economy, we will overestimate the actual welfare. In cases of positive
externalities, GDP will underestimate the actual welfare of the economy.
 Type of goods produced: GDP does not describe the kinds of goods that are being produced.
Since GDP measures the value of all finished goods and services within an economy, it also
includes products that may have negative effects on social welfare. For example, tobacco,
armaments etc. sold and used within the country, would adversely impact the overall social
welfare.
In view of the shortcomings mentioned above, there have been various attempts to develop more
accurate and reliable indicators in order to measure social well-being. Among others, these
alternative approaches include the Human Development Index (HDI), the Gross National Happiness
Index (GNH), and the Social Progress Index (SPI).

7. Bringing out the difference between depreciation and devaluation of a currency, explain how
they affect foreign trade of a country.
Approach:
 Briefly discuss the meaning of depreciation and devaluation of a currency.
 Highlight the key differences between depreciation and devaluation of a currency.
 Bring out their effect on the foreign trade of a country.
Answer:
Both depreciation and devaluation highlight the economic condition where there is a decrease in
the value of a domestic currency in comparison to any other currency, leading to a decline in the
currency’s purchasing power. However, the manner in which they occur are different. The
differences between depreciation and devaluation are:
 Depreciation happens in the floating exchange rate regime, in which the market forces
determine the value of a country's currency. On the other hand, devaluation is associated with
the fixed/pegged exchange rate regime.
 Depreciation is a decrease in the value of domestic currency due to the market forces of
demand and supply. Whereas, in case of devaluation, the Central bank deliberately makes
downward adjustment of the value of the domestic currency vis-a-vis any other
currency.Depreciation can occur on a daily basis, while devaluation is usually done
occasionally by the Central bank.
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 Effects of depreciation and devaluation on the foreign trade of a country are:
 Reducing trade deficit: Both depreciation and devaluation make imports expensive. Hence,
residents often buy fewer imported goods. On the other hand, exported goods become less
costly for international buyers, thereby, growing demand for exports. Thus, fewer imports and
more exports will reduce the trade deficit and could also lead to surplus. However, the trade
deficit may not reduce as much as expected or even increase if imports constitute essential
commodities that are difficult to replace with domestic products.
 Reduced foreign investment: Both depreciation and devaluation are viewed as a sign of
economic weakness, therefore, the creditworthiness of the nation may be jeopardized. It may
dampen investor confidence in the country's economy and hurt the country's ability to secure
foreign investment. However, if the increased aggregate demand for domestic goods, owing to
reduced imports and more external demand, leads to higher inflation and in turn higher interest
rates, then it may also attract foreign investment.
 Instability in the global markets: Trading partners may become concerned that it might
negatively affect their export industries. Also, neighboring countries might devalue their own
currencies to offset the effects of their trading partner's devaluation. Such competitive
devaluations tend to exacerbate economic difficulties by creating instability in the global
financial markets.
In a free market economy, devaluation should be used sparingly. While the negative effects of
depreciation can be countered by focusing on long term measures like improving export
competitiveness, increasing efficiency of supply chains and pro-active government policies.

8. Explain the mechanism of credit creation by the banking system in an economy. What are the
factors that limit such credit creation?
Approach:
 Introduce with a brief note on credit creation.
 Discuss the factors important in determining credit creation.
 Explain the process of credit creation in detail.
 Discuss the factors limiting creation of credit by the banks.
 Conclude on the basis of the above points.
Answer:
Credit creation refers to the ability of the commercial banks to multiply loans and advances by
creating deposits. Commercial banks create credit by advancing loans and purchasing securities.
The money lent to individuals and businesses comes from deposits of the public held by these
banks. The banks are required to reserve a certain portion of these deposits with it, to serve cash
requirements of depositors and lend only the remaining portion of public deposits.
Mechanism of credit creation:
Suppose a customer of Bank X deposits an amount of Rs. 1000 in this bank. Bank X keeps a cash
reserve of 20 per cent, i.e. Rs. 200 and uses the excess reserve i.e. Rs. 800 in advancing loan to one of
its customers by opening an account in his name. This borrower from Bank X uses this amount in
buying goods from some trader and makes payment by drawing a cheque on Bank X. Suppose this
trader has his account in Bank Y. It will deposit this cheque of Rs 800 in Bank Y to be collected from
Bank X.
Thus, Rs. 800 will be transferred from Bank X to Y. Bank Y also keeps 20 per cent, i.e. Rs. 160 and is
left with an excess reserve of Rs 640, which it lends to another customer. Another such transaction,
say with Bank Z, will leave it with Rs. 512. Thus an initial deposit of Rs. 1000 has resulted in the
creation of deposits by three banks amounting to Rs. (1000+800+640+512) = Rs. 2952. This is how
the entire banking system will be able to create new deposits and hence credit creation happens.

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 The bank’s credit creation process is based on the assumption that during any time interval, only a
fraction of its customers genuinely need cash. Also, the bank assumes that all its customers would
not turn up demanding cash against their deposits at one point in time.
Factors limiting credit creation:
 Higher the cash with the commercial banks in the form of public deposits, more will be the
credit creation.
 The cash reserve ratio affects the credit creation. The lower is the ratio, the greater is the
ability to create credit.
 The process of credit creation gets started only when borrowers come to a bank for loan
purposes. So, the number of reliable borrowers affects the credit creation.
 A commercial bank lends money against accepted securities. Also, the value of the securities
must be equal to the amount of the loan. Even if the bank has a large cash base for creating
credit, it will not lend money if it does not get acceptable security.
 The credit creation process may suffer from cash leakages in the form of excess reserves or
currency drain.
 Business conditions of the banks like inflation, depression, etc. also affect the credit creation
process.

9. With the help of a diagram, explain the circular flow of income in a simple economy.
Approach:
 Briefly highlight the concept of circular flow of income.
 State the different phases of the flow of income, using a diagram.
 Explain, in detail, the concept of circular flow of income in a simple economy using a diagram
and conclude accordingly.
Answer:
The circular flow of income is an economic model, which depicts exchanges between different
agents in an economy as flows of money, services etc. It basically demonstrates how money/factor
services moves from producers to consumers and back again in an endless loop.
Phases of circular flow of income:
 Production phase: Firms produce goods and services with the help of factor services i.e. land,
labour, capital and entrepreneurship.
 Income phase: It involves the flow of factor income (rent, wages, interest, profit) from firms to
households.
 Expenditure phase: The income received by the factors of production is spent on goods and
services produced by firms.

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 Circular flow of income in a simple economy:
In a simple economy, the underlying assumption is that there are only two sectors in the economy
i.e. ‘households’ and ‘firms’ and there is no government, external trade or any savings by the
households. Thus all other channels of household expenditure i.e. taxes or import of goods are
closed. Consequently, they can only spend their income on the goods and services produced by the
domestic firms, which they themselves assisted in producing. Thus, aggregate consumption by the
households equals the aggregate expenditure on goods and services produced by the firms in the
economy. The entire income of the economy, thus, comes back to the producers/firms in the form of
sales revenue and there is no leakage.
In the next period, the firms will again produce goods and services and pay remunerations to the
factors of production i.e. households, which will once again be used to buy the goods and services.
Hence, every year, the aggregate income of the economy goes through the two sectors i.e. firms and
households, in a circular way.

However, the above illustration is a simplified model, which does not describe the actual economy
in detail. For instance, in an actual economy, households save, the government is involved, there is
international trade etc.

10. Explain the meaning of Balance of Payments and give an account of various components
included within current and capital account.
Approach:
 Briefly explain Balance of Payment and mention its components.
 Explain Current and Capital accounts and also, mention their various components as well.
 Concluding statement may contain the overall idea of BOP.
Answer:
The Balance of Payments (BoP) is a statement of all transactions (goods, services, and assets)
made between entities in one country and the rest of the world over a defined period of time. The
Balance of Payments is maintained by the central monetary authority of a nation.
According to the IMF, there are two main accounts in the BoP i.e. the current account and the capital
& financial account. However, in India we club the financial and capital account into one and call it
the capital account. Consequently, there are two main accounts in the BoP i.e. the current account
and the capital account.
Current account: The Current Account records transactions relating to export and import of
goods, services, unilateral transfers and international incomes. Thus, the balance on current
account is the value of exports minus the value of imports, adjusted for international incomes and
transfers. The net difference between exports and imports of goods is called Balance of Trade.
When trade in services and net transfers are also factored in with the trade balance, the result is
current account balance. The balance of current account need not always be equal i.e. in
equilibrium, and can show a surplus or deficit. A surplus current account means that the nation is a

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 A country is said to be in balance of payments equilibrium when the sum of its current account
and its non-reserve capital account equals zero. This means that the current account balance is
financed entirely by international lending without movements in foreign exchange reserves.
Besides the current and capital accounts, errors and omissions constitute the third element in the
BoP. In practice, BoP accounts rarely balance because of our inability to record all international
transactions accurately. That is why errors and omissions are considered the ‘balancing item’, so
that the BoP accounts are kept in balance.

11. Explain the demand-pull and cost-push factors of inflation in India.

Approach:
 Briefly introduce with a definition of inflation.
 Discuss the demand-pull and cost-push factors of inflation in India.
 Conclude on the basis of the above points.
Answer:
Inflation refers to the general rise in the prices of goods and services. The same unit of currency
buys lesser goods and services than it did previously, thereby reducing purchasing power of the
currency in an economy. There are two kinds of factors that lead to inflation:
Demand–pull factors of inflation:
When an economy’s aggregate demand exceeds its aggregate supply i.e. production in the economy
cannot keep up with the demand, it leads to rise in the prices of goods. This is demand-pull inflation.
Following are the major causes of demand–pull inflation:
 Increased growth: When the GDP increases, the per capita income increases consequently.
This will usually translate into increased demand for goods and services. Demand will also
increase when consumers feel confident about economic growth.
 Higher demand from a fiscal stimulus: When taxes are reduced, consumers have more
disposable income leading to rise in demand. Higher government spending and increased
borrowing also lead to increased demand in the economy.
 Easy Monetary Policy: When the monetary policy is designed to stimulate spending in the
economy for instance decreasing interest rates, it leads to higher demand.
 Enhanced foreign investment: It leads to inflow of money in the economy, which eventually
leads to increase in demand.
 Depreciation of the domestic currency: It increases the price of imports and reduces that of
country's exports. Fewer imports with growing exports will increase the aggregate demand
translating to price rise as well.
Cost-push factors of inflation:
It occurs when aggregate supply of goods and services decreases because of an increase in
production costs. Generally, cost-push inflation occurs in case of an inelastic demand (where the
demand does not change as per the rising prices). Following are the major causes of cost-push
inflation:
 Cost of Components: An increase in the prices of raw materials, machinery, surging rent and
other components causes increase in the cost of production.
 Rising wages: Increase in wages leads to rise in the cost of production.
 Supply Shocks: A supply shock occurs when there is a big increase in prices of critical
commodities like oil. This results in higher transport costs and all firms would see a rise in
costs. There could be other supply shocks such as natural disasters or depletion of natural
resources as well.
 Devaluation: Devaluation increases the domestic price of imports. Therefore, after devaluation,
there is often an increase in inflation due to rising cost of imports.
 Miscellaneous Factors: Such as higher taxation by the government, monopoly, fall in exchange
rates, etc. which could increase the cost of production.
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 In India, the RBI maintains the price level at a certain level or within a range by using a monetary
policy strategy, known as Inflation Targeting.

12. Explain the different quantitative and qualitative policy tools used to regulate money supply in
the economy.
Approach:
 Start with a brief note on money supply and how it works.
 Mention the definitions of quantitative and qualitative methods of money supply regulation in
the economy.
 Enlist different quantitative and qualitative methods.
 Conclude on the basis of the above points.
Answer:
The money supply is the entire stock of currency and other liquid instruments circulating in a
country's economy as of a particular time. It is regulated by the central bank using monetary policy
tools. In India, it is done by the RBI, using various quantitative and qualitative methods, to ensure
inflation targeting, price stability and stable economic growth.
Quantitative or General methods are those which are used by the central bank to influence the
total volume of credit and money supply in the banking system, without any regard for the use to
which is put while qualitative or selective measures are those which are used by the central bank
to regulate the flow of credit in specific sectors of the economy.
Quantitative methods of money regulation include:
 Bank rate Policy - A deliberate manipulation of the bank rate (rate charged by the central bank
for lending funds to commercial banks) to influence the flow of credit created by the
commercial banks is known as bank rate policy. A decrease in the bank rate results in credit
becoming cheaper.
 Open market operations - Open market operations (OMOs) refer to the sale and purchase of
government securities by the central bank to the commercial banks. It includes Repo and
Reverse Repo Rates. They enable mobilization of budgetary resources and act as an instrument
to siphon off the excess liquidity in the system.
 Reserve Requirements: A certain amount of bank deposits is kept with the central bank. It
regulates money supply by influencing the volume of excess reserves with the commercial
banks and also the credit multiplier of the banking system. In India this is the Cash Reserve
Ratio (CRR).
 Statutory Liquidity Ratio (SLR): SLR is the percentage of funds banks need to maintain in the
form of liquid assets at any point in time. When the SLR is high, banks have less money for
commercial operations and hence less money to lend out.
 Deficit Financing: The central bank can print more money, but it results in more inflation and
isn’t the wisest choice to control money supply.
 Quantitative Easing: The central bank infuses a pre-determined quantity of money into the
economy by buying government bonds or other financial assets from commercial banks and
private entities.
Qualitative methods include following:
 Regulation of margin requirement- ‘Margin’ refers to the part of loan amount not financed by
the bank. A rise in the margin requirement results in a contraction in the borrowing value of the
security and vice-versa. Changes in margin requirements are designed to influence the flow of
credit against specific commodities.
 Credit rationing- It is a method by which the central bank seeks to limit the maximum amount
of loans. It helps in lowering banks credit exposure to unwanted sectors.
 Regulation of consumer credit – The central bank uses this method to restrict or liberalise the
loan conditions in order to check inflation and stabilise the economy.

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  Moral Suasion: Moral suasion is the process in which the central bank advises or persuades the
commercial banks to comply with the general monetary policy.
 Direct Action: It refers to the directions issued by the central bank to the commercial banks
regarding their lending and investment policies. It is often deployed when banks violate the
conditions and requirements set by the central bank.

Overall, the money supply and the effectiveness of credit control measures in an economy depends
upon a number of factors and these measures are essential towards maintaining the overall
financial health of an economy and stabilise its macro-economic indicators.

13. What is liquidity trap? Discuss its implications on the economy.

Approach:
 Introduce by defining the concept of liquidly trap.
 Discuss in detail, the implications of liquidity trap on the economy.
 Conclude by suggesting ways to overcome it.
Answer:
A liquidity trap is a situation in which prevailing market interest rates are so low that an increase in
money supply has no effect on interest rates and people will hold this money in the form of money
balance instead of investing or spending it. In this situation, people avoid bonds under the
assumption that interest rates will soon rise, which would push bond prices down causing a capital
loss to them. This, in turn, further lowers the interest rate.
Implications on the economy:
 A major implication of liquidity trap is that it renders expansionary monetary policy
ineffective as a tool to boost economic growth.
 The bond market provides funds for long term financing of the projects. As people don’t invest
in bonds, the funds required for sectors like infrastructure dry up.
 Further, it may push the economy into recession as increased money supply fails to provide
stimulus to the economy. If it persists, may lead to increase in unemployment.
 Businesses don't invest in expansion. Instead of buying new capital equipment, they make do
with the old. They take advantage of low interest rates and borrow money, but they use it to buy
back shares and artificially boost stock prices.
 Companies don't hire as they should, so wages remain stagnant. Without rising incomes,
families only buy what they need and save the rest. Low wages aggravate income inequality.
 Consumer prices remain low. Without inflation, there's no incentive for people to buy before
prices go up. There might even be deflation instead of inflation. People will delay buying
things because they know prices will be lower later.
 Banks don't increase lending. Usually, the banks are supposed lend the extra money, pumped
into the economy by the central bank, out in mortgages, small business loans etc. But if people
aren't confident, they won't borrow, thereby limiting banks’ lending.
Measures to overcome it include:
There are a number of ways of helping the economy to come out of a liquidity trap. None of these
ways may work on its own, but it may help induce confidence in the consumers to start
spending/investing again.
 Raising the interest rates: It may motivate people to invest more of their money, rather than
hoarding it. Higher long-term rates encourage banks to lend since they'll get a higher return.
However, it may not always work.
 Decline in general price level: When this happens, people can’t resist spending money. The
lure of lower prices becomes too attractive, and savings are used to take advantage of those low
prices.

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  Increased government spending: When the government does so, it implies that the
government is committed and confident in the national economy. It further fuels job growth.
 Financial innovation: It involves creating an entirely new market. For instance- It happened
with the internet boom in 1999.
 Global Rebalancing: Governments can coordinate global rebalancing i.e. countries that have
a surplus of one thing (for instance cash, labour etc.) can trade with those that have its deficit.

14. Why is the RBI called as the 'lender of last resort'? What other functions are performed by RBI
while acting as a banker to commercial banks and the government?
Approach:
 Give a brief introduction about the concept of ‘lender of last resort’.
 Discuss why the RBI is called as the 'lender of last resort'.
 Enumerate the other functions that are performed by the RBI.
 Conclude on the basis of the above points.
Answer:
A ‘lender of last resort’ is an institution, usually a country's central bank, which offers loans to banks
or other eligible institutions that are experiencing financial difficulty or are considered highly risky
or near collapse.
In India, when the commercial banks exhaust all resources to supplement their funds at times of
liquidity crisis, they approach the Reserve Bank of India (RBI) as a last resort. As a ‘lender of last
resort’, the RBI gives guarantee of solvency and provides financial accommodation to these
commercial bank by counting their eligible securities and bills of exchange and providing loans
against their securities.
Thus, 'lender of last resort' is a financial safety net provided by the RBI to the commercial banks.
The RBI extends this facility to protect the interest of the depositors of the bank and to prevent
possible failure of the bank, which in turn may also affect other banks and institutions leading to the
possible breakdown of the banking system. This can have an adverse impact on financial stability
and thus on the economy of the country.
Commercial banks usually try not to borrow from the RBI because such action indicates that the
bank is experiencing a financial crisis. Also, the unlimited extension of 'lender of last resort' will
make banks take risky decisions, expecting the RBI to come to the rescue of a risk taking and failing
bank.
In addition to the above role as a ‘lender of last resort’, the RBI performs the following functions:
1) As a banker of banks:
 Under the Banking Regulation Act, 1949, the RBI has extensive powers to supervise and control
the banking system of the country.
 It enables smooth and swift clearing and settlements of inter-bank transactions.
 It provides efficient means of fund transfer for all banks.
 It enables banks to maintain their accounts with the RBI for statutory reserve requirements and
maintenance of transaction balances.
2) As a banker to the Government:
 Under the Reserve Bank of India Act, 1934, the RBI acts as a banker agent and adviser to the
government. It has an obligation to transact the banking business of the Central government and
the state governments. For example, the RBI receives and makes all payments on behalf of the
government, remits its funds, buys and sells foreign currencies for it and advices it on all
banking matters.
 The RBI helps both the Central and state governments to float new loans and manage public
debt.
 On behalf of the Central government, it sells treasury bills and provides short-term finance.

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 Thus, the RBI plays a very crucial role in maintaining the stability of the financial system and
thereby the economy of the country.

15. What are the key issues in fiscal management in India? How can these issues be addressed?
Approach:
 Give a brief introduction about the importance of fiscal management.
 Discuss the various issues regarding fiscal management in India.
 Bring out measures to address the issues.
 Conclude on the basis of the above points.
Answer:
Fiscal management is the process of planning, directing and controlling the financial resources. It is
important to improve investment sentiment, increase credit availability to the private sector,
control inflation and bring fiscal deficit under control.
Issues with fiscal management in India:
 Inadequate budget reporting: Budgets often overstate revenue projections and understate
expenditures.
 Increased reliance on Extra Budgetary Resources (EBRs): Over the years, the government’s
reliance on EBRs such as funds of state-owned enterprises like the LIC, SBI etc. to fund public
programmes has increased. However, it does not appear in real time fiscal deficit numbers.
 Limited tax buoyancy: Tax buoyancy shows no stable pattern, thus, it becomes difficult to
forecast tax revenues.
 Understating fiscal deficits: Fiscal deficits are understated by the use of creative accounting
techniques such as rolling over a part of the overall subsidy bill and dues to the states to the
next financial year, using PSEs like LIC to purchase divested stakes in the disinvestment process,
etc.
 Absence of uniform fiscal consolidation rules for the Centre and states: Due to which states
have constraints in managing their finances.
 Non-adherence to the Fiscal Responsibility and Budget Management Act (FRBMA)
targets: Since its enactment, there have been many occasions when the FRBMA targets have
been flouted. Further, there has only been post-facto assessment regarding Compliance of the
FRBMA by the CAG.
 Adoption of fiscal populism measures: Like loan waivers to farmers, tax waivers to MSMEs
etc., which add a burden to the public exchequer.
These issues can be addressed through various measures as follows:
 Establishing an Independent Fiscal Council to monitor fiscal policies, help attain fiscal targets
and keep a check on the fiscal consolidation of the Centre and states, as suggested by the N K
Singh Committee.
 Stating correct estimates of revenue and expenditure on the budget in order to formulate
sound economic policies thereafter.
 Bringing coherence between the Centre and states in terms of laws related to fiscal
management.
 Enhancing cooperation between the Finance Commission and the GST Council.
 Curbing populism and strictly adhering to fiscal targets by the government. Further, there
should be proper monitoring and efficient management of public expenditure.
 Rationalisation of the FRBMA so that the ratio of public debt to GDP is stabilized at a
sustainable level.
 Establishing an institutional mechanism for sound fiscal practices, which will bring in
transparency and instill confidence among domestic and foreign investors.
Adequate fiscal management is pertinent to stabilize the economy and attain India’s goal of
becoming a 5 trillion dollar economy by 2024.

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16. What is sterilization? Explain how it is deployed by RBI in stabilizing the money supply against
external shocks.
Approach:
 Introduce by explaining what you understand by sterilization.
 Explain in brief the mechanism of sterilization employed by RBI in stabilizing the money supply
against external shocks.
 Conclude on the basis of the above points.
Answer:
Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows
and outflows of capital on the money supply through the purchase or sale of financial assets. It is an
important instrument employed by the RBI to respond to external shocks, which operate in the
form of large net capital movement i.e. inflow (positive shock) or outflow (negative shock). India,
being an attractive destination for foreign investment, sees sterilization done by RBI, mainly in case
of capital inflows.
Sterilization by the RBI in case of capital inflows:
The foreign investors buy Indian bonds with foreign currency, thereby increasing its supply. It leads
to appreciation of domestic currency, which adversely affects Indian exports. So, the RBI sells the
domestic currency to buy foreign-currency denominated assets. But this release of domestic
currency leads to inflation in the country. Increased money supply without a proportionate
increase in demand will also lead to decline in interest rates.
In these cases, the Reserve Bank of India undertakes an open market sale of government
securities of an amount equal to the amount of foreign exchange inflow, thereby soaking up new
cash that would otherwise circulate in the domestic economy. Other lesser used sterilization
methods include increase in cash reserve ratio (CRR) of commercial banks, or a ceiling on the total
credit extended. This keeps the stock of high-powered money and total money supply unchanged.
Thus, it sterilizes the economy against the adverse external shocks. It leads to following benefits:
 It averts a situation of undesirable expansionary effects of capital inflows by keeping the
monetary base unchanged.
 Foreign exchange market intervention accompanied by sterilization allows the RBI to build
international reserves (FOREX) that will help to withstand future shocks.
 It instils confidence among the market participants.
In case of capital outflows, as happened in 2008 global crisis, there is a flight of capital from the
country and the domestic currency depreciates. To prop up its value, the RBI resorts to creating
artificial demand for its currency by using some of its FOREX to buy domestic currency. It results in
lowering of the money supply which likely will have a deflationary effect. To offset the effect on the
money supply, RBI sterilizes its foreign exchange intervention by engaging in open market
operations that supply liquidity into the system.
However, prolonged sterilization may not be possible without making interest rates higher. This
could attract further foreign exchange inflows thereby neutralising the impact of sterilization.
Undertaking sterilization also has financial costs that the RBI has to bear. Thus, the decision to
undertake sterilization operations by the RBI should be taken after assessing its costs and benefits.

17. Bringing out the difference between fiscal deficit, primary deficit and revenue deficit, explain
the implications of a high fiscal deficit on the economy.
Approach:
 Start with a definition of deficit and differentiate between fiscal deficit, primary deficit and
revenue deficit by explaining their meanings.
 Discuss the implications of a high fiscal deficit on the economy.
 Conclude briefly.

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Answer:
A deficit in an economy occurs when expenditure exceeds income. There can be different types of
deficits in a budget depending upon the types of receipts and expenditure taken into consideration.
 Fiscal deficit refers to the excess of total budget expenditure over total budget receipts
excluding borrowings during a fiscal year.
Fiscal Deficit = Total Budget Expenditure – Total Receipts excluding borrowings
= Revenue Expenditure + Capital Expenditure – Revenue receipts – Capital Receipts of
only non-debt type
If we add debt-incurring capital receipts the fiscal deficit would be zero. In simple words, fiscal
deficit gives borrowing requirements of the government.
 Primary deficit is a measure of budget deficit, which is obtained by deducting interest
payments from fiscal deficit. The difference between the fiscal deficit and primary deficit shows
the importance of interest payments on public debt incurred in the past.
 Revenue deficit is excess of total revenue expenditure of the government over its total revenue
receipts. It signifies that government’s own earning is insufficient to meet normal functioning of
government departments and provision of services.
Implications of high fiscal deficit on economy:
 Debt trap: A high fiscal deficit means high borrowing and as the government borrowing
increases, its liability in future to repay loan amount along with interest thereon also increases.
Interest payments increase revenue expenditure leading to higher revenue deficit which may
compel government to borrow further.
 Inflationary pressure: It leads to higher inflation due to demand push being generated by
higher government expenditure.
 Retards future growth: Borrowing is a financial burden on future generation to pay loan and
interest amount, which retards growth of economy.
 Increase in taxation: Higher fiscal deficit means government is not able to earn as much as it is
spending so often it raises taxes in some form or other.
 Interest Rates: In an emerging economy like India, a higher fiscal deficit leaves little room for
interest rate cuts. A higher interest rate may affect private investments from taking off in a
growing economy like India.
 Foreign Dependence: Government may have to depend on external borrowings, which raises
its dependence on other countries. Further, high fiscal deficit affects India’s Sovereign rating
and hurts the confidence of foreign investors, which also raises the costs of borrowings.
 Affects Private sector investment: More than average borrowing by the government from the
market leaves that much less pool for private sector to borrow, stalling its growth plans.
The fiscal deficit is detrimental for the economy if it is used just to cover revenue deficit. However,
fiscal deficit may also have a positive effect on an economy, if it creates new capital assets, which
increases productive capacity and generates future income stream.

18. What do you understand by fiscal policy? Explain its key objectives.
Approach:
 Briefly explain the term fiscal policy and its role in economy.
 Discuss the key objectives of Fiscal Policy.
 Give a brief conclusion accordingly.

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Answer:
Fiscal Policy is the mechanism by means of which a government makes adjustments to its
spending levels and tax rates to monitor and thus in turn influence the performance of a country’s
economy.
It is largely based on ideas from John Maynard Keynes, who argued governments could stabilize
the business cycle and regulate economic output by adjusting spending and tax policies. There
are two types of fiscal policy – expansionary (to stimulate economic growth by increasing
spending or lowering taxes or both) and contractionary (to curtail inflation) fiscal policy.
Main objectives of fiscal policy:
 Development by effective resource mobilization: The principal objective of fiscal policy is to
ensure rapid economic growth and development by mobilization of financial resources via.
taxation, use of public and private savings.
 Optimum allocation of resources: Fiscal measures like taxation and public expenditure
programmes, greatly affect the allocation of resources in various occupations and sectors.
 Effective Redistribution of Income: Fiscal policy aims at equitable distribution of wealth and
income to reduce inequalities in society.
 Price stability and control of inflation: Fiscal policy has to be such as to maintain a
reasonably stable price level and keep inflation under check thereby benefiting all sections of
society.
 Employment generation: It is a key objective of fiscal policy in a developing economy. For
example, investment in infrastructure results in direct and indirect employment.
 Balanced regional development: The government provides various incentives for setting up
projects in backward areas such as cash subsidy, tax concessions, finance at concessional
interest rates, etc.
 Maintain equilibrium in the Balance of Payment: Fiscal policy attempts to encourage more
exports and discourage import to solve balance of payments problem. This also helps in
achieving the objective of increase in FOREX earnings.
 Capital formation: The objective of fiscal policy in India is also to increase the rate of capital
formation so as to accelerate the rate of economic growth by increasing investment in key areas.
The objectives of fiscal policy can be achieved only if the policy tools such as public expenditure,
taxation, borrowing and deficit financing are effectively used. The success of fiscal policy also
depends upon taking timely measures and their effective administration during implementation.

19. Explain, in brief, the various components of budget receipts and expenditure.
Approach:
 Introduce with the definition of budget and its constitutional provisions in India.
 Elaborate the different components of budget receipts as well as budget expenditure.
 Write brief conclusion.
Answer:
A government budget is an annual financial statement showing item wise estimates of expected
revenue and anticipated expenditure during a fiscal year. There is a constitutional requirement in
India U/A 112 to present before the Parliament an ‘Annual Financial Statement’, which constitutes
the main budget document of the government.
Various components of a government Budget is shown below:

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 Components of Budget Receipts
1. Revenue Receipts: Revenue receipts are those receipts that neither create asset nor reduce any
liability on the government. They are divided into tax and non-tax revenues.
 Tax revenues includes receipts in the form of direct taxes such as personal income tax,
corporation tax, wealth tax, gift tax etc. and indirect taxes such as GST, custom duties (taxes
imposed on goods imported into and exported out of India).
 Non-tax revenue of the central government mainly consists of interest receipts on account
of loans by the central government, dividends and profits on investments made by the
government, fees and other receipts for services rendered by the government. Cash grants-
in-aid from foreign countries and international organisations are also included.
2. Capital Receipts: All those receipts of the government which create liability or reduce financial
assets are termed as capital receipts. These include recovery of loans, disinvestment,
borrowings etc. These receipts can be debt creating or non-debt creating.
Components of Budget Expenditure
1. Revenue Expenditure: It is expenditure incurred for purposes other than the creation of physical
or financial assets of the central government. It relates to those expenses incurred for the normal
functioning of the government departments and various services, interest payments on debt
incurred by the government, and grants given to state governments and other parties (even though
some of the grants may be meant for creation of assets).
2. Capital Expenditure: There are expenditures of the government which result in creation of
physical or financial assets or reduction in financial liabilities. This includes expenditure on the
acquisition of land, building, machinery, equipment, investment in shares, and loans and advances
by the central government to state and union territory governments, PSUs and other parties.
In 2017-18, the Union government has done away with the division of expenditure in Indian budget
into plan and non-plan. Also, Rail Budget was merged with the Union Budget from budget year
2017-18.

20. Highlight the monetary and fiscal measures that can be taken to address the phenomenon of
inflation. Also explain their limitations.
Approach:
 Define Inflation.
 Discuss the monetary and fiscal measures that are adopted to control inflation separately.
 Briefly mention the mechanism of inflation targeting in India.

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Answer:
Inflation refers to the general rise in the prices of goods and services. The same unit of currency
buys lesser goods and services than it did previously, thereby reducing purchasing power of the
currency in an economy. While moderate inflation is usually good for an economy, higher inflation
rates can be disastrous for the consumers and the economy.
Measures to control inflation
1. Monetary Measures:
These measures taken by central bank, aims at reducing the supply of money which leads to curbing
the aggregate demand ultimately leading to fall in prices. Its main tools include:
 Repo rate: It is the rate at which the RBI provides overnight liquidity to the banks. Increase in
the rate reduces liquidity and flow of money.
 Bank Rate: An increase in bank rate subsequently increases the cost of borrowing for banks
and the borrrowers. This reduces borrowing from commercial banks.
 Reserve requirements: Increased reserve requirements under Cash Reserve Ratio/Statutory
Liquidity Ratio reduces the lending capacity of the commercial bank. This reduces the flow of
the money to the public.
 Open Market Operations: These include both, outright purchase and sale of government
securities, for injection and absorption of durable liquidity
2. Fiscal Measures:
Fiscal measures taken by the government, to reduce spending and also manage supply side inflation
includes
 Reduction in Expenditure: The government may reduce unnecessary expenditure on non-
development activities, postpone repayment of public debt etc. till inflationary pressures are
controlled.
 Increase in Taxes: It would cut personal consumption expenditure due to reduced disposable
income. It helps in reducing aggregate demand in the economy.
 Surplus Budgets: Having surplus budget would mean that the government has removed more
money from private holdings via taxes than it has put back in via spending. This consequently
lowers demand.
 Protectionist measures: The government can take some protectionist measures such as
banning the export of essential items such as pulses, oils etc. to support domestic consumption;
encouraging imports by lowering duties etc.
Limitations of above measures in controlling inflation
 Time Lags: There can be a time lag of up to 18 months before higher interest rates have the
effect of reducing demand. Thus, it would require accurate prediction of future inflation trends.
 Multiple factors affect consumer spending: In practice, higher interest rates might not always
reduce consumer spending. For example, if consumer confidence is very high and house prices
are rising, increased interest rates may be insufficient in reducing consumer spending.
 Political considerations: Fiscal policy is not always based on economic considerations. For
example: Raising taxes may help in reducing aggregate demand greatly but in reality, such a
decision is difficult to take by government in power.
 Trade-off with growth: Although both the above measures may help to reduce the aggregate
demand but lower demand would also reflect itself in low investments and economic growth.
Thus, it is very difficult to achieve a right blend of monetary and fiscal measures to influence
aggregate spending. In addition to these two methods other direct methods may also be taken such
as increase in production to meet demands, rationalize wage policy, direct price control etc.