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TEST-8 EXPLANATION PDF

October 6th, 2019

Lesson 5
Inflation
Inflation .................................................................... 2 Reasons for Periodic Spurt in Inflation in India
Understanding Inflation ....................................... 2 ......................................................................... 13

Why Study Inflation?............................................ 2 Inflation Targeting in India .............................. 14

Uncertainty ....................................................... 2 How to Control Inflation? ................................... 14
Haphazard Redistribution ................................. 3 Interest Rate.................................................... 15

Causes of Inflation ............................................... 3 Reserve Ratios ................................................. 15

Demand-Pull Inflation ....................................... 3 Open Market Operations ................................ 15
Cost-Push Inflation ........................................... 4 Reducing the Money Supply ........................... 15
Types of Inflation Indexes .................................... 4 MCQs for Practice................................................... 17
Wholesale Price Index ...................................... 4 MCQs with Answer and Explanation ...................... 18
Consumer Price Index ....................................... 5
Wholesale Price Index Vs Consumer Price Index
.......................................................................... 5
Headline Inflation ............................................. 6
Core Inflation .................................................... 6
Consumer Food Price Index .............................. 6
WPI Food Index ................................................. 7
Producer Price Index......................................... 7
PPI vs Wholesale Price Index ............................... 7
PPI vs Consumer Price Index ................................ 7
Application of Inflation in Economic Analysis ...... 8
Inflation and Nominal & Real GDP ................... 9
Nominal GDP ........................................................ 9
Real GDP............................................................... 9
Inflation and Value of Money ........................... 9
Inflation and Nominal & Real Interest Rate ..... 9
Inflation and Base Effect ................................. 10
Bonds, Interest Rates and the Impact of
Inflation........................................................... 10
The price-yield seesaw and interest rates .........10
What moves the seesaw? ..................................11
If inflation means higher prices, why do bond
prices drop? .......................................................11
Inflation, Interest Rate and Bonds .....................11
Pros and Cons of Inflation .................................. 12
Advantages of Inflation .................................. 12
Disadvantages of Inflation .............................. 12
Inflation Management in India .......................... 13

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INFLATION
UNDERSTANDING INFLATION
Inflation occurs when the average price level (that
is, prices in general) increases over time. This does
not mean that all prices increase the same, nor that
all prices necessarily increase. Some prices might
increase a lot, others a little, and still other prices
decrease or remain unchanged. Inflation results
when the average of these assorted prices follows
an upward trend.
While short-term bouts of inflation can be triggered
by anything that would cause aggregate demand to
increase more than aggregate supply, long-term
inflation can be sustained only through increases in
the money supply. The price level, and any
"inflation" of the price level, depends directly on the
amount of money in circulation. On the flip side of
this relationship, inflation leads to a continual
erosion in the purchasing power of money.
KEY DEFINITION
Price Level: The average of the prices of goods and
services produced in the aggregate economy. In a
theoretical sense, the price level is the price of
aggregate production. In a practical sense, the
price level is measured by either of two price
indexes, the Consumer Price Index (CPI) or the
GDP price deflator.
Aggregate Demand: The total (or aggregate) real
expenditures on final goods and services produced
in the domestic economy that buyers would be
willing and able to make at different price levels,
during a given time period (usually a year). The
aggregate expenditures are consumption,
investment, government purchases, and net
exports made by the four macroeconomic sectors
(household, business, government, and foreign).
Aggregate Supply: The total (or aggregate) real
production of final goods and services available in
the domestic economy at a range of price levels,
during a given time period.
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Money Supply: The quantity of money balances
that exists in the economy. The money supply is
controlled by the Reserve Bank of India through its
monetary policy.
Purchasing Power: In general, the quantities of
goods and services that can be bought with a given
amount of money. The notable feature of
purchasing power is that it declines as prices rise.
In particular, inflation is the number one nemesis
of purchasing power. When inflation gives higher
prices, purchasing power falls.
Inflation: A persistent increase in the average
price level in the economy. It is measured by the
inflation rate, the annual percentage change in a
price index such as the Consumer Price Index (CPI)
or GDP price deflator. Inflation is the most
common phenomenon associated with the price
level. Two related phenomena are deflation, a
decrease in the price level, and disinflation, a
decrease in the inflation rate. Inflation is one of
two key macroeconomic problems.
QUESTION 1
Q. Which one of the following statements is an
appropriate description of deflation? [2010]
(a) It is a sudden fall in the value of a currency
against other currencies
(b) It is a persistent recession in both the financial
and real sectors of economy
(c) It is a persistent fall in the general price level
of goods and services
(d) It is a fall in the rate of inflation over a period
of time
Answer: C
WHY STUDY INFLATION?
Inflation attracts the interest of economists, policy
makers, and regular everyday ambling folks for a
couple of reasons: uncertainty and haphazard
redistribution.
UNCERTAINTY
First, inflation creates uncertainty, especially when
inflation catches people unexpectedly off guard or
fluctuates widely from month to month or year to
year.
The reason that most people, consumers and
producers alike, do not like unexpected inflation is
that they are risk averse; they prefer a knowable,
stable, predictable life. Known, constant, or
expected inflation can be integrated into the fabric
of the economy. If people know that prices will be
increasing by 10 percent, then they can adjust plans
accordingly. However, unexpected or changing
inflation creates uncertainty, making long-range
planning exceedingly difficult.
For example, a significant amount of household,
business, and government activity involves long-
term commitments--such as borrowing to purchase
cars and homes, investing in multi-year capital
construction projects, anticipating tax or revenue
collections, and planning expenditure budgets.
Not knowing, or not correctly anticipating, inflation
makes such commitments difficult at best and might
even be financial disastrous. Households and
businesses can be forced into bankruptcy.
Governments can encounter serious fiscal
problems.
A worker might not know whether to accept a multi-
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
13 percent increase in raw material prices.
HAPHAZARD REDISTRIBUTION
Second, inflation can haphazardly redistribute
income and wealth. The redistribution of income
and wealth has always been an inherent part of the
economy. However, inflation can redistribute
income in ways that society might not want.
While inflation is an increase in the average price
level, all prices do not increase at the same rate.
When prices change at different rates, the owners of
resource used in the production of goods with
above-average price increases receive more real
income. Resource owners involved in the
production of goods with below-average price
increases (even declining prices) get relatively less
real income. The end result is the income and wealth
are redistributed from some resource owners to
others.
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One of the most noted areas of inflation-induced
redistribution is between borrowers and lenders.
When borrowers and lenders correctly anticipate
inflation over the life of a loan, they adjust the
interest rate to ensure that the purchasing power of
the money loaned is equal to the purchasing power
of the money repaid.
However, income and wealth are redistributed
between borrowers and lenders when inflation is
not correctly anticipated.
If inflation is more than expected, then the
purchasing power of the repayment is less than the
original loan, so income and wealth are
redistributed from lenders to borrowers.
If inflation is less than expected, then the
purchasing power of the repayment is more than
the original loan, so income and wealth are
redistributed from borrowers to lenders.
CAUSES OF INFLATION
The causes of inflation are conveniently analysed
within the framework of a simple market. In general,
prices increase as a result of market shortages,
which occur when quantity demanded exceeds
quantity supplied.
Market shortages can be created by either increases
in demand or decreases in supply. Translating this
to the macroeconomy suggests that inflation occurs
when aggregate demand exceeds aggregate supply.
Inflation-inducing, economy-wide shortages can be
created by either increases in aggregate demand or
decreases in aggregate supply.
This analysis suggests the two basic types of
inflation: demand-pull inflation and cost-push
inflation.
DEMAND-PULL INFLATION
Demand-pull inflation places responsibility for
inflation squarely on the shoulders of increases in
aggregate demand. This type of inflation results
when the four macroeconomic sectors (household,
business, government, and foreign) collectively try
to purchase more output than the economy is
capable of producing.
In general, if aggregate demand increases beyond
aggregate supply, buyers seek to buy more
production than the economy can provide. The
buyers bid up the price. This extra demand "pulls"
the price level higher.
Any increase in aggregate demand resulting from
changes in any of the aggregate demand
determinants can trigger demand-pull inflation.
However, the only way to sustain demand-pull
inflation is with an increase in the money supply.
Inflation simply cannot persist for any extended
period of time (that is, a year or more) without
increases in the amount of money available to the
economy.
COST-PUSH INFLATION
Cost-push inflation places responsibility for inflation
directly on the shoulders of decreases in aggregate
supply that result from increases in production
cost. This type of inflation occurs when the cost of
using any of the four factors of production (labour,
capital, land, or entrepreneurship) increases.
In general, higher production cost means the
economy simply cannot continue to supply the
same production at the same price level. If buyers
want the production, they must pay higher prices.
The higher cost "pushes" the price level higher.
While any of the factors of production "could"
trigger cost-push inflation, labour and land are the
two factors most likely to do so--especially wages
and energy prices.
QUESTION 2
Q. A rise in general level of prices may be caused
by [2013 - I]
1. an increase in the money supply
2. a decrease in the aggregate level of output
3. an increase in the effective demand
Select the correct answer using the codes given
below:
(a) 1 only
(b) 1 and 2 only
(c) 2 and 3 only
(d) 1, 2 and 3
Answer: D
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TYPES OF INFLATION INDEXES
WHOLESALE PRICE INDEX
▪ Wholesale Price Index (WPI) measures the
average change in the prices of commodities for
bulk sale at the level of early stage of
transactions.
▪ The index basket of the WPI covers commodities
falling under the three major groups namely
Primary Articles, Fuel and Power and
Manufactured products.
▪ The prices tracked are ex-factory price for
manufactured products, mandi price for
agricultural commodities and ex-mines price for
minerals.
▪ Weights given to each commodity covered in the
WPI basket is based on the value of production
adjusted for net imports.
▪ WPI basket does not cover services.
▪ In India, Office of Economic Advisor (OEA),
Department for Promotion of Industry and
Internal Trade, Ministry of Commerce and
Industry calculates the WPI.
▪ The main uses of WPI are the following:
1. It provides estimates of inflation at the
wholesale transaction level for the economy
as a whole. This helps in timely intervention
by the Government to check inflation in
particular, in essential commodities, before
the price increase spill over to retail prices.
2. WPI is used as deflator for many sectors of
the economy including for estimating GDP by
Central Statistical Organisation (CSO).
3. WPI is also used for indexation by users in
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,
1970-71, 1981-82, 1993-94 and 2004-05 so far.
▪ The base year of All-India WPI has been revised
from 2004-05 to 2011-12 on 12 May 2017 to
align it with the base year of other
macroeconomic indicators like the Gross
 Domestic Product (GDP) and Index of Industrial
Production (IIP). The current series is the seventh
revision.
▪ The revision entails not just shifting the base
year to 2011-12 from 2004-05, but also changing
the basket of commodities and assigning new
weights to the commodities.
▪ The weight of an item in the WPI basket is based
on the net traded value of the item in the base
year i.e. 2011-12. The net traded value is the
value of output of the item in the year 2011-12
adjusted for net imports. Thus, net traded value
represents the total transactions of each
product in the economy during the base year.
▪ In the updated WPI basket, the number of items
has been increased from 676 to 697. In all 199
new items have been added and 146 old items
have been dropped. Efforts have been made to
enhance the number of quotations from 5482 to
8331, an increase by 2849 quotations (52%). The
increase in number of quotations has been done
across the major groups to ensure
comprehensive coverage and
representativeness.
▪ Wholesale price index calculated with 2011-12
base year does not include taxes in order to
remove the impact of fiscal policy. This also
brings the present WPI series closer to Producer
Price Index, as is practised globally. A Producer
Price Index reflects the change in average prices
that producers get.
CONSUMER PRICE INDEX
▪ Consumer Price Index (CPI) is a measure of
change in retail prices of goods and services
consumed by defined population group in a
given area with reference to a base year. This
basket of goods and services represents the level
of living or the utility derived by the consumers
at given levels of their income, prices and tastes.
▪ The CPI number measures changes only in one
of the factors: prices. This index is an important
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economic indicator and is widely considered as a
barometer of inflation, a tool for monitoring
price stability and as a deflator in national
accounts.
▪ The dearness allowance of Government
employees and wage contracts between labour
and employer is based on this index.
▪ The formula for calculating CPI is Laspeyre’s
index which is measured as follows: [Total cost
of a fixed basket of goods and services in the
current period * 100] divided by Total cost of
the same basket in the base period.
▪ Presently the consumer price indices compiled in
India are CPI for Industrial workers CPI(IW), CPI
for Agricultural Labourers CPI(AL) and; Rural
Labourers CPI(RL) and (Urban) and CPI(Rural).
▪ The CPI(IW) and CPI (AL & RL) compiled are
occupation specific and centre specific and are
compiled by Labour Bureau. This means that
these index numbers measure changes in the
retail price of the basket of goods and services
consumed by the specific occupational groups in
the specific centres.
▪ CPI (Urban) and CPI (Rural) are new indices in
the group of CPI and has a wider coverage of
population. This index compiled by Central
Statistical Organisation, Ministry of Statistics
and Programme Implementation, tries to
encompass the entire population and is likely to
replace all the other indices presently compiled.
▪ The Reserve Bank of India (RBI) has started
using CPI-combined (both Urban & Rural) as the
sole inflation measure for the purpose of
monetary policy. As per the agreement on
Monetary Policy Framework between the
Government and the RBI dated February 20,
2015 the sole of objective of RBI is price stability
and a target is set for inflation as measured by
the Consumer Price Index-Combined.
WHOLESALE PRICE INDEX VS
CONSUMER PRICE INDEX
▪ WPI reflects the change in average prices for
bulk sale of commodities at the first stage of
transaction while CPI reflects the average
change in prices at retail level paid by the
consumer.
▪ The prices used for compilation of WPI are
collected at ex-factory level for manufactured
products, at ex-mine level for mineral products
and mandi level for agricultural products. In
 contrast, retail prices applicable to consumers
and collected from various markets are used to
compile CPI.
▪ The reasons for the divergence between the
two indices can also be partly attributed to the
difference in the weight of food group in the
two baskets. CPI Food group has a weight of 39.1
per cent as compared to the combined weight of
24.4 per cent (Food articles and Manufactured
Food products) in WPI basket.
▪ The CPI basket consists of services like housing,
education, medical care, recreation etc. which
are not part of WPI basket. A significant
proportion of WPI item basket represents
manufacturing inputs and intermediate goods
like minerals, basic metals, machinery etc. whose
prices are influenced by global factors but these
are not directly consumed by the households and
are not part of the CPI item basket.
▪ Thus, even significant price movements in items
included in WPI basket need not necessarily
translate into movements in CPI in the short run.
The rise or fall in prices at wholesale level spill
over to the retail level after a lag.
HEADLINE INFLATION
▪ In general, headline inflation reflects the rate of
change in prices of all goods and services in an
economy over a period of time. Every country
has its own set of commodity basket to track
inflation. While some countries use Wholesale
Price Index (WPI) as their official measure of
inflation, most others use the Consumer Price
Index (CPI).
▪ Up until March 2014, Reserve Bank of India (RBI)
had given more weightage to Wholesale Price
Index (WPI) than CPI as the key measure of
inflation for all policy purposes.
▪ Since April 2014, RBI has adopted the new
Consumer Price Index (CPI) (combined) as the
key measure of inflation.
▪ Therefore CPI-combined is the measure of
headline inflation in India now.
CORE INFLATION
▪ Core Inflation is also known as underlying
inflation, is a measure of inflation which
excludes items that face volatile price
movement, notably food and energy. In other
words, Core Inflation is nothing but Headline
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Inflation minus inflation that is contributed by
food and energy commodities.
▪ To understand the concept in a better way we
can say that food and fuel prices may go up in
the short run due to some disturbance in the
agriculture sector or oil economy. However,
over the long term they tend to revert back to
their normal trend growth. On the other hand,
prices of other commodities do not fluctuate as
regularly as food and fuel – as such increase in
their prices could be taken relatively to be much
more of a permanent nature.
▪ If this is so, then it follows logically for Central
Banks to target only core inflation, as it reflects
the demand side pressure in the economy. In
practice too, the Reserve Bank of India (RBI) and
Central Banks around the World always keep an
eye on the core inflation.
▪ Whenever core inflation rises, Central Banks
increase their key policy rates to suck excess
liquidity from the market and vice versa. It is,
therefore, a preferred tool for framing long-
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
subdued when policy responds to core inflation.
▪ This is because, it is important to distinguish
between temporary (like seasonal variation in
fruits and vegetable prices) and permanent
changes in prices. While temporary changes
would reverse and might not warrant attention,
permanent changes would require standard
remedies involving monetary and fiscal policies.
▪ Research has shown that headline inflation
tends to revert strongly towards core inflation
once the temporary fluctuation in food and
energy sector stabilizes.
CONSUMER FOOD PRICE INDEX
▪ Consumer Food Price Index (CFPI) is a measure
of change in retail prices of food products
consumed by a defined population group in a
given area with reference to a base year.
▪ The Central Statistics Office (CSO), Ministry of
Statistics and Programme Implementation
(MOSPI) started releasing CFPI for three
categories - rural, urban and combined -
separately on an all India basis with effect from
May, 2014.
▪ Like CPI, the CFPI is also calculated on a monthly
basis and methodology remains the same as CPI.
The base year presently used is 2012. The CSO
revised the Base Year of the CPI and CFPI from
2010=100 to 2012=100 with effect from the
release of indices for the month of January 2015.
▪ CFPI (Rural/ Urban/ Combined) is compiled as
the weighted average of the Cereals and
Products sub group of CPI for each of those
categories - Rural/ Urban/ Combined. Modified
weights of these Sub-groups within CFPI are as
follows:
▪ Inflation rates (on point to point basis i.e.
August, 2014 over August, 2013), based on
general Indices and CFPIs, are issued by CSO.
▪ Price data are collected from selected towns by
the Field Operations Division of NSSO and from
selected villages by the Department of Posts.
Price data are received through web portals
being maintained by the National Informatics
Centre.
▪ Globally, food price index is being released by
Food and Agriculture Organization of the United
Nations. The FAO Food Price Index is a measure
of the monthly change in international prices of
a basket of food commodities. It consists of the
average of five commodity group price indices
(Cereal, Vegetable Oil, Dairy, Meat and Sugar)
weighted with the average export shares of each
of the groups.
WPI FOOD INDEX
▪ After the revision of WPI with the new base year
2011-12, a new “WPI Food Index” is being
compiled by combining the “Food Articles”
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under “Primary Articles” in WPI and “Food
Products” under “Manufactured Products” in
WPI.
▪ WPI food index is a new Food price Index
launched on 12 May 2017 as part of revised WPI
series with base year 2011-12.
▪ WPI food index measures the changes in prices
of food items at the level of producers.
▪ Together with the Consumer Food Price Index
released by Central Statistics Office, this would
help monitor the price situation of food items
better.
PRODUCER PRICE INDEX
▪ Producer Price Index (PPI) measures the average
change in the price of goods and services either
as they leave the place of production, called
output PPI or as they enter the production
process, called input PPI.
▪ PPI estimates the change in average prices that
a producer receives.
PPI VS WHOLESALE PRICE INDEX
PPI is different from WPI on following grounds:
▪ WPI captures the price changes at the point of
bulk transactions and may include some taxes
levied and distribution costs up to the stage of
wholesale transactions. PPI measures the
average change in prices received by the
producer and excludes indirect taxes.
▪ Weight of an item in WPI is based on net traded
value whereas in PPI weights are derived from
Supply Use Table.
▪ PPI removes the multiple counting bias inherent
in WPI.
▪ WPI does not cover services and whereas PPI
includes services.
PPI VS CONSUMER PRICE INDEX
PPI is different from CPI on following grounds:
▪ PPI estimates the change in average prices that
a producer receives while CPI measures the
change in average prices that consumer pays.
The prices received by the producers differ from
the prices paid by the consumers on account of
various factor such as taxes, trade and transport
margin, distribution cost etc.
▪ Weights of items in CPI are derived from
Consumer Expenditure Surveys whereas for PPI
it is calculated on the basis of Supply Use tables.

Supply and use tables or in short supply use tables
are in the form of matrices that record how supplies
of different kinds of goods and services originate
from domestic industries and imports and how those
supplies are allocated between various intermediate
or final uses, including exports.
KEY DEFINITION
Consumer Price Index: The Consumer Price Index
(CPI) is a measure that examines the weighted
average of prices of a basket of consumer goods
and services, such as transportation, food, and
medical care. It is calculated by taking price
changes for each item in the predetermined
basket of goods and averaging them. Changes in
the CPI are used to assess price changes
associated with the cost of living; the CPI is one of
the most frequently used statistics for identifying
periods of inflation or deflation.
Wholesale Price Index: A wholesale price index
(WPI) is an index that measures and tracks the
changes in the price of goods in the stages before
the retail level – that is, goods that are sold in bulk
and traded between entities or businesses instead
of consumers. Usually expressed as a ratio or
percentage, the WPI shows the included goods'
average price change and is often seen as one
indicator of a country's level of inflation.
measures price movements from the seller's point
of view.
QUESTION 3
Q. In India, inflation is measured by the: [1997]
(a) Wholesale Price Index number*
(b) Consumers Price Index for urban non-manual
workers
(c) Consumers Price Index for agricultural
workers
(d) National Income Deflation
Answer: A
* Note that this is a 1997 question. At that time
WPI was the measure of inflation in India. If a
similar question is asked today, the answer will be
CPI-Combined.
QUESTION 4
Q. The new series of Wholesale Price Index (WPI)
released by the Government of India is with
reference to the base prices of: [2001]
(a) 1981-82
(b) 1990-91
(c) 1993-94*
(d) 1994-95
Answer: C
* Note that this is a 2001 question. At that time
WPI’s base year was 1993-94. If a similar question
is asked today, the answer will be 2011-12.

Headline Inflation: Headline inflation is a measure QUESTION 5

of the total inflation within an economy, including Q. Which of the following brings out the
commodities such as food and energy prices (e.g., 'Consumer Price Index Number for Industrial
oil and gas), which tend to be much more volatile Workers'? [2015-I]
and prone to inflationary spikes. (a) The Reserve Bank of India
(b) The Department of Economic Affairs
Core Inflation: Core inflation is the change in the (c) The Labour Bureau
costs of goods and services but does not include (d) The labour Bureau brings out consumer price
those from the food and energy sectors. This index numbers.
measure of inflation excludes these items because Answer: C
their prices are much more volatile. It is most
often calculated using the consumer price index
(CPI), which is a measure of prices for goods and
services. APPLICATION OF INFLATION IN
ECONOMIC ANALYSIS
Producer Price Index: The producer price index, or
PPI, is a group of indexes that calculates and When we examine economic statistics, it's crucial to
represents the average movement in selling prices distinguish between nominal and real
from domestic production over time. The PPI measurements so we know whether or not inflation
has distorted a given statistic.
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Looking at economic statistics without considering
inflation is like looking through a pair of binoculars
and trying to guess how close something is—unless
you know how strong the lenses are, you cannot
guess the distance very accurately.
Similarly, if you do not know the rate of inflation, it
is difficult to figure out if a rise in gross domestic
product, or GDP, is due mainly to a rise in the overall
level of prices or to a rise in quantities of goods
produced.
The nominal value of any economic statistic means
the statistic is measured in terms of actual prices
that exist at the time. The real value refers to the
same statistic after it has been adjusted for
inflation. Generally, it is the real value that is more
important.
INFLATION AND NOMINAL & REAL GDP
NOMINAL GDP
The nominal GDP is the value of all the final goods
and services that an economy produced during a
given year. It is calculated by using the prices that
are current in the year in which the output is
produced. In economics, a nominal value is
expressed in monetary terms. For example, a
nominal value can change due to shifts in quantity
and price. The nominal GDP takes into account all of
the changes that occurred for all goods and services
produced during a given year. If prices change from
one period to the next and the output does not
change, the nominal GDP would change even
though the output remained constant.
REAL GDP
The real GDP is the total value of all of the final
goods and services that an economy produces
during a given year, accounting for inflation. It is
calculated using the prices of a selected base year.
To calculate Real GDP, you must determine how
much GDP has been changed by inflation since the
base year, and divide out the inflation each year.
Real GDP, therefore, accounts for the fact that if
prices change but output doesn’t, nominal GDP
would change.
INFLATION AND VALUE OF MONEY
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The impact inflation has on the time value of money
is that it decreases the value of a rupee over time.
The time value of money is a concept that describes
how the money available to you today is worth
more than the same amount of money at a future
date.
This also assumes you do not invest the money
available to you today in an equity security, a debt
instrument, or an interest-bearing bank account.
Essentially, if you have a rupee in your pocket today,
that rupee’s worth, or value, will be lower one year
from today if you keep it in your pocket.
Inflation increases the price of goods and services
over time, effectively decreasing the number of
goods and services you can buy with a rupee in the
future as opposed to a rupee today. If wages remain
the same but inflation causes the prices of goods
and services to increase over time, it will take a
larger percentage of your income to purchase the
same good or service in the future.
So, for example, if a candy costs Rs 1 today, it's
possible that it could cost Rs 2 for the same candy
one year from today. This effectively decreases the
time value of money, since it will cost twice as much
to purchase the same product in the future.
To mitigate this decrease in the time value of money,
you can invest the money available to you today at
a rate equal to or higher than the rate of inflation.
INFLATION AND NOMINAL & REAL
INTEREST RATE
When you borrow or lend, you normally do so in
rupee terms. If you take out a loan, the loan is
denominated in rupees, and your promised
payments are denominated in rupees. These rupee
flows must be corrected for inflation to calculate the
repayment in real terms. A similar point holds if you
are a lender: you need to calculate the interest you
earn on saving by correcting for inflation.
The Fisher equation provides the link between
nominal and real interest rates. To convert from
nominal interest rates to real interest rates, we use
the following formula:
Real Interest Rate = Nominal Interest Rate −
inflation rate.

To find the real interest rate, we take the nominal
interest rate and subtract the inflation rate. For
example, if a loan has a 12 percent interest rate and
the inflation rate is 8 percent, then the real return on
that loan is 4 percent.
In calculating the real interest rate, we used the
actual inflation rate. This is appropriate when you
wish to understand the real interest rate actually
paid under a loan contract. But at the time a loan
agreement is made, the inflation rate that will occur
in the future is not known with certainty. Instead,
the borrower and lender use their expectations of
future inflation to determine the interest rate on a
loan. From that perspective, we use the following
formula:
Contracted Nominal Interest Rate = Real Interest
Rate + Expected Inflation Rate.
We use the term contracted nominal interest rate to
make clear that this is the rate set at the time of a
loan agreement, not the realized real interest rate.
INFLATION AND BASE EFFECT
The base effect is the distortion in a monthly
inflation figure that results from abnormally high or
low levels of inflation in the year-ago month. A base
effect can make it difficult to accurately assess
inflation levels over time. It diminishes over time if
inflation levels are relatively constant.
Inflation is often expressed as a month-over-month
figure or a year-over-year figure. Typically,
economists and consumers want to know how much
higher or lower prices are today than they were one
year ago.
But a month in which inflation spikes may produce
the opposite effect a year later, essentially creating
the impression that inflation has slowed.
Inflation is calculated based on price levels that are
summarized in an index. The index may spike in
June, for example, perhaps due to a surge in oil
prices. Over the following 11 months, the month-
over-month changes may return to normal, but
when June arrives again its price level will be
compared to those of a year earlier in which the
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index reflected a spike in oil prices. In that case,
because the index for that month was high, the
price change this June will be less, implying that
inflation has become subdued when, in fact, the
small change in the index is just a reflection of the
base effect—the result of the higher index value a
year earlier.
Consider another example:
Price Index Inflation
Year 2007 2008 2009 2010 2008 2009 2010
April 100 120 140 160 20 16.67 14.29
The index has increased by 20 points in all the three
years – 2008, 2009, 2010. However, the inflation rate
(calculated on year-on-year basis) tends to decline
over the three years from 20% in 2008 to 14.29% in
2010. This is because the absolute increase of 20
points in the price index in each year increases the
base year price index by an equivalent amount, while
the absolute increase in price index remains the
same. Remember, year-on-year inflation is
calculated as:
Current Inflation Rate =
(Current Price Index – Last year’s Price Index)
(
Last year ′ s price index
) ∗ 100
BONDS, INTEREST RATES AND THE
IMPACT OF INFLATION
There are two fundamental ways that you can profit
from owning bonds: from the interest that bonds
pay, or from any increase in the bond’s price. Many
people who invest in bonds because they want a
steady stream of income are surprised to learn that
bond prices can fluctuate, just as they do with any
security traded in the secondary market. If you sell a
bond before its maturity date, you may get more
than its face value; you could also receive less if you
must sell when bond prices are down. The closer the
bond is to its maturity date, the closer to its face
value the price is likely to be.
THE PRICE-YIELD SEESAW AND INTEREST
RATES
Just as a bond’s price can fluctuate, so can its yield–
its overall percentage rate of return on your
investment at any given time. A typical bond’s
coupon rate–the annual interest rate it pays–is
fixed. However, the yield isn’t, because the yield
percentage depends not only on a bond’s coupon
rate but also on changes in its price.
Both bond prices and yields go up and down, but
there’s an important rule to remember about the
relationship between the two: They move in
opposite directions, much like a seesaw. When a
bond’s price goes up, its yield goes down, even
though the coupon rate hasn’t changed. The
opposite is true as well: When a bond’s price drops,
its yield goes up.
WHAT MOVES THE SEESAW?
In some cases, a bond’s price is affected by
something that is unique to its issuer–for example, a
change in the bond’s rating. However, other factors
have an impact on all bonds. The twin factors that
affect a bond’s price are inflation and changing
interest rates. A rise in either interest rates or the
inflation rate will tend to cause bond prices to drop.
Inflation and interest rates behave similarly to bond
yields, moving in the opposite direction from bond
prices.
IF INFLATION MEANS HIGHER PRICES, WHY
DO BOND PRICES DROP?
The answer has to do with the relative value of the
interest that a specific bond pays. Rising prices over
time reduce the purchasing power of each interest
payment a bond makes. Let’s say a five-year bond
pays Rs 10,000 every six months. Inflation means
that Rs 10,000 will buy less five years from now.
When investors worry that a bond’s yield won’t keep
up with the rising costs of inflation, the price of the
bond drops because there is less investor demand
for it.
INFLATION, INTEREST RATE AND BONDS
When the RBI raises its target interest rate to
control high inflation, other interest rates and bond
yields typically rise as well. That’s because bond
issuers must pay a competitive interest rate to get
people to buy their bonds. New bonds paying
higher interest rates mean existing bonds with
lower rates are less valuable. Prices of existing
bonds fall.
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Just the opposite happens when interest rates are
falling. When rates are dropping, bonds issued
today will typically pay a lower interest rate than
similar bonds issued when rates were higher. Those
older bonds with higher yields become more
valuable to investors, who are willing to pay a
higher price to get that greater income stream. As a
result, prices for existing bonds with higher interest
rates tend to rise.
The inflation/interest rate cycle at a glance:
▪ When prices rise, bondholders worry that the
interest they’re paid won’t buy as much.
▪ To control inflation, the RBI may raise interest
rates to get investors to purchase bonds.
▪ When interest rates go up, borrowing costs rise.
Economic growth and spending tend to slow.
▪ With less demand for goods and services,
inflation levels off or falls. Bond investors worry
less about the buying power of future interest
payments. They may accept lower interest rates
on bonds, and prices of older bonds with higher
interest rates tend to rise.
▪ Interest rates in general fall, fuelling economic
growth and potentially new inflation.
Key Definition
Nominal: The actual rupee price of stuff when it's
bought or sold. The contrast is with the term real,
which is actual value adjusted for price changes
or inflation.
Real: The value after adjusting for inflation.
Economist are frequently interested in comparing
stuff (production, income, or whatever) in one
year with similar stuff in another year. However,
in that inflation can distort such a comparison, it's
best made using a fixed set of prices that eliminate
inflationary changes. In practice, this is
accomplished by using the prices in an arbitrary
"base year." Once the price differences have been
eliminated, the numbers are said to be measured
in real dollars.
Nominal Gross Domestic Product: The total
market value, measured in current prices, of all
goods and services produced within the political
boundaries of an economy during a given period
of time, usually one year. The key is that nominal
gross domestic product is measured in current, or
 actual prices; the prices buyers actually pay for
goods and services purchased.
Real Gross Domestic Product: The total market
value, measured in constant prices, of all goods
and services produced within the political
boundaries of an economy during a given period
of time, usually one year. The key is that real gross
domestic product is measured in constant prices,
the prices for a specific base year. Real gross
domestic product, also termed constant gross
domestic product, adjusts gross domestic product
for inflation.
Time Value of Money: It is the concept that
money available at the present time is worth more
than the identical sum in the future due to its
potential earning capacity.
Real Interest Rate (RIR): The market, or nominal
interest rate (NIR), after adjusting for inflation.
This is the interest rate lenders receive and
borrowers pay expressed in real terms.
Base Effect: The base effect is the distortion in a
monthly inflation figure that results from
abnormally high or low levels of inflation in the
year-ago month. A base effect can make it difficult
to accurately assess inflation levels over time.
QUESTION 6
Q. A rapid increase in the rate of inflation is
sometimes attributed to the “base effect”. What
is “base effect”? [2011 - I]
(a) It is the impact of drastic deficiency in supply
due to failure of crops
(b) It is the impact of the surge in demand due to
rapid economic growth
(c) It is the impact of the price levels of previous
year on the calculation of inflation rate
(d) None of the statements (a), (b) and (c) given
above is correct in this context
Answer: C
PROS AND CONS OF INFLATION
Inflation occurs when there is a sustained increase in
the general price level. Traditionally high inflation
rates are considered to be damaging to an economy.
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High inflation creates uncertainty and can wipe away
the value of savings. However, most Central Banks in
developed economies target an inflation rate of 2%
(Reserve Bank of India seeks to keep inflation
measured by Consumer Price Index within a band of
4% +/- 2%), suggesting that low inflation can have
various advantages to the economy. Some
economists even argue we should target a higher
inflation rate during periods of economic stagnation.
ADVANTAGES OF INFLATION
▪ Deflation (a fall in prices – negative inflation) is
very harmful: When prices are falling, people
are reluctant to spend money because they feel
that goods will be cheaper in the future;
therefore, they keep delaying purchases. Also,
deflation increases the real value of debt and
reduces the disposable income of individuals
who are struggling to pay off their debt.
o Assume Inflation is – 1%; RIR = NIR –
Inflation; Assume NIR = 10%; therefore,
RIR = 10 – ( – 1%) = 11%.
▪ Moderate inflation enables adjustment of
wages: It is argued a moderate rate of inflation
makes it easier to adjust relative wages. For
example, it may be difficult to cut nominal wages
(workers resent and resist a nominal wage cut).
But, if average wages are rising due to moderate
inflation, it is easier to increase the wages of
productive workers; unproductive workers can
have their wages frozen – which is effectively a
real wage cut.
▪ Inflation can boost growth: At times of very low
inflation, the economy may be stuck in a
recession. Arguably targeting a higher rate of
inflation can enable a boost in economic
growth. This view is controversial. Not all
economists would support targeting a higher
inflation rate. However, some would target
higher inflation, if the economy was stuck in a
prolonged recession.
DISADVANTAGES OF INFLATION
Inflation is usually considered to be a problem when
the inflation rate rises above tolerance levels. The
higher the inflation, the more serious the problem
is. In extreme circumstances, hyperinflation can
wipe away people’s savings and cause great
instability, e.g. Germany 1920s, Hungary 1940s,
Zimbabwe 2000s. However, in a modern economy,
this kind of hyperinflation is rare. However, inflation
can still cause problems.
▪ Inflationary growth tends to be unsustainable
leading to a damaging period of boom and bust
economic cycles.
▪ Inflation tends to discourage investment and
long-term economic growth: This is because of
the uncertainty and confusion that is more likely
to occur during periods of high inflation. Low
inflation is said to encourage greater stability
and encourage firms to take risks and invest.
▪ Inflation can make an economy uncompetitive:
For example, a relatively higher rate of inflation
in India can make Indian exports uncompetitive,
leading to lower Aggregate Demand, a current
account deficit and lower economic growth.
▪ Reduce the value of savings: Inflation leads to a
fall in the value of money. This makes savers
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
lose out most from inflation. This is particularly
a problem if inflation is high and interest rates
low.
▪ Fall in real wages: In some circumstances, high
inflation can lead to a fall in real wages. If rate
of inflation is higher than rate of increase of
nominal wages, then real incomes fall.
KEY DEFINTION
Hyperinflation: Exceptionally high inflation rates.
While there are no hard and fast guidelines, an
annual inflation rate of 20 percent or more is likely
to get you the hyperinflation title. Some countries
in the past have been quite good at creating
hyperinflation. An annual inflation rate of 1,000
percent has not been uncommon. On occasion,
the trillion percent inflation rate mark has been
achieved. (That is, something with a one dollar
price tag in early January would have a one trillion
dollar price in late December. We're talking
serious hyperinflation.)
QUESTION 7
Q. Economic growth is usually coupled with [2011
- I]
(a) Deflation
(b) Inflation
(c) Stagflation
(d) Hyperinflation
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Answer: B
QUESTION 8
Q. Consider the following statements: [2013 - I]
1. Inflation benefits the debtors.
2. Inflation benefits the bondholders.
Which of the statements given above is/are
correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: A
INFLATION MANAGEMENT IN
INDIA
REASONS FOR PERIODIC SPURT IN
INFLATION IN INDIA
▪ Impact of Global Economy: Maybe inflation can
intrude from outside since India is now
integrated with the world economy. Further, a
spurt in world crude oil prices will increase the
cost of energy in India and consequently raise the
prices of most goods and services in India. Rise in
global food prices (example: protein inflation)
will also have a bearing on inflation in India.
▪ Minimum Support Price (MSP) linked Inflation:
Key driver of inflation in India is food inflation
(food accounts for 50 per cent of the CPI) and the
key driver of food inflation is the MSP set by the
government.
▪ Demand-Supply Mismatch: High demand and
low production or supply of multiple
commodities create a demand-supply gap, which
leads to a hike in prices. This happens when
consumer preferences and buying habits have
changed and supply is yet to catch up.
▪ Rising income/credit: With people having more
money, they also tend to spend more, which
causes increased demand.
▪ Structural Factors: The supply side inflation is a
key ingredient for the rising inflation in India. The
agricultural scarcity or the damage in transit
creates a scarcity causing high inflationary
pressures. Similarly, the high cost of labour
eventually increases the production cost and
leads to a high price for the commodity.
INFLATION TARGETING IN INDIA
Inflation targeting is a monetary policy strategy
used by Central Banks for maintaining price level at
a certain level or within a range. It indicates the
primacy of price stability as the key objective of
monetary policy.
The argument for price stability stems from the fact
that rising prices create uncertainties in decision
making, adversely affecting savings and encouraging
speculative investments. Inflation targeting brings
in more predictability and transparency in deciding
monetary policy. If the central banks could ensure
price stability, households and companies can plan
ahead, negotiating wages on the basis of expecting
low and stable inflation.
Various advanced economies including United
States, Canada and Australia have been using
inflation targeting as a strategy in their monetary
policy framework. The case for inflation targeting
has been made in India as the country has been
experiencing a high level of inflation till recently.
The Reserve Bank of India and Government of India
signed a Monetary Policy Framework Agreement on
20th February 2015. As per terms of the agreement,
the objective of monetary policy framework would
be primarily to maintain price stability, while
keeping in mind the objective of growth. The
monetary policy framework would be operated by
the RBI. RBI would aim to contain consumer price
inflation within 6 percent by January 2016 and
within 4 percent with a band of (+/-) 2 percent for
all subsequent years.
The central bank would be seen as failing to meet
the targets, if retail inflation is more than 6 per cent
for three consecutive quarters from 2015-16 and
less than 2 per cent for three consecutive quarters
from 2016-17. If this happens, RBI will have to
explain the reason for its failure to meet as well as
give a timeframe within which it will achieve it.
The RBI will also be required to bring a document
every six months to explain the sources of inflation
and forecast for inflation for next 6-18 months.
RBI has been using headline CPI (Combined)
inflation as the nominal anchor for monetary policy
stance from April 2014 onwards.
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Management of monetary policy and the express
objective of inflation targeting has been enshrined
as the responsibility of RBI by amending the
preamble of the RBI Act, 1934 through the Finance
Act 2016 (Chapter XII). Thus, ensuring price stability
through inflation targeting is a legal responsibility
of RBI since 2016. A new Chapter (Chapter IIIF,
Section 45Z) was introduced in the RBI Act, through
this Finance Bill, 2016, for detailing the operation of
a Monetary Policy Committee (MPC), which would
be the institutional arrangement at the disposal of
RBI for targeting inflation.
Under Section 45ZA(1) of the RBI Act, 1934, the
Central Government determines the inflation
target in terms of the Consumer Price Index, once in
every five years in consultation with the RBI. This
target would be notified in the Official Gazette.
Amongst other measures, RBI targets inflation
primarily by changing the "Policy Rate” which
means the rate for repo-transactions as defined
under sub-section (12AB) of section 17 of the RBI
Act.
QUESTION 9
Q. India has experienced persistent and high food
inflation in the recent past. What could be the
reasons? [2011 - I]
1. Due to a gradual switchover to the cultivation of
commercial crops, the area under the cultivation
of food grains has steadily decreased in the last
five years by about 30%.
2. As a consequence of increasing incomes, the
consumption patterns of the people have
undergone a significant change.
3. The food supply chain has structural constraints.
Which of the statements given above are
correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: B
HOW TO CONTROL INFLATION?
Inflation occurs when an economy grows due to
increased spending. When this happens, prices rise.
The popular method of controlling inflation is capacity of the banks. RBI uses this instrument
through a contractionary monetary policy. The goal for credit control in the market.
of a contractionary policy is to reduce the money
supply within an economy by decreasing bond OPEN MARKET OPERATIONS
prices and increasing interest rates. This helps
▪ The RBI can purchase or sell Government
reduce spending because when there is less money
securities from or to the public. To control
to go around, those who have money want to keep
inflation, the RBI sells the securities in the
it and save it, instead of spending it. It also means
money market which sucks out excess liquidity
that there is less available credit, which can also
from the market. As the amount of liquid cash
reduce spending. Reducing spending is important
decreases, demand goes down. This part of
during inflation because it helps halt economic
monetary policy is called the open market
growth and, in turn, the rate of inflation.
operation.

REDUCING THE MONEY SUPPLY

INTEREST RATE
▪ Another method is to directly or indirectly
▪ Repo Rate: Repo rate (Repurchase or
reduce the money supply by enacting policies
Repossession) is the rate at which RBI buys
that encourage reduction of the money supply.
government securities with an agreement of
▪ Two examples of this include calling in debts that
repossession, from the commercial banks. It is a
are owed to the government and increasing the
short term borrowing from the central bank,
interest paid on bonds so that more investors
against securities, to inject money to meet the
will buy them. The latter policy raises the
gap between the demand for money (loans) and
exchange rate of the currency due to higher
deposits in the bank.
demand and, in turn, increases imports and
▪ Reverse Repo rate: It is the rate at which the RBI
decreases exports.
borrows money from the commercial banks.
▪ Both of these policies will reduce the amount of
Banks deposit money in RBI when there is no
money in circulation because the money will be
other profitable option to invest the short-term
going from banks, companies and investors
excess liquidity or when there is uncertainty in
pockets and into the government’s pocket where
the market for a significant period of time.
it can control what happens to it.
▪ Increase in these interest rates means that the
RBI is making it expensive for the commercial
There are many methods used to control inflation;
banks to borrow money (in case of reverse repo
some work well while others may have damaging
rate, lucrative to keep the deposits in RBI), thus
effects. For example, controlling inflation through
limiting the injection of money the market. RBI
wage and price controls can cause a recession and
does this to decrease the liquidity in the market.
cause job losses.
RESERVE RATIOS
QUESTION 10
▪ Cash Reserve Ratio: Banks are required to keep
Q. Which one of the following is likely to be the
a fraction of deposit liabilities in the form of
most inflationary in its effect? [2013 - I]
liquid cash, CRR, with the RBI to ensure safety
(a) Repayment of public debt
and liquidity of the deposits.
(b) Borrowing from the public to finance a budget
▪ Statutory Liquidity Ratio: Every bank in India has
deficit
to maintain a minimum proportion of their net
(c) Borrowing from banks to finance a budget
demand and time deposits as liquid assets in the
deficit
form of cash, gold, precious and semiprecious
(d) Creating new money to finance a budget
stones.
deficit
▪ If there is increase in the reserve ratios, the total
Answer: D
amount of deposits left with commercial banks
which it can give as commercial loans decreases
and hence there is reduction in the loan granting QUESTION 11

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 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

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 Q. 5 Consider the following statements with
MCQS FOR PRACTICE reference to Consumer Price Index (CPI):
1. It accounts for all goods and services produced
Q.1 With reference to the recently launched WPI in an economy.
Food Index, consider the following statements: 2. It includes prices of imported goods.
1. It measures the changes in prices at the level of 3. Weights in CPI differ according to production
producers. level of each good.
2. It considers 2011-12 as the base year. Which of the statements given above is/are
Which of the statements given above is/are correct?
correct? (a) 1 and 2 only
(a) 1 only (b) 2 only
(b) 2 only (c) 1 and 3 only
(c) Both 1 and 2 (d) 1, 2 and 3
(d) Neither 1 nor 2

Q.2 With respect to economy, which of the

following correctly describes the term skewflation?
(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
(b) 3>1>2
(c) 2>1>3
(d) 1>3>2

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MCQS WITH ANSWER AND
EXPLANATION
Q.1 With reference to the recently launched WPI
Food Index, consider the following statements:
1. It measures the changes in prices at the level of
producers.
2. It considers 2011-12 as the base year.
Which of the statements given above is/are
correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: C
Explanation:
▪ WPI food index is a new Food price Index
launched on 12 May 2017 as part of revised WPI
series with base year 2011-12. WPI food index
measures the changes in prices of food items at
the level of producers. (Hence both statements 1
and 2 are correct)
▪ The WPI Food index is compiled by taking the
aggregate of WPI for 'Food Products' under
'Manufacture Products' and 'Food Articles' under
'Primary Article' using weighted arithmetic
mean. (Indices for Food Articles and Food
Products were being released separately in WPI
(2004-05) also. But no separate estimate like WPI
food index was being generated then).
▪ Together with the Consumer Food Price Index
released by Central Statistics Office, this would
help monitor the price situation of food items
better.
Q.2 With respect to economy, which of the
following correctly describes the term skewflation?
(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.
Answer: A
Explanation:
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▪ Skewflation is an episodic price rise pertaining to
one or a small group of commodities. It is an
unusual inflation, with inflation in one particular
sector for a particular period of time, while the
other sector is experiencing no changes at all or
facing deflation. (Hence option A is correct)
▪ As food commodities are regularly affected by
market forces (i.e. Demand-Supply), such
commodities are most vulnerable to skewflation.
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
Answer: D
Explanation:
▪ When RBI increases Statutory Liquidity Ratio
(SLR) and Cash Reserve Ratio (CRR), banks are
left with low reserves hence liquidity in the
market get reduced.
▪ RBI uses Cheap money policy to counter
deflationary trends. To reduce inflation the RBI
adopts Dear money policy wherein it increases
SLR, CRR, Repo rate and Bank rates. (Hence
option D is correct)
▪ Repo rate is the rate at which the central bank of
a country (Reserve Bank of India in case of India)
lends money to commercial banks in the event of
any shortfall of funds. Repo rate is used by
monetary authorities to control inflation.
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
(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
to production levels. Hence, statement 3 is not
correct.

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