UPSC STATIC QUIZ – Economy : 28 February 2024

Solution: a)

Only Statement 1 is correct.

The SDR was created by the IMF in 1969 as a supplementary international reserve asset, in the context of the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves—government or central bank holdings of gold and widely accepted foreign currencies—that could be used to purchase its domestic currency in foreign exchange markets, as required to maintain its exchange rate.

The value of the SDR is based on a basket of five major currencies—the US dollar, the euro, the Chinese renminbi (RMB), the Japanese yen, and the British pound sterling. No gold backing is needed.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions.

Solution: b)

Statement 1 is incorrect.

Current Account Deficit or CAD is the shortfall between the money flowing in on exports, and the money flowing out on imports. Current Account Deficit (or Surplus) measures the gap between the money received into and sent out of the country on the trade of goods and services and also the transfer of money from domestically-owned factors of production abroad.

The current account constitutes net income, interest and dividends and transfers such as foreign aid, remittances, donations among others.

A country with rising CAD shows that it has become uncompetitive, and investors are not willing to invest there. They may withdraw their investments.

Current Account Deficit may be a positive or negative indicator for an economy depending upon why it is running a deficit. Foreign capital is seen to have been used to finance investments in many economies. Current Account Deficit may help a debtor nation in the short-term, but it may worry in the long-term as investors begin raising concerns over adequate return on their investments.

High software receipts and private transfers can lower current account deficit.

Solution: c)

Option 3 is incorrect.

When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up. Economists describe demand-pull inflation as a result of too many dollars chasing too few goods.

If a government reduces taxes, households are left with more disposable income in their pockets. This, in turn, leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation.

Cost-push inflation is when prices go up.

Solution: b)

Statement 1 is incorrect.

How does the MPC target inflation?

The MPC has six members including the RBI Governor — three each nominated by the RBI and the government. The MPC meets every two months to evaluate the current status and outlook for inflation and economic growth. Based on that assessment, it tweaks the repo rate, which is the interest rate at which the RBI loans money to the banking system. It is for this reason that movements in the repo rate influence the overall interest rates in the economy.

Typically, when the MPC wants to contain inflation, it raises the repo rate. Such a “dear money” policy makes all types of borrowing — both for consumers (say, car loans) and producers (say, fresh business investments) — costlier and effectively slows down economic activity in the economy.

When inflation outlook is benign but growth is stalling, the RBI can choose to lower the repo rate and promote economic activity; such a “cheap money” policy incentivises people to spend money instead of saving it.

Solution: a)

Factor costs are the actual production costs at which goods and services are produced in an economy.

Factor cost refer to the price arrived after deducting from the market price the indirect taxes and adding to the resulting number government subsidies if any.