MPSC 2021 Prelims Paper-I · Question 38 of 100

Correct — option (4), which accepts statements (a) and (c) and no others. Statement (a) is sound. Creeping inflation is a mild rise in the general price level, in the low single digits year on year, and it is generally regarded as favourable for growth: gently rising prices mean gently rising profit margins, which encourages producers to invest and expand output and employment, and they keep the economy away from deflation, in which falling prices lead buyers to postpone purchases and debts become heavier in real terms. That is why central banks target a small positive rate of inflation rather than zero — the Reserve Bank of India's target under the flexible inflation targeting framework is four per cent consumer price inflation with a tolerance band of two to six per cent, given statutory footing by the 2016 amendment to the Reserve Bank of India Act, 1934. Statement (c) is also sound, and it follows from what inflation does to a debt of fixed money value. A borrower who has contracted to repay a fixed number of rupees repays them in money that buys less than the money he borrowed, so the real burden of the debt falls; the lender bears the corresponding loss. That is why unanticipated inflation is described as a transfer from creditors to debtors, and it applies to governments as much as to households, since inflation erodes the real value of public debt. Statement (b) fails: the value of money means its purchasing power, and purchasing power moves inversely with the price level, so during inflation the value of money falls, not rises. Statement (d) fails too: inflation generally widens income inequality rather than narrowing it. With (a) and (c) standing and (b) and (d) failing, option (4) is the row that matches.

• (1)(a) only — This row accepts only the statement about creeping inflation and rejects the statement that inflation benefits debtors, but the second is as well established as the first. A debt fixed in money terms loses real value as prices rise: a borrower repays the same number of rupees with money that commands fewer goods, so the real burden of repayment falls, and the gain to the borrower is exactly the loss to the lender. This is one of the oldest propositions in monetary economics, and it is the reason lenders build an inflation premium into nominal interest rates and the reason inflation erodes the real value of government debt. Rejecting it leaves this row with one true statement out of two, which is not enough when a row accepting both is on offer.
• (2)(b), (c) and (d) — This row accepts the three statements the question does not support and rejects the one about creeping inflation that it does. Its first claim, that the value of money increases during inflation, inverts the definition: the value of money is its purchasing power, purchasing power is the reciprocal of the price level, and inflation is by definition a rise in the price level, so money buys less. Its third claim, that inflation decreases the inequality of income, runs against how the burden actually falls: fixed-income groups such as pensioners, salaried employees on slow-moving pay scales and holders of money savings lose, while profit earners, traders and owners of land, property and shares tend to gain, so the spread of real incomes widens. The row is worth studying as a checklist of the three commonest misconceptions about inflation.
• (3)(b) and (d) — This row accepts the claim that the value of money increases during inflation and the claim that inflation decreases income inequality, and both fail. On the first, the value of money is what a unit of money will buy, so a general rise in prices is the same event as a fall in the value of money, described from the other side; a candidate who chooses this row has usually confused the value of money with the quantity of money or with the nominal value of incomes, which do rise. On the second, inflation redistributes towards those whose incomes adjust quickly or who hold real assets and away from those on fixed money incomes, and it also works as a regressive tax, since the poor hold a larger share of their wealth in cash. Both effects widen inequality rather than narrowing it.

Inflation is a sustained rise in the general price level, and its mirror image is a fall in the value or purchasing power of money. Economists classify it by speed — creeping inflation of a few per cent a year, walking or trotting inflation of moderate single digits, running inflation in double digits, and galloping inflation or hyperinflation beyond that — and by cause, into demand-pull inflation, where aggregate demand outruns the economy's capacity to supply, and cost-push inflation, where rising input costs such as wages, oil or imported materials push prices up. India measures it through the Consumer Price Index, which is the target variable for monetary policy, and the Wholesale Price Index; the Reserve Bank targets four per cent consumer price inflation with a two to six per cent tolerance band, a framework notified in August 2016 and given statutory basis by the amendment of that year to the Reserve Bank of India Act, 1934, with a six-member Monetary Policy Committee setting the policy repo rate. The distributional effects are what this question tests. Inflation favours debtors over creditors, profit earners over fixed-income earners, and holders of real assets over holders of money, and because low-income households hold more of their wealth in cash and have less bargaining power over wages, it usually widens inequality. Mild inflation, however, lubricates growth, which is why the target is a small positive number rather than zero.

Inflation is a permanent fixture of the MPSC economy section, and the Commission tests it conceptually rather than through current numbers, since a rate quoted in a question paper would be stale by the time it was answered. The statement cluster is its preferred form, and the statements used are drawn from a small and stable pool: what inflation does to the value of money, who gains and who loses, what kind of inflation is good for growth, and how inflation is measured. This particular set is a good illustration of how the pool is used. Two statements are textbook propositions that a prepared candidate should accept without hesitation, and two are inversions of textbook propositions — not exotic claims, but the standard results stated backwards. That is the most economical way to build a hard question, and the defence is equally economical: state the correct proposition to yourself before reading the statement, and see whether the statement agrees or disagrees with it. Note also that the word 'correct' is printed in bold in the stem, in both language blocks, so the question is asking which statements hold, not which fail.

• The value of money is its purchasing power and moves inversely with the price level, so inflation always means a fall in the value of money, never a rise.
• Creeping inflation, a mild rise of a few per cent a year, is generally regarded as favourable to growth because it supports profit margins and investment and keeps the economy clear of deflation.
• Inflation transfers real wealth from creditors to debtors, because a debt fixed in money terms is repaid in money of lower purchasing power; the same logic erodes the real value of public debt.
• Inflation generally widens income inequality: fixed-income earners, pensioners and holders of money savings lose, while profit earners, traders and owners of real assets gain, and it acts as a regressive tax on those who hold cash.
• The Reserve Bank of India targets consumer price inflation of four per cent with a tolerance band of two to six per cent, notified in August 2016 under the amended Reserve Bank of India Act, 1934, with a six-member Monetary Policy Committee setting the policy repo rate.

• Confusing the value of money with the quantity of money or with nominal incomes; inflation raises money incomes while lowering what each rupee will buy
• Assuming inflation must be harmful in every degree; a mild creeping inflation is regarded as favourable to growth, which is why central banks target a small positive rate rather than zero
• Reversing the debtor-creditor effect; the borrower gains from unanticipated inflation and the lender loses, not the other way round
• Believing that inflation reduces inequality because it reduces the real value of debts; the far larger effect runs the other way, since fixed-income and cash-holding households are the least protected

Inflation reaches MPSC papers as statement clusters like this one, as definitional items asking what a named type of inflation is, as institutional questions about the Monetary Policy Committee and the inflation target, and as cause-and-effect questions about who gains and who loses. The Commission avoids asking for the current rate, so effort spent memorising monthly figures is wasted; effort spent on the conceptual framework is not. A single page carrying the classification of inflation, the two price indices with their coverage, the monetary policy framework and its instruments, and a short table of gainers and losers will answer almost any inflation question, and it should be paired with the standard propositions about deflation, since those are tested as the mirror image.

No directly related past PYQ was found.

• practice — not a real PYQ

  Which of the following groups is most likely to gain during a period of unanticipated inflation?

  • (a)pensioners living on a fixed money income
  • (b)borrowers who have contracted debts fixed in money terms
  • (c)holders of long-term fixed-rate bonds
  • (d)salaried employees whose pay scales are revised once a decade

  Answer(b) borrowers who have contracted debts fixed in money terms — the real burden of a debt fixed in rupees falls as prices rise, since the borrower repays money that buys less than the money borrowed, and the lender bears the matching loss. Pensioners on fixed money incomes, holders of fixed-rate bonds and employees whose pay is revised rarely all lose, because their money incomes are fixed while the prices they pay rise.

• practice — not a real PYQ

  Under India's flexible inflation targeting framework, the Reserve Bank of India is required to aim at which rate of consumer price inflation?

  • (a)two per cent with a band of one to three per cent
  • (b)four per cent with a band of two to six per cent
  • (c)five per cent with a band of three to seven per cent
  • (d)six per cent with no tolerance band

  Answer(b) four per cent with a band of two to six per cent — the framework was notified in August 2016 and has been retained at each five-yearly review. It rests on the 2016 amendment to the Reserve Bank of India Act, 1934, under which the Central Government sets the inflation target in consultation with the Reserve Bank, and it is implemented by a six-member Monetary Policy Committee that sets the policy repo rate, the Governor having a casting vote in the event of a tie.