Economics - II : Previous Year Questions (2014)

PART – A

Q1. Define Repo Rate.

Ans. The rate at which the RBI lends money to commercial banks for short-term periods against government securities.

If the RBI wants to control inflation, it increases the Repo Rate. This makes borrowing expensive for banks, leading to higher interest rates for consumers, which reduces the money supply.

Q2. What do you understand by Hedging?

Ans. Hedging is a risk-management strategy used to offset potential losses from adverse exchange rate movements. It allows traders to protect themselves against the risk of future changes in exchange rates by locking in rates for future transactions.

Q3. Write the meaning of free trade.

Ans. Free trade refers to the international exchange of goods, services, and capital without the imposition of excessive government restrictions or barriers such as tariffs, quotas, subsidies, or import/export licensing requirements. It is the unrestricted importing and exporting of goods and services between countries. It is a policy approach that advocates for minimal government intervention and emphasizes the principles of open markets and unrestricted competition.

Q4. What are the main poverty alleviation programmes in India?

Ans. Main poverty alleviation programmes in India:

1. Pradhan Mantri Awas Yojana – Gramin (PMAY – G)
2. Indira Gandhi National Old Age Pension Scheme (IGNOAPS)
3. Pradhan Mantri Jan Dhan Yojana (PMJDY)
4. Annapurna Scheme
5. Pradhan Mantri Gram Sadak Yojana (PMGSY)

Q5 Define micro-finance.

Ans. Microfinance is a banking service providing small loans, savings, insurance, and money transfers to low-income individuals or entrepreneurs who lack access to traditional banking. Aimed at promoting self-sufficiency and financial inclusion, particularly for women and rural populations, it helps lift people out of poverty by financing small business initiatives.

Q6. Define National Income.

Ans. National income means the value of goods and services produced by a country during a financial year. Thus, it is the net result of all economic activities of any country during a period of one year and is valued in terms of money.

Q7. Write the canons of taxation propounded by Adam Smith.

Ans. Canons of taxation propounded by Adam Smith:

1. Canon of Equity
2. Canon of Certainty
3. Canon of Convenience
4. Canon of Economy

Q8. Define flexible exchange rate.

Ans. The rate is determined entirely by market forces without government intervention.

Q9. Write the main land reform programmes.

Ans. Key land reform programmes include:

1. Abolition of the Intermediary (Zamindari) System
2. Tenancy Reforms
3. Land Ceiling Laws
4. Land Consolidation (Chakbandi)
5. Rights for Forest-Dwelling Communities
6. Modern Digital Land Records

Q10. Define fiscal policy.

Ans. Fiscal policy refers to the budgetary policy of the government, which involves controlling its level of spending and taxation within the economy to regulate aggregate demand. While monetary policy is managed by a country's central bank (like the RBI), fiscal policy is entirely regulated by the government.

PART – B

Q11. Briefly discuss the classification of taxes.

Ans. Taxation is a mandatory financial charge or levy imposed by the government on individuals, businesses, or other entities to generate revenue for public expenditures and to finance various government functions and services. In a modern economy, taxes are not just revenue tools but also instruments for income redistribution and economic stabilization.

1. Classification Based on Incidence and Impact (Form)

The most common classification of taxes is based on whether the tax burden can be shifted from the original taxpayer to others.

1.1 Direct Taxes

A direct tax is one where the person who pays the tax to the government also bears the ultimate economic burden (incidence). The impact and incidence fall on the same person, and the tax cannot be shifted to others.

Examples Include: Personal Income Tax, Corporate Tax, Capital Gains Tax, and Wealth Tax.

• Merits:
  • Equity: Direct taxes are generally progressive, meaning they are based on the "ability to pay" principle.
  • Certainty: The taxpayer knows exactly how much they have to pay and when.
  • Civic Consciousness: Since people feel the pinch of direct taxes, they are more likely to monitor how the government spends their money.
• Demerits:
  • Evasion: High direct tax rates often lead to tax evasion and the creation of black money.
  • Inconvenience: The process of filing returns can be complex and time-consuming for taxpayers.

1.2 Indirect Taxes

An indirect tax is levied on goods and services rather than on income or profit. The person who pays the tax to the government (e.g., a shopkeeper) can shift the burden to the final consumer by including the tax in the price of the commodity.

Examples Include: Goods and Services Tax (GST), Customs Duty, and Excise Duty.

• Merits:
  • Convenience: They are paid in small amounts at the time of purchase, making them less burdensome to the taxpayer at once.
  • Broad Base: They cover everyone, including those whose income is below the direct tax threshold.
  • Discouragement of Harmful Consumption: High indirect taxes (sin taxes) can be used to discourage the consumption of harmful goods like tobacco and alcohol.
• Demerits:
  • Regressive Nature: Since the tax rate is the same for everyone regardless of income, it takes a larger percentage of a poor person's income than a rich person's.
  • Inflationary: They increase the price of goods and services directly.

2. Classification Based on Tax Rates (Method)

This classification looks at how the tax rate changes as the tax base (income or value) increases.

2.1 Proportional Taxation

Under this system, the tax rate remains constant regardless of the size of the income or tax base. Everyone pays the same percentage of their income.

• Example: If the tax rate is 10%, a person earning Rs. 10,000 pays Rs. 1,000, and a person earning Rs. 100,000 pays Rs. 10,000.

2.2 Progressive Taxation

A progressive tax is one where the tax rate increases as the income or tax base increases. It is based on the principle of "vertical equity," where those with higher income pay a higher proportion of their income in taxes.

• Example: Income tax slabs where higher income brackets attract higher tax rates (e.g., 5%, 20%, 30%).

2.3 Regressive Taxation

In a regressive tax system, the tax rate decreases as the income increases. Although the absolute amount might be the same or higher, the tax as a percentage of income falls as income rises.

• Example: A flat tax on essential goods (like salt or bread). A poor person spending a large portion of their income on these items pays a much higher percentage of their total income in tax than a wealthy person.

2.4 Degressive Taxation

Degressive taxation is a blend of progressive and proportional taxation. The tax rate increases up to a certain limit (progressive), after which it remains flat or constant (proportional). It ensures that the burden increases with income but not indefinitely.

Classification Based on Tax Unit

This relates to how the tax is calculated on the product.

• Specific Taxes: These are levied based on the physical unit of the commodity, such as weight, length, or volume (e.g., a tax per liter of petrol or per meter of cloth).
• Ad-Valorem Taxes: The term "ad valorem" is Latin for "according to value". These taxes are calculated as a percentage of the assessed value of the item being taxed, such as a 12% GST on the price of a laptop.

Q12. Differentiate between forward and spot exchange rate.

Ans. The timing of delivery and payment defines the type of exchange rate used in a transaction.

A. Spot Exchange Rate

The rate at which a currency is traded for immediate delivery. Although called "immediate," most spot transactions take two business days (T+2) to settle. It reflects the current market price based on real-time supply and demand.

B. Forward Exchange Rate

The rate agreed upon today for a transaction that will occur on a specified future date (e.g., 30, 60, or 90 days from now). It allows businesses to avoid the uncertainty of future rate fluctuations. Forward rates may be at a premium (if the currency is expected to be more expensive in the future) or a discount.

Q13. Discuss the functions of commercial bank.

Ans. Commercial bank functions are broadly categorized into primary and secondary roles, alongside modern utility services.

A. Primary Functions

1. Accepting Deposits: This is the most fundamental function where banks collect surplus funds from the public.
   • Savings Accounts: Aimed at encouraging small savings; they offer modest interest and limited withdrawal flexibility.
   • Current Accounts: Used mainly by businesses; these accounts offer high liquidity with no interest and sometimes incur service charges.
   • Fixed Deposits (FDs): Deposits for a specific period with higher interest rates.
   • Recurring Deposits (RDs): Regular monthly deposits for a fixed term.
2. Providing Loans and Advances: Banks lend a portion of their deposits to earn interest income, which is their primary source of profit.
   • Cash Credit: A short-term loan against a bond or other security.
   • Overdraft Facility: Allows customers to withdraw more than their account balance up to a specified limit.
   • Term Loans: Provided for specific periods (short, medium, or long-term) for personal or business use.
3. Credit Creation: This is a unique and vital function. When a bank grants a loan, it does not typically provide cash; instead, it opens a deposit account in the borrower's name. This "derivative deposit" increases the total money supply in the economy beyond the initial cash reserves.

B. Secondary and Agency Functions

1. Discounting Bills of Exchange: Banks provide immediate cash to businesses by purchasing their bills of exchange at a discount before the maturity date.
2. Agency Services: Acting as an agent for customers by collecting cheques, paying insurance premiums, managing dividends, and acting as trustees or executors for wills.
3. General Utility Services: This includes providing safe deposit lockers, issuing traveller’s cheques, and acting as a referee for the financial standing of customers.

C. Modern Functions

1. Digital Banking: Facilitating real-time, cashless transactions through NEFT, RTGS, and UPI.
2. Advisory and Capital Services: Assisting corporations with Mergers and Acquisitions (M&A), Initial Public Offerings (IPOs), and merchant banking.

Q14. Describe the advantages of globalisation for a developing economy.

Ans. Globalisation is the process of integrating a nation's economy with the world economy. It involves the conscious movement towards greater interaction with other countries through the removal of barriers to trade and investment.

Advantages for a Developing Economy (like India)

Globalisation offers several transformative benefits that can accelerate the development of an emerging economy.

A. Economic Growth and Efficiency

India’s average annual GDP growth rate surged to 6–7% post-1991, at times reaching over 8–9%. Resources are allocated more efficiently as industries specialize in areas where they have a comparative advantage. Increased competition forces domestic industries to improve their productivity and adopt better management practices.

B. Foreign Investment and Infrastructure

With Globalisation comes capital influx. FDI provides the long-term capital necessary for setting up new industries and businesses in previously reserved sectors. It helps in resource transfer as foreign investors bring advanced technologies, managerial expertise, and global best practices. Globalisation helps in building forex reserves; India’s foreign exchange reserves grew from less than $1 billion in 1991 to over $600 billion by 2022.

C. Benefits to Consumers and Sectors

Global brands (e.g., Samsung, Amazon, Hyundai) have made a wide variety of quality goods available at competitive prices. India emerged as a global hub for IT, BPO, and software development, leveraging its skilled, English-speaking workforce. Globalisation opened international markets for Indian auto parts, pharmaceuticals, and textiles.

PART – C

Q15. Discuss the effects of inflation on the economy.

Ans. Inflation is a persistent rise in the general price level of goods and services in an economy over a period of time. While moderate inflation is often seen as a sign of a growing economy, high or unpredictable inflation can create significant distortions.

Effects of Inflation on Production

Inflation doesn't just change prices; it changes how businesses operate and how resources are used.

1. Misallocation of Resources: Investors shift money away from productive sectors (like manufacturing) into "speculative" assets like gold or real estate, which hold value better during price hikes.
2. Reduced Quality: To maintain profit margins without raising prices too aggressively, producers may resort to "skimpflation", reducing the quality of raw materials or the size of the product.
3. Hoarding and Black Marketing: Anticipating further price rises, traders may hoard essential goods to sell them later at higher prices, creating artificial scarcity.
4. Discouragement of Savings: As the value of money falls, people prefer to spend now rather than save, which reduces the total capital available for long-term industrial investment.

Effects on Distribution of Income and Wealth

Inflation acts as a "hidden tax," but it doesn't affect everyone equally. It creates distinct winners and losers:

Other Macroeconomic & Social Effects

The ripple effects of inflation extend to the government's balance sheet and the moral fabric of society.

1. Balance of Payments (BOP) Crisis: High domestic inflation makes a country's exports more expensive and less competitive abroad. Meanwhile, imports become relatively cheaper, leading to a trade deficit.
2. Currency Depreciation: As the internal purchasing power of a currency falls, its value in the foreign exchange market usually drops as well.
3. Increased Public Expenditure: The government must spend more on public projects, defence, and administration because the cost of materials and labour has increased.
4. Social and Moral Impact: Rapid inflation can lead to social unrest. It often encourages "social evils" such as corruption, adulteration of goods, and a general loss of faith in the monetary system.
5. Risk of Collapse: In extreme cases (hyperinflation), the monetary system can fail entirely as people lose confidence in the currency.

Q16. Explain the theories for determination of foreign exchange rate.

Ans. There are three main theories for determination of foreign exchange rate.

1. The Mint Parity Theory

This is the "old school" approach, relevant during the era of the Gold Standard (when currencies were directly convertible into gold). If two countries use gold as their standard of value, the exchange rate is determined by the gold content of their respective currencies. If 1 US Dollar contains 2 grams of gold and 1 British Pound contains 4 grams, the exchange rate naturally becomes £1 = $2. This theory is largely historical. Since modern currencies aren't backed by physical gold (fiat money), this theory doesn't apply to today's floating exchange rates.

2. Purchasing Power Parity (PPP) Theory

Developed by Swedish economist Gustav Cassel, this theory suggests that exchange rates are determined by the relative purchasing power of two currencies.

In an efficient market, identical goods should cost the same in different countries when priced in a common currency.

• Absolute PPP: The exchange rate between two currencies is the ratio of the price levels in the two countries. E = Pd / Pf (Where E is the exchange rate, Pd is the domestic price level, and Pf is the foreign price level).
• Relative PPP: This version is more realistic; it argues that the change in the exchange rate is determined by the difference in inflation rates between the two countries.

3. Balance of Payments (BOP) Theory

Also known as the Demand and Supply Theory or the Modern Theory, this is the most widely accepted explanation for exchange rate determination in a free market.

Under this theory, the exchange rate is the "price" of a currency, and like any other commodity, it is determined by the forces of demand and supply.

A. Demand for Foreign Exchange

People demand foreign currency (e.g., USD) to:

1. Import goods and services from abroad.
2. Invest in foreign assets (stocks, bonds, or real estate).
3. Send remittances or gifts to other countries.
4. Speculate on the currency's future value.

Relationship: The demand curve is downward sloping. As the exchange rate falls (domestic currency gets stronger), foreign goods become cheaper, and demand for foreign currency increases.

B. Supply of Foreign Exchange

The supply of foreign currency comes from:

1. Exporting domestic goods and services to other countries.
2. Foreign Direct Investment (FDI) coming into the country.
3. Foreigners buying domestic assets.

Relationship: The supply curve is upward sloping. As the exchange rate rises (domestic currency gets weaker), our goods become cheaper for foreigners, leading to more exports and a higher supply of foreign currency.

C. Equilibrium

The equilibrium exchange rate is settled at the point where the Demand Curve (D) intersects the Supply Curve (S).

Q17. Write a note on Foreign Direct Investment (FDI).

Ans. FDI refers to a long-term investment made by a foreign individual or company in the physical assets or business operations of another country. It usually involves acquiring a significant stake (often defined as 10% or more) in a local company, granting the investor a say in management and operations. 

FDI focuses on building "brick and mortar" assets, such as factories, retail outlets, and infrastructure. Because it involves physical assets and long-term commitments, FDI is considered a stable and "sticky" form of capital that is difficult to withdraw quickly during economic downturns.

Advantages and Disadvantages of FDI Inflow

FDI is generally preferred by developing nations because it brings more than just money; it brings "packaged" resources.

Advantages of FDI

1. Economic Development Stimulation: FDI is a primary source of external capital that funds new factories and industrial centres, increasing the national income.
2. Employment Opportunities: By establishing new businesses and expanding existing ones, FDI directly creates jobs for the local population.
3. Human Capital Development: Foreign firms often provide advanced training and skills to their local employees, which enhances the overall quality of the workforce (the "ripple effect").
4. Technology and Resource Transfer: FDI gives host countries access to cutting-edge technologies, management practices, and operational tools that they might not have developed independently.
5. Increased Productivity and Competition: The entry of foreign players forces local firms to become more efficient and innovative to remain competitive, benefiting consumers with better products.
6. Improved International Trade: FDI often involves firms that produce goods for export, helping the host country improve its trade balance and foreign exchange reserves.

Disadvantages and Risks of FDI

1. Hindrance to Domestic Investment: Large foreign firms with massive resources may crowd out small local businesses that cannot compete, potentially leading to domestic monopolies.
2. Political and Sovereignty Risks: Foreign investors may gain significant influence over a country's key industries or infrastructure, potentially undermining national sovereignty.
3. Exchange Rate Volatility: Large inflows and outflows of FDI can cause fluctuations in the value of the host country's currency, sometimes to the detriment of other sectors.
4. Profit Outflow: While FDI brings capital in, the profits earned are eventually repatriated (sent back) to the investor's home country, which can drain foreign exchange in the long run.
5. Cultural and Social Impact: The introduction of foreign values and consumer preferences can lead to the erosion of local traditions and identities.
6. Unequal Distribution of Benefits: FDI often concentrates in developed urban regions or specific lucrative sectors, leaving backward areas or essential but low-profit sectors underdeveloped.
7. Expropriation Risk: Changes in the political landscape can lead to "expropriation," where the host government seizes the assets of foreign investors.

Conclusion

While FDI provides stable, long-term growth and technology, it requires careful regulation to prevent the marginalization of domestic industries and ensure that benefits are distributed equitably across the economy.