Economics - II : Previous Year Questions (2018)

PART – A

Q1. What is deficit financing?

Ans. This refers to the practice where the government spends more than its revenue, often by printing new money or borrowing from the central bank. It is frequently used in developing countries to finance developmental activities that cannot be funded through taxes alone. If not managed carefully, excessive deficit financing can lead to high inflation.

Q2. Define Taх.

Ans. Tax / Taxation is the primary instrument used by a government to finance its expenditures. It is a mandatory financial charge or levy imposed upon a taxpayer (an individual or legal entity) by a governmental organization in order to fund various public expenditures.

Q3. Define Inflation.

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.

Q4. What is Microfinancing?

Ans. Microfinancing (or microcredit) is a specialized branch of financial services that provides small-scale loans and financial support to individuals or microenterprises that are typically excluded from traditional banking due to a lack of collateral or formal credit history.

Q5. Define NBFI.

Ans. Non-Banking Financial Institutions are entities that offer various banking-like services, such as loans, investments, and asset financing, without holding a formal banking license. In India, these are typically incorporated under the Companies Act, 1956. They operate as specialized intermediaries that cater to specific financial needs or underserved segments of the population.

Q6. What is 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.

Q7.  What is FII?

Ans. Foreign Institutional Investment (FII) involves foreign institutional entities (like pension funds, mutual funds, or insurance companies) investing in the financial markets (stocks and bonds) of another country.

Q8. What is 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.

Q9. 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.

Q10. Define direct tax.

Ans. 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.

PART – B

Q11. What are the instruments of 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.

Instruments of Fiscal Policy

Governments utilize several key instruments to implement fiscal policy effectively.

1. Taxation

Taxation is a powerful tool to influence disposable income, consumption, and investment.

• Direct Taxes: Taxes levied directly on individuals or corporations (e.g., Income Tax). They are often progressive, meaning the rate increases with income, helping reduce inequality.
• Indirect Taxes: Taxes on goods and services (e.g., GST). They can be used to regulate consumption (e.g., high taxes on luxury goods).
• Impact: Lowering taxes increases disposable income and spurs demand; raising taxes helps curb excessive demand and inflation.

2. Public Expenditure

Government spending on goods, services, and infrastructure is a direct component of aggregate demand.

• Developmental Expenditure: Spending on education, healthcare, and infrastructure (roads, dams) which builds the economy's long-term capacity.
• Non-Developmental Expenditure: Spending on defence, administration, and interest payments.
• Welfare Payments: Subsidies, pensions, and unemployment benefits act as a buffer for the vulnerable sections of society.

3. Public Borrowing (Public Debt)

When government expenditure exceeds revenue, it borrows funds internally or externally.

• Internal Borrowing: From citizens, commercial banks, and financial institutions within the country.
• External Borrowing: From foreign governments or international organizations like the World Bank.
• Purpose: Borrowing is used to fund large-scale infrastructure projects or to cover budget deficits during economic slowdowns.

4. Deficit Financing

This refers to the practice where the government spends more than its revenue, often by printing new money or borrowing from the central bank. It is frequently used in developing countries to finance developmental activities that cannot be funded through taxes alone. If not managed carefully, excessive deficit financing can lead to high inflation.

Q12. Differentiate between Banks and NBFIs.

Ans. The Indian financial system is a sophisticated framework designed to mobilize savings and allocate credit. While Commercial Banks act as the primary pillar of this system, Non-Banking Financial Institutions (NBFIs), often referred to as Non-Banking Financial Companies (NBFCs), have emerged as critical components that fill essential gaps in the credit delivery mechanism.

The distinction between these two entities lies in their regulatory framework, operational scope, and systemic importance.

Q13. Write the advantages and disadvantages of FDI.

Ans. 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.

Q14. What is the role of deficit financing?

Ans. Deficit financing is a fiscal tool employed by governments when their total expenditure exceeds their total revenue (current income from taxes, fees, and other sources). In simple terms, it is the practice of financing a budgetary gap. While the concept varies across different economies, in the context of developing nations like India, it specifically refers to the measures taken by the government to bridge the gap between "excess expenditure" and "available receipts."

Role of Deficit Financing in Economic Development

Deficit financing is often considered a "necessary evil" for developing economies. Its role in economic development is multifaceted:

A. Mobilization of Resources and Capital Formation

Developing nations often suffer from a "vicious circle of poverty," where low income leads to low savings and low investment. Deficit financing acts as a tool for forced savings. When the government invests newly created money into productive sectors, it mobilizes resources that would otherwise remain idle. This leads to the creation of capital assets like machinery, factories, and infrastructure.

B. Financing Development Plans

Large-scale national plans (like India’s Five-Year Plans) require massive financial outlays. When traditional sources like taxation and public borrowing reach their limits, deficit financing provides the necessary "extra" funds to ensure that development projects are not stalled due to a lack of liquidity.

C. Infrastructure and Basic Industries

Infrastructure projects (transport, communication, energy) have long gestation periods and require huge capital. Deficit financing allows the state to invest in these "Social Overhead Capitals," which are essential for private industry to flourish later.

D. Promotion of Industrialization

By providing subsidies, setting up industrial estates, and investing in heavy industries (steel, chemicals), the government uses deficit-financed funds to diversify the economy. This reduces dependence on agriculture and increases the overall productivity of the nation.

E. Employment Generation

Investment in public works programs through deficit financing creates direct employment. As money flows into the hands of workers, their consumption increases, leading to a multiplier effect that creates secondary employment in the consumer goods sector.

F. "Pump Priming" during Depression

During an economic slowdown, private investment dries up. Deficit financing serves as "pump priming", a small amount of government spending stimulates the economy, boosts demand, and encourages private investors to start spending again.

PART – C

Q15. Explain in detail the credit control policy of RBI.

Ans. The RBI controls the volume and direction of credit in the economy using two types of instruments: Quantitative (General) and Qualitative (Selective) methods.

I. Quantitative Instruments

These tools aim to regulate the overall volume of money supply and credit in the entire banking system.

1. Repo Rate (Repurchase Rate): 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.
2. Reverse Repo Rate: The rate at which the RBI borrows money from commercial banks, or effectively, the rate at which banks "park" their excess funds with the RBI. An increase in the Reverse Repo Rate encourages banks to park more funds with the RBI instead of lending to the public, thereby reducing liquidity in the economy.
3. Cash Reserve Ratio (CRR): The specific percentage of a bank's Net Demand and Time Liabilities (NDTL) that must be kept as cash with the RBI. By increasing the CRR, the RBI reduces the amount of "loanable" funds available with banks, thereby contracting credit.
4. Statutory Liquidity Ratio (SLR): The percentage of NDTL that banks must maintain with themselves in the form of liquid assets like gold, cash, or unencumbered government securities. A higher SLR forces banks to invest more in government securities rather than lending to the private sector, which helps control credit expansion.
5. Bank Rate: The standard rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercial papers. Unlike the Repo rate, this is usually for long-term lending and does not involve collateral.
6. Open Market Operations (OMO): The buying and selling of government securities by the RBI in the open market. To reduce money supply (Inflation control), the RBI sells securities, absorbing cash from the banking system. To increase money supply (Recession control), the RBI buys securities, injecting cash into the system.
7. Marginal Standing Facility (MSF): A window for banks to borrow from the RBI in an emergency (overnight) when inter-bank liquidity dries up, by dipping into their SLR portfolio up to a certain limit.

II. Qualitative (Selective) Instruments

These tools are used to regulate the direction or use of credit to specific sectors of the economy.

1. Margin Requirements: The "margin" is the difference between the market value of the security offered for a loan and the actual loan amount granted. To discourage credit to a specific sector (e.g., real estate), the RBI increases the margin requirement, meaning the borrower must provide more collateral for the same loan amount.
2. Rationing of Credit: The RBI may fix a "ceiling" or limit on the amount of credit that can be granted to specific industries or sectors.
3. Moral Suasion: This is a psychological tool where the RBI uses informal means like meetings, letters, and speeches to persuade or "request" commercial banks to follow certain credit policies (e.g., reducing lending during inflation).
4. Direct Action: If a bank fails to comply with RBI directives, the RBI can take direct action, such as imposing penalties, refusing to rediscount their bills, or even cancelling their license.

Q16. What is National Income? Explain the various problems in estimating 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.

The estimation of National Income is a complex statistical and conceptual exercise, particularly in developing economies like India. These difficulties are broadly classified into two categories: Conceptual (Theoretical) Difficulties and Practical (Statistical) Difficulties.

I. Conceptual (Theoretical) Difficulties

These pertain to the logical and definitional challenges in deciding what should be included in the national income and how it should be valued.

1. Non-Market (Non-Monetized) Activities

Economic activities occurring outside the formal market, such as household production (housewives' services), volunteer work, and informal services, are often excluded. While these activities significantly contribute to societal well-being, they are challenging to quantify and include in traditional measures. In countries like India, a vast amount of production (e.g., kitchen gardening, child-rearing) never enters the market, leading to a systematic underestimation of the true economic output.

2. The Problem of Double Counting

Double counting occurs when the value of intermediate goods (goods used to produce other goods) is included alongside the final product's value. To avoid overestimation, only the value-added at each stage of production must be counted. For example, if the value of wheat is counted, and then the value of flour made from that wheat is also counted, the national income will be artificially inflated.

3. Price Level Fluctuations

National income is often measured at current market prices. However, prices fluctuate over time due to inflation. If prices rise without an increase in actual production, the "Nominal National Income" increases while "Real National Income" remains stagnant. Measuring real growth requires adjusting current prices using a price index (deflator).

4. Rapid Technological Change & New Economies

Modern advancements, such as the digital economy and the sharing economy (e.g., Uber, Airbnb), often do not fit neatly into traditional national income frameworks. Capturing the economic impact of these rapidly evolving industries remains a conceptual challenge for statisticians.

II. Practical (Statistical) Difficulties

These involve the actual hurdles faced during data collection and the reliability of the figures obtained.

1. Incomplete Coverage & The Informal Sector

National income relies on data from surveys, tax records, and official statistics. Ensuring complete coverage is difficult, especially in the informal sector, which comprises unregistered businesses and informal employment. These activities often go unrecorded and do not contribute to official figures, leading to a distorted picture of the economy.

2. Quality and Reliability of Data

Data collection processes are frequently subject to errors, inconsistencies, and sampling biases. In many regions, flawed or outdated data leads to inaccurate estimations. This is compounded in developing nations by a lack of trained enumerators and low levels of literacy among respondents who cannot maintain accurate accounts of their income or expenditure.

3. International Transactions & Complexities

National income must account for exports, imports, and income from foreign investments. These are subject to complexities such as exchange rate fluctuations, transfer pricing (where MNCs manipulate prices to minimize tax), and intricate corporate structures, making accurate measurement difficult.

4. Lack of Occupational Specialization

In agrarian economies like India, many individuals do not have a single, specialized occupation. A farmer might also work as a seasonal labourer or a small-scale trader. This lack of clear occupational boundaries makes it difficult to categorize and estimate income based on the "Productive Method" or "Income Method."

III. Impact of Estimation Errors on Policy

• Distorted Fiscal Policy: Inaccurate national income figures can lead to flawed government policies regarding taxation and public expenditure.
• Misleading Growth Indicators: If the informal sector's contribution is ignored, the growth rate may appear lower than it actually is, affecting international competitiveness and investor confidence.
• Ineffective Deficit Financing: The government uses national income data to plan deficit financing (spending more than revenue) for infrastructure and human capital development. Faulty data can lead to excessive money supply, triggering high or "galloping" inflation.

Q17. Explain the advantages and disadvantages of Fixed Exchange Rate?

Ans. Fixed Exchange Rate system (also known as a "pegged" rate) is a regime where a country’s currency value is tied to another major currency (like the US Dollar), a basket of currencies, or a commodity like gold.

The central bank maintains this value by buying and selling its own currency in the foreign exchange market to offset fluctuations in demand and supply.

Advantages of a Fixed Exchange Rate

1. Price Stability and Certainty

The primary benefit is the elimination of exchange rate volatility. This creates a predictable environment for international trade. Exporters and importers know exactly how much they will pay or receive in the future, which encourages long-term contracts.

2. Inflationary Discipline

A fixed peg acts as a "nominal anchor." Since the government cannot simply print money to finance deficits without risking the peg, it imposes strict monetary and fiscal discipline. This is particularly helpful for developing nations looking to import the low-inflation reputation of a stronger currency (like the Euro or Dollar).

3. Encourages Foreign Investment

Foreign investors are often wary of "currency risk", the fear that the value of their investment will vanish if the local currency crashes. A fixed rate provides the confidence needed for Foreign Direct Investment (FDI) and long-term capital inflows.

4. Reduction in Speculation

If the peg is viewed as credible and backed by sufficient reserves, speculators are less likely to bet against the currency, preventing the wild "boom and bust" cycles often seen in floating regimes.

Disadvantages of a Fixed Exchange Rate

1. Loss of Independent Monetary Policy

This is the most significant drawback, often explained by the Impossible Trinity (or Trilemma). To maintain a fixed rate and free capital flow, a country gives up control over its interest rates. If the US raises rates, a country pegged to the Dollar must usually follow suit, even if its own economy is in a recession and needs lower rates.

2. Requirement for High Foreign Reserves

To defend the currency, the central bank must hold massive amounts of foreign exchange (like USD or Gold). This is "dead capital" that could otherwise be invested in infrastructure, education, or healthcare.

3. Risk of Speculative Attacks

If the market senses that a country’s reserves are running low or its economy is weak, speculators may "attack" the currency by selling it off. If the central bank can't keep up, the country is forced into a sudden, painful devaluation, which can trigger a financial crisis (e.g., the 1997 Asian Financial Crisis).

4. Inability to Adjust to External Shocks

In a floating system, if a country’s exports become unpopular, its currency depreciates, making its goods cheaper and helping the economy recover. In a fixed system, this automatic "shock absorber" doesn't exist. Instead, the country must endure internal devaluation, meaning wages and prices must fall, which often leads to high unemployment.

In conclusion, a fixed exchange rate offers stability at the cost of flexibility. It’s a great tool for small, open economies or those fighting hyperinflation, but it requires a very disciplined government to pull it off successfully.

Q18. Write in detail the role of public and private sector in Indian economy.

Ans. The balance between the public and private sectors defines the economic architecture of a nation. In a Mixed Economy like India, both sectors coexist to achieve a synergy between social welfare and economic efficiency.

Public Sector

The public sector consists of various organizations owned, managed, and controlled by the government (Central, State, or Local). Its primary objective is not profit, but the maximization of social welfare and the provision of essential services.

Roles and Objectives

1. Infrastructure Development: The public sector invests in "long-gestation" projects where private capital is often hesitant to enter due to high risks and slow returns (e.g., Railways, National Highways, and Nuclear Power).
2. Correction of Regional Imbalances: By setting up industries in backward areas (as seen in the early Five-Year Plans with steel plants in Bhilai and Rourkela), the government ensures that economic growth is geographically inclusive.
3. Provision of Public Goods: Items like national defence, street lighting, and public parks are non-excludable and non-rivalrous. Since the private sector cannot easily charge for these, the public sector must provide them.
4. Control of Monopolies: To prevent the concentration of economic power in a few hands, the government manages strategic sectors (Atomic Energy, Space) and regulates essential services to protect consumers from exploitation.

The Private Sector

The private sector comprises businesses owned and managed by individuals or groups of individuals. Its primary heartbeat is the profit motive, which inherently drives innovation and resource optimization.

Roles and Contributions

1. Economic Dynamism and Innovation: Competition in the private sector forces firms to innovate constantly. This leads to technological advancement and a wider variety of goods and services for the consumer.
2. Employment Generation: While the public sector provides stability, the private sector (especially MSMEs) is the largest employer in the modern economy, absorbing a significant portion of the labour force.
3. Capital Formation: Through the stock market and private investments, this sector mobilizes public savings into productive economic activities.
4. Global Competitiveness: Private firms are generally more agile in adapting to global market trends, helping the nation improve its export potential and foreign exchange reserves.

Comparative Analysis: Public vs. Private Sector

The Shifting Paradigm: Post-1991 Reforms

Following the LPG (Liberalization, Privatization, and Globalisation) reforms in India, the demarcation between these sectors shifted significantly. 

The government began selling its stakes in Public Sector Undertakings (PSUs) to invite private efficiency and reduce the fiscal deficit. Most sectors previously reserved for the public sector (like telecommunications and mining) were opened to private players. The government’s role evolved from being a "producer" to a "regulator" (e.g., SEBI, TRAI, and CCI).

Public-Private Partnership (PPP)

In the modern context, the debate is no longer "Public vs. Private" but "Public and Private." The PPP model combines the strengths of both. Technical expertise, managerial efficiency, and speed of the Public Sector. And, regulatory backing, land acquisition, and social legitimacy of the Private Sectort. 

Common frameworks include BOT (Build-Operate-Transfer) and the Hybrid Annuity Model (HAM), widely used in Indian highway construction.

Strategic Challenges

Despite their roles, both sectors face inherent challenges. Public Sector faces the "Agency Problem" where managers may lack the incentive to optimize costs, leading to high "Red Tape" and fiscal drains through loss-making PSUs. Whereas Private Sector, when left unregulated, it can lead to market failures, environmental degradation, and widening income inequality (Wealth Concentration).

Note on Economic Rationale: The optimal balance is often found by applying the principle of Subsidiarity: the government should only perform those tasks which cannot be performed effectively by the private sector or the local community.

The synergy of these two sectors ensures that an economy remains both productive (through private enterprise) and just (through public oversight and welfare).