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Indian and AP Economy — Mains Depth · Chapter 3

Challenges of the Indian economy

What to remember

  • Inflation is a sustained rise in the general price level. India targets CPI inflation through the RBI's Monetary Policy Committee, with a 4 per cent target and a band of 2 to 6 per cent.
  • The balance of payments always balances in accounting terms. A current account deficit (CAD) must be financed by the capital account or by reserves.
  • NPAs are loans overdue for more than 90 days. India fights them with SARFAESI, DRTs, the IBC (2016), asset reconstruction and recapitalisation.

Inflation: types, causes and measures

Inflation is a continuous rise in the general price level, so each rupee buys less.

By cause

  • Demand-pull: too much money chasing too few goods; aggregate demand exceeds supply.
  • Cost-push: a rise in the cost of inputs such as wages, fuel or raw material pushes prices up.
  • Structural: supply bottlenecks in agriculture, storage and transport.
  • Imported inflation: a rise in global prices or a weak rupee raises the cost of imports.

By speed: creeping (very slow), walking, running and hyperinflation (extremely rapid).

Related terms

  • Deflation: a fall in the general price level.
  • Disinflation: a fall in the rate of inflation, while prices still rise.
  • Reflation: deliberate policy to raise prices after deflation.
  • Stagflation: high inflation with slow growth and high unemployment.
  • Core inflation: inflation after leaving out food and fuel items, which are volatile.

Price indices in India

IndexCompiled byRemarks
WPI (Wholesale Price Index)Office of the Economic Adviser, DPIITWholesale goods; no services; base year 2011-12
CPI-CombinedNSO, MoSPIRetail prices, rural and urban; used by the RBI for inflation targeting
CPI-IWLabour BureauIndustrial workers; used for dearness allowance
CPI-AL and CPI-RLLabour BureauAgricultural and rural labourers

Flexible inflation targeting. An amended RBI Act (2016) set up a six-member Monetary Policy Committee (MPC): three from the RBI (including the Governor as chair) and three external members appointed by the Government. The Government sets the target every five years, now 4 per cent with a tolerance band of plus or minus 2 per cent. The idea came from the Urjit Patel committee.

Control measures

TypeTools
MonetaryRepo rate, Standing Deposit Facility (SDF, which replaced the fixed-rate reverse repo as the floor of the policy corridor in 2022), Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), open market operations, Marginal Standing Facility
FiscalLower government spending, higher taxes, lower fiscal deficit
Supply sideBuffer stocks, imports, better storage and transport, Public Distribution System, export curbs

A higher repo rate makes borrowing costlier and reduces demand. A higher CRR locks more bank deposits with the RBI and reduces lending power.

Effects of inflation. Inflation hurts people with fixed incomes, such as pensioners and savers who earn low interest. It helps borrowers, because the real value of their debt falls. It raises the cost of living, can lower exports by making goods costlier, and reduces the real value of savings. The real interest rate is the nominal interest rate minus the rate of inflation. If it is negative, savers lose. The food and fuel items have a large weight in the Indian CPI basket, so a bad monsoon or a rise in oil prices quickly shows in the index.

Balance of payments and the current account deficit

The Balance of Payments (BoP) records all economic transactions between residents and the rest of the world in a period.

  • Current account: trade in goods (the "visible" trade balance), trade in services, primary income (interest, dividends, wages) and secondary income (remittances, transfers).
  • Capital account (including financial account): foreign direct investment, portfolio investment, external commercial borrowings, NRI deposits, loans and changes in foreign exchange reserves.

Because every payment has a matching entry, the total BoP always balances. But a current account deficit means the country spends more foreign exchange than it earns from current transactions. It must then be financed by capital inflows or by running down reserves.

TermMeaning
Trade balanceExports minus imports of goods
Current account deficit (CAD)Imports of goods and services plus net outflows exceed receipts on the current account
Capital account surplusNet capital inflows
BoP crisisReserves are too low to finance the gap

India usually has a large trade deficit in goods, partly offset by a surplus in services (IT and business services) and remittances. A large CAD makes the rupee weak and the economy depend on volatile inflows. Measures to reduce CAD include export promotion, import substitution, and attracting stable long-term inflows such as FDI. India faced a serious BoP crisis in 1991, which led to the economic reforms.

Exchange rate regimes and the rupee

  • Fixed rate: the currency is pegged to gold or another currency. India followed a fixed par value under the Bretton Woods system until the early 1970s.
  • Pegged to a basket: from 1975 the rupee was linked to a basket of currencies.
  • Dual rate (LERMS, 1992): part of foreign exchange was sold at an official rate and part at the market rate.
  • Market-determined rate (1993): the rupee became unified and market-determined.
  • Current account convertibility: accepted in 1994 (IMF Article VIII). Capital account convertibility is only partial.
  • Present system: a managed float. The market decides the rate, and the RBI steps in to reduce sharp swings.

Depreciation is a fall in the value of a currency in a floating system. Devaluation is a deliberate cut in the official value in a fixed system. A weaker rupee helps exports but raises the cost of imports such as crude oil.

NPAs and bank reforms

A loan becomes a Non-Performing Asset (NPA) when interest or principal is overdue for more than 90 days. Banks classify assets as:

CategoryMeaning
StandardPerforming
Sub-standardNPA for up to 12 months
DoubtfulNPA for more than 12 months
Loss assetJudged uncollectable

Why NPAs rise: over-lending in the investment boom, project delays, weak appraisal, wilful default, and a slowing economy.

Reforms and tools

  • Narasimham Committees (1991 and 1998): reforms of the financial system, including prudential norms, lower SLR and CRR, and capital adequacy.
  • Debt Recovery Tribunals (1993).
  • SARFAESI Act (2002): lets banks take possession of secured assets without going to court.
  • Asset Reconstruction Companies (ARCs): buy bad loans from banks.
  • Asset Quality Review (2015) and Mission Indradhanush (2015): clean the books and recapitalise public sector banks. The 4R strategy: recognition, resolution, recapitalisation and reforms.
  • Insolvency and Bankruptcy Code (2016): time-bound resolution through the National Company Law Tribunal (NCLT), with the Insolvency and Bankruptcy Board of India (IBBI) as the regulator.
  • Prompt Corrective Action (PCA): RBI restrictions on weak banks.
  • Bank mergers of public sector banks to create larger banks.
  • National Asset Reconstruction Company Ltd (NARCL, 2021): the so-called "bad bank".
  • Basel norms: international rules on capital adequacy.

Black money and measures

Black money is income that has not been declared to tax authorities, often earned from illegal activity or hidden to evade tax. Related terms: tax evasion (illegal), tax avoidance (using loopholes) and money laundering.

Main measures:

  • Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015: targets undisclosed foreign assets.
  • Benami Transactions (Prohibition) Amendment Act, 2016: allows confiscation of benami property.
  • Prevention of Money Laundering Act (PMLA), 2002.
  • Demonetisation on 8 November 2016: old Rs 500 and Rs 1,000 notes ceased to be legal tender.
  • Income Declaration Scheme (2016), Voluntary disclosure schemes.
  • Special Investigation Team (SIT) on black money, set up in 2014 under a retired Supreme Court judge.
  • Fugitive Economic Offenders Act, 2018.
  • GST and e-invoicing make transactions traceable; PAN-Aadhaar linking and tax information exchange agreements with other countries help detect hidden assets.
  • The Wanchoo Committee (1971) was an early study on direct taxes and black money.

Exam traps

  • Core inflation leaves out food and fuel; headline inflation includes them.
  • Disinflation is a slower rise in prices, not a fall in prices.
  • WPI has no services; CPI covers retail prices.
  • The RBI targets CPI (Combined), not WPI.
  • The MPC has six members; the Governor chairs it.
  • BoP always balances, but its parts (current and capital accounts) need not.
  • Depreciation is market-driven; devaluation is a policy decision.
  • A loan turns NPA after 90 days, not 30.
  • Doubtful assets are those NPA for more than 12 months.
  • SARFAESI works without court intervention; IBC works through the NCLT.
  • Demonetisation (2016) is not the same as the 2015 Black Money Act.

One-liners

  • 1. Inflation target: 4 per cent with a 2 to 6 per cent band.
  • 2. The MPC has six members.
  • 3. WPI base year is 2011-12.
  • 4. CPI-IW is compiled by the Labour Bureau.
  • 5. India adopted market-determined exchange rate in 1993.
  • 6. Current account convertibility came in 1994.
  • 7. NPA means overdue for more than 90 days.
  • 8. SARFAESI Act was passed in 2002.
  • 9. The IBC was enacted in 2016.
  • 10. DRTs were set up in 1993.
  • 11. NARCL is the bad bank set up in 2021.
  • 12. PMLA was enacted in 2002.

Practice questions

  1. Inflation caused by aggregate demand exceeding supply is called

    1. Structural inflation
    2. Demand-pull inflation
    3. Cost-push inflation
    4. Imported deflation
    Answer

    B. Demand-pull inflation

    Too much money chasing too few goods is demand-pull.

  2. A rise in prices because wages and input costs go up is

    1. Disinflation
    2. Demand-pull inflation
    3. Cost-push inflation
    4. Reflation
    Answer

    C. Cost-push inflation

    Rising costs push prices up.

  3. A fall in the rate of inflation while prices still rise is

    1. Deflation
    2. Disinflation
    3. Stagflation
    4. Reflation
    Answer

    B. Disinflation

    Disinflation slows the rise in prices.

  4. High inflation together with slow growth and high unemployment is called

    1. Reflation
    2. Deflation
    3. Creeping inflation
    4. Stagflation
    Answer

    D. Stagflation

    This is the meaning of stagflation.

  5. Core inflation excludes

    1. Services
    2. Education
    3. Food and fuel
    4. Housing
    Answer

    C. Food and fuel

    Food and fuel are volatile and are left out.

  6. Which index is used by the RBI for inflation targeting?

    1. CPI-IW
    2. CPI-Combined
    3. GDP deflator
    4. WPI
    Answer

    B. CPI-Combined

    The RBI Act mandate uses CPI-Combined.

  7. The Consumer Price Index (Combined) is compiled by

    1. Labour Bureau
    2. RBI
    3. NSO under MoSPI
    4. SEBI
    Answer

    C. NSO under MoSPI

    The NSO compiles CPI-Combined.

  8. Which price index is used to decide dearness allowance for industrial workers?

    1. CPI-AL
    2. WPI
    3. PPI
    4. CPI-IW
    Answer

    D. CPI-IW

    CPI-IW is compiled by the Labour Bureau.

  9. The Monetary Policy Committee of the RBI has how many members?

    1. Five
    2. Six
    3. Nine
    4. Four
    Answer

    B. Six

    Three from RBI and three external members.

  10. The inflation target set for the RBI is

    1. 8 per cent with band of 4 per cent
    2. 2 per cent with no band
    3. 6 per cent with band of 1 per cent
    4. 4 per cent with a band of plus or minus 2 per cent
    Answer

    D. 4 per cent with a band of plus or minus 2 per cent

    The flexible inflation target is 4 per cent, within 2 to 6.

  11. Which tool does the RBI raise to reduce demand and control inflation?

    1. Subsidies
    2. Fiscal deficit
    3. Repo rate
    4. Money supply through purchases of securities
    Answer

    C. Repo rate

    A higher repo rate makes loans costlier.

  12. Raising the CRR has what effect on banks?

    1. Increases the repo rate automatically
    2. Increases funds available for lending
    3. Has no effect on lending
    4. Reduces funds available for lending
    Answer

    D. Reduces funds available for lending

    More deposits must be kept with the RBI.

  13. The balance of payments records

    1. Bank deposits and loans
    2. Savings and investment within the country
    3. Transactions between residents and the rest of the world
    4. Government revenue and expenditure
    Answer

    C. Transactions between residents and the rest of the world

    BoP is an external accounts statement.

  14. Remittances from Indians abroad are recorded in the

    1. Reserve account
    2. Current account
    3. Fiscal account
    4. Capital account
    Answer

    B. Current account

    Remittances are secondary income in the current account.

  15. Foreign direct investment is recorded in the

    1. Fiscal deficit
    2. Current account
    3. Trade balance
    4. Capital (financial) account
    Answer

    D. Capital (financial) account

    FDI is a capital flow.

  16. India has traditionally had a surplus in which part of its current account?

    1. Services
    2. Goods trade
    3. Gold imports
    4. Primary income
    Answer

    A. Services

    IT and business services earn a surplus.

  17. India's economic reforms of 1991 followed

    1. A fall in the budget deficit
    2. An export boom
    3. A balance of payments crisis
    4. A banking merger
    Answer

    C. A balance of payments crisis

    Falling reserves led to the 1991 reforms.

  18. A deliberate cut in the official value of a currency in a fixed-rate system is

    1. Revaluation
    2. Devaluation
    3. Depreciation
    4. Appreciation
    Answer

    B. Devaluation

    Devaluation is a policy act.

  19. The rupee became market-determined in

    1. 1947
    2. 2005
    3. 1975
    4. 1993
    Answer

    D. 1993

    The rupee was unified and made market-determined in 1993.

  20. India accepted current account convertibility in which year?

    1. 2000
    2. 1980
    3. 1994
    4. 1991
    Answer

    C. 1994

    India accepted IMF Article VIII obligations in 1994.

  21. The present exchange rate regime of the rupee is best described as

    1. Managed float
    2. Currency board
    3. Rigid peg to the dollar
    4. Gold standard
    Answer

    A. Managed float

    The RBI intervenes only to smooth sharp swings.

  22. A loan becomes an NPA when overdue for more than

    1. 180 days
    2. 90 days
    3. 30 days
    4. One year
    Answer

    B. 90 days

    The standard norm is 90 days.

  23. An NPA that has remained so for more than 12 months is

    1. Doubtful asset
    2. Standard asset
    3. Reserve asset
    4. Sub-standard asset
    Answer

    A. Doubtful asset

    The classification follows the period as NPA.

  24. Which law allows banks to seize secured assets without court intervention?

    1. PMLA, 2002
    2. Benami Act, 2016
    3. SARFAESI Act, 2002
    4. FRBM Act, 2003
    Answer

    C. SARFAESI Act, 2002

    SARFAESI enables enforcement of security interest.

  25. Time-bound resolution of insolvency through the NCLT is provided by

    1. SARFAESI Act
    2. Insolvency and Bankruptcy Code, 2016
    3. Banking Regulation Act, 1949
    4. Companies Act, 1956
    Answer

    B. Insolvency and Bankruptcy Code, 2016

    The IBC created a time-bound process.

  26. The so-called bad bank set up in 2021 is

    1. SIDBI
    2. IDBI
    3. NaBFID
    4. NARCL
    Answer

    D. NARCL

    National Asset Reconstruction Company Ltd buys stressed loans.

  27. Debt Recovery Tribunals were established in

    1. 2016
    2. 1993
    3. 2002
    4. 1969
    Answer

    B. 1993

    DRTs were set up by a 1993 law.

  28. Which committees recommended financial sector reforms in 1991 and 1998?

    1. Tendulkar Committees
    2. Rangarajan Committees
    3. Narasimham Committees
    4. Urjit Patel Committees
    Answer

    C. Narasimham Committees

    The two Narasimham Committees reformed banking.

  29. Which act aims at undisclosed foreign income and assets?

    1. Black Money Act, 2015
    2. Benami Act, 1988 only
    3. FEMA 1973
    4. SEBI Act, 1992
    Answer

    A. Black Money Act, 2015

    This 2015 Act applies to undisclosed foreign assets.

  30. Old Rs 500 and Rs 1,000 notes were demonetised on

    1. 31 March 2015
    2. 1 July 2017
    3. 1 April 2016
    4. 8 November 2016
    Answer

    D. 8 November 2016

    The demonetisation was announced on 8 November 2016.

  31. If nominal interest is 7 per cent and inflation is 9 per cent, the real interest rate is

    1. Zero
    2. Negative
    3. 16 per cent
    4. Positive
    Answer

    B. Negative

    Real rate = nominal - inflation = -2 per cent.

  32. Who gains most from unexpected inflation?

    1. Savers with fixed deposits
    2. Lenders on fixed-rate loans
    3. Pensioners on fixed income
    4. Borrowers with fixed-rate loans
    Answer

    D. Borrowers with fixed-rate loans

    The real value of debt falls for borrowers.

  33. A rise in global crude oil prices that raises domestic prices is an example of

    1. Imported (cost-push) inflation
    2. Disinflation
    3. Demand-pull inflation
    4. Structural deflation
    Answer

    A. Imported (cost-push) inflation

    Higher import costs push up prices.

  34. A weaker rupee generally

    1. Reduces the trade deficit automatically
    2. Has no effect on oil import bill
    3. Helps exports but raises import costs
    4. Lowers all prices
    Answer

    C. Helps exports but raises import costs

    Export goods become cheaper abroad; imports cost more.

  35. Consider the following statements: 1. WPI includes services in its basket. 2. CPI measures retail prices. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    B. 2 only

    WPI covers goods only.

  36. Consider the following statements: 1. MPC members are all appointed by the RBI. 2. The Governor of the RBI chairs the MPC. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    B. 2 only

    Three members are external, appointed by the Government.

  37. Consider the following statements: 1. The balance of payments always balances in accounting terms. 2. A current account deficit is financed by capital inflows or reserves. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    C. Both 1 and 2

    Both statements are correct.

  38. Consider the following statements: 1. Depreciation is a deliberate policy cut in the official rate. 2. Devaluation happens in a fixed-rate regime. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    B. 2 only

    Depreciation is market-driven; devaluation is a policy cut.

  39. Consider the following statements: 1. IBC provides time-bound resolution of insolvency. 2. IBBI is the regulator under the IBC. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    C. Both 1 and 2

    Both are correct.

  40. Consider the following statements: 1. DRTs were set up in 1993. 2. SARFAESI needs court orders for every recovery. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    A. 1 only

    SARFAESI allows recovery without court intervention.

  41. Consider the following statements: 1. Core inflation includes food and fuel. 2. Headline inflation excludes food. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    D. Neither 1 nor 2

    Core excludes food and fuel; headline includes them.

  42. Consider the following statements: 1. Mission Indradhanush aimed to recapitalise public sector banks. 2. The 4R approach includes recognition and recapitalisation. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    C. Both 1 and 2

    Both are correct.

  43. Consider the following statements: 1. Disinflation means prices are falling. 2. Reflation is a policy to raise prices after deflation. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    B. 2 only

    Disinflation is a slower rate of rise, not a fall.

  44. Consider the following statements: 1. The Benami Transactions law allows confiscation of benami property. 2. The Wanchoo Committee studied direct taxes and black money. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    C. Both 1 and 2

    Both statements are correct.

  45. Consider the following statements: 1. The PMLA was enacted in 2002. 2. Demonetisation in 2016 was part of the 2015 Black Money Act. Which of the statements is/are correct?

    1. 1 only
    2. 2 only
    3. Both 1 and 2
    4. Neither 1 nor 2
    Answer

    A. 1 only

    Demonetisation was an executive notification, separate from the 2015 Act.

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