Flash Card

LAKSHYA-75 [Day-43] Static Flash Cards for IAS Prelims 2020

Liabilities of Government of India; Real Effective Exchange Rate (REER); Differences between Traditional Budgeting and Zero Base Budgeting; Causes of Inflation; India’ Public Debt; Base Year; Difference Between GDP and GNP; Bull Market Vs Bear Market; Budget; Monetary Policy Committee (MPC);
By IASToppers
April 21, 2020

What is the duration of period for which MPC members are appointed?

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Answer:

  • The MPC members are appointed for a period of four years.

Enrich Your Learning:

Monetary policy:

Monetary policy refers to the use of monetary instruments under the control of the central bank to regulate magnitudes such as interest rates, money supply and availability of credit with a view to achieving the ultimate objective of economic policy.

  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
  • MPC is headed by RBI governor.
  • The MPC replaces the previous arrangement of Technical Advisory Committee.

Monetary Policy Committee (MPC)

  • The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation; and modulation of liquidity conditions to anchor money market rates at or around the repo rate.
  • Repo rate changes transmit through the money market to the entire the financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
  • Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.
  • The operating framework is fine-tuned and revised depending on the evolving financial market and monetary conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework was last revised significantly in April 2016.
  • The main responsibility of the MPC is to administer the inflation targeting monetary policy regime through determining the policy rate or repo rate to contain inflation.

Structure of the MPC:

  • The Monetary Policy Committee (MPC) is formed under the RBI with six members.
  • Three of the members are from the RBI while the other three members are appointed by the government.
  • Members from the RBI are the Governor who is the chairman of the MPC, a Deputy Governor and one officer of the RBI.
  • The government members are appointed by the Centre on the recommendations of a search-cum-selection committee which is to be headed by the Cabinet Secretary.

What happens if the budget is not passed within the announced date?

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Answer:

  • If the Budget is not passed within the announced date, Article 116 of the Constitution empowers the Lok Sabha to pass the Vote-On-Account, a document which covers only the expenditure incurred.

Enrich Your Learning:

What is a budget and what does it consist of?

  • A Budget is an estimate of outflows and inflows that a Government will incur during a financial year.
  • It consists of actual figures for the preceding year and the budgetary estimate for the current year.

When is it presented and by whom?

  • The Budget is presented on a day that is determined by the Parliament.
  • It is traditionally presented on the last working day of February, this year, the interim budget was presented on 1stFeb 2019.
  • The Budget is presented by the Finance Minister.
  • The Budget division in the Finance Ministry has complete responsibility over it, though it requires final approval from the Prime Minister.
  • A timetable is drawn up by the Budget Advisory Committee of the Parliament.
  • In this schedule, a fixed time is given for each Ministry to discuss their needs prior to the Budget presentation.

Is an annual Budget necessary?

  • It is not only necessary, but compulsory.
  • Under Article 112 of the Constitution, a Statement of Receipts and Payments (estimated) has to be tabled in the Parliament for every financial year.
  • The Receipts and Payments statement contains consolidated fund, contingency fund and the public account.
  • The consolidated fund is a statement of all the inflows, such as tax revenues; and all expenditure, which constitute outflows.
  • To withdraw from this fund, the government requires parliamentary authorization.
  • The public account is one where all money raised from government schemes, such as Provident Fund, is accounted for.

What does the Budget document contain?

  • The budget speech and the document has two parts – Part A and B. Part A is the macroeconomic part of the budget where various schemes are announced, and allocations are made to several sectors.
  • The priorities of the government are also announced in this part.
  • Part B deals with the Finance Bill, which contains taxation proposals such as income tax revisions and indirect taxes.

 

What is the tendency of international investments during the period of Bulls market and bear market?

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Answer:

  • International investments are encouraged at a faster pace during Bull market and stable or has receding approach in Bear market.

Enrich Your Learning:

What is Bull Market?

This situation is defined as a marketplace whereby the prices of listed securities are continuously rising due to favourable macro-economic scenario or improved internal circumstances of the firm or sector.

What is Bear Market?

Such a situation depicts a downward trend in the market over a period of time.

  • The markets have a pessimistic approach and the prices of assets are either in decline or expected to fall in the immediate future. It will cost investors lot of money as security prices will fall across the board and investor confidence is also expected to take a hit.

Bull Market Vs Bear Market – Key Differences

  • The market is mentioned as Bulls when the overall market scenario is positive and the market performance is on the rise. A bearish market is when the performance of the market is on the decline.
  • In a bullish market, the outlook of the investor is very optimistic and this is visible from the fact that investors will be taking long positions in the market. This way, the anticipation is security prices will rise further and investor has an opportunity to maximise profit opportunities. Conversely, in a bearish market, the market sentiment is quite pessimistic and reflected by investors taking a short position i.e. selling a security or undertaking a put position with increased anticipation of a falling market. Hence, if the price falls below the contracted price, the option holder will accordingly book a profit.
  • The economy grows sustainably in a bullish market whereas in a bearish market the economy will either fall or not grow at a faster pace as in the bullish outlook scenario. In both these situations (bull vs bear market), an indicator like the GDP (Gross Domestic Product) plays an important role in giving a bird’s eye view of how the economy is performing based on the existing factors.
  • In a bullish market, the market indicators are very strong. These indicators are used in technical analysis for forecasting market trends and various ratios and formulas which explain current gains and losses in stocks and indexes and its expected movement in the future. For e.g. the market breadth index is an indicator measuring the increasing number of stocks versus those which are falling. An index of greater than 1.0 indicates a future rise in market indices and vice-versa if it is below 1.0. In a bearish market, the market indicators are not strong. In either of the scenarios (bull vs bear market), the causes are interdependent and cascading effect for the same is observed.
  • The job market in a bullish situation is very bright and there are more disposable incomes in the hands of the public in general. However, in a bearish market, the job market is stiff and efforts are being made to control expenses and at a rapid pace if the situation is not improving.
  • In a bullish market, the liquidity flowing in the market is very large and investors continue to pump more funds with increased trading activity and investing in stocks, gold, real estate etc. but in a bearish market, the liquidity dries up in the system and investors are reluctant before making any commitments. The investments made during a bullish scenario are either sold preventing further downsides or holding back to them for future usage. It may give rise to hoarding and black marketing situations.
  • IPO activities are encouraged in a bullish market since the market sentiments are positive and investors are willing to invest more money, though, in a bearish market, IPO’s are avoided since investments would not be encouraged and people will prefer to hold on to the existing positions and liquidity.
  • International investments will automatically get encouraged in a bullish market with the intention to expand the existing portfolio. For instance, if India is going through a bullish phase and South Korea decides to make generous investments in India, such a move will encourage the smooth phase for India, enhance the investment made by South Korea and in turn boost the economy for South Korea thereby spreading the effects of a bullish market across borders. However, in a bearish market, international investments may not be a favorable option for other countries and such a move could be postponed to a futuristic date.
  • A bullish market will encourage the banking sector to reduce the interest rates on loans encouraging business activities to grow prompting expansionary policies by the Central Bank and the Government. Conversely, in a bearish market, the banking sector will curb the usage of money for emergency situation prompting contractionary policies by the highest authorities. The interest loans would either be held stable or increased.
  • In a bullish market, the yields on securities and dividends will be low highlighting the financial strength of the investor and security others can receive on investment made whereas, in a bearish market, these yields shall be very high indicating requirement of funds and attempting to lure investors by offering higher yields on securities at a later date.

 

What are the fundamentals of calculating GDP and GNP respectively?

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Answer:

  • The fundamentals for calculating the GDP is the location, while GNP is based on citizenship.

Enrich Your Learning:

What is GDP vs GNP?

  • Gross Domestic Product considers the market value of all final goods and services produced by factors of production such as capital and labour located within a country or economy during the given period of time, generally a yearly or a quarterly.
  • Gross national product considers the market value of all final goods and services produced by factors of production such as capital and labor supplied by citizens of a country, regardless of whether this similar production takes place internally within the province or outside of the country.

Difference Between GDP and GNP:

  • The aggregate of all the goods and the services generated within the of the country’s geographical limits is known as GDP and the aggregate of all the goods and services generated by the citizens of the country is known as GNP.
  • GDP considers the production of products within the boundaries of the country. and on the other hand, GNP measures the production of products by the companies, industries and all other firms owned by the country’s residents.
  • .
  • With the case GDP, the calculation of productivity is done on a country’s scale while we talk about GNP, its calculation is the productivity on an international level.
  • GDP focuses on calculating domestic production, but GNP only considers on the production by the individuals, firms, and corporations, of the country.
  • GDP measures the strength of a country domestic economy. On the other hand, the GNP measured how the residents are contributing towards the country’s economy.

Key Facts:

Measurement:

  • GDP measures only domestic production.
  • GNP measures production by the nationals.

Includes:

  • GDP includes the production of goods and services by foreigners within that country.
  • GNP includes the production of goods and services by its citizens outside of the country.

Excludes:

  • GDP excludes the production of goods and services by its citizens outside of the country.
  • GNP excludes the production of goods and services by foreigners within that country.

Widely used:

  • GDP is widely used to study the outlines of the domestic economy.
  • GNP is widely used to study how the residents are contributing to the economy.

 

In context of banking, what is a Base Year?

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Answer & Enrich Your Learning:

  • The base year is a benchmark with reference to which the national account figures such as gross domestic product (GDP), gross domestic saving, gross capital formation is calculated. Gross domestic product is the value of all goods and services produced in a country.
  • The base year must be a representative year and must not experience any abnormal incidents such as droughts, floods, earthquakes etc.
  • It must be a year which is reasonably proximate to the year for which the national accounts statistics are being calculated.
  • Base year is carefully selected because of the impact it has on the numbers and the year chosen is usually one in which no serious anomaly was present.

The new base year

  • From January 2015, the Central Statistics Office (CSO) updated base year for GDP calculation to 2011-12, replacing the old series base year of 2004-05, as per the recommendations of the National Statistical Commission.
  • The new series includes corporate information from the MCA21 database of the Ministry of Corporate Affairs instead of the results obtained from the RBI study on company finances, which means a more comprehensive inclusion of corporate data in GDP numbers.
  • It also helps improve accuracy, particularly for the services sector, which accounts for about 60 per cent of GDP.
  • The new series is also compliant with the United Nations guidelines in System of National Accounts-2008.
  • It takes information for the corporate sector and has better estimates of the unorganized sector from 2010-11 National Sample Survey on unincorporated enterprises and data on sales and service taxes.
  • After the base year is changed, the GDP in previous years is revised according to the new base year for a fair comparison.

Why is the base year for national accounts changed every few years?

The base year has to be revised periodically in order to reflect the structural changes taking place within an economy, such as increasing share of services in GDP.

  • The more frequently the base year can be updated, the more accurate the statistics will be.
  • In India, the first estimates of national income were published by the Central Statistical Organisation (CSO) in 1956 taking 1948-49 as the base year.
  • Earlier, CSO depended on the population figures in the National Census to estimate the workforce in the economy. Therefore, the base year always coincided with the census figures like 1970-71, 1980-81 etc.
  • Subsequently, CSO decided that the National Sample Survey (NSS) figures on the workforce size were more accurate and hence, the base year would change every five years when the NSS conducted such survey.

Public Debt, sometimes also referred to as government debt, includes small saving and provident funds. Right or Wrong?

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Answer:

Wrong

Right statement:

  • Public debt does not include small savings, provident funds and other accounts, reserve funds and deposits.

Enrich Your Learning:

Public Debt

  • Public debt, sometimes also referred to as government debt, represents the total outstanding debt (bonds and other securities) of a country’s central government.
  • Public debt as a percentage of GDP is usually used as an indicator of the ability of a government to meet its future obligations.
  • It is an important source of resources for a government to finance public spending and fill holes in the budget.
  • Public debt can be split into internal (money borrowed within the country) and external (funds borrowed from non-Indian sources).
  • However, it does not include small savings, provident funds and other accounts, reserve funds and deposits.

India’ Public Debt:

  • India recorded a government debt equivalent to 68 percent of the country’s Gross Domestic Product in 2017. This is a comfortable figure because it is well below 100% and leaves the country room to borrow more in the event of a financial crisis.
  • Government Debt to GDP in India averaged 73.24 percent from 1991 until 2017, reaching an all-time high of 84.20 percent in 2003 and a record low of 66 percent in 1996.
  • In India, most government debt is held in long-term interest bearing securities such as national savings certificates, rural development bonds, capital development bonds, etc.
  • The Government has been publishing an annual Status Paper on Government Debt since 2010-11, which provides a detailed analysis of the Government’s debt position.

How do (i) Money supply (ii) National debt (iii) Cost push and Demand pull effects and (iv) Exchange rates cause inflation?

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Answer & Enrich Your Learning:

What is Inflation?

  • Inflation is the long term rise in the prices of goods and services caused by the devaluation of currency.

Causes of Inflation

Increase in the money supply:

  • When the Government decides to put more money into circulation at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency.
  • As a result, this devaluation will force prices to rise due to the fact that each unit of currency is now worth less. When a government decides to print new currency, they essentially water down the value of the money already in circulation causing inflation.

National Debt:

  • As a country’s debt increases, the government can either raise taxes or print more money to pay off the debt.
  • A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax rate causing inflation. In latter case, printing more money can also raise inflation.

Demand-Pull effect

  • According to demand-pull effect, as wages increase within an economic system, people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products.
  • As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand which causes inflation.
  • In other words, Demand-pull inflation occurs when aggregate demand for goods and services in an economy rises more rapidly than an economy’s productive capacity.

Cost-Push Effect

  • According to Cost-push effect, when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices.
  • The sharp rise in the price of imported oil during the 1970s provides a typical example of cost-push inflation.
  • Rising energy prices caused the cost of producing and transporting goods to rise. Higher production costs led to a decrease in aggregate supply and an increase in the overall price level.

Exchange Rates

  • When the exchange rate goes down such that the Indian currency become less valuable relative to foreign currency, foreign commodities and goods will become more expensive to Indian consumers causing potential inflation.

Corporate Decisions:

  • Companies that make popular items frequently raise prices simply because consumers are willing to pay the increased amount.

Unlike a traditional budget that is based on previous budgets, Zero-based budgeting prepare the budget from the scratch. What are other differences between Zero-based budgeting and Traditional budgeting?

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Answer & Enrich Your Learning:

Zero Based Budgeting (ZBB)

  • Zero-based budgeting is an approach to plan and prepare the budget from the scratch. Zero-based budgeting starts from zero, rather than a traditional budget that is based on previous budgets.
  • The primary objective of zero-based budgeting is the reduction of unnecessary cost by looking at where costs can be cut.

 

Differences between Traditional Budgeting and Zero Base Budgeting

  • In traditional Budgeting, the previous year’s budget is taken as a base for the preparation of a budget. Whereas, each time the budget under zero-based budgeting is created, the activities are re-evaluated and thus started from scratch.
  • Traditional Budgeting works on cost accounting principle, thereby, it is more accounting oriented. Whereas the zero-based budgeting is decision oriented.
  • In the traditional budgeting, justification of the line items and expenses are not at all required. On the other hand, in zero-based budgeting, proper justification is required, taking into account the cost and benefit.
  • In traditional budgeting, the top management take decisions regarding any amount that will be spent on a particular product. In contrast, in zero-based budgeting, the decision regarding the spending a specific sum on a particular product is on the managers.
  • Zero-based budgeting is better than traditional budgeting when it comes to clarity and responsiveness.
  • Traditional budgeting follows a monotonous approach while zero-based budgeting follows a straightforward approach.

Zero Based Budgeting Advantages

  • Efficiency: It helps a business in the allocation of resources efficiently (department-wise) as it does not look at the previous budget numbers.
  • Accuracy: This budgeting approach makes all departments relook every item of the cash flow and compute their operation costs.
  • Budget inflation: It compensates the weakness of incremental budgeting of budget inflation.
  • Coordination and Communication: It provides better coordination and communication within the department and motivation to employees by involving them in decision-making.
  • Reduction in redundant activities: This approach leads to identify doing things by eliminating all the redundant or unproductive activities.

Zero Based Budgeting Disadvantages

  • High Manpower Turnover: It require the involvement of a large number of employees. Many departments may not have adequate human resource and time for the same.
  • Time-Consuming: It is highly time-intensive for a company to do annually as against incremental budgeting approach, which is a far easier method.
  • Lack of Expertise: Providing an explanation for every line item and every cost is a problematic task and requires training for the managers.

Classify the Government liabilities. Is there an acceptable level of debt-to-GDP?

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Answer & Enrich Your Learning:

Liabilities of Government of India

  • A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.
  • The liability of Indian government was nearly 70 lakh crores in 2016-17. Central government liability was 46% of GDP while general government liabilities was 68% of GDP in 2016-17.
  • The NK Singh Committee on FRBMhad envisaged a debt-to-GDP ratio of 40 per cent for the central government and 20 per cent for states aiming for a total of 60 per cent general government debt-to-GDP.
  • Government liabilities have been broadly classified as debt contracted against the Consolidated Fund of India (defined as Public Debt) and liabilities in the Public Account, called Other Liabilities.
  • Public debt is further classified into internal and external debt. Internal debt consists of marketable debt and non-marketable debt. Government dated securities and Treasury Bills, issued through auctions, together comprises marketable debt.
  • Intermediate Treasury Bills issued to State governments and select Central Banks (14 days ITB), special securities issued to National Small Savings Fund (NSSF), etc., are part of non-marketable internal debt.
  • Other Liabilities include liabilities on account of Provident Funds, Reserve Funds and Deposits, Other Accounts, etc.
  • Government published its first Debt Management Strategies (DMS) on December 31, 2015. The objective of the debt management strategy (DMS) is to secure the Government’s funding at all times at low cost over the medium /long-term while avoiding excessive risk.
  • The DMS revolves around three broad pillars, viz., low cost, risk mitigation and market development.

Real Effective Exchange Rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies. What are its limitations?

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Answer:

Limitations of the Real Effective Exchange Rate:

  • It doesn’t take into account price changes, tariffs or other factors affecting trade. In other words, the amount of trade being done with a country can be impacted by many factors.
  • The REER would be impacted in case of central banks adjusting monetary policy which can lower or raise interest rates in their home country resulting in money flows strengthening the currency exchange rate.

Enrich Your Learning:

Real Effective Exchange Rate (REER):

  • The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies.
  • This weights are decided by comparing, within the index, the relative trade balance of a country’s currency against each country.
  • An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness.
  • For Example, If India has trade relationships with U.S. and Australia whereby the U.S. does 70% of its trading with India and 30% for Australia.
  • S. dollar exchange rate would comprise 70% of the basket. A move in the U.S. dollar would have a larger impact on the basket than a move in the Australian dollar.
  • In case of the exchange rates moved significantly, however the weighted average of the basket didn’t change, it could mean that the other currencies moved in the opposite direction offsetting the move of the first currency.
  • It is used to understand how well a currency is doing with respect to other currencies and also with respect itself in the past.

The Difference Between REER and a Spot Exchange Rate:

  • A spot exchange rate is the price to exchange one currency for another for delivery on the earliest possible value date.
  • The spot exchange rate is for a currency between two countries, such as the euro, which is the exchange rate between the U.S. and the eurozone. The REER is a basket of currencies and a weighted average based on how much the countries trade with the base currency.

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