UPSC Mains Daily Answer Writing (26-12-2022) - GS 3

Questions

Q1. Inflation in an economy is related to high demand and low supply. However, the Indian economy faces a unique problem of high inflation, low demand and high supply. Why? (150 words)   10 marks

Q2. It is not only the amount but also the manner of forex accumulation that determines a country's macroeconomic stability. Discuss in the Indian context. (150 words)  10 marks

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Model Solutions

Q1. Inflation in an economy is related to high demand and low supply. However, the Indian economy faces a unique problem of high inflation, low demand and high supply. Why? (150 words) 10 marks

Model Structure
Introduction:

• In 2020-21, the Indian economy witnessed high inflation, which is a peculiar case as it is happening with low demand and high supply in the economy.

Main Body:

• The following are the reasons for this:
  • Supply chain disruption: During the COVID-19 crisis, supply chains were disrupted.
    • This resulted in supply bottlenecks and increased costs for manufacturers and retailers, leading to price rises.
  • Food inflation: Government efforts to double farmers' income with high MSP, loan waivers and artificial scarcity of some food crops.
  • High tariffs: The government has levied high taxes on some imported commodities and petrol and diesel, leading to a price rise.
  • Increase in cost of production: Due to the lack of low-wage workers during Covid-19.
    • The shift towards working from home and mass exiting old companies to join new ones has increased wages.
  • After lockdown increase: Sectors that have been hit hardest by COVID-19, like transportation and hotels, have begun propping up prices to cover losses.
  • Larger than adequate liquidity: Interest rates are kept the same to ensure enough liquidity. This has led to larger than sufficient liquidity in the banking system, leading to inflation.

Conclusion:

• Inflation is not only wrong in terms of reduced economic efficiency and competitiveness, but it also affects poor people the most. There is a need to correct inflationary tendencies in the Indian economy.
• There is a need for strengthening the fundamentals of the Indian economy in terms of formalising the Indian economy, land reforms, self-sufficiency in production (Atmanribhar) etc.

Q2. It is not only the amount but also the manner of forex accumulation that determines a country's macroeconomic stability. Discuss in the Indian context. (150 words) 10 marks

Model Structure
Introduction:

• Foreign exchange reserves are assets denominated in foreign currency held by a central bank. India's foreign currency (forex) reserves have recently surpassed the record $600 billion mark, making it the fourth largest in the world.

Main Body:

• Significance of a high amount of forex in the maintenance of macroeconomic stability:
  • Comfortable Position to Government: It helps manage India’s external and internal financial issues at a time of significant contraction in economic growth and avoids the Balance of Payment (BoP) crisis.
    • It can also cover surges in import bills.
  • External Debt Obligations: Assist the government in meeting its foreign exchange needs and external debt obligations.
  • Confidence in the Market: Reserves will provide certainty to markets and investors that a country can meet its external obligations.
    • This can reduce the cost of borrowing for India in the external markets.
  • Can influence rupee vs other currencies' appreciation & depreciation: RBI can affect the value of the rupee based on our imports & exports to secure a favourable position for India in International Trade.
• The most desirable way of building forex is by surplus exports. But Indian forex built-up is a consequence of the high inflow of foreign capital (FDI, FPI). Importance of manner of accumulation of forex in India:
  • Volatile forex: We are still import-dependent, and these reserves from various investments and loans can be pulled out of our economy.
  • High US dollar basket: Too much dependence upon the US dollar could expose our reserves and, thereby, our economy to external shocks.
    • Also, RBI buying dollars with rupees can appreciate the dollar, and, in an import-dependent country, this can increase inflation.
  • High debt to forex ratio: India’s foreign loans or external commercial borrowing stands at $560, equivalent to 93% of our foreign exchange reserves.
    • These dollar obligations also threaten the macro economy as it increases the country's debt-to-GDP ratio.
  • Fiscal addiction: Large forex size means RBI’s balance sheet gets bloated during the depreciation of rupees, as balance sheets are measured in rupees.
    • This free gain can be passed as a dividend to the union government.
    • This results in free money addiction or even dilution of RBI’s independence.

Conclusion:

• The government with RBI must bring a dedicated national plan on foreign exchange, which should emphasise diversifying the forex, systematic investment of forex, and restrictions on using dividends for fiscal purposes.

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