Monetary Policy and Inflation — Practice Questions
UPSC Prelims-pattern practice questions on monetary policy and inflation with full explanations: the policy corridor, CRR and SLR, MPC rules and price indices.
Questions
These are original UPSC-pattern practice questions. Attempt each one before revealing the answer.
Since April 2022, which one of the following forms the floor of the RBI’s liquidity adjustment facility (LAF) corridor?
Solution
The Standing Deposit Facility (repo − 25 basis points) replaced the fixed-rate reverse repo as the floor; it absorbs liquidity without collateral. The MSF (repo + 25 bp) is the ceiling; the bank rate is aligned with the MSF.
Answer: B
The term “stagflation” refers to a situation of:
Solution
Stagflation = stagnation + inflation, as seen after the oil shocks of the 1970s. Option B describes deflation with growth; option C is disinflation; option D describes an overheating economy.
Answer: A
Consider the following statements:
- Banks maintain the Cash Reserve Ratio as balances with the RBI and earn no interest on it.
- The Statutory Liquidity Ratio may be maintained in the form of gold.
- Under the Marginal Standing Facility, banks may borrow by dipping into their SLR holdings up to a limit.
How many of the statements given above are correct?
Solution
All three are correct. CRR: RBI Act, Section 42, no interest. SLR: Banking Regulation Act, Section 24, in cash, gold or approved securities. MSF: overnight borrowing at repo + 25 bp, including against SLR securities up to a specified limit.
Answer: C
The Consumer Price Index for Industrial Workers (CPI-IW), used to revise dearness allowance of government employees, is compiled by:
Solution
The Labour Bureau (Ministry of Labour and Employment) compiles CPI-IW and the CPI for agricultural and rural labourers. The NSO compiles CPI (Combined); the Office of the Economic Adviser compiles the WPI.
Answer: A
Under the RBI Act, the RBI is deemed to have failed to meet the inflation target if average inflation is above the upper tolerance level or below the lower tolerance level for:
Solution
The trigger is three consecutive quarters outside the band. The RBI must then report to the Central Government the reasons, the remedial actions and the expected time to return to target (Section 45ZN). The first such report was sent in November 2022.
Answer: D
Distinguish between demand-pull and cost-push inflation. Why is monetary policy less effective against the latter?
Solution
Introduction: Inflation is a sustained rise in the general price level. Its cause matters for the cure: demand-pull inflation arises when aggregate demand outruns supply; cost-push inflation arises when production costs rise.
Body:
- Demand-pull: driven by strong consumption, credit growth, fiscal expansion or capital inflows. Raising the repo rate and draining liquidity reduce spending, so monetary policy works well here.
- Cost-push: driven by fuel and commodity prices, crop failures, supply-chain disruptions or wage pressures. Output falls as prices rise.
- Why monetary tools struggle: higher interest rates cannot produce more vegetables or cheaper crude oil; they act with a lag; tightening against a supply shock can deepen the output loss (stagflation risk).
- What monetary policy can still do: prevent a one-time shock from feeding into inflation expectations and wages (second-round effects).
- Complementary measures: buffer stocks and open market sales of grain, trade policy, storage and cold chains, rationalising fuel taxes.
Conclusion: Demand-pull inflation calls for monetary tightening; cost-push inflation needs supply-side action, with monetary policy guarding expectations.