UPSC Prelims 2013 Q82: Indian Economy – Inflation & Price Indices
A rise in general level of prices may be caused by
1. An increase in the money supply
2. A decrease in the aggregate level of output
3. An increase in the effective demand
Select the correct answer using the codes given below.
- (a) 1 only
- (b) 1 and 2 only
- (c) 2 and 3 only
- (d) 1, 2 and 3
Answer: (d) 1, 2 and 3
Explanation
Causes of a rise in the general price level
Inflation happens when demand grows faster than supply.
| Cause | Leads to a rise in prices? | Type |
|---|---|---|
| 1. An increase in the money supply | Yes | More money chases the same goods: demand-pull |
| 2. A decrease in the aggregate level of output | Yes | Fewer goods for the same money: supply-side |
| 3. An increase in the effective demand | Yes | Demand-pull inflation |
Two kinds of inflation:
| Type | Cause | Examples |
|---|---|---|
| Demand-pull | Too much demand | More money supply, higher incomes, big government spending |
| Cost-push | Higher costs or lower supply | Costly crude oil, crop failure, higher wages |
Measures of inflation in India: CPI (used by the RBI for its target) and WPI.
Answer: (d) 1, 2 and 3.
Why each option is right or wrong
- (a) Incorrect. Lower output and higher demand also raise prices.
- (b) Incorrect. An increase in effective demand also raises prices.
- (c) Incorrect. An increase in the money supply also raises prices.
- (d) CORRECT. All three can cause a rise in the general level of prices.
Key point
Inflation: demand-pull (more money, more demand) or cost-push (less output, higher costs). CPI is the RBI's target measure.
Remember
More money, more demand, less output: all inflationary.
Common mistakes
- Thinking inflation has only a monetary cause.
- Forgetting that a fall in output raises prices.
- Confusing demand-pull and cost-push.
Exam tip
Prices rise when demand goes up or supply goes down. All three do one or the other.
Sources
- NCERT Class XII — Introductory Macroeconomics (Money and Banking; Determination of Income and Employment)
- Reserve Bank of India — Monetary Policy Report