Comprehension : Comprehension

Q 69 / 466

UPSC CSE Prelims 2024

As inflation rises, even governments previously committed to budget discipline are spending freely to help households. Higher interest rates announced by central banks are supposed to help produce modest fiscal austerity, because to maintain stable debts while paying more to borrow, governments must cut spending or raise taxes. Without the fiscal backup, monetary policy eventually loses traction. Higher interest rates become inflationary, not disinflationary, because they simply lead governments to borrow more to pay rising debt-service costs. The risk of monetary unmooring is greater when public debt rises, because interest rates become more important to budget deficits.

Based on the above passage, the following assumptions have been made:

  1. Fiscal policies of governments are solely responsible for higher prices.
  2. Higher prices do not affect the long-term government bonds.

Which of the assumptions given above is/are valid?

EXPLANATION

Correct Option (D)

Neither assumption 1 nor assumption 2 is valid based on the provided passage.

Incorrect Options:

  • Assumption 1: Fiscal policies of governments are solely responsible for higher prices. The passage describes a dynamic interaction between fiscal policies (government spending) and monetary policies (central bank interest rates) in influencing inflation. It explicitly states that "monetary policy eventually loses traction" without fiscal backup and that "higher interest rates become inflationary" if governments increase borrowing to cover rising debt-service costs. This indicates that inflation is a result of complex interplay, not solely attributable to fiscal policies. Therefore, this assumption is not supported by the passage.
  • Assumption 2: Higher prices do not affect the long-term government bonds. The passage directly links rising inflation and higher interest rates to increased debt-service costs for governments. It highlights that "interest rates become more important to budget deficits" when public debt rises, compelling governments to "pay more to borrow." As government bonds represent public debt, higher prices (inflation) leading to increased interest rates and debt-service burdens directly impact the government's financial obligations and, consequently, the market value and yields of its long-term bonds. The passage implies a significant effect on debt dynamics, which are intrinsically tied to government bonds. Therefore, this assumption is not supported by the passage.

Since both assumptions are invalid according to the passage, options (A) 1 only, (B) 2 only, and (C) Both 1 and 2 are incorrect.