Question

There are fundamentally two possible changes in an economy that will each cause inflation unless other compensating changes also occur. These changes are either reductions in the supply of goods and services or increases in demand. In a pre-banking economy the quantity of money available, and hence the level of demand, is equivalent to the quantity of gold available.

If the statements above are true, then it is also true that in a pre-banking economy

Option A
Option B
Option C
Option D
Option E

(This question is from Official Guide. Therefore, because of copyrights, the complete question cannot be copied here. The question can be accessed at GMAT Club)

Solution

The Story

There are fundamentally two possible changes in an economy that will each cause inflation unless other compensating changes also occur.

Inflation is caused by one of the two changes in an economy unless other changes occur that compensate for the impact of the initial change.

These changes are either reductions in the supply of goods and services or increases in demand.

What are the two possible changes? (1) reductions in supply, and (2) increases in demand. (So, if the supply reduces OR the demand increases, inflation will occur. Unless other changes compensate for the supply/ demand change)

In a pre-banking economy the quantity of money available, and hence the level of demand, is equivalent to the quantity of gold available.

In a pre-banking economy, the quantity of gold available = the quantity of money available = the level of demand. I.e, the level of demand corresponds to the quantity of gold available. (More the gold available, higher the demand. Less the gold available, lower the demand.)

Gist:

Two factors cause inflation: (1) reduction in supply, and (2) increase in demand. Before banking became prevalent, the level of demand was determined by the quantity of gold available.

(Since the given passage is not an argument, we are not going to try to find any gaps here.)

The Goal

What can we infer about a pre-banking economy? An economy in which demand is governed by the quantity of gold. And we know that ‘reduction in supply’ or ‘increase in demand’ causes inflation. One thing that comes to mind is: if the quantity of available gold increases, and all else remains the same, there will be inflation (since demand will increase).

The Evaluation

(A) Incorrect. Inflation can be caused by either an increase in demand or a reduction in supply. We cannot infer that ‘any inflation’ is the result of reductions in the supply. There might very well also be inflations that are the result of an increase in demand. There is nothing mentioned in the passage for us to infer that demand does not fluctuate in the pre-banking economy.

(B) Correct.This is completely in line with our prediction above. Increasing the quantity of gold available will increase demand, and if other factors are unchanged, that increase in demand will lead to inflation.

(C) Incorrect. This option might seem attractive in the first look. However, on reading it precisely, one can understand that the option actually is in the opposite direction. Reduction in the quantity of gold available would reduce demand. What does a reduction in demand lead to? Nothing is given in the passage. Common sensically, if an increase in demand leads to inflation, a decrease in demand should not lead to inflation.

Ok, let’s try a modification. Can we infer the following:

  • if there is a reduction in the quantity of gold available, then, other things being equal, inflation deflation must result

(D) Incorrect. ‘Inflation’ is a general increase in prices. The quantity purchasable by a given amount of gold would remain constant only if there were no inflation (or deflation). That would happen only if the factors that impact the economy do not change. There is nothing in the passage that even suggests that these factors do not change.

(E) Incorrect. There is no correlation given between ‘demand’ and ‘supply’. Changes in demand could very well occur without compensating changes in supply.

Additional Notes

Inflation and role of demand and supply are quite often used as subject matter in CR questions. While the questions do not need any pre-existing knowledge of economics to answer, some familiarity does make it easier to understand the passage. At the same time, as always, it is imperative that we do not add our own pre-existing knowledge to what has been stated. Here’s a post that elaborates a bit on demand and supply.

SC Notes:

Use of ‘being’ in option C. Being is a part of the English language, and can very well be used in a grammatically correct sentence.

This solution was created by Chiranjeev Singh and Anish Passi.