Inflation

Inflation, in simple terms, is a sustained increase in the general price level of goods and
services in an economy over a period of time. This means that your money buys less than it
used to.

Here are some key ways to understand it:

●​ Expanding Money Income vs. Output: Pigou suggested that inflation happens
when people's money income grows faster than the actual goods and services
(output) being produced. If there's more money chasing the same amount of goods,
prices will go up.
●​ Too Much Currency: Hawtrey linked inflation to "the issue of too much currency." If
the government prints too much money, the value of that money goes down, and you
need more of it to buy things.
●​ Abnormal Increase in Purchasing Power (Quantity): Gregory described it as a
state where there's an "abnormal increase in the quantity of purchasing power." This
ties back to the idea of too much money in circulation.
●​ Keynes' View - The Inflationary Gap: Keynes had a more nuanced view.
○​ He didn't entirely agree that just the volume of money causes price rises. For
him, inflation becomes a significant issue when demand exceeds supply,
especially when the economy is already at or near full employment
(meaning almost everyone who wants a job has one, and factories are
running at full capacity).
○​ Inflationary Gap: This is a core concept from Keynes. It's the situation where
anticipated expenditures (what people, businesses, and the government
want to spend) are greater than the available output (what the economy
can produce) at existing prices.
■​ Imagine a scenario where income is measured on the horizontal axis
and consumption/investment on the vertical axis. There's a 45-degree
line representing a zero-saving level (where all income is spent).
■​ The 'C' curve shows consumption at different income levels. The 'C+I'
curve shows consumption plus investment. The point where 'C+I'
intersects the 45-degree line (say, point E0​) is the initial equilibrium,
representing full employment income (say, Y0).
■​ Now, if businesses or the government decide to invest or spend more,
the 'C+I' curve shifts upwards to 'C+I+I' (or C+I′). This new curve
intersects the 45-degree line at a higher point (say, E1​), indicating a
higher demand for income (say, OY1).
■​ However, if the economy was already at full employment (Y0), it
cannot immediately produce more output. The difference between the
new, higher demand (E1​G1​in one of the diagrams) and the actual full
employment output represents the inflationary gap. This excess
 demand pulls prices up because there's more money trying to buy a
limited amount of goods.

■​
○​ Semi-inflation or Bottleneck Inflation: Keynes also acknowledged that
prices might rise even before full employment if there are specific shortages
or "bottlenecks" in the production of certain goods.

Salient Features of Inflation (Key Characteristics):

1.​ Always Accompanied by Rising Prices: This is the most obvious feature – a
continuous, uninterrupted increase in prices.
2.​ Economic Phenomenon: It arises from within the economic system due to the
interplay of economic forces (like demand, supply, and money).
3.​ Dynamic Process: Inflation isn't a one-time event; it unfolds over a period.
 4.​ Not a Cyclical Movement: Don't confuse it with temporary price fluctuations that go
up and down as part of a normal business cycle. Inflation is a sustained upward
trend.
5.​ Monetary Phenomenon: Often caused by an excessive supply of money.
6.​ Pure Inflation Starts After Full-Employment: According to Keynes, the most
"pure" form of inflation (where more money just leads to higher prices without
increasing output) occurs when the economy has already reached full employment.

4.3 Types of Inflation

Inflation can be classified in different ways:

A. Classification Based on the Degree of Price Rise (Speed of Inflation):

1.​ Creeping Inflation:
○​ Slow and mild price rise, typically a few percent per year.
○​ Some economists see it as not necessarily bad, and it might even help an
economy avoid stagnation (a period of no growth). However, others worry it
could worsen.
○​ Example: Prices of groceries going up by 2-3% annually.
2.​ Walking Inflation:
○​ Prices rise more noticeably than in creeping inflation.
○​ It's a warning sign that inflation could get out of control and turn into running
or jumping inflation.
○​ Example: Prices consistently rising by 5-10% per year.
3.​ Running Inflation:
○​ A more serious stage where prices rise rapidly.
4.​ Jumping or Galloping or Hyperinflation:
○​ Prices rise extremely fast, every moment, with no apparent limit.
○​ This indicates a severe abnormality in the monetary system.
○​ Under hyperinflation, assets with fixed income (like salaries, savings,
pensions, bonds) lose their real value very quickly because the money they
provide buys less and less.
○​ Example: Post-World War I Germany, or more recently, Zimbabwe, where
prices might double in a few days or even hours.

B. Classification Based on the Processes (How it's Caused):

1.​ Deficit-Induced Inflation:
○​ Caused by deficit financing, where the government spends more than its
revenue and covers the gap by printing more money or borrowing heavily.
This increases the money supply, leading to inflation.
2.​ Wage-Induced Inflation:
 ○​ Results from an increase in money wages that is not matched by an
increase in productivity. If workers get paid more but don't produce more,
businesses might raise prices to cover the higher labor costs.
3.​ Profit-Induced Inflation:
○​ Occurs when manufacturers increase their profit margins, leading to higher
prices for consumers.
●​ Peace-time Inflation: Rise in prices during periods of peace due to increased
government spending.
●​ Sporadic Inflation: Sectional inflation, meaning it affects only certain sectors or
goods, often due to temporary shortages (e.g., a crop failure leading to higher food
prices). It can also occur from a successful monopoly restricting output or a
disruption in the supply of goods.

C. Open vs. Suppressed Inflation:

●​ Open Inflation: Prices rise freely without any government attempts to control them.
●​ Suppressed Inflation: The government tries to prevent price increases through
measures like price controls and rationing of essential goods. However, the
underlying inflationary pressures still exist.

Major Explanations of the Sources of Inflation

4.3.1 Demand-Pull Inflation
●​ This occurs when aggregate demand (total spending in the economy) exceeds
the aggregate supply (total output the economy can produce) at the full
employment level.
●​ It's often described as "too much money chasing too few goods."
●​ Causes:
○​ Increase in the quantity of money: If there's more money available, people
and businesses tend to spend more.
○​ Lower interest rates: Cheaper borrowing encourages spending and
investment.
○​ Increased consumption expenditure: If consumers suddenly decide to buy
more.
○​ Increased investment expenditure: If businesses invest more in new
projects.
○​ Increased government spending: If the government spends more without a
corresponding increase in taxes.
○​ Increase in marginal efficiency of capital or a rise in the propensity to
consume: If businesses expect higher profits from investments or if people
are more inclined to spend rather than save.
●​ Diagrammatic Explanation (Demand-Pull Inflation):
 ○​ Imagine a graph with the Price Level on the vertical axis (Y-axis) and
Output on the horizontal axis (X-axis).
○​ The Aggregate Supply (S) curve is initially shown as being somewhat flat or
gently sloping upwards, and then becoming vertical at the full employment
output level (QF​). This vertical part means that once full employment is
reached, the economy cannot produce any more output in the short run,
regardless of how high prices go.
○​ Several Aggregate Demand (D) curves (D1​, D2​, D3​, D4​, D5​) are shown.
○​ As demand increases (the D curve shifts to the right, from D1​to D2​, then to
D3​, etc.), initially, both output and price level might increase if there's spare
capacity.
○​ However, once output reaches the full employment level (QF​), any further
increase in demand (e.g., from D3​to D4​to D5​) only leads to higher price
levels (P3​to P4​to P5​) without any increase in output. This is true inflation or
bottleneck inflation. The economy is at its capacity, so more demand just
"pulls" prices up.

○​

4.3.2 Cost-Push Inflation

●​ This type of inflation arises from factors that increase the cost of production,
causing the aggregate supply to decrease (shift upwards/leftwards).
●​ It's also known as "new inflation theory" and gained attention after the 1950s.
●​ It occurs even if demand isn't excessive. The increased costs are "pushed" onto
consumers in the form of higher prices.
●​ Main Causes (Factors that shift the aggregate supply curve upward):
○​ Increase in wage rates: If wages go up (e.g., due to strong labor unions)
without a corresponding increase in worker productivity, production costs rise.
This is called wage-push inflation.
○​ Increase in profit margins: If businesses, especially those in monopolistic or
oligopolistic industries (where there's little competition), decide to increase
their profits by raising prices. This is called profit-push inflation.
○​ Increase in material costs: Higher prices for key raw materials or energy
(like oil) increase production costs. This is called material-cost push
inflation.
●​ Diagrammatic Explanation (Cost-Push Inflation):
○​ Again, use a graph with the Price Level on the vertical axis and Output on
the horizontal axis.
○​ You have several downward-sloping Aggregate Demand (D) curves (D1​,
D2​, D3​).
○​ You also have several upward-sloping Aggregate Supply (S) curves (S1​,
S2​, S3​).
○​ Let's say the initial equilibrium is at point A, where demand curve D1​
intersects supply curve S1​. The output is OQ1​and the price level is P1​.
○​ If production costs rise (e.g., due to higher wages or oil prices), the aggregate
supply curve shifts upwards/leftwards from S1​to S2​.
○​ This new supply curve S2​intersects the demand curve D1​(assuming
demand hasn't changed initially) at a new point (say, B or C in the diagram).
At this new equilibrium, the output has decreased (e.g., to OQ2​) and the
price level has increased (e.g., to P2​).
○​ If costs continue to rise, the supply curve shifts further to S3​, leading to even
lower output (OQ3​) and a higher price level (P3​).
○​ So, cost-push inflation leads to a situation often called stagflation: rising
prices (inflation) combined with falling output and rising unemployment
(stagnation).
 ○​

4.4 Effects of Inflation

Inflation is not always bad, especially if it's mild and anticipated. However, high and
uncontrolled inflation can be very damaging.

General Negative Impacts:

●​ "Robbing Peter to pay Paul": Inflation can unfairly redistribute wealth.
●​ Disrupts the economy: Makes planning difficult for businesses and individuals.
●​ Highly demoralising: Especially for those on fixed incomes.
●​ Reduces purchasing power: Your money buys less.
●​ Leads to social and economic upheaval.

Specific Effects on Different Aspects and Groups:

1.​ Effects on Production:
 ○​ Initially (mild inflation with unemployment): Can be a stimulus. If
businesses expect prices to rise, they might invest more and hire more
people, leading to increased output. This is Keynes' view – a moderate
inflation might be an "incentive."
○​ Later (high inflation or hyperinflation): Becomes very harmful.
■​ Distorts price signals: Makes it hard for businesses to know the true
value of goods and inputs.
■​ Hinders capital formation: Uncertainty discourages long-term
investment.
■​ Stimulates speculative activities and hoarding: People and
businesses might buy assets or goods not for use, but just because
they expect prices to rise further. This diverts resources from
productive uses.
■​ Misallocation of productive resources: Resources flow to
speculative ventures rather than efficient production.
2.​ Effects on Distribution (Redistribution of Income and Wealth):
○​ Inflation does not affect all prices and incomes equally.
○​ Entrepreneurs, speculators, hoarders, black marketers gain: They can
often raise their prices or benefit from rising asset values faster than their
costs increase.
○​ Wage earners and fixed-income groups lose: Their income doesn't rise as
fast as prices, so their real income (purchasing power) falls.
○​ "Inflation is a kind of hidden tax": It particularly hurts the poorer sections of
society as they have less ability to protect their savings or increase their
income. The poor become poorer.
3.​ Debtors and Creditors:
○​ Debtors (borrowers) gain: They borrow money when it has a certain
purchasing power, but repay it later when money is worth less due to inflation.
So, the real value of their repayment is lower.
○​ Creditors (lenders) lose: They lend money but get back less in real terms
because the purchasing power of the repaid money has decreased.
4.​ Entrepreneurs:
○​ Generally gain: Prices of goods they sell often rise faster than their costs of
production (like wages, rent, interest, which may be fixed for a period).
○​ Windfall profits: They benefit from the lag between rising prices and rising
costs.
○​ Inventory appreciation: The value of their stocks (inventories) goes up due
to inflation.
○​ Often borrowers: Entrepreneurs tend to be borrowers for their businesses,
so they also benefit from the debtor-gains effect.
5.​ Investors:
○​ The effect depends on the type of investment.
 ○​ Equity/Shares (Stocks): Investors in stocks may gain if company profits rise
with inflation, leading to higher dividends and share prices.
○​ Bonds and Debentures (Fixed Income): Investors in these fixed-interest
securities lose. The interest payments they receive are fixed, but the real
value of that interest and the principal amount (when repaid) decreases due
to inflation. Bond and debenture holders gain during deflation (falling prices).
6.​ Farmers:
○​ Often gain during inflation: The prices of farm products usually go up faster
than their costs (like interest, taxes, land revenue, which might not rise as
quickly).
○​ Benefit as debtors: Many farmers have loans, and inflation reduces the real
burden of that debt.
○​ Post-war periods: Historically, inflationary periods (like after wars) have
often helped farmers pay off debts.
7.​ Wage Earners:
○​ Generally suffer: Wages often don't rise as quickly or as much as the cost of
living.
○​ Lag in wage adjustment: There's a delay between price increases and wage
increases.
○​ Organized vs. Unorganized workers:
■​ Organized workers (e.g., in unions): May be able to negotiate wage
increases to keep pace with inflation, so they might not suffer as
much.
■​ Unorganized workers (e.g., agricultural laborers): Often suffer
more as they have less bargaining power to get their wages increased.
8.​ Middle Class and Salaried Persons:
○​ Hardest hit: This group includes people on fixed salaries, pensions, or those
who live off past savings and fixed interest income.
○​ Their incomes remain relatively fixed while prices rise, leading to a sharp
decline in their standard of living.
○​ They often have savings built through hard work, and inflation erodes the
value of these savings. This can lead to a "desperate situation in a time of
serious inflation."
9.​ Government:
○​ Affected by price fluctuations: In a mixed economy, the public sector
(government) also has to spend more on goods and services (including raw
materials for projects) when prices rise.
○​ Revenue and expenditure: Government revenues (like taxes) might
increase, but expenditures also rise.
10.​Public Morale:
 ○​ Arbitrary redistribution of wealth: Inflation unfairly favors some
(businessmen, debtors) and hurts others (consumers, creditors, small
investors, fixed-income earners).
○​ Lowers public morale: This perceived unfairness can lead to social unrest.
○​ Ethical standards decline: Especially during hyperinflation, as people might
engage in hoarding or other desperate measures.

4.5 Control of Inflation

If inflation is not controlled, it can turn into hyperinflation, which is very dangerous.
Therefore, measures are needed to manage it.

Key Approaches to Controlling Inflation:

1.​ Monetary Measures (Actions by the Central Bank, e.g., Reserve Bank of India):
○​ Aim: To reduce the supply of money and credit in the economy, or to make
borrowing more expensive.
○​ Tools:
■​ Bank Rate Policy: Increasing the rate at which the central bank lends
to commercial banks. This makes borrowing more expensive for
commercial banks, who in turn charge higher interest rates to their
customers, thus reducing borrowing and spending.
■​ Open Market Operations: The central bank sells government
securities in the open market. People and banks buy these securities,
so money flows from them to the central bank, reducing the money
supply in circulation.
■​ Varying Reserve Requirements: Increasing the Cash Reserve Ratio
(CRR) or Statutory Liquidity Ratio (SLR). This means commercial
banks have to keep a larger portion of their deposits with the central
bank or as liquid assets, reducing their capacity to lend.
○​ Limitations in Developing Countries: These measures might be less
effective in countries with underdeveloped money and capital markets.
○​ Selective Credit Control: Instead of general controls, the central bank can
restrict lending for specific purposes (e.g., to stop hoarding of certain
commodities) or in certain regions. This has been used in India.
2.​ Fiscal Measures (Actions by the Government):
○​ Aim: To reduce aggregate demand by managing government spending and
taxation.
○​ Tools:
■​ Reducing Government Expenditure: Cutting down on unnecessary
government spending.
 ■​ Increasing Taxes: Higher taxes (especially on income and profits)
reduce the disposable income of people and businesses, thereby
reducing their spending power.
■​ Increasing Public Borrowing (Savings): Encouraging people to
save more, perhaps through government bonds or savings schemes.
This takes money out of circulation.
■​ A surplus budget (where revenue exceeds expenditure) is
anti-inflationary.
■​ Managing Public Debt: The government might try to pay back past
debts to reduce liquidity or manage new borrowing in a way that
doesn't fuel inflation.
■​ Compulsory Saving: In extreme cases (like wartime), the
government might force people to save a portion of their income.
3.​ Direct Controls and Other Measures:
○​ Aim: To directly influence prices and the availability of goods.
○​ Tools:
■​ Price Control and Rationing: Setting maximum prices for essential
goods and distributing them in limited quantities to ensure fair access.
However, these can be difficult to administer and may lead to black
markets if not implemented well. They are often used for essential
goods when there are severe shortages.
■​ Control of Wages: Trying to limit wage increases to prevent
wage-push inflation. This is often unpopular and difficult to enforce.
■​ Increasing Production: The most fundamental long-term solution.
Taking steps to expand the supply of goods and services to meet
demand. This includes:
■​ Providing incentives for production.
■​ Ensuring availability of raw materials.
■​ Investing in projects that yield output quickly.
■​ Encouraging foreign capital investment if it helps increase
production.
○​ Control of Hoarding and Speculation: Taking action against those who
hoard goods to create artificial shortages and profit from rising prices.

Important Considerations for Control:

●​ Inflation feeds on itself: Once it starts, it can become difficult to control because
people expect prices to keep rising, leading to further spending and wage demands.
●​ Hyperinflation is extremely difficult to stop: It often requires drastic measures
and can severely damage an economy.
●​ No single measure is enough: A combination of monetary, fiscal, and direct
controls is usually needed.
 ●​ Dependence on a single measure may not help much in curbing inflation.

This covers the main points from the images you provided. Remember that these concepts
are interconnected, and understanding them will help you analyze economic situations
effectively.

MONETARY POLICY

Understanding the Central Bank and Its Role

A central bank, like the Reserve Bank of India (RBI), is like the "big boss" of a
country’s money system. It controls how much money is available in the economy
and manages the credit (loans) that banks give out. This is important because
money and credit affect prices, jobs, and overall economic growth.

Why Does the Central Bank Care About Money and Credit?
●​ Too much money can cause prices to rise (inflation), making things expensive.
●​ Too little money can slow down the economy, causing job losses.
●​ The central bank ensures a balance by controlling the money supply and credit.

The central bank also looks after the overall economy by planning carefully,
especially during emergencies like inflation or recessions. It works with commercial
banks (like SBI or HDFC in India) to achieve its goals.

7.5.1 Quantitative Methods: Tools to Control Money and

Credit
The central bank uses quantitative methods to control the total amount of money
and credit in the economy. These methods affect everyone—banks, businesses,
and even you! There are four main tools under this category:

1. Bank Rate Policy

●​ What is it? The bank rate is the interest rate at which the central bank lends
money to commercial banks. It’s like the "cost of borrowing" for banks.
●​ How does it work?
 ○​ If the central bank increases the bank rate, borrowing becomes expensive
for commercial banks. So, they lend less to people and businesses,
reducing the money supply.
○​ If the bank rate decreases, borrowing becomes cheaper, so banks lend
more, increasing the money supply.
●​ Example: If the bank rate is 5% and the RBI raises it to 7%, banks might increase
loan interest rates for customers to 10%. People borrow less, so there’s less
money in the economy.
●​ When does it work best?
○​ Works well when commercial banks rely on the central bank for funds.
○​ Not effective if banks have lots of extra cash or if businesses don’t want to
borrow due to a bad economy.
●​ During inflation: Higher bank rates help reduce money in the economy.
●​ During recession: Lower bank rates encourage borrowing and spending.

2. Open Market Operations (OMO)

●​ What is it? The central bank buys or sells government securities (like bonds) in
the open market to control money.
●​ How does it work?
○​ Selling securities: When the central bank sells bonds, people and banks
buy them, giving their money to the central bank. This reduces money in
the economy.
○​ Buying securities: When the central bank buys bonds, it pays money to
people and banks, increasing money in the economy.
●​ Example: During inflation, if prices are rising, the RBI might sell bonds worth Rs.
100 crore. Banks and people pay Rs. 100 crore to buy them, so that money
leaves the economy, reducing inflation.
●​ When does it work best?
○​ Works well in countries with a big securities market (like the USA).
○​ Not effective if the market for securities is small or if banks have extra
cash.
●​ Diagram Reference: The conceptual diagram (Figure 1) shows how selling
securities reduces money (M1 to M2) and buying securities increases money (M1
to M3).

3. Variable Legal Cash Reserve Ratio (CRR)

●​ What is it? CRR is the percentage of a bank’s total deposits that it must keep with
the central bank as cash.
●​ How does it work?
○​ If the CRR increases, banks have to keep more money with the central
bank, leaving them with less to lend. This reduces credit in the economy.
 ○​ If the CRR decreases, banks can lend more, increasing credit.
●​ Formula: Credit creation = Total Deposits × (1/CRR)
○​ Example: If a bank has Rs. 100 crore in deposits and the CRR is 10%, it
must keep Rs. 10 crore with the RBI. The rest (Rs. 90 crore) can be lent. If
CRR rises to 20%, the bank keeps Rs. 20 crore, leaving only Rs. 80 crore
to lend.
●​ When does it work best?
○​ Very effective because it directly controls how much banks can lend.
○​ Not used often because small changes in CRR can have a big impact on
the economy.
●​ Limitation: Banks with extra cash may not be affected by CRR changes.

4. Secondary Reserve Requirements

●​ What is it? This is an additional reserve that banks must hold, often in the form of
government securities (not just cash like CRR).
●​ How does it work?
○​ It limits how much banks can lend by forcing them to hold more assets
(like bonds).
○​ Helps the central bank control credit and also ensures banks have safe
investments.
●​ Example: If the RBI says banks must hold 5% of their deposits in government
bonds, a bank with Rs. 100 crore in deposits must hold Rs. 5 crore in bonds,
reducing the money it can lend.
●​ When does it work best?
○​ Useful for long-term credit control.
○​ Not effective if banks already hold a lot of securities.

7.5.2 Qualitative Methods: Selective Credit Controls

While quantitative methods control the total money, qualitative methods target
specific sectors or industries. These are used when the central bank wants to
control credit in certain areas without affecting the whole economy.

1. Variation in Margin Requirements

●​ What is it? The central bank sets rules on how much loan a bank can give
against certain securities (like stocks or property).
●​ How does it work?
○​ If the margin is high, banks lend less against a security. If the margin is
low, banks lend more.
 ●​ Example: If the margin for a stock is 20%, you can get a loan of Rs. 80 for a
stock worth Rs. 100. If the RBI raises the margin to 50%, you can only borrow
Rs. 50.
●​ When does it work?
○​ Useful to control speculative activities (like stock market bubbles).
○​ Not effective for non-banking institutions that don’t follow these rules.

2. Rationing of Credit
●​ What is it? The central bank sets limits on how much credit banks can give to
certain sectors.
●​ How does it work?
○​ The central bank may tell banks, “Don’t lend more than Rs. 50 crore to the
real estate sector.”
●​ Example: During World War II, the USA used credit rationing to limit loans for
non-essential goods, ensuring money went to war efforts.
●​ When does it work?
○​ Useful in emergencies or to prioritize key sectors.
○​ Not effective if banks find ways to bypass the rules.

3. Moral Suasion
●​ What is it? The central bank persuades commercial banks to follow its guidelines
without making it a strict rule.
●​ How does it work?
○​ The RBI might say, “Please reduce loans to speculative sectors like
stocks.” Banks follow to maintain a good relationship with the RBI.
●​ Example: If the RBI asks banks to lend more to farmers, banks might do so
voluntarily.
●​ When does it work?
○​ Works when banks trust the central bank.
○​ Not effective if banks ignore the advice.

4. Direct Action
●​ What is it? The central bank takes strict action against banks that don’t follow its
rules.
●​ How does it work?
○​ The central bank might stop lending to a bank or fine it.
●​ Example: If a bank gives too many loans to the stock market against RBI rules,
the RBI might stop giving it funds.
●​ When does it work?
○​ Effective as a last resort.
○​ Not used often as it can harm the banking system.
Limitations of Selective Credit Controls
●​ Non-Banking Institutions: These controls don’t apply to non-banking financial
companies.
●​ Difficult to Enforce: Some banks may find ways to bypass the rules.
●​ Limited Scope: These controls only target specific sectors, not the whole
economy.

Central Bank’s Role in National Economic Goals

●​ The central bank must work with commercial banks to achieve big economic
goals like price stability, growth, and financial stability.
●​ Success depends on how well commercial banks cooperate with the central
bank.

7.7 Key Definitions

●​ Monetary Policy: The central bank’s plan to control money in the economy to
achieve goals like price stability and growth.
●​ Securities: Financial papers (like bonds) traded in markets.

21.4 Goals of Monetary Policy

The central bank has three main goals for its monetary policy:

1. Price Stability
●​ What is it? Keeping prices steady so things don’t get too expensive (inflation) or
too cheap (deflation).
●​ Why is it important? Stable prices help people plan their spending and saving.
●​ Example: In 2016, the RBI adopted a flexible inflation targeting framework to
keep inflation around 4%, ensuring price stability while supporting growth.

2. Economic Growth
●​ What is it? Helping the economy grow so there are more jobs and prosperity.
●​ How does the central bank help? By keeping prices stable and ensuring banks
lend enough to businesses.
●​ Example: The RBI lowers interest rates to encourage businesses to borrow and
invest, leading to more factories and jobs.
3. Financial Stability
●​ What is it? Ensuring the financial system (banks, markets) works smoothly
without crises.
●​ How does the central bank help? By making rules for banks and managing risks
like loan defaults.
●​ Example: The RBI might ask banks to hold more cash reserves to prevent a
banking crisis.

Key Point: These goals can conflict. For example, lowering interest rates for growth
might increase inflation, harming price stability. The central bank must balance
these goals.

21.2 Expansionary vs. Contractionary Monetary Policy

Monetary policy can be of two types based on the economy’s needs:

1. Expansionary Monetary Policy

●​ What is it? Increases money and credit to boost the economy.
●​ When is it used? During a recession (when the economy is slow).
●​ How does it work?
○​ The central bank lowers interest rates, buys securities, or reduces CRR.
○​ This encourages borrowing and spending, increasing money in the
economy.
●​ Example: If people aren’t spending, the RBI might lower the bank rate from 6% to
4%. Banks lower loan rates, so people borrow more to buy homes or cars.
●​ Diagram Reference: The conceptual diagram (Figure 2a) shows how
expansionary policy increases money (M1 to M2), investment (I1 to I2),
consumption (C1 to C2), and GDP (GDP1 to GDP2).

2. Contractionary Monetary Policy

●​ What is it? Reduces money and credit to slow down the economy.
●​ When is it used? During inflation (when prices are rising too fast).
●​ How does it work?
○​ The central bank raises interest rates, sells securities, or increases CRR.
○​ This reduces borrowing and spending, decreasing money in the economy.
●​ Example: If inflation is high, the RBI might sell bonds worth Rs. 50 crore, taking
money out of the economy and reducing spending.
 ●​ Diagram Reference: The conceptual diagram (Figure 2b) shows how
contractionary policy reduces money (M1 to M2), investment (I1 to I2),
consumption (C1 to C2), and prices (P1 to P2).

Rules-Based vs. Discretionary Policy:

●​ Rules-Based: Follow a fixed rule, like keeping inflation at 4%.

●​ Discretionary: The central bank decides based on the situation, but this can be
risky for long-term stability.

21.5 Monetary Policy Framework

The monetary policy framework is the central bank’s plan to achieve its goals. It
includes:

●​ Instruments: Tools like bank rate, OMO, CRR.

●​ Operating Targets: Things the central bank directly controls, like interest rates or
money supply.
●​ Intermediate Targets: Short-term goals, like controlling bank credit.
●​ Goals: Final aims like price stability, growth, and financial stability.
●​ Diagram Reference: The conceptual diagram (Figure 2) shows how instruments
lead to operating targets, then intermediate targets, and finally the goals.

Summary for Easy Learning

●​ Central Bank’s Role: Controls money and credit to balance the economy.
●​ Quantitative Methods: Control total money using bank rate, OMO, CRR, and
secondary reserves.
●​ Qualitative Methods: Target specific sectors using margin requirements, credit
rationing, moral suasion, and direct action.
●​ Goals: Price stability, economic growth, financial stability.
●​ Expansionary Policy: Increases money to boost the economy.
●​ Contractionary Policy: Reduces money to control inflation.

This covers everything in a simple, to-the-point way for your exam! Let me know if
you need more examples.
MPC = ​
What is the MPC?​

○​ A six-member committee that decides India’s key policy interest rate

(repo rate) and sets the inflation target.​

○​ Created to make monetary policy decisions more transparent and

rules-based.​
●​ Legal basis and framework​

○​ Formed under Section 45ZB of the RBI Act, 1934, by an amendment in

2016.​

○​ Established as part of the Monetary Policy Framework Agreement

between RBI and Government of India.​

●​ Main objective​

○​ Keep retail inflation at 4 %, with an allowable band of ± 2 % (i.e. 2–6

%).​

○​ If RBI misses the target for three consecutive quarters, it must explain
to the government.​

●​ Composition​

○​ 3 RBI representatives:​

■​ Governor (ex-officio Chair)​

■​ Deputy Governor in charge of monetary policy​

■​ One Executive Director of RBI​

○​ 3 external members:​

■​ Appointed by a Search-cum-Selection Committee​

■​ Experts in economics, banking, finance or monetary policy​

■​ Cannot be serving public servants or politicians​

●​ Decision process​

○​ Meets at least four times a year (usually every two months).​

 ○​ Decisions by simple majority; the Governor has a casting vote in
case of a tie.​

●​ First meeting & impact​

○​ Held on 4 October 2016 under Governor Urjit Patel.​

○​ Since inception, repo rate has been cut by about 250 basis points to 4
%.​

●​ Policy stances​

○​ Hawkish: Focus on fighting inflation (raising rates).​

○​ Dovish: Focus on growth (lowering rates).​

Example:

●​ When retail inflation rises above 6 %, the MPC may raise the repo rate to cool
demand.​

●​ If growth slows and inflation is below 2 %, it may lower the repo rate to
encourage lending.​

Each member serves a four-year term and is not eligible for reappointment

●​ After every meeting, the RBI publishes an MPC resolution, explaining the
rate decision and outlook.​

●​ RBI also releases an Minutes of the Meeting with individual members’ votes
and views.​

●​ Data-driven decisions​

○​ MPC reviews wide-ranging data: inflation drivers (food, fuel), GDP

growth, global cues, currency movements.​
 ○​ Uses models and forecasts to balance price stability and growth.​

●​ Forward guidance​

○​ Through its “stance” and press statements, MPC gives markets hints
about future rate moves, helping businesses and investors plan.​

●​ Coordination with fiscal policy​

○​ Works alongside the government’s budget & spending plans to support

overall economic stability.​

●​ Role in financial stability​

○​ While focused on inflation, MPC decisions also affect credit growth,

bank lending rates, and financial market stability.​

●​ External member expertise​

○​ Experts often include academics or former central bankers who bring

global best practices and independent judgment.​

●​ Pre-MPC era​

○​ Before 2016, rate decisions were made solely by RBI Governor and
Board, with less formalized meeting schedule or published minutes.​

●​ Global context​

○​ Many major central banks (e.g., US Fed, ECB) also use committees for
policy decisions, promoting collective wisdom and reducing
single-person bias.​

●​ Emergency powers​

○​ In crisis times (e.g., pandemic), MPC can meet off-schedule and take
special measures like long-term repo operations to inject liquidity.​
BANKING STRUCTURE OF INDIA​
​

Banking in India: Key Exam Notes

1. What Is a Bank?

●​ Definition (Banking Regulation Act, 1949):​

○​ A bank accepts deposits (repayable on demand or otherwise) and

makes loans or investments.​

○​ Deposits must be withdrawable by cheque, draft or order.​

●​ Bank vs. Non-Bank:​

○​ Post offices accept chequable deposits but do not lend, so they are
not banks.​

○​ Institutions like LIC or IFCI accept money but are classified as

Non-Banking Financial Companies (NBFCs).​

2. Banking Structure in India

1.​ Central Bank​

○​ Reserve Bank of India (RBI) is the apex bank.​

○​ Functions: issue currency, banker to government & banks, credit

control, clearing house, foreign-exchange custodian.​

2.​ Development Banking​

○​ Provide medium- & long-term finance to industry & infrastructure.​

 ○​ Key institutions: IFCI (1948), IDBI (1964), SIDBI, SBI-subsidiaries,
NABARD, EXIM Bank.​

3.​ Commercial Banking​

○​ Short-term finance to business, trade, agriculture, industry, housing,

export–import.​

○​ Two types:​

■​ Public sector (e.g. SBI, PNB)​

■​ Private & foreign banks (e.g. ICICI, HSBC)​

4.​ Co-operative Banking​

○​ Rural & urban co-op banks governed by co-operative societies law.​

○​ Serve farmers, small borrowers, credit societies at low rates.​

5.​ Rural Banking​

○​ Regional Rural Banks (RRBs): Serve weaker rural sections.​

○​ District Co-op banks & Primary Agricultural Credit Societies for

local credit.​

6.​ Export–Import Banking​

○​ EXIM Bank—provides finance and guarantees for international trade.​

7.​ Housing Banking​

○​ National Housing Bank & specialized housing finance companies for

home loans.​
3. Organized vs. Unorganized & Scheduled vs. Non-Scheduled

●​ Organized Banking: Under RBI regulation (commercial, development,

agricultural banks).​

●​ Unorganized Banking: Indigenous bankers (Mahajans, Sahukars) not

supervised directly by RBI.​

●​ Scheduled Banks: Listed in Schedule II of RBI Act, minimum capital

reserves ≥ ₹5 lakhs.​

●​ Non-Scheduled Banks: Not in RBI schedules; capital < ₹5 lakhs; fewer

privileges.​

4. Types of Banks & Their Roles

Bank Type Core Role

Commercial Accept deposits from public; provide short-term loans to

Bank households/firms.

Development Provide medium/long-term loans; promote new industries

Bank and infrastructure.

Co-operative Finance agriculture & small borrowers via co-operative

Bank societies.

Land Mortgage Offer long-term farm loans secured by land mortgages.

Bank

Regional Rural Cater to credit needs of rural weaker sections.

Bank

Investment Bank Mobilise capital via shares/bonds; advise on M&A;

underwrite securities.

Universal Bank Combine commercial- and investment-banking under one

roof.
5. Brief History of Indian Banking

●​ 1786: General Bank of India (first bank)​

●​ 1806–1843: Presidency Banks (Bengal, Bombay, Madras)​

●​ 1865–1913: Allahabad Bank; pioneering Indian-owned banks (PNB, Bank of

India, BoI, BoM, Canara, Indian Bank, Mysore)​

●​ 1935: Reserve Bank of India established under RBI Act, 1934​

6. Development Banks: Purpose & Features

●​ Origin: Post-WWII and Great Depression; focused on economic

reconstruction.​

●​ Role: Supply medium/long-term funds, technical advice, and project

support.​

●​ Major Indian Development Banks:​

○​ IFCI (1948), IDBI (1964), SIDBI, plus State Financial & Industrial
Development Corporations and NABARD.​

Key Features of Development Banks

1.​ Project Appraisal:​

○​ Evaluate economic & social viability (cost–benefit analysis,

employment impact).​

2.​ Stimulate Savings & Investment:​

○​ Match private capital with promising projects; promote investment

habit.​
 3.​ Lender of Last Resort (Long-Term):​

○​ Finance projects not served by commercial banks due to higher risks

or longer pay-back.​

4.​ Capital Market Development:​

○​ Underwrite securities; improve long-term funds availability.​

5.​ Loan Facilitation:​

○​ Act as co-financer, combine multiple funding sources (domestic &

foreign).​

6.​ Technical Assistance:​

○​ Provide expert consultants and ongoing project guidance.​

7. Why Banks Matter for the Economy

●​ Intermediary Role: Channel society’s savings into productive investment.​

●​ Credit Creation: Multiply deposits into loans—fuels growth in industry,

trade, agriculture.​

●​ Stability & Trust: Offer safe deposits, legal-tender currency, and

regulation.​

●​ Financial Inclusion: Through co-ops, RRBs and rural banks, extend banking
to unserved areas.​
INTEREST
3.1 Introduction to Interest Rates
●​ Interest as a Payment for Capital: In economics, interest is the payment made for
using capital. Think of it as the "rent" you pay for borrowing money (which is
financial capital) to buy physical capital (like machinery or equipment).
●​ Return on Capital: For the lender, interest is a return on the capital they provided.
For the borrower (e.g., an entrepreneur who buys equipment), using that capital in
production should generate additional revenue, which is also a form of return on
capital.
●​ Financial Capital vs. Real Capital:
○​ Financial Capital: The funds (money) made available for investment.
○​ Real Capital Assets: The actual physical assets like machinery, buildings,
etc., used in production.
●​ Market Rate of Interest: This is the price paid to those who supply financial capital
for its use. It's usually expressed as a percentage of the amount borrowed.
○​ Example: If you borrow ₹1000 and the market rate of interest is 5% per year,
you'll pay ₹50 as interest for that year.

3.2 Pure Interest and Gross Interest Rates

When you see an interest rate quoted, it's usually the gross interest rate. This includes
more than just the payment for the use of money.
●​ Pure Interest:​

○​ This is the payment made solely for the use of money when there's no risk,
no inconvenience, and no management work involved for the lender. It's a
theoretical concept representing the basic cost of borrowing money in a
perfect scenario.
○​ According to Keynes, interest is a purely monetary phenomenon, determined
by the demand and supply of money. It's the reward for parting with liquidity
(cash) and the payment made by the borrower for using that capital.
●​ Gross Interest:​

○​ This is the total payment a lender receives from a borrower.

○​ It includes not only the pure interest but also payments for other elements.

Elements of Gross Interest:

1.​ Payment for Risk:​
 ○​ Every loan has a risk that the borrower might not repay (due to inability or
unwillingness).
○​ Lenders charge extra to compensate for taking this risk of non-payment.
The higher the perceived risk, the higher this component.
○​ Example: A loan to a startup company will likely have a higher risk premium
than a loan to a well-established, stable company.
2.​ Payment for Inconvenience:​

○​ Lending money can involve inconvenience for the lender.

○​ For example, the lender might need the money themselves before the loan
period ends, or they might have to lend for a longer period than they prefer.
○​ The moneylender may add extra charges for the inconvenience caused.
○​ Example: If a lender ties up their money for 10 years, they might charge
more for the inconvenience of not having access to that money for such a
long duration.
3.​ Payment for Management:​

○​ Lending involves administrative work for the lender. This includes:

■​ Keeping accounts.
■​ Sending notices and reminders.
■​ Other incidental work.
○​ The lender expects compensation for this additional management effort.
4.​ Payment for Exclusive Use of Money (i.e., Pure Interest):​

○​ This is the core component – the actual payment for allowing the borrower to
use the money.

In short: Gross Interest = Pure Interest + Payment for Risk + Payment for Inconvenience +
Payment for Management.

Net interest is just another term for pure interest, which is only a part of the gross interest.

3.3 Bond Price and Yield to Maturity

●​ Inverse Relationship: The price of a bond moves inversely to its yield to
maturity (YTM).
○​ If market interest rates (which influence YTM) go up, existing bond prices go
down.
○​ If market interest rates go down, existing bond prices go up.
○​ Why? Imagine you have an old bond paying 5% interest. If new bonds are
now being issued at 7%, your old 5% bond is less attractive, so its price will
 fall. Conversely, if new bonds are paying 3%, your 5% bond is more
attractive, and its price will rise.
●​ Yield to Maturity (YTM): This is the total return an investor can expect to receive if
1
they hold the bond until it matures (pays back the principal). It depends on market
interest rates, which fluctuate.
●​ Fluctuations in YTM arise from factors internal (specific to the bond issuer) and
external (market-wide) to the firm using the funds.

Factors Affecting Bond Yields (and thus Prices):

1.​ Internal Factors (Default Risk):​

○​ Default Risk: The probability that the bond issuer (borrower) might fail to
make interest payments or repay the principal amount. This is a part of an
investment's total risk that results from changes in the financial solvency
(ability to pay debts) of the issuer.
■​ If a company's financial health weakens (moves towards bankruptcy),
the default risk of its bonds increases, its bonds become less
attractive, and their market price falls (YTM rises).
○​ Default risk can be further divided into:
■​ i) Business Risk: Risk related to the company's operating income or
earnings before interest and taxes. It's influenced by things like
demand variability for its products, price variability, and operating
leverage (fixed operating costs).
■​ ii) Financial Risk: Risk arising from the company's use of debt capital.
A company with a lot of debt has higher financial risk because it has
more fixed interest payments to make.
2.​ External Factors (Market Risk):​

○​ These factors affect all bonds simultaneously.

○​ Changes in the overall supply and demand for credit in the macroeconomic
environment.
○​ These are also called market risk factors. They determine the general level
and structure of market interest rates and, thus, bond prices.
3.​ Purchasing Power Risk (Inflation Risk):​

○​ What it is: An increase in the amount of currency in circulation can lead to a

sharp fall in its value. This means your money buys less – this is inflation.
Purchasing power risk is the danger that inflation will erode the real value
of your investment returns.
○​ Measurement: Economists measure inflation using a Price Index (like the
Consumer Price Index - CPI), prepared by government agencies. It measures
 the cost of a representative basket of consumer goods and services (food,
clothing, housing, healthcare, etc.). The change in this index from one period
to another (e.g., month to month) as a percentage is the inflation rate.
■​ Example: If the price index was 100 last month and 102 this month,
the monthly inflation is ($ (102-100)/100 $) * 100% = 2%.
■​ If inflation is 1% per month, the annual inflation can be calculated
(e.g., (1.01)12−1, which is roughly 12.68%, not simply 12%).
○​ Goods in high demand experience faster inflation than goods not in strong
demand.
4.​ Real Return vs. Nominal Return:​

○​ Nominal Return: The stated interest rate or money return on an investment,

not adjusted for inflation.
■​ Example: A savings deposit earns a nominal interest rate of 5%. If
you deposit ₹100, it grows to ₹105 in a year.
○​ Real Return: The nominal return adjusted for the effects of inflation. It
tells you how much your purchasing power has actually increased.
■​ Example (continuing from above): If inflation during that year was
also 5%, the real value (purchasing power) of your ₹105 at the end of
the year is still equivalent to ₹100 at the beginning of the year. Your
real return is 0%.
■​ Calculation: Real value = Nominal value / (1 + inflation rate).
So, ₹105 / (1 + 0.05) = ₹100.
■​ A wise investor compares the inflation rate with the nominal rate
of return to see if the investment's real rate of return is positive or
negative.
○​ Investors should focus on real returns to:
■​ Avoid being fooled by the "money illusion" (thinking you're richer just
because you have more money, even if it buys less).
■​ Choose investments that will genuinely maximize their purchasing
power.
5.​ Market Risk (Volatility):​

○​ Market ups and downs are often measured using a Security Market Index
(like the S&P 500 or Sensex).
○​ Bull Market: A period when a security index rises fairly consistently,
indicating an upward trend. This ends when the market reaches a peak and
starts a downward trend.
○​ Bear Market: A period when the market declines.
○​ Market risk arises from this variability in market returns, resulting from
alternating bull and bear market forces. The economy typically follows cycles
 of recessions and expansions, causing stock markets to rise "bullishly" and
then fall "bearishly."

Determinants of the Level of Interest Rate:

●​ The nominal or market interest rate is determined by:​

○​ Real Rate of Interest: The rate at which capital grows in a physical sense
(the underlying return on investment in the economy).
○​ Various Possible Risk Premiums: Investors demand these to compensate
for taking risks (like default risk, inflation risk). Lenders require one or more
risk premiums to be paid over and above the real rate of interest to lend their
funds when loss risk exists.
○​ Expected Rate of Inflation: Lenders want to be compensated for the
expected loss in purchasing power due to inflation.
●​ Formula: Nominal (Market) Interest Rate = Real Rate of Interest + Various Risk
Premiums + Expected Rate of Inflation.​

●​ Rising inflation generally pushes up interest rates. However, changes in interest

rates can also occur due to changes in risk premiums or shifts in the supply and
demand for loanable funds, independent of inflation.​

○​ Economic Expansion: Unemployment falls, businesses need more money

for machinery and plants, leading to higher demand for credit and thus higher
interest rates.
○​ Slowdowns/Recessions: Unemployment increases, manufacturing activity
falls, demand for credit decreases, leading to lower interest rates (if other
factors are constant).
6.​ Term Structure of Interest Rates (Yield Curve):​

○​ Bonds with different terms to maturity (the length of time until the bond's
principal is repaid) often have different yields, even if they are otherwise
similar.
○​ Yield Curve: A plot of the relationship between yield and maturity for bonds
of the same credit quality. It graphically shows how yields differ across
different maturities.
■​ A normal yield curve slopes upward, meaning longer-term bonds
have higher yields than shorter-term bonds (to compensate for tying
up money longer and greater uncertainty).
■​ An inverted yield curve slopes downward (short-term yields are
higher than long-term yields), which can sometimes signal an
upcoming recession.
 ■​ A flat yield curve means yields are similar across maturities.
○​ The level of inflationary expectations and the phase of the business cycle are
two of the main factors affecting interest rates and thus the shape of the yield
curve. Risk premiums also play an important role.
7.​ Yield Spread:​

○​ The difference between the promised yields on any two bond issues or
classes of bonds.
○​ Often, it refers to the additional yield (risk premium) that riskier bonds
pay to induce investors to buy them instead of less risky bonds.
○​ Yield spreads (other than those due to maturity differences) are primarily
caused by differences in risk and taxability. They are also influenced by
factors affecting the supply and demand for various types of bonds.
○​ When Risk Premiums are Higher:
■​ During recessions: Fear of job loss and general risk aversion are
higher. Investors demand larger risk premiums to buy risky bonds.
■​ Corporations issuing bonds: Typically experience reduced sales
and profits during recessions, making them seem riskier, so investors
require larger risk premiums.
○​ Daily trading: The daily sale and purchase of bonds by bankers and
investment managers can significantly impact yield spreads.
○​ Government actions: When a country is at war, it usually spends more,
often financing deficits by printing new money. This leads to inflation, which
exerts harmful effects on the economy and can influence yield spreads.

3.5 Factors Affecting Market Interest Rates

Market interest rates don't always move in the same direction or by the same amount. It's
common to look at one representative short-term rate.

Four Dominant Factors Determining Interest Rate Levels:

1.​ State of the Economy
2.​ Monetary Policy
3.​ Inflation Expectations
4.​ Federal Budget (Government Deficit)

Three Other Important Factors:

i. Saving by individuals

ii. International capital flows

iii. Amount of premium required by investors to compensate for interest rate risk

Let's detail some of these:

1.​ Economic Conditions:​

○​ Interest rates tend to move up and down with changes in the volume of
business activities.
○​ Rapid Economic Growth: Businesses need more capital to finance
increased working capital and fixed assets. This increased demand for
borrowed funds, combined with increased consumer borrowing, puts upward
pressure on interest rates.
2.​ Monetary Policy:​

○​ Actions taken by the Central Bank of a country (e.g., the Reserve Bank of
India - RBI) to influence the cost and availability of credit.
○​ Policy regarding the growth of the money supply also falls under this.
○​ Instruments of Monetary Policy:
■​ i) Bank Rate (or Discount Rate):
■​ The rate at which the central bank lends money to
commercial banks (often by rediscounting their bills of
exchange).
■​ Raising the bank rate: Makes borrowing more expensive for
commercial banks. They, in turn, raise their lending rates.
Higher interest rates discourage businesses from borrowing,
reducing aggregate demand and potentially curbing inflation or
rising prices.
■​ Lowering the bank rate: Encourages commercial banks to
borrow more from the central bank. This increases their
capacity to lend to businesses, potentially boosting investment
and economic activity.
■​ ii) Open Market Operations (OMO):
■​ The purchase and sale of government securities by the
central bank.
■​ Selling securities: The central bank sells securities, and
buyers (banks, public) pay for them. This sucks money out of
the banking system, contracting credit. Used during inflation to
reduce money supply.
■​ Buying securities: The central bank buys securities, injecting
money into the system. This increases the cash reserves of
commercial banks, enabling them to lend more. Used during a
depression to expand credit and stimulate demand.
■​ iii) Cash Reserve Ratio (CRR):
 ■​ The fraction of a bank's total deposits that they are legally
required to keep as a deposit with the central bank.
■​ Increasing CRR: Banks have less money available to lend,
thus contracting credit.
■​ Decreasing CRR: Banks have more money to lend, increasing
the availability of credit.
■​ iv) Supply of Money:
■​ A primary objective of monetary policy is stable economic
growth with low inflation.
■​ If legal reserves are allowed to grow faster, the volume of
lending and the money supply grow faster.
■​ If the money supply grows faster than the economy's needs for
a considerable time, nominal interest rates will rise due to an
increase in the rate of inflation (as more money chases the
same amount of goods, leading to price increases and thus an
inflation premium being added to interest rates).
3.​ Expected Rate of Inflation:​

○​ Purchasing power risk arises from unanticipated inflation.

○​ It's the risk that the actual rate of inflation will be higher than what the investor
expected when making the investment, causing the real rate of return to be
lower than expected.
○​ Because of these risks (market risk, interest rate risk, inflation risk), other
required returns include an inflation premium built into the nominal interest
rate. Lenders want to be compensated for expected inflation.
4.​ Government Deficit:​

○​ An increase in government borrowing (e.g., by issuing more government

securities) to finance its deficit, unless offset by a decrease in other
borrowing, leads to an increase in the total demand for loanable funds.
○​ There's a positive correlation between the amount of government deficit
and the money supply. If the government borrows heavily, it can push up
interest rates.

3.6 Effect of Changes in Interest Rates

●​ Basic Argument of Interest Rate Policy (as a Contractional Measure):
1.​ Rising interest rates:
■​ Raise the cost of credit (borrowing becomes more expensive).
■​ Discourage investment (as project financing costs go up).
■​ Discourage consumption financed with loans (e.g., buying cars or
houses on credit).
 2.​ Lowering interest rates:
■​ Cheapens the cost of credit.
■​ Encourages investment expenditure.
■​ Encourages consumption expenditure.
●​ A change in the short-term bank rate (the rate at which the central bank lends to
commercial banks) directly influences the rates charged by commercial banks and
other short-term interest rates (like those for money at call, bill discounted, hire
purchase finance).
●​ Limitations on Investment:
1.​ The short-term interest rate is relevant to investment in inventories (stocks of
goods).
2.​ A change in this rate is not likely to influence fixed investment significantly, as
interest cost is usually only a small part of the total cost of long-term projects.
It may also not affect consumption significantly (e.g., if it's for provident fund
contributions or insurance premiums which are more contractual).
●​ Other Effects of an Increase in Short-Term Interest Rates (e.g., to control
inflation):
1.​ Balance of Payments Difficulties: May add to the balance of payment
difficulties if it leads to increased short-term borrowing from abroad (as
interest payments to foreigners increase).
2.​ Cost of Servicing National Debt: It will increase the cost to the government
of paying interest on its own debt.
3.​ Pull up Long-Term Rates: If people expect short-term rates to remain high,
they might also expect long-term rates to rise. This could lead them to sell
long-term securities now (to avoid future price drops). This selling pressure
causes the prices of long-term securities to fall, and consequently, the interest
rates (yields) on them will rise.
NITI AAYOG​
NITI Aayog – Quick Facts & Key Points

●​ What & Why?​

○​ Replaced the Planning Commission on 1 Jan 2015 (by Cabinet

resolution).​

○​ Not created by law (i.e. neither statutory nor constitutional) – works as

a policy think-tank.​

○​ Set up because the old Planning Commission was too centralised; NITI
brings in bottom-up & decentralised planning.​

●​ Main Role​

○​ Provide directional and policy inputs to both Centre and States.​

○​ Promote cooperative & competitive federalism: Centre & States

work together but also compete via rankings.​

○​ Act as “State’s best friend at the Centre” – help States fix their own
challenges.​

●​ Core Documents​

○​ 15-Year Vision (roadmap to 2030+)​

○​ 7-Year Strategy (broad strategic priorities)​

○​ 3-Year Action Agenda (concrete programmes & milestones)​

●​ Structure​

○​ Chairman: Prime Minister​

○​ Governing Council: All Chief Ministers + Lt Governors​

 ○​ Regional Councils: Address multi-state issues (e.g. climate, river
basins)​

○​ Full-time Members: Includes Vice-Chair & up to 2 part-time members​

○​ Ex-officio Members: Up to 4 Union Ministers nominated by PM​

○​ CEO & Secretariat: Support day-to-day work​

●​ Key Functions​

○​ Cooperative Federalism: Platform for joint Centre–State policy

making.​

○​ Shared Agenda: Build a common national development vision.​

○​ Network of Expertise: Bring in academics, practitioners & global best

practices.​

○​ Decentralised Planning: Empower States → empower local bodies →

bottom-up plans.​

○​ Vision & Scenario Planning: Map medium-/long-term futures,

consider “what‐if” scenarios.​

○​ Knowledge & Innovation Hub: Research, curate, disseminate good

governance models.​

○​ Harmonisation: Coordinate across ministries, levels of government,

and stakeholders.​

○​ Interface with the World: Benchmark global trends, attract best

practices.​

○​ Capacity Building: Train & upgrade technical know-how in

governments.​
 ○​ Monitoring & Evaluation: Track programmes, use data for
course-corrections.​

●​ 7 Pillars of Governance​

○​ Pro-people​

○​ Pro-activity​

○​ Participation​

○​ Empowerment​

○​ Inclusion​

○​ Equality​

○​ Transparency​

●​ Performance & Challenges​

○​ Wins:​

■​ State ranking indices (e.g. health, infrastructure) have spurred

healthy competition.​

■​ Quick response Groups formed for pandemic, disaster

management.​

■​ Innovation initiatives (Atal Tinkering Labs, Digital Platforms).​

○​ Limits:​

■​ Only advisory—no budget-making power like the old Planning

Commission.​

■​ Recommendations can stall without formal enforcement.​

 ■​ Coordination across many states/ministries remains complex.​

In short: NITI Aayog is India’s non-statutory policy think-tank—chaired

by the PM—designed to drive decentralised, data-driven planning and
promote federal cooperation, backed by clear vision, strategy and action
documents.

RBI

Reserve Bank of India (RBI) – Quick Overview

1. Brief History

●​ Founded as a shareholders’ bank on 1 April 1935 (modeled on Bank of

England).​

●​ Nationalised on 1 January 1949, now fully owned by the Government of

India.​

●​ Evolved from pure “note-issuing bank” to a full-fledged central bank with

development mandate.​

2. Structure & Governance

●​ Governor (Chief Executive) + Deputy Governors​

●​ Central Board of Directors: appointed by Centre, includes government

nominees & RBI experts​

●​ Regional Boards: advise on local banking conditions​

 ●​ Offices: Head Office in Mumbai + 31 regional / sub-offices across India​

3. Main Functions

A. Traditional (Common to Most Central Banks)

1.​ Issue Currency​

○​ Sole power to print & circulate banknotes.​

2.​ Banker to Government​

○​ Manages Union and State government accounts and public debt.​

3.​ Bankers’ Bank​

○​ Lender-of-last-resort to commercial banks; maintains their reserves.​

4.​ Supervision & Regulation​

○​ Licenses banks, sets prudential norms, conducts inspections.​

5.​ Foreign Exchange Management​

○​ Manages India’s forex reserves; intervenes to stabilize rupee.​

6.​ Credit Control​

○​ Uses tools (rates, reserve ratios, open market ops) to regulate money
supply.​

B. Developmental & Promotional (Distinctive for India)

1.​ Agricultural Credit​

 ○​ Pioneered rural lending via NABARD, cooperative banks, farm credit
schemes.​

2.​ Financial Inclusion​

○​ Drives banks to serve unbanked areas: no-frills accounts, payment

banks.​

3.​ Development Banks & Trusts​

○​ Helped set up IDBI, Unit Trust of India (UTI) to mobilize long-term

funds.​

4.​ Technology & Innovation​

○​ Promotes digital payments (UPI, RBI’s CBDC pilot), fintech regulations.​

4. Note-Issuing & Asset Backing

●​ Issue Dept. vs Banking Dept. hold two pools of assets.​

●​ Proportional Reserve System (pre-1956): linked note issue to gold + forex

reserves.​

●​ Minimum Reserve System (post-1956): RBI must hold a fixed minimum of

gold + forex; balance in government securities.​

5. Credit Control Tools

1. Quantitative (General)

●​ Bank Rate / Repo Rate: Cost of funds for banks → influences lending rates.​
 ●​ Cash Reserve Ratio (CRR): % of deposits banks must hold as cash with
RBI.​

●​ Statutory Liquidity Ratio (SLR): % of deposits banks must invest in

government securities.​

●​ Open Market Operations: RBI buys/sells government bonds to manage

liquidity.​

2. Qualitative (Selective)

●​ Selective Credit Controls: Margin requirements, credit ceilings for specific

sectors.​

●​ Moral Suasion: Persuading banks to follow RBI guidance (e.g. priority

sectors).​

6. Unique “Controlled Expansion” Approach

●​ Unlike many developed-country central banks (which sometimes restrict

money to fight inflation), RBI’s goal is balanced growth + price stability.​

●​ Controlled Expansion:​

○​ Allow credit growth to fuel industry, agriculture, trade​

○​ But curb unproductive or speculative lending​

7. Appraisal & Key Milestones

●​ First Note Issue (1935): Monopoly began; tied initially to gold/sterling

reserves​
 ●​ Plan‐Era Adjustments:​

○​ 1950s–60s: Bank-rate rises during inflation, selective controls in growth

spurts​

○​ 1970s–80s: Frequent CRR/SLR hikes to tame rising prices​

●​ Modernization:​

○​ Introduction of monetary targeting (1990s)​

○​ Adoption of Inflation Targeting Framework (2016)​

8. Important “Stand‐Out” Points

●​ Dual Mandate in a Developing Economy: Growth + stability​

●​ Strong Development Role: Not just regulator but promoter of agricultural &
rural credit​

●​ Flexible Note Issue: Shift from gold-backing to securities-backing for agility​

●​ Digital Leader: UPI, RTP, and pilot Central Bank Digital Currency (CBDC)​

In essence, the RBI is India’s central bank, balancing its traditional

duties (currency, banking supervision, inflation control) with a strong
developmental role (rural credit, inclusion, innovation), all guided by a
policy of “controlled expansion” to support growth without letting
inflation run away.
SEBI

SEBI – Key Points Summary

1. History & Legal Status

●​ 1988: Constituted as a non-statutory regulator for capital markets.​

●​ 12 April 1992: SEBI Act enacted; SEBI becomes a statutory body with
independent powers.​

●​ 1995 & 1999 Amendments: Expanded SEBI’s enforcement, inspection &

rule-making authority.​

2. Evolution & Rationale

●​ Pre-SEBI Regulator: Controller of Capital Issues under Capital Issues

(Control) Act, 1947.​

●​ Post-SEBI: Companies no longer need CCI/government permission to issue

securities—only SEBI clearance of offer documents.​

●​ Why SEBI?​

○​ Check malpractices (insider trading, price rigging)​

○​ Protect investors with timely, accurate information​

○​ Foster a fair, efficient marketplace for issuers, intermediaries &

investors​

3. Objectives
 1.​ Regulate Stock Exchanges & Intermediaries for smooth, efficient trading.​

2.​ Protect Investors via disclosure norms, grievance redressal, financial

education.​

3.​ Prevent Fraudulent Practices (insider trading, unfair trades).​

4.​ Develop the Securities Market: innovation, technology, professional

standards.​

5.​ Mobilise & Allocate Capital by strengthening market infrastructure.​

4. Functions

●​ Protective​

○​ Ban insider trading & price manipulation​

○​ Mandate fair practices & investor education​

○​ Oversee depositories, custodians, FPIs, credit-rating agencies​

●​ Regulatory​

○​ Frame rules/codes for issuers, brokers, merchant bankers, mutual

funds​

○​ Monitor takeovers, acquisitions, large-shareholdings​

○​ Register & audit market intermediaries; enforce LODR &

anti-money-laundering norms​

●​ Developmental​

○​ Train intermediaries; promote electronic/internet trading​

 ○​ Simplify issuance (optional underwriting)​

○​ Encourage competition, innovation (e.g. UPI-style market platforms)​

5. Structure & Governance

●​ Board of 9 Members:​

○​ Chair: Appointed by Government (typically Finance Ministry nominee)​

○​ 2 Finance Ministry officers, 1 RBI nominee, 5 government-nominated

members (≥3 whole-time)​

●​ Departments: CFD, FPI&C, ITD, DEPA, Legal, Surveillance, Mutual Funds,

etc.​

●​ Offices: HQ in Mumbai; regional (Ahmedabad, Delhi, Chennai, Kolkata) +

local offices​

6. Powers & Authority

●​ Quasi-Legislative: Draft regulations (insider trading, LODR, MF norms).​

●​ Quasi-Executive: Conduct inspections, issue orders, impose penalties,

suspend market access.​

●​ Quasi-Judicial: Adjudicate violations; appeals to SAT → Supreme Court.​

●​ Enforcement Tools: Search & seizure, disgorgement orders, market-wide

circulations.​

7. Mutual Fund Regulation

 ●​ AMC Registration & Oversight; trustees ensure compliance with SEBI rules.​

●​ Classification & Disclosure: 34 categories (equity, debt, hybrid…),

risk-based naming.​

●​ Recent Reforms (2022–23):​

○​ “MF-Lite” for passive funds (reduced compliance)​

○​ Backstop fund for stressed debt schemes​

○​ Allow private equity sponsors, multiple ESG schemes​

○​ Unit-Holder Protection Committees​

8. Market-Wide Initiatives

●​ Primary Market: Simplified IPO norms, book-building, ASBA.​

●​ Corporate Governance: Clause 49 (board independence), Kotak Committee

reforms.​

●​ Trading & Settlement: Electronic order books, T+2 rolling settlement,

dematerialisation (since 2001).​

●​ Market Integrity: Surveillance for insider trading, front-running, spoofing;

SEBI (Fraudulent & Unfair Trade) Regs 2003.​

●​ Exchange Governance: Demutualisation & public ownership (≥51% public

shareholding).​

9. Appraisal & Performance

 ●​ Strengths:​

○​ Robust disclosure regime; cost-competitive markets; resilient during

crises.​

○​ IOSCO “high compliance” scores on core principles (clarity,

independence, resourcing).​

●​ Challenges:​

○​ Enforcement speed; specialized courts absence; compliance fatigue

among intermediaries.​

○​ Rising “finfluencer” scams on social media; concealed FPI beneficial

ownership.​

10. Key Challenges & Suggested Reforms

●​ Digital Era Risks: Regulate financial influencers; plug social-media

loopholes.​

●​ Tech & Data: Acquire IT/decryption powers; build data-science teams for
real-time surveillance.​

●​ Human Resources: Increase headcount; lateral hires in fintech, analytics.​

●​ ESG Integration: Mandate environment, social & governance disclosures in

listing norms.​

●​ Simplify & Update Laws: Remove redundant rules; ensure rapid rule-making
to match market innovations.​

In essence, SEBI’s statutory mandate, broad enforcement powers

and multi-pronged functions—protective, regulatory and
 developmental—have transformed India’s capital markets into fair,
efficient and globally competitive arenas, while ongoing challenges call
for digital-age reforms, stronger enforcement, and enhanced
investor safeguards.

​
​
FINANCIAL REFORMS
Okay, here's a simple overview of the Financial Sector Reforms in India, broken down into
easy-to-understand points:

Why Were Financial Reforms Needed?

India launched economic reforms to speed up its growth. A strong financial system (banks,
stock markets, etc.) is crucial for this. It helps gather people's savings and invests them in
businesses efficiently. However, India's financial system, especially government-owned
banks, had problems:
●​ Poor Customer Service: Banking services were slow and outdated.
●​ Slow Technology Adoption: Banks weren't using new computer and
communication technologies, leading to inefficiency and errors.
●​ Low Profitability and Efficiency: This hurt the banks' financial health and the
overall economy.
●​ Bad Loans: Many loans given out by banks were not being repaid, which was a
major concern.

A committee headed by Mr. M.N. Narasimham was set up in 1991 to suggest

improvements. A major securities scam in 1992 further highlighted the urgent need for
these reforms.

Key Reforms Suggested by the Narasimham Committee (Mainly for Banks):

The committee focused on improving the quality and efficiency of banks, rather than just the
number of branches. Here are their main suggestions:
1.​ More Lending Power for Banks:​

○​ Reduce SLR and CRR: Banks were forced to keep a large chunk of their
money with the government (SLR) or as cash reserves (CRR). Reducing
these would give banks more money to lend.
○​ Market-based Interest on Government Debt: Ensure the government pays
fair, market-driven interest on its borrowings from banks.
2.​ Fairer Lending to Important Sectors (like Agriculture):​
 ○​ Focus on making credit available rather than giving big subsidies.
○​ Limit subsidies on loans to only the smallest borrowers.
○​ Ensure lending to priority sectors is done wisely, without risking the bank's
money.
3.​ Better Accounting:​

○​ Use international standards for bank accounting to clearly show their financial
health. This would push banks to be more careful with lending and recovery.
4.​ Stronger Financial Position for Banks:​

○​ Provide more capital (money) to banks from the government and by selling
shares in the stock market.
○​ Government capital would only be given if banks showed improvement in
management and loan recovery.
○​ Selling shares to the public would make banks more accountable.
5.​ Faster Loan Recovery:​

○​ Set up special courts (recovery tribunals) to deal with loan defaulters quickly.
6.​ Sharing Information on Borrowers:​

○​ Create a database to share information (confidentially) about large borrowers'

credit history.
7.​ Better Bank Leadership:​

○​ Appoint qualified people to top bank positions and ensure they have stable
tenures.
8.​ Accountable Bank Managers:​

○​ Make managers responsible for their bank's performance and link promotions
to performance.
9.​ Modernize Banks:​

○​ Encourage computerization and flexible work practices.

10.​More Competition:​

○​ Allow new private banks, including foreign ones, to operate in India to create
healthy competition for public sector banks.
11.​Stronger Supervision:​

○​ Create a new board focused solely on supervising banks and ensuring they
follow rules. Review banking laws.
 12.​Credit for Rural and Small Sectors:​

○​ Ensure there are effective ways to provide loans to rural areas, small-scale
industries, and weaker sections of society.

Targets Set for Public Sector Banks (by June 1996):

●​ All public sector banks to maintain a capital to risk-weighted assets ratio (CRAR) of
8%.
●​ Half of the public sector banks (by deposit size) to be listed on the stock market.
●​ Significant entry of new private banks.
●​ SLR and CRR to be notably reduced.
●​ Interest rates to be freed from government control (deregulated).
●​ At least 500 branches of public sector banks to be fully computerized.

Capital Market Reforms (Making Stock Markets Fair and Transparent):

The Securities Exchange Board of India (SEBI) introduced several measures:

●​ Rules for Underwriters and Brokers: Set regulations for those who help
companies raise money and for stockbrokers, including capital requirements.
●​ Bonus Shares: Companies can issue bonus shares only from genuine profits or
share premiums, protecting the interests of debenture holders.
●​ Stock Exchange Governance: Directed stock exchanges to have more diverse
governing boards and fairer dispute resolution.
●​ Bankers to Issues: Made it compulsory for bankers involved in public issues (IPOs)
to register with SEBI and follow a code of conduct. RBI would inspect them if SEBI
requested.
●​ NRI Investments: Allowed Non-Resident Indians (NRIs) and overseas corporate
bodies to invest in Indian companies more easily, without prior RBI permission.
●​ Foreign Institutional Investors (FIIs): Allowed FIIs (like pension funds, mutual
funds) to invest in the Indian stock market after registering with SEBI.
●​ Credit Rating: Made credit rating mandatory for long-term company bonds (maturity
over 18 months).
●​ Bank Debt-Equity Ratio: Set a maximum debt-to-equity ratio of 2:1 for banks.

Why Reduce SLR and CRR?

●​ SLR (Statutory Liquidity Ratio): This is the portion of a bank's deposits that they
must invest in government securities. High SLR meant banks lent to the government
at low rates, reducing their profits.
 ●​ CRR (Cash Reserve Ratio): This is the portion of a bank's deposits they must keep
as cash with the RBI. High CRR was used to control inflation caused by government
deficits but also limited funds for banks to lend.

High SLR and CRR effectively acted like a tax on bank savings, making them less profitable
and forcing them to charge higher interest rates on loans to businesses.
●​ The Goal: The government decided to reduce SLR from 38.5% to 25% over three
years and CRR to 10% over a longer period (initially stated as forty years in the text,
which seems unusually long and might be a typo for a shorter, more practical
timeframe for significant reduction).

Reforms in Development Banking (For Institutions that Fund Long-Term Projects):

Development Financial Institutions (DFIs) like IDBI used to operate without much
competition. Banks focused on short-term (working capital) loans, while DFIs gave
long-term (investment) loans. Borrowers had no choice.
●​ The Suggestion: The Narasimham Committee recommended making these DFIs
more independent from state governments to improve efficiency. DFIs should make
their own loan decisions based on professional project assessments.
●​ Government Action: The government started selling its stake (disinvestment) in
some larger DFIs like IDBI.

In short, these financial sector reforms aimed to make India's banking and capital markets
more efficient, competitive, transparent, and globally integrated to support the country's
economic growth.