Test 7 model answers
1. Discuss the components of money supply in India. How does the Reserve Bank of India
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(RBI) measure money supply?
he money supply refers to the total stock of money circulating in an economy at a particular
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time. In India, the Reserve Bank of India (RBI) measures the money supply using different
monetary aggregates, classified as M1, M2, M3, and M4.
The components of money supply are:
1. C
urrency with the public: Includes notes and coins in circulation, excluding cash held by
the banking system.
2. D
emand deposits with banks: These are deposits which can be withdrawn on demand by
cheque or electronically.
3. T
ime deposits with banks: Fixed deposits and recurring deposits that can be withdrawn
after a fixed period.
The RBI defines monetary aggregates as:
● M
1 (Narrow Money): Currency with the public + Demand deposits + Other deposits with
RBI.
● M2: M1 + Savings deposits with post office savings banks.
● M
3 (Broad Money): M1 + Time deposits with the banking system. It is the most widely
used measure for policy formulation.
● M4: M3 + Total deposits with post offices (excluding National Savings Certificates).
BI uses M3 as the principal indicator of money supply due to its high stability and relevance
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for economic analysis.
ignificance: Monitoring money supply helps the central bank in controlling inflation, ensuring
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liquidity, and stabilizing the economy. An excess of money supply may lead to inflation, while
too little can cause deflation and hamper growth.
I n India, RBI’s management of money supply is crucial for implementing an effective monetary
policy and maintaining macroeconomic stability.
2. Critically examine the functions of the central bank in developing economies with
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special reference to India.
hecentral bank, such as the RBI in India, playsa crucial role in maintainingmonetary and
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financial stability.
Key functions of a central bank:
1. I ssuing currency: It has the sole authority to issuethe nation’s currency (except one
rupee notes and coins).
2. M
onetary policy implementation: Uses tools likereporate, CRR, and SLRto control
inflation and growth.
3. Credit control: Regulates credit flow to balance liquidityand promote development.
4. Regulation of commercial banks: Supervises banks toensure financial stability.
5. Foreign exchange management: Manages the exchangerate and forex reserves.
6. Promoting financial inclusion: Encourages access tobanking in rural areas.
Critical issues and limitations:
● P
olicy trade-offs: The RBI often faces the dilemmaof balancingprice stability and
economic growth, especially during supply-side inflation.
● I neffective transmission mechanism: Structural rigiditiesin the financial system
weaken the impact of monetary policy.
● L
imited control over external shocks: Capital flowvolatility due to globalization
constrains RBI’s autonomy.
● D
ependence on government borrowing: Excessive publicdebt sometimes pressures
RBI’s independence.
● O
verreach debates: Critics argue that RBI’s developmental roles may dilute its focus on
core monetary functions.
I n a developing economy like India, the central bank must strike a balance betweenautonomy
and coordinationwith fiscal authorities to ensureinclusive and sustainable development.
3. Explain the role of commercial banks in credit creation. How does this process
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influence the money supply in the economy?
ommercial banksare financial institutions that acceptdeposits and provide loans to the public.
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One of their critical functions iscredit creation,which significantly impacts themoney supply.
Process of credit creation:
1. Banks receivedepositsfrom customers.
2. They keep a fraction asreserves(CRR) and lend outthe rest.
3. The amount lent becomes adeposit in another bank,and the process repeats.
This mechanism is called themultiplier effect.
Formula:
Money Multiplier =1 / Reserve Ratio
Impact on money supply:
● Higher lending increases the money supply, potentially leading toinflation.
● Conversely, reduced lending contracts the money supply, possibly slowing growth.
hus, commercial banks play a pivotal role ineconomicdevelopmentby channeling savings
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into investments.
4. Evaluate the effectiveness of monetary policy instruments (quantitative and
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qualitative) in controlling inflation and promoting growth.
onetary policy instrumentsare tools used by the central bank to regulate money supply and
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credit.
Quantitative tools:
● Repo and Reverse Repo Rate
● Cash Reserve Ratio (CRR)
● Statutory Liquidity Ratio (SLR)
● Open Market Operations (OMO)
Qualitative tools:
● Credit rationing
● Margin requirements
● Moral suasion
Effectiveness in India:
● Inflation control: Repo rate hikes help curb demand-pullinflation.
● Growth promotion: Reduced rates stimulate borrowingand investment.
● L
imitations: Structural issues, supply-side constraints,and transmission lags reduce
effectiveness.
or optimal outcomes, monetary policy must becomplementedby fiscal policyand structural
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reforms.
5. Discuss the significance and functions of Non-Banking Financial Companies (NBFCs)
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in India. How are they different from commercial banks?
BFCsare financial institutions that provide bankingservices without holding a banking
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license.
Functions:
1. Providing creditto sectors underserved by banks.
2. Asset financingand leasing.
3. Investment in financial instrumentslike stocks andbonds.
4. Promotingfinancial inclusionin rural areas.
Differences from banks:
● Cannot acceptdemand deposits.
● Do not issuechequesdrawn on themselves.
● Not a part of thepayment and settlement system.
ignificance:NBFCs complement the banking systemby catering to thepriority sectorsand
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supportingeconomic growth.
6. Examine the role of capital markets in economic development. What measures have
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been taken by SEBI to regulate capital markets in India?
apital marketsplay a crucial role in mobilizinglong-term funds for businesses and
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governments, enabling efficient allocation of financial resources in an economy. In India, they
comprise theprimary market(raising fresh capitalthrough IPOs) andsecondary market
(trading of existing securities like shares and bonds).
Role in Economic Development
1. Mobilization of savings: Transforms household savingsinto productive investments.
2. E
fficient allocation of capital: Directs funds toindustries and sectors with higher
returns.
3. E
ncouragement of entrepreneurship: Provides access to risk capital for innovation and
growth.
4. W
ealth creation and employment: Expands opportunitiesthrough market-driven
investments.
5. G
overnment financing: Helps governments raise fundsvia bonds for infrastructure
projects.
well-functioning capital market is thus vital foraccelerated economic growth and financial
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deepening.
SEBI’s Regulatory Measures
o ensureefficiency, transparency, and investor protection,theSecurities and Exchange
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Board of India (SEBI)has implemented several reforms:
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Strengthened disclosure norms: Companies must provideaccurate and timely information
to investors.
✅
Insider trading regulations: Prevention of unfairpractices through stricter surveillance.
✅
Investor protection mechanisms: Establishment ofthe Investor Protection Fund (IPF) and
grievance redressal platforms.
✅
Introduction of T+1 settlement system: Faster tradesettlement to enhance liquidity.
✅
Regulation of intermediaries: Licensing and monitoringof brokers, merchant bankers, and
mutual funds.
✅
Promotion of digital platforms: Boosts retail participationthrough apps and online trading
systems.
hile SEBI has improvedmarket transparency and investorconfidence, challenges like
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corporate governance failures, market volatility, and limited rural participationremain.
Also,global financial contagionexposes Indian marketsto external shocks.
EBI must strengthenrisk management frameworks, promotefinancial literacy, and deepen
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capital markets to support India’s vision of becoming a$5 trillion economy.
7. "Monetary policy in India faces the dilemma of balancing growth and price stability."
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Discuss with suitable examples.
onetary policyrefers to the use of policy instrumentsby theReserve Bank of India (RBI)to
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regulate money supply, interest rates, and credit availability in the economy. In India, monetary
policy seeks to achieve two primary objectives:pricestabilityandeconomic growth. However,
these objectives often conflict, creating apolicydilemma.
The dilemma explained:
● P
rice stabilityrequires controlling inflation, oftenthroughtight monetary policy
(raising repo rates, increasing CRR/SLR), which reduces demand and slows growth.
● E
conomic growthrequires stimulating demand, oftenthroughloose monetary policy
(lowering interest rates, increasing liquidity), which may fuel inflationary pressures.
Examples:
● I n2013, the RBI increased repo rates sharply to tacklehigh inflation (CPI >10%), but
this led to a slowdown in GDP growth.
● D
uringCOVID-19 (2020), the RBI reduced repo ratesto a historic low (4%) to support
growth despite the risk of future inflation.
● I n2022-23, post-pandemic recovery was accompaniedby global supply shocks. RBI
faced criticism for delaying rate hikes, resulting in CPI inflation exceeding itstolerance
band of 2%-6%.
Structural challenges:
● S
upply-side inflation(e.g., food and fuel prices)is less responsive to monetary
tightening.
● W
eak monetary transmission due to inefficiencies in the banking system reduces policy
effectiveness.
Way forward:
● R
BI needs acalibrated approach, balancing growth and price stability using a mix of
quantitative (repo, CRR)andqualitative tools (credit rationing, moral suasion).
● C
oordination withfiscal policyis crucial to addressstructural bottlenecks and achieve
inclusive, sustainable growth.
hus, thedual mandate of growth and stabilityiscomplex in an emerging economy like India,
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requiring careful policy fine-tuning.
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Q8. Analyze the relationship between the central bank and commercial banks in the
context of liquidity management.
Liquidity managementinvolves ensuring adequate cashin the banking system to meet demand.
Relationship:
● The central bank (RBI) acts as alender of last resort.
● It regulates liquidity through:
○ Repo and Reverse Repo operations
○ CRR and SLR adjustments
○ Open Market Operations
Impact on commercial banks:
● Influences their ability to lend and maintain reserves.
● Helps avoidliquidity crunchand ensures financialstability.
Effective coordination ensuressmooth monetary transmissionand macroeconomic balance.
9. Describe the impact of globalization on the Indian banking system and financial
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institutions.
Globalizationhas significantly transformed India’s banking sector.
Positive impacts:
1. Entry of foreign banksincreased competition and innovation.
2. Adoption oftechnologylike Internet and mobile banking.
3. Access toglobal capital marketsfor funding.
Challenges:
● Exposure toglobal financial crises.
● Increased risk ofnon-performing assets (NPAs)dueto volatile capital flows.
To succeed, Indian banks must enhancerisk managementandadopt global best practices.
10. Discuss the challenges faced by the Indian capital market and evaluate the recent
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regulatory reforms undertaken to address them.
Challenges:
1. Market volatilitydue to global factors.
2. Corporate governance failures.
3. Limitedretail investor participation.
4. Prevalence ofinsider trading and scams.
Recent reforms:
● SEBI’s tightening of disclosure norms.
● Introduction of T+1 settlement.
● Enhanced focus oncorporate governanceandinvestor protection.
● Digital platformsto encourage small investors.
hese measures have improvedmarket transparency,depth, and resilience, contributing to
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sustainable growth.
