Economy 2013 MCQs

• Borrowing by scheduled banks from the RBI: This option refers to the process where scheduled banks borrow money from the Reserve Bank of India (RBI). While this is a monetary policy tool, it is not an Open Market Operation. This is typically done through instruments like the repo rate, where banks borrow from the RBI for short-term needs.
• Lending by commercial banks to industry and trade: This option describes the regular lending activities of commercial banks to businesses and individuals. This is a primary function of commercial banks and is not directly related to the RBI's monetary policy tools or Open Market Operations.
• Purchase and sale of government securities by the RBI: This is the correct definition of Open Market Operations. In these operations, the RBI either buys or sells government securities in the open market. When the RBI buys securities, it adds money to the banking system, increasing the money supply. Conversely, when it sells securities, it takes money out of the banking system, decreasing the money supply. These actions help in managing liquidity and controlling inflation in the economy.

• Currency: Currency is the most liquid asset as it is already in the form of cash and can be used immediately for transactions.
• Demand deposits with the banks: These are very liquid because you can withdraw them on demand, typically without any limitations or penalties.
• Savings deposits with the banks: Savings deposits are slightly less liquid than demand deposits. While they can generally be withdrawn without penalties, there might be some restrictions or limits on the number or amount of transactions.
• Time deposits with the banks: These are the least liquid among the options. Time deposits, like fixed deposits, have a set maturity date, and withdrawing funds before this date often results in penalties or loss of accrued interest.

Therefore, the sequence in decreasing order of liquidity is Currency (4), Demand deposits (1), Savings deposits (3), and Time deposits (2), which aligns with option D: 4-1-3-2.

• Inflation benefits the debtors: This statement is true. When there is inflation, the value of money decreases over time. Debtors who have borrowed money can repay their debts with money that is worth less than when they originally borrowed it. This means that in real terms, the amount they repay is less than the amount they borrowed. Therefore, inflation tends to benefit debtors.
• Inflation benefits the bondholders: This statement is false. Bondholders are individuals or entities that hold bonds, which are fixed-income investments. Inflation erodes the purchasing power of the fixed interest payments that bondholders receive, making the real value of their investment lower. Hence, inflation typically harms bondholders, as it reduces the real value of the future payments they will receive from their bonds.

Inflation benefits debtors by reducing the real value of the money they owe, but it typically harms bondholders by reducing the real value of the fixed payments they receive from their bond investments.

• Foreign Loans: These are part of the capital account. They represent borrowing from foreign lenders and result in an inflow of capital.
• Foreign Direct Investment (FDI): This is also part of the capital account. FDI involves investments made by a company or individual in one country into business interests located in another country.
• Private Remittances: These are part of the current account, not the capital account. Private remittances are transfers of money by foreign workers to their home countries.
• Portfolio Investment: This is included in the capital account. Portfolio investment refers to investments in securities such as stocks and bonds across borders.

• The national income of a country for a given period is defined as the total money value of all the final goods and services produced by the country during that period.
• Total value of goods and services produced by the nationals refers to Gross Domestic Product but does not account for intermediate goods.
• Sum of total consumption and investment expenditure refers to an expenditure approach calculation.
• Sum of personals income of all individuals refers to aggregate personal income, which also includes transfer payments.

• When demand for money increases while the supply remains unchanged, it leads to higher interest rates. This can be explained using the money market equilibrium:
• Higher demand for money means people want to hold more cash balances. To make them cut spending and increase their money holdings, the interest rate (cost of money) needs to rise.
• On the other hand, unchanged or inelastic money supply cannot match this increased demand. The excess demand for money pushes the interest rates upward to reach equilibrium.
• Therefore, with the supply of money remaining fixed, a rise in demand for money leads to an increase in the rate of interest, rather than a fall in price level, decrease in interest rates or an increase in income and employment.

Thus option B correctly states that there will be an increase in the rate of interest when demand for money rises while the supply is unchanged. This concept is based on the equilibrium money market conditions.

• Creating new money to finance a budget deficit is likely to be the most inflationary in its effect.
• When new money is printed to cover fiscal deficits, it leads to excess money supply in the system relative to output of goods and services. This excess money supply results in too much money chasing too few goods, which causes high inflation.
• Options A, B and C referring to repayment of debt, public borrowing and bank borrowing respectively do not directly increase overall money supply. Hence, they are less inflationary than option D.
• Additionally, creating new money is under direct control of the central bank and can be done without limits, making it potentially very inflationary.
• Therefore, creating new money to fund government budget deficits tends to fuel money supply excessively, making it the most inflationary option.

• India's foreign-exchange reserves consist of:

1. Foreign Currency Assets: India's holdings of foreign currencies
2. Gold Reserves: RBI's gold stock
3. SDRs: Special Drawing Rights with the IMF

• Loans from foreign countries or the World Bank are not part of the foreign exchange reserves.
• India's forex reserves consist of foreign currency assets, RBI's gold reserves and SDRs only. Hence option B is the right answer.

All 3 factors can lead to a rise in the general price level or inflation:

1. Increase in money supply: More currency availability makes people willing to pay higher prices, driving prices up.
2. Decrease in aggregate output: Lower production and supply of goods leads to scarcity which allows producers to charge higher prices.
3. Increase in effective demand: People have more income to spend on goods; this increased spending power drives up prices if production doesn't match pace.

More money supply -> People able to spend more -> Bids up prices

Lower output -> Scarcity -> Producers can markup prices

Higher demand -> Chases too few goods -> Pulls up prices

Priority sector lending by banks in India includes lending to all of the following categories:

• Agriculture - Farmers for agriculture, allied activities
• Micro and small enterprises - Small business units, small scale industries etc
• Weaker sections - Low income groups, poorer households, vulnerable groups
• Export Credit
• Education
• Housing
• Social Infrastructure
• Renewable Energy

Banks have lending targets across each of these priority areas as part of financial inclusion policies.

• In India, deficit financing is used by the government to raise resources for economic development purposes.
• Deficit financing in India refers to the government borrowing from the RBI to fund development projects and schemes. The budget deficit is covered by asking the RBI to print new currency.
• This intentional deficit spending is aimed at public infrastructure building and jobs creation - with the objective of boosting productivity and economic growth.
• The key goals of deficit financing in India are:
  • Enabling higher public investment to boost growth
  • Increased spending on agriculture, industry, social schemes
  • Infrastructure building for long-term productivity
• The key point is deficit spending is a recommended policy tool in developing countries to enable higher public investment in growth-oriented sectors. Hence option A is the right answer.

• An increase in the Bank Rate refers to the Central Bank (RBI in India) raising its benchmark policy rate. This generally indicates that the Central Bank is adopting a tight or contractionary monetary policy stance.
• A tight money policy is followed to curb excess demand and control inflation in the economy. Tools used for tightening include increasing bank rates along with other rates like repo rate, reverse repo rate etc. that make borrowing expensive.
• Option A is incorrect because market interest rates typically follow an upward trend in response to higher bank rate signals.
• Option B is invalid since bank loans are not stopped.
• Option C incorrectly refers to an easy money/expansionary policy while bank rate hikes reflect tightening.

Therefore, option D accurately states that a hike in bank rate indicates that the Central Bank is following a contractionary or tight money policy to control inflation by discouraging borrowing and spending.

The Reserve Bank of India (RBI) regulates commercial banks in all the following matters:

1. Liquidity of assets - RBI mandates cash reserve ratio and statutory liquidity ratio
2. Branch expansion - RBI approval required to open new branches
3. Merger of banks - RBI sanction required for any merger or acquisition
4. Winding-up of banks - RBI oversees voluntary or involuntary liquidation

Therefore, RBI regulates commercial banks in matters of asset liquidity, expansion of branches, bank mergers as well as winding up operations of banks.

The RBI has a supervisory and regulatory role over banks in all these areas.

• The balance of payments is officially defined by the IMF as the record of all economic transactions between the residents of a country and the rest of the world over a particular time period. It specifically includes:
• • Trade in goods and services (exports and imports)
  • Income flows (primary income payments and receipts)
  • Financial and capital transactions (capital account flows)
• Option B referring to only goods exported and Option D referring to only capital movements capture only select portions of what balance of payments covers.
• Option C is incorrect because the transactions are not just between governments but between all possible entities.