Q. The money multiplier in an economy increases with which one of the following?

a) Increase in the Cash Reserve Ratio in the banks.
b) Increase in the Statutory Liquidity Ratio in the banks
c) Increase in the banking habit of the people
d) Increase in the population of the country

Answer: c) Increase in the banking habit of the people

Money multiplier
  • Money multiplier is a term in monetary economics that is a phenomenon of creating money in the economy in the form of credit creation, which is based on the fractional reserve banking system.
  • In monetary economics, the money multiplier is the ratio of the money supply to the monetary base (i.e. central bank money).
  • Money multiplier is also known as the monetary multiplier. It is the maximum limit to which money supply can be affected by bringing about changes in the amount of money deposits.
  • The money multiplier effect is seen in commercial banks as they accept deposits, and after keeping a certain amount as a reserve, they distribute the money as loans for injecting liquidity in the economy.
  • The amount of money that should be kept by commercial banks in their reserve for withdrawal purposes by the customers is referred to as the reserve ratio, required reserve ratio, or cash reserve ratio.
  • Mathematically, money multiplier formula can be represented as follows:
    • Money multiplier = 1/r
      • Where: r = Required reserve ratio or cash reserve ratio
  • It means that if the reserve ratio is higher, then the money multiplier will be lower and the banks need to keep more reserves. As a result, they will not be able to lend more money to individuals and businesses.
  • Similarly, a lower reserve ratio results in a higher money multiplier that allows a lesser amount of money to be kept as a reserve and more lending opportunities to the public.
  • The multiplier will depend on the preferences of households, the legal regulation and the business policies of commercial banks.
    • An increase in banking activity will lead to more money in the bank’s hands in the form of Time Deposits (FD, RD), Demand Deposits (Savings Bank Account), Cash, etc, thus increase in banking habits of the people will increase the money multiplier.
Multiplier Effect
  • The multiplier effect is an economic term, referring to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of capital.
  • In effect, Multipliers effects measure the impact that a change in economic activity — like investment or spending—will have on the total economic output of something.
  • This amplified effect is known as the multiplier.
Surplus Liquidity
  • Surplus liquidity occurs where cashflows into the banking system persistently exceed withdrawals of liquidity from the market by the central bank.
    • Liquidity in the banking system refers to readily available cash that banks need to meet short-term business and financial needs.
  • Causes of Increased Liquidity:
    • Advance tax and goods and services tax (GST) payments,
    • The deposit of withdrawn Rs 2,000 notes,
    • Redemption of government bonds,
    • Higher government spending,
    • The sale of dollars by the RBI to defend the rupee from depreciation.
  • Impact of Increased liquidity:
    • It may lead to increased levels of inflation.
    • Interest rates in the market will remain low.
  • RBI’s Measures:
    • The RBI takes action if liquidity levels deviate from its comfort range.
    • The RBI, under its Liquidity Adjustment Facility, infuses liquidity in the banking system via repos and sucks it out using reverse repos after assessing liquidity conditions.
      • The RBI also uses a 14-day variable rate repo and/or reverse repo operation.
Tools Used by RBI to control Money Supply

Q. With reference to the Indian economy, demand-pull inflation can be caused/increased by which of the following?

1. Expansionary policies
2. Fiscal stimulus
3. Inflation-indexing wages
4. Higher purchasing power
5. Rising interest rates

Select the correct answer using the code given below.
a) 1, 2 and 4 only
b) 3, 4 and 5 only
c) 1, 2, 3 and 5 only
d) 1, 2, 3, 4 and 5

Answer: a) 1, 2 and 4 only

Inflation
  • Inflation is a rise in prices, which can be translated as the decline of purchasing power over time. The rate at which purchasing power drops can be reflected in the average price increase of a basket of selected goods and services over some time.
  • It reflects the rising cost of living and indicates how much more expensive a set of goods and/or services has become over a specified period, usually a year.
    • In India, inflation’s impact is particularly significant due to economic disparities and a large population.
  • Different Causes of Inflation:
    • Demand-Pull Inflation:
      • Demand Pull inflation occurs when the demand for goods and services exceeds their supply. When the overall demand in the economy is high, consumers are willing to pay more for the available goods and services, leading to a general rise in prices.
      • A booming economy with high consumer spending can create excess demand, putting upward pressure on prices.
        • Cause for Demand-pull inflation are:
          • Increasing government expenditure
          • Increasing money supply (liberal monetary/fiscal policy)
          • Parallel economy/black money
          • Increasing forex reserves (As foreign currency reserves rise demand for rupee goes up and that creates inflation.)
          • Rising population
          • Rise in income and wages
          • Climatic changes
          • Specific consumer preferences
        • Expansionary policies: When the government spends more freely, money in the market is increased. It leads to increase demand for the goods and fuels demand-pull inflation.
        • Fiscal Stimulus: It also increases the money in the market leads to increase demand for the goods and fuels demand-pull inflation
        • Higher Purchasing Power: When consumers earn higher income, they feel confident and spend more. This leads to more demand and fuels Demand-pull inflation
          • The rising interest rate – It decreases the money supply in the economy. This may result in a credit crunch in the economy. It is costlier to borrow money in the economy and it leads to a decreased money supply. So, it can not cause demand-pull inflation in the economy.
          • Inflation-indexing wages – Inflation indexing wages, wages in the economy is linked to inflation which means wage moves as inflation changes in the economy. Such indexing is provided to reduce the effect of inflation on wages. For example – a worker is getting 100 rs as a wage and inflation in the economy increases to 5%, so the wage of the worker increases by 5% i.e. 105. So effective change in the wages is zero and it does not increase/decrease purchasing power. So, it can not lead to a demand to pull inflation in the economy.
    • Cost-Push Inflation:
      • Cost-push inflation is driven by an increase in the production costs for goods and services. This can be caused by factors such as increased incomes, increased costs of raw materials, or disruptions in the supply chain.
      • Causes for Cost-push inflation are:
        • Infrastructural surcharges
        • Increase in indirect taxes
        • Increase in prices of raw materials
        • Supply shocks
        • Rise in administered prices
        • Rise in imported inputs
    • Built-In or Wage-Price Inflation:
      • This type of inflation is often described as a feedbackloop between wages and prices. When workers demand higher wages, businesses may raise prices to cover the increased labor costs. This, in turn, prompts workers to seek higher wages, and the cycle continues.
        • Collective bargaining by labor unions can result in higher wages, leading to increased production costs and subsequently higher prices for goods and services.

Q. With reference to India, consider the following statements:

1. Retail investors through Demat account can invest in Treasury Bills and Government of India Debt Bonds in the primary market
2. The “Negotiated Dealing System-Ordering Matching” is a government securities trading platform of the Reserve Bank of India.
3. The “Central Depository Services Ltd” is jointly promoted by the Reserve Bank of India and the Bombay Stock Exchange.

Which of the statements given above is/are correct?
a) 1 only
b) 1 and 2
c) 3 only
d) 2 and 3

Answer: b) 1 and 2

Notes:
  • Retail investors have multiple channels to invest in treasury bills (T-Bills) and Government bonds. It is mandatory to open demat account for a retail investor to invest in ‘Treasury Bills’ and ‘Government of India Debt Bonds’ in primary market.
  • The Negotiated Dealing System Order Matching is an electronic trading platform operated by the Reserve Bank of India to facilitate the issuing and exchange of government securities and other types of money market instruments. 
  • CDSL was promoted by BSE Ltd. jointly with leading banks such as State Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank and Union Bank of India.
    • Reserve Bank of India is not its promoter.
RBI Retail Direct Scheme
  • As part of continuing efforts to increase retail participation in Government Securities, the RBI Retail Direct facility was announced in the Statement of Developmental and Regulatory Policies dated February 05, 2021 for improving ease of access by retail investors through online access to the Government Securities Market – both primary and secondary – along with the facility to open their gilt securities account (Retail Direct) with the RBI.
    • Retail Investor is a non-professional investor who buys and sells securities or funds that contain a basket of securities such as mutual funds and Exchange Traded Funds (ETFs).
    • A Gilt Account can be compared with a bank account, except that the account is debited or credited with treasury bills or government securities instead of money.
  • Scope:
    • RBI Retail Direct is a comprehensive scheme which provides the following facilities to retail investors in Government Securities market through an online portal:
      • Open and maintain a Retail Direct Gilt Account (RDG Account)
      • Access to primary issuance of Government Securities
      • Access to Negotiated Dealing System-Order Matching Segment (NDS-OM)
  • Eligibility:
    • Retail investors, as defined under the scheme, can register under the Scheme and maintain a RDG Account, if they have the following:
      • Permanent Account Number (PAN) issued by the Income Tax Department
      • Access to primary issuance of Government Securities
      • Any Officially Valid documents (OVD) for KYC purpose
      • Valid e-mail ID
      • Registered mobile number
    • Non-Resident retail investors eligible to invest in Government Securities under Foreign Exchange Management Act, 1999 are eligible under the scheme.
    • The RDG account can be opened singly or jointly with another retail investor who meets the eligibility criteria.
  • Significance:
    • Building an Atmanirbhar Bharat:
      • So far, in the government securities market, small investors class, salaried class, small traders had to invest through banks and mutual funds in an indirect manner.
    • Improved Ease of Access:
      • It will make the process of G-sec trading smoother for small investors therefore it will raise retail participation in G-secs and will improve ease of access.
    • Facilitate Government Borrowings:
      • This measure together with relaxation in mandatory Hold To Maturity (securities that are purchased to be owned until maturity) provisions will facilitate smooth completion of the government borrowing programme in 2021-22.
    • Financialise Domestic Savings:
      • Allowing direct retail participation in the G-Sec market will promote financialisation of a vast pool of domestic savings and could be a game-changer in India’s investment market.
  • Other Measures Taken to Increase Retail Investment in Government Securities:
    • Introduction of non-competitive bidding in primary auctions.
      • Non-competitive bidding means the bidder would be able to participate in the auctions of dated government securities without having to quote the yield or price in the bid.
    • Stock exchanges to act as aggregators and facilitators of retail bids.
    • Allowing a specific retail segment in the secondary market.
      • The secondary market is the market where investors buy and sell securities they already own.
      • Primary market deals with new securities being issued for the first time.

Q. In India, the central bank’s function as the “lender of last resort” usually refers to which of the following?

1. Lending to trade and industry bodies when they fail to borrow from other sources
2. Providing liquidity to the banks having a temporary crisis
3. Lending to governments to finance budgetary deficits

Select the correct answer using the code given below
a) 1 and 2
b) 2 only
c) 2 and 3
d) 3 only

Answer: b) 2 only

Notes:
  • A lender of last resort is an institution, usually a country’s central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse.  
  • The lender of last resort functions to protect individuals who have deposited funds and to prevent customers from withdrawing out of panic from banks with temporary limited liquidity. Commercial banks usually try not to borrow from the lender of last resort because such action indicates that the bank is experiencing a financial crisis. 
    • Some argue that having a lender of last resort encourages moral hazard: that banks can take excessive risks knowing that they will be bailed out.
  • In India, RBI is the lender of last resort. As a Banker to Banks, the Reserve Bank also acts as the ‘lender of the last resort’.
    • Lender of last resort does not lend money to trade and industry bodies when they fail to borrow from other sources.
    • RBI does lend to governments to finance budget deficits but it does not come under Lender of last resort.
Bank Runs
  • A bank run is a situation that occurs during periods of the financial crisis when bank customers, worried about an institution’s solvency, descend on the bank en masse, and withdraw funds. Because banks only keep a small percentage of total deposits as cash, a bank run can quickly drain a bank’s liquidity and, in a perfect example of a self-fulfilling prophecy, cause the bank to become insolvent.
Reserve Bank as Banker to Banks
  • The current accounts of individual banks are being opened in e-Kuber (CBS of RBI) by Banking Departments of the Regional Offices. These current accounts are also maintained for participation in centralized and decentralized Payment Systems and are used for settling inter-bank obligations, such as clearing transactions or clearing money market transactions between two banks, buying and selling securities and foreign currencies. Thus, Reserve Bank acts as a common banker, known as ‘Banker to banks’ function, the operational instructions for which are issued by the concerned Central Office departments of the Reserve Bank.
  • Among other provisions, the Reserve Bank stipulates minimum balances to be maintained by banks in these accounts. It is the responsibility of each bank maintaining current account with the Reserve Bank to ensure that sufficient balance is available in the account to avoid defaults in payments and settlements.
  • As Banker to banks, the Reserve Bank provides short-term loans and advances to select banks, when necessary, to facilitate lending to specific sectors and for specific purposes.

Q. Consider the following statements:

1. The Governor of the Reserve Bank of India (RBI) is appointed by the Central Government.
2. Certain provisions in the Constitution of India give the Central Government the right to issue directions to the RBI in the public interest.
3. The Governor of the RBI draws his power from the RBI Act.

Which of the above statements are correct?

a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3

Answer: c) 1 and 3 only

Notes:
  • The RBI Governors are appointed by the government of India for a fixed time period.
  • The Reserve Bank of India was established on April 1, 1935, in accordance with the provisions of the Reserve Bank of India Act, 1934. RBI is not a constitutional body.
    • Hence, nothing is mentioned in the Constitution of India that gives the Central Government the right to issue directions to the RBI in the public interest.
  • The Governor of the Reserve Bank of India is the Chief Executive Officer of the Central Bank of India and the Ex-officio Chairman of its Central Board of Directors.
  • The Governor of the RBI draws his power from the RBI Act.

Q. With reference to the casual workers employed in India, consider the following statements:

1. All casual workers are entitled to employees Provident Fund Coverage
2. All casual workers are entitled to regular working hours and overtime payment
3. The government can by notification specify that an establishment or industry shall pay wages only through its bank account.

Which of the above statements are correct?
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3

Answer: d) 1, 2 and 3

Notes:
  • An employer cannot differentiate between contractual and permanent employees; the Supreme Court has ruled that casual workers are also entitled to social security benefits under the Employees’ Provident Funds and Miscellaneous Provisions Act.
    • “As per Section 2(f) of the EPF Act, the definition of an employee is an inclusive definition, and is widely worded to include any person engaged either directly or indirectly in connection with the work of an establishment, and is paid wages,” a bench of SC said.
  • Employees in India are entitled for regular working hours and overtime payment according to Minimum Wages Rules, Casual workers have all those rights that are enjoyed by regular workers since the definition of employee includes casual labor as per Supreme Court guidelines.
  • The Payment of Wages (Amendment) Act 2017 provides that the government may specify that the employer of any industrial or other establishment shall pay wages to every employee only by cheque or by crediting the wages in his bank account“.
Employees’ Provident Fund Organisation (EPFO)
  • Employees’ Provident Fund Organisation (EPFO) was established by an act of Parliament of India, to provide social security to workers working in India.
  • It is a statutory body that came into force by Employee Provident Fund and Miscellaneous Provision Act, 1952.
  • EPFO comes under the control of the Ministry of Labour and Employment, Government of India.
  • EPFO is the largest social security organization in the world in terms of the number of covered beneficiaries and the largest in terms of the volume of financial transactions undertaken.
    • On 1st October 2014, Prime Minister launched Universal Account Number for Employees covered by EPFO to enable PF number portability.
  • There are 3 major schemes of EPFO:
    1. EPFO Scheme 1952
      • Salient features of EPFO schemes
        • Accumulation plus interest upon retirement and death
        • Partial withdrawals allowed for education, marriage, illness and house construction
        • Housing scheme for EPFO members to achieve the Prime Minister’s vision of Housing for all by 2022.
    2. Pension Scheme 1995 (EPS)
      • Salient features of the Pension Scheme
        • The monthly benefit for superannuation/benefit, disability, survivor, widow(er) and children
        • Minimum pension of disablement
        • Past service benefit to participants of the erstwhile Family Pension Scheme, 1971.
    3. Insurance Scheme 1976 (EDLI)
      • Salient features of the scheme
        • The benefit provided in case of the death of an employee who was a member of the scheme at the time of death.
        • Benefit amount 20 times the wages, maximum benefit of 6 Lakh.

Q. Which among the following steps is most likely to be taken at the time of an economic recession?

a) Cut in tax rates accompanied by increase in interest rate
b) Increase in expenditure on public projects
c) Increase in tax rates accompanied by reduction of interest rate
d) Reduction of expenditure on public projects

Answer: b) Increase in expenditure on public projects

Recession
  • A recession is a nationwide economic slowdown, measured by factors such as industrial production, employment and income.
  • A recession typically involves the overall output in an economy contracting for at least two consecutive quarters, along with job losses and reduction in overall demand.
  • There are a variety of reasons recessions take place.
    • Some are associated with sharp changes in the prices of the inputs used in producing goods and services.
      • For example, a steep increase in oil prices can be a harbinger of a recession. As energy becomes expensive, it pushes up the overall price level, leading to a decline in aggregate demand.
    • A recession can also be triggered by a country’s decision to reduce inflation by employing contractionary monetary or fiscal policies. When used excessively, such policies can lead to a decline in demand for goods and services, eventually resulting in a recession.
  • Here are three common causes of recession:
    • Oversupply. In an economic boom, companies tend to increase production to meet consumer demand. When demand peaks and starts to decline, the excessive supply of goods and services that aren’t consumed can lead to a recession, with companies producing less and downsizing while people lose purchasing power and consumption continues to fall.
    • Uncertainty. Not knowing how the economy will change makes business decision-making riskier. Wars and pandemics are two situations that can make consumer trends unpredictable in the short, medium and long term, thus generating economic uncertainty. Because businesses and people hold off on spending and investment decisions, economic activity declines.
    • Speculation. In general, economic bubbles form when the price of something suddenly rises due to speculation, market trends or consumer confidence. Investors buy it up, hoping to earn a return from the price increase. However, when they start to sell it off, supply exceeds demand (i.e. there are fewer new buyers) and drives prices down, causing the bubble to burst. This happened with tulips in the 17th century and the housing market in 2008.
  • During a recession, businesses may sell fewer products, leading to layoffs and decreased wages. As a result, consumers tend to save their money rather than spend it, further dampening their contribution to the economy. This domino effect creates financial hardships that can affect the entire world.
  • Governments respond to these recessions by altering fiscal policies to boost economic growth. The following are some measures policymakers may implement to deal with a recession:
    • Increasing government spending 
    • Lowering interest rates 
    • Implementing tax cuts 
    • Increasing money supply
economic recession

Q. Consider the following statements

Other things remaining unchanged, market demand for a good might increase if

1. Price of its substitute increases
2. Price of its complement increases
3. The good is an inferior good and income of the consumers increases
4. Its price falls

Which of the above statements are correct?
a) 1 and 4 only
b) 2, 3 and 4
c) 1, 3 and 4
d) 1, 2 and 3

Answer: a) 1 and 4 only

Notes:
  • The main factors that can increase the demand for a good in market are:  
    • Prices of related goods 
    • Income 
    • Expectations  
    • Number of buyers  
    • Preferences 
  • The following are the relations between the demand and price of the products, with changing economic conditions: 
    • The demand for a good increase, if the price of one of its substitutes rises. The demand for a good decrease, if the price of one of its substitutes falls. 
      • A substitute is a good or service that can be used in place of another good or service.
    • The demand for a good increase, if the price of one of its complement’s falls. For example, ice cream and fudge sauce. 
      • Complementary goods are two or more goods typically consumed or used together, such that a change in the price or availability of one good affects the demand for the other good.
        • Examples of complementary goods include hot dogs and hot dog buns, smartphones and protective cases, printer and ink cartridges, cereal and milk, and laptops and laptop cases.
    • The demand for an inferior good decrease if income increases. The demand for a normal good increase if income increases. 
    • If the Price of the good falls, then its demand increases. 
  • Normal and inferior goods:
    • A product whose demand rises when income rises, and vice versa, is called a normal good.
      • A few exceptions to this pattern do exist, though. As incomes rise, many people will buy fewer generic-brand groceries and more name-brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home, and so on.
    • A product whose demand falls when income rises, and vice versa, is called an inferior good.

Q. With reference to Urban Cooperative Banks in India, consider the following statements:

1. They are supervised and regulated by local boards set up by the State Governments.
2. They can issue equity shares and preference shares.
3. They were brought under the purview of the Banking Regulation Act, 1949 through an Amendment in 1996
Which of the statements given above is/are correct?
a) 1 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3

Answer: b) 2 and 3 only

Urban Cooperative Banks (UCBs)
  • Co-operative Banks, which are distinct from commercial banks, were born out of the concept of co-operative credit societies where members from a community group together to extend loans to each other, at favorable terms.
  • Co-operative banks in India are registered under the Cooperative Societies Act. They are also regulated by the RBI and governed by Banking Regulations Act, 1949 and Banking Laws (Co-operative Societies) Act, 1955.
  • Cooperative banks lend as well as accept deposits. They are established with the aim of funding agriculture and allied activities and financing village and cottage industries. National Bank for Agriculture and Rural Development (NABARD) is the apex body of cooperative banks in India.
  • Co-operative Banks are broadly classified into Urban and Rural co-operative banks based on their region of operation.
  • UCBs are regulated and supervised by State Registrars of Co-operative Societies (RCS) in case of single-state co-operative banks and Central Registrar of Co-operative Societies (CRCS) in case of multi-state co-operative banks and by the RBI.
    • But in 2020, all UCBs and multi-state cooperatives were brought under the supervision of RBI.
  • The banking related functions such as issue of license to start new banks/branches, matters relating to interest rates, loan policies, investments and prudential exposure norms are regulated and supervised by the Reserve Bank under the provisions of the Banking Regulation Act, 1949 after an amendment in 1966.
  • The Reserve Bank of India came out with draft guidelines allowing primary UCBs to augment capital through issuance of equity shares, preference shares and debt instruments.
    • The UCBs could raise share capital by issue of equity to persons within their area of operation enrolled as members and also through additional equity shares to the existing members.
  • In 2021 RBI appointed a committee that suggested a 4-tier structure for the UCBs.
    • Tier 1 with all unit UCBs and salary earner’s UCBs (irrespective of deposit size) and all other UCBs having deposits up to Rs 100 crore.
    • Tier 2 with UCBs of deposits between Rs 100 crore and Rs 1,000 crore,
    • Tier 3 with UCBs of deposits between Rs 1,000 crore and Rs 10,000 crore, and
    • Tier 4 with UCBs of deposits more than Rs 10,000 crore.

Q. Indian Government Bond yields are influenced by which of the following?

1. Actions of the United States Federal Reserve
2. Actions of the Reserve Bank of India
3. Inflation and short-term interest rates.

Select the correct answer using the code given below
a) 1 and 2 only
b) 2 only
c) 3 only
d) 1, 2 and 3

Answer: d) 1, 2 and 3

Bond:
  • A bond is a loan made by an investor to a borrower for a set period of time in return for regular interest payments.
  • The time from when the bond is issued to when the borrower has agreed to pay the loan back is called its ‘term to maturity’. 
  • The bond issuer uses the money raised from bonds to undertake various activities such as funding expansion projects, refinancing existing debt, undertaking welfare activities, etc. 
Bond Yield:
  • Bond Yield is the return an investor expects to receive each year over its term to maturity.
  • It partially depends on coupon payments, which refer to the periodic interest income obtained as a reward for holding bonds.
  • The bondholders receive the bond’s face value at the end of the bond’s life. However, one may buy bonds at par value, discount (at a price lower than par value) or premium (at a price higher than par value) as they trade in the secondary market. Therefore, the prevailing market price of bonds also affects the bond yield.
  • It is calculated by using the following formula:
    • Bond Yield= Coupon Amount / Price
  • Bond Yield vs. Price:
    • Price and yield are inversely related.
    • As the price of a bond goes up, its yield goes down and as yield goes up, the price of the bond goes down.
      • A fall in interest rates makes bond prices rise and bond yields fall and vice versa. In short, a rise in bond yields means interest rates in the monetary system have fallen.
        • In other words, the returns for investors (those who invested in bonds and government securities) have declined.
      • Example:
        • Suppose interest rates fall. New bonds that are issued will now offer lower interest payments. This makes existing bonds that were issued before the fall in interest rates more valuable to investors, because they offer higher interest payments compared to new bonds. As a result, the price of existing bonds will increase.
        • However, if a bond’s price increases it is now more expensive for a potential new investor to buy. The bond’s yield will then fall because the return an investor expects from purchasing this bond is now lower.
  • The major factors affecting the bond yields are –
    • the monetary policy of the RBI, especially the course of interest rates
    • the fiscal position of the government
    • government’s borrowing programme
    • global markets, economy, and inflation
Bond Yields

Q. Consider the following:

1. Foreign currency convertible bonds
2. Foreign institutional investment with certain conditions
3. Global depository receipts
4. Non-resident external deposits

Which of the above can be included in Foreign Direct Investments?

a) 1, 2 and 3
b) 3 only
c) 2 and 4
d) 1 and 4

Answer: a) 1, 2 and 3

Foreign Direct Investment (FDI)
  • Foreign direct investment (FDI) is a type of cross-border investment in which an investor from one country establishes a lasting interest in an enterprise in another country.
  • FDI can take various forms, such as acquiring shares, establishing a subsidiary or a joint venture, or providing loans or technology transfers.
    • FDI is considered to be a key driver of economic growth, as it can bring in capital, technology, skills, market access and employment opportunities to the host country.
  • It is different from foreign portfolio investment where the foreign entity merely buys equity shares of a company.
    • Foreign Portfolio Investment is any investment made by a person resident outside India in capital instruments where such investment is
      • (a) less than 10 percent of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company or
      • (b) less than 10 percent of the paid up value of each series of capital instruments of a listed Indian company.  
      • It is the percentage which defines whether it is direct or institutional investment.  
    • FII made above 10 percent of the post issue paid-up equity capital will be considered as FDI. But Once an FDI always an FDI.  
  • In FDI, the foreign entity has a say in the day-to-day operations of the company.
  • It is a major source of non-debt financial resources for the economic development of a country.
  • FDI generally takes place in an economy which has the prospect of growth and also a skilled workforce.
  • FDI has developed radically as a major form of international capital transfer since the last many years.
  • The advantages of FDI are not evenly distributed. It depends on the host country’s systems and infrastructure. 
  • The determinants of FDI in host countries are:
    • Policy framework
    • Rules with respect to entry and operations/functioning (mergers/acquisitions and competition)
    • Political, economic and social stability
    • Treatment standards of foreign affiliates
    • International agreements
    • Trade policy (tariff and non-tariff barriers)
    • Privatisation policy
  • Foreign investment in Indian securities has been made possible through the purchase of Global Depository Receipts, Foreign Currency Convertible Bonds and Foreign Currency Bonds issued by Indian issuers which are listed, traded and settled overseas.  
    • ‘Foreign Currency Convertible Bond’ (FCCB) is a bond issued under the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993, as amended from time to time.   
      • Automatic Route for Issue of Foreign Currency Convertible Bonds (FCCBs) is allowed.  
  • A Non-Resident External (NRE) account is a rupee dominated account opened by an NRI to facilitate deposit of foreign currency earnings. It is not an FDI. 

Q. Consider the following statements:

The effect of the devaluation of a currency is that it necessarily

  1. Improves the competitiveness of the domestic exports in the foreign markets
  2. Increase the foreign value of the domestic currency
  3. Improves the trade balance

Which of the above statements is/are

a) 1 only
b) 1 and 2
c) 3 only
d) 2 and 3

Answer: a) 1 only

Notes:
  • Devaluation of a currency means a reduction in the value of a currency vis-a-vis major internationally traded currencies.
  • Devaluation occurs when a country intentionally reduces the value of its currency relative to one or more foreign countries. Thus, Devaluation of a currency decreases the foreign value of domestic currency.  
  • When the country follows a fixed exchange rate regime the government constantly has to revalue and devalue the currency to maintain the pegged exchange rate.
  • When there is upwards market pressure on the currency to appreciate, the central bank will artificially devalue the currency by buying up foreign reserves. 
  • Devaluation occurs when a government wishes to increase its balance of trade by decreasing the relative value of its currency.
  • The government does this by adjusting the fixed or semi-fixed exchange rate of its currency versus that of another country.
  • Exports become cheaper and more competitive to foreign buyers. Higher exports relative to imports can increase aggregate demand as increased consumer spending on domestic goods and services. Hence, it improves the competitiveness of the domestic exports in the foreign markets.
    • With exports more competitive and imports more expensive, we may see higher exports and lower imports, which will reduce the current account deficit.
  • Devaluation of currency increases the volume of exports and reduces the volume of imports, both of which have a favourable effect on the balance of trade, that is, they will lower the trade deficit or increase the trade surplus. 
  • Although devaluation is done to improve the trade balance, the difference between the value of imports and exports as well as the preference of people in both countries will determine the improvement or deterioration of the trade balance, and we cannot conclude that devaluation will necessarily improve trade balance.
  • Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. Thus, devaluation may not improve the trade balance in the long run. 

Q. Which one of the following effects of creation of black money in India has been the main cause of worry to the Government of India?

a) Diversion of resources to the purchase of real estate and investment in luxury housing
b) Investment in unproductive activities and purchase of precious stones, jewellery, gold etc.
c) Large donations to political parties and growth of regionalism
d) Loss of revenue to the State Exchequer due to tax evasion

Answer: d) Loss of revenue to the State Exchequer due to tax evasion

Notes:
  • Black Money in India, is a term used to describe money that is illegitimately owned.
  • Black money includes all funds earned through illegal activity and otherwise legal income that is not recorded for tax purposes. 
  • The generation of black income has been resulting in a huge loss of revenue to the state exchequer due to continuous evasion of taxes both from direct and indirect taxes. 
    • In addition, these funds rarely enter the banking system. As a result, it can be more difficult for legitimate small businesses and entrepreneurs to obtain loans.
  • Black money and tax evasion which go hand in hand, have also the effect of seriously undermining the equity concept of taxation and warping its progressiveness.
  • Together, they throw a greater burden on the honest taxpayer and lead to economic inequality and concentration of wealth in the hands of the unscrupulous few in the country.

Q. Which one of the following is likely to be one of the most inflationary in its effects?

a) Repayment of public debt
b) Borrowing from the public to finance a budget deficit
c) Borrowing from the banks to finance a budget deficit
d) Creation of new money to finance a budget deficit

Answer: d) Creation of new money to finance a budget deficit

Notes:
  • Deficit financing means generating funds to finance the deficit which results from excess of expenditure over revenue. The gap being covered by borrowing from the public by the sale of bonds or by printing new money.
  • There are three ways to finance a budget:
    • ​Creating new currency
    • Borrowing from internal sources like RBI, issuing bonds, etc.
    • Borrowing from External sources like WB, IMF, etc.
  • Government expenditure by printing money boosts incomes and raises private demand in the economy. Thus, it fuels inflation. A little increase in inflation is healthy as it encourages business activity. But if the government doesn’t stop in time, more and more money floods the market and creates high inflation.
    • And since inflation is revealed with a lag, it is often too late before governments realise, they have over-borrowed. Higher inflation and higher government debt provide grounds for macroeconomic instability. 
  • Borrowing from the public by issuing bonds at a lower interest rate will not create inflation. Similarly, borrowings from banks will not generate inflation.