MONEY SUPPLY & FRBM ACT

Question 1

What are the two main types of borrowing the government engages in?

Answer 1

Short-term loans (e.g., Treasury Bills) to cover temporary cash flow needs.
Long-term loans (e.g., Government Bonds) to fund major projects.

Question 2

Describe the RBI’s role in facilitating government borrowing.

Answer 2

Issues debt instruments like T-Bills and bonds on behalf of the government.
Regulates the government securities market for smooth functioning.
Influences the cost of borrowing through monetary policy tools.

Question 3

What is the difference between primary and secondary markets for government securities?

Answer 3

Primary Market: Where new government securities are issued.
Secondary Market: Where existing securities are traded among investors.

Question 4

How can the RBI purchase government securities in the primary market?

Answer 4

Underwriting auctions (guaranteeing to buy unsold securities)
In rare cases, through direct purchase from the government

Question 5

What is the main way the RBI buys and sells government securities in the secondary market?

Answer 5

Open Market Operations (OMOs) - buying to inject liquidity, selling to absorb liquidity.

Question 6

Why is the RBI’s participation in both primary and secondary markets important?

Answer 6

Primary market: Ensures successful government borrowing even in tough times.
Secondary market: Helps manage money supply and interest rates.
Offers potential for direct economic intervention in exceptional circumstances.

Question 7

What are Treasury Bills (T-Bills)?

Answer 7

Short-term government debt instruments with maturities of less than one year, used to bridge temporary funding gaps.

Question 8

What are Government Bonds?

Answer 8

Long-term government debt instruments with maturities ranging from one year to 40 years, used to finance major projects. They offer investors regular interest payments (coupons).

Question 9

Explain the purpose of Open Market Operations (OMOs).

Answer 9

OMOs are the primary tool used by the RBI to manage money supply and liquidity in the economy. The RBI buys government securities to increase money supply and sells government securities to decrease money supply.

Question 10

How does the secondary market for government securities benefit investors?

Answer 10

Liquidity: It allows investors to sell their holdings before maturity.
Price Discovery: Reflects market sentiment and investor confidence in the government.
Wider Participation: Attracts a broader range of investors due to ease of trading.

Question 11

What is the Fiscal Responsibility and Budget Management (FRBM) Act?

Answer 11

An Indian law enacted in 2003 that aims to reduce the government’s fiscal deficit, limit excessive borrowing, and promote long-term fiscal discipline.

Question 12

What is the fiscal deficit?

Answer 12

The situation where a government’s spending exceeds its revenue in a given fiscal year.

Question 13

How does the RBI’s repo rate influence government borrowing?

Answer 13

Higher repo rate makes it more expensive for banks to borrow from the RBI, which can indirectly increase the cost of government borrowing as well.
Lower repo rate makes borrowing cheaper, potentially lowering interest rates on government bonds.

Question 14

Besides OMOs, what other monetary policy tools does the RBI use to influence the money supply?

Answer 14

Cash Reserve Ratio (CRR): The percentage of deposits banks must keep with the RBI.
Statutory Liquidity Ratio (SLR): The percentage of deposits banks must invest in government securities.

Question 15

What are some of the objectives of the FRBM Act?

Answer 15

Reduce the fiscal deficit to a sustainable level.
Ensure responsible fiscal management (not burdening future generations with excessive debt).
Promote macroeconomic stability.

Question 16

Why might the RBI directly purchase government securities from the primary market in exceptional circumstances?

Answer 16

To support the government during a financial crisis when investor demand for securities is low.
To finance specific government initiatives in line with broader economic goals.

Question 17

What is the difference between inflation and interest rates?

Answer 17

Inflation: A general increase in the price level of goods and services over time, leading to a decline in purchasing power.
Interest Rates: The cost of borrowing money, expressed as a percentage of the loan amount.

Question 18

How does an increase in money supply typically affect inflation?

Answer 18

An excessive increase in money supply relative to economic growth can lead to inflation. This is because more money chasing the same amount of goods leads to higher prices.

Question 19

Why is the secondary market for government securities important for determining the price of government debt?

Answer 19

The secondary market reflects real-time investor sentiment. Prices in the secondary market fluctuate based on demand and supply. This helps determine the interest rate (yield) for government bonds, indicating the market’s perception of risk and return.

Question 20

What are some potential drawbacks of excessive government borrowing?

Answer 20

Crowding out: Government borrowing can compete with private sector borrowing, driving up interest rates for businesses and consumers.
Intergenerational debt: Excessive debt can burden future generations with repayment obligations.
Inflationary pressure: If borrowing leads to excessive increases in money supply, it can contribute to inflation.

Question 21

In a simplified scenario, how might the RBI use its monetary policy tools to combat inflation?

Answer 21

Increase the repo rate to make borrowing more expensive.
Increase CRR and SLR requirements, reducing banks’ ability to lend.
Sell government securities in the open market (OMOs) to absorb liquidity.

Question 22

What is the primary objective of the Fiscal Responsibility and Budget Management Act (FRBM) of 2003?

Answer 22

To enforce fiscal discipline on the Indian government, primarily by limiting the fiscal deficit to a specified percentage of GDP.

Question 23

Under the FRBM Act, what is a key restriction placed on government borrowing?

Answer 23

The government generally cannot borrow directly from the Reserve Bank of India (RBI). This means the RBI cannot purchase government securities directly from the primary market.

Question 24

Name the TWO exceptional scenarios where the RBI is allowed to buy government securities directly in the primary market.

Answer 24

Short-term Ways and Means Advances (WMA) – to cover temporary budget shortfalls.
During national emergencies like war, disaster, agricultural crisis, or a significant fall in GDP.

Question 25

Even with the restrictions, how can the RBI still influence the government securities market?

Answer 25

The RBI can participate in the secondary market by buying or selling government securities through Open Market Operations (OMO)

Question 26

What is the key difference between the RBI buying government securities in the primary vs. secondary markets?

Answer 26

Primary Market: Provides direct financing to the government from the RBI.
Secondary Market: Regulates liquidity and money supply in the economy, indirectly influencing the cost of government borrowing.

Question 27

What is meant by the monetization of deficit?

Answer 27

Monetization of deficit occurs when the Reserve Bank of India (RBI) directly finances the government’s spending gap by printing new currency notes and extending a loan to the government.

Question 28

Why is the monetization of deficit considered a potentially inflationary practice?

Answer 28

When the RBI prints more currency to finance the deficit, it increases the overall money supply without a corresponding increase in economic output. This excess money can chase the same amount of goods, leading to higher prices (inflation).

Question 29

How does the FRBM Act make the monetization of deficit a more difficult process?

Answer 29

The FRBM Act sets limits on the government’s fiscal deficit and generally prohibits direct borrowing from the RBI. This makes it difficult for the government to resort to monetization of deficit as a primary means of financing its spending.

Question 30

Despite the FRBM Act restrictions, are there situations where some degree of monetization of deficit might occur?

Answer 30

Yes. The exceptions outlined in the FRBM Act (short-term Ways and Means Advances, or during emergencies) can create scenarios where the RBI ends up directly financing some portion of the government’s deficit.

Question 31

What is the key difference between the monetization of deficit and the RBI’s Open Market Operations (OMO)?

Answer 31

Monetization of deficit: Direct lending to the government, increasing the money supply.
OMO: Buying or selling government securities in the secondary market, primarily intended to manage liquidity and interest rates.

Question 32

Velocity of Money Circulation

Answer 32

Definition: The average number of times a unit of currency is exchanged for goods and services within a specific time period.
Example:
You buy a notebook costing ₹50.
The shopkeeper uses the same ₹50 to purchase groceries.
The grocer uses that money to pay for utility bills.
In this instance, ₹50 facilitated ₹150 worth of transactions.

Question 33

Why does money circulate faster in the hands of poorer individuals?

Answer 33

Answer: People with lower incomes tend to spend a higher proportion of their money on necessities like food, housing, and transportation. This creates a faster circulation of money as they must quickly turn their income into spending.
Explanation: Those with higher incomes tend to save a portion, and may invest in assets that slow the movement of money within the economy.

Question 34

How do developed countries’ spending patterns affect the velocity of money?

Answer 34

Developed countries, with consumerist cultures and established social security systems, often have a higher velocity of money.
Explanation:
People tend to spend more freely when they feel confident about future income and safety nets.
Easy access to credit and loans leads to increased spending.

Question 35

What is the relationship between economic booms and the velocity of money?

Answer 35

The velocity of money tends to increase during economic booms.
Explanation:
Businesses invest in expansion and purchase more raw materials.
More workers are hired with disposable income to spend.
This leads to a faster circulation of money throughout the economy.