Hyderabad Campus Comprehensive Exam – (Part A - Closed Book) - Solution Semester I - 2022-23 Course Title: Money, Banking, and Financial Markets Course No: ECON F312 Date: 24/12/2022 Duration: 75 Minutes Total Marks: 20 Important Instructions: All questions are compulsory. Answers to all the questions should be to the point. Use of only scientific calculator is allowed. All the best! 1. Select the most appropriate answer. (0.75M*8=6M; Correct Answer – +100%; Incorrect Answer - -33%) (i). The political business cycle refers to the phenomenon that just before elections, politicians enact ________ policies. After the elections, the bad effects of these policies (for example, ________) have to be counteracted with ________ policies. a) expansionary; higher unemployment; contractionary b) expansionary; a higher inflation rate; contractionary c) contractionary; higher unemployment; expansionary d) contractionary; a higher inflation rate; expansionary (ii). The time-inconsistency problem in monetary policy can occur when the central bank conducts policy: - a) using a nominal anchor. b) using a strict and inflexible rule. c) on a discretionary, day-by-day basis. d) using a flexible, discretionary rule. (iii). Both ________ and ________ are part of liabilities in the RBI Balance sheet. a) currency in circulation; reserves b) currency in circulation; government securities c) government securities; discount loans d) government securities; reserves (iv). When the ________ interest rate is low, there are greater incentives to ________ and fewer incentives to ________. a) nominal; lend; borrow b) real; lend; borrow c) real; borrow; lend d) market; lend; borrow (v). If stock prices are expected to climb next year, everything else held constant, the ________ curve for bonds shifts ________ and the interest rate ________. a) demand; left; rises b) demand; right; rises c) demand; left; falls d) supply; left; rises (vi). When a commercial bank sells a government bond to the central bank, reserves in the banking system ________ and the monetary base ________, everything else held constant. a) increase; increases b) increase; decreases c) decrease; increases d) decrease; decreases (vii). In the model of the money supply process, the depositor’s role in influencing the money supply process is represented by: a) only the currency ratio. b) both the currency ratio and excess reserve ratio. c) the currency ratio, excess reserve ratio, and the market interest rate. d) only the market interest rate. (viii). In the market for reserves, when the federal funds rate (interbank lending rate) equals the interest rate paid on excess reserves ________. a) the supply curve of reserves is vertical b) the supply curve of reserves is horizontal c) the demand curve for reserves is vertical d) the demand curve for reserves is horizontal
2. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don’t have any excess reserves to lend out? Why or why not? What options are available that will enable you to provide the funds your customer needs? [3M] Sol: No. - Borrow from another bank. (0.5M) - Borrow from central banks. (0.5M) - Sell government bond and securities. (0.5M) - Loan sales (Not good). (0.5M) Mention cost and benefit of each option and conclude with the best option. (1M) 3. The existence of the government safety net lead to increased concentration in the banking industry? Do you agree or disagree? Whether increased concentration in the banking industry is good thing or bad thing. Explain with a suitable example. [4M] Sol: Sol: 2-2.5M [In an effort to avoid financial crisis, large institutions realize that government would not allow them to fail. This too-big-to-fail policy adds moral hazard problems and allows large banks to engage in extremely risky behavior. This, in turn, puts small banks at competitive disadvantage and may drive these small institutions out of the market, leading to an increase in concentration (decrease in competitions with only few banks in the country). In India, you can write how some banking scam (Nirav Modi Scam) didn’t affect big banks like PNB while some (Laxmi Vilas Bank Scam, PMC Bank Scam) led to almost closure of these banks.] 1.5-2M [Increased concentration = Decreased competition; Based on discussion in the class, write some points which is for and against bank concentration; discuss the recent Indian banking scenario. Increased concentration decreases moral hazard incentives for financial institutions to take on more risk. Increasing profitability as a result of increased concentration could tip the incentives of financial institutions toward assuming lower risk. Increased concentration also leads to higher charges to consumers and decrease the efficiency of banking institutions, which don’t have to compete as vigorously. In the last few years, some of the banks have been merged in India which lead to increase in concentration. What kind of effect it may have on cost raising fund and the related risk.]
4. Explain and differentiate between ‘goal independence’ and ‘instrument independence’ of the central bank with suitable examples. [2M] Sol: Goal Independence – When monetary policy makers are given independence in deciding the goal of monetary policy like price stability, output stability, exchange rate stability etc. [1M] Need to mention some goal of monetary policy to get full marks. Instrument Independence - When monetary policy makers are given independence in deciding the instruments of monetary policy like reserve aggregate and interest rates to achieve its goal. Need to mention some goal and instruments of monetary policy to get full marks. 5. In which economic conditions would a central bank want to use an unconventional monetary policy tools like “forward-guidance” strategy? How can ‘forward guidance’ impact the policy instrument, intermediate targets, and goals? [3M] Sol: When conventional MP tools don’t work (during crisis situation) because of negative sentiments of investors and zero lower bound problem (MP ineffective), central banks rely on unconventional MP tools. [0.5+0.5=1M] Forward Guidance - FG – both implicit and explicit – pertains to central bank communication on the ‘stance’ of monetary policy going ahead, i.e., the future path of the policy interest rate which influence the public expectations. Forward guidance can be (a) time-based; or (b) state- based. Under ‘time-based guidance’, the central bank commits to a stance of monetary policy until a specific point in time. In contrast, ‘state-based guidance’ pertains to a stance until an explicit set of economic conditions are met. During the GFC and COVID-19, central banks were active in providing FG to (i) reinforce their commitment to low interest rates; and (ii) communicate their strategy in uncertain times. [1M] e.g. CB commitment to low interest rates (instrument) positive sentiments of investors bank lending increases (intermediate target) investment increases output increases (goal) [1M]
6. If junk bonds are ‘Junk’, then why do investors buy them? Explain. [2M] Sol: The reasons investors would buy a junk bond is to benefit from the higher yield, however, that comes with taking on higher risk [1M]. Investors who believe that economic conditions would improve will purchase a junk bond in anticipation that the company can become investment grade [1M]. BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE, PILANI Hyderabad Campus Comprehensive Exam – (Part B - Open Book) - Solution Semester I - 2022-23 Course Title: Money, Banking, and Financial Markets Course No: ECON F312 Date: 24/12/2022 Duration: 105 Minutes Total Marks: 40 Important Instructions: All questions are compulsory. Answers to all the questions should be to the point. Use of only scientific calculator is allowed. All the best! 1. One of the solutions to the adverse selection problem associated with asymmetric information is the pledging of collateral. However, the collateral may be riskier than initially thought. As an example, explain why the collateral did not work adequately to mitigate the mortgage securitization problems associated with the financial crisis of 2007–2009. [3M] Sol: Financial Crisis Output and Price decline Debt deflation [1M] Value of assets (home) declines while liabilities remain same Decline in net worth It’s better to default rather than pay the housing EMI
2. Using the supply and demand analysis of the market for reserves, indicate what effects the following situations would have on central bank interest rates and economies in general. [3M] Sol: a. The central bank eliminates interest paid on excess reserve. Sol: If interest on the excess reserve is removed, commercial banks would have no profits from keeping the reserve. So, they would increase lending. This increase in lending would further contribute to a rise in the money supply. b. The central bank decreases reserve requirements. Sol: When the central bank decreases the reserve rate, the amount of money that banks are required to hold for possible future use decreases. This would increase lending by commercial banks. Consequently, the money supply would increase. Decreasing the reserve requirements causes the demand curve to shift right and FFR (interbank lending rate) to fall.
Sol:
Only explanation [0.5-0.75*2=1-1.5M]
To get full marks, you need to draw graph with explanation. 3. “Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans.” Is this statement true, false, or uncertain? Explain your answer with suitable examples from Indian banking industry. [3M] Sol: The solution for this is based on your argument for or against diversification and related example supporting your argument. One of the arguments given below: Diversification is the strategy adopted to lower the risk in investment. Under this strategy, all the capital is not invested on one thing rather it is spread over a variety of high-risk and low-risk assets. The given statement is misleading because when a bank specializes in making particular sorts of loans, it can show economies of scale and perform all the more proficiently. Specialization permits the bank to collect data regarding regional firms and find their creditworthiness more comfortable. This decreases the negative choice situation in which banks do not understand which firms have more adequate credit than the rest and decreases the chance of default. In addition, when the bank expands loans, it collects interest periodically and these charges are backed by agreements and collaterals. Therefore, reimbursement on its loans is not that unsafe. Example: - Many financial institutions (DHFL) provides lending to real estate industry. When real estate industry collapsed, these financial institutions went bankrupt. In contrast, when some regional banks (South Indian Bank, Laxmi Vilas Bank) provide lending on PAN India basis or different industry, their loans become bad (they don’t have expertise in provide loan to firms operating in North India or to different industry) because they are not able to collect accurate information about the borrowers. Explanation – 2M Example – 1M 4. Explain how each of the following events affects the amount of M1 (increase / decrease / constant) that people hold: [2M] a. Debit cards are invented. Debit cards permit customers to fulfill basic transactions without the help of a branch agent. Debit card debits the money from saving account The money in the saving account is already included in M1. Hence, invention of debit card doesn’t effect M1. [Constant] b. Credit cards are invented. If any person uses credit card for purchase of goods and services, he or she automatically increases the money supply. The vendor gets a new deposit in his account, which expands total demand deposits in the bank till the purchaser payoff the loan. Hence, invention of credit card has increased the M1. [Increase] c. Interest rate on bonds fall. Decreased interest rate on bond reduces demand for bond and increases demand for deposit. Therefore, a decrease in interest rate leads to increase in money supply or M1. [Increase] d. Sweep account is invented. Sweep account shift the money from saving or current account to another account which is not part of traditional account. Therefore, invention of sweep account leads to decrease in M1. [Decrease] 5. Using the Taylor Rule, suggest what should the policy makers at the RBI do to the policy rate (call money rate or fed fund rate) under the following scenario: [2M] a. Recently, due to persistently high inflation rate, the RBI revises its inflation target upward (from 4% to 5%). Sol: If the inflation target is revised upward, this would decrease the inflation gap at any given inflation rate. This would result in a lower policy rate according to the Taylor rule. b. Potential output increases while actual output remains unchanged. Sol: Increase in potential output causes the output gap to decline, resulting in a decline in the policy rate according to the Taylor rule. 6. Answer the below questions using the given data: [7M]
'Other' Bankers' Currency Cash Currency Deposits Deposits in with with the with the with the Demand Time Reserve Narrow Broad Year Circulation Banks Public RBI RBI Deposits Deposits Money Money Money CRR(%) 2012-13 1190975 49914.46 1141061 3239.995 320671.2 753225.3 6492293 1514886 1897526 8389819 4.36 2013-14 1301074 55254.74 1245819 1965.119 429702.8 811977.5 7457624 1732742 2059762 9517386 4.00 2014-15 1448312 62130.66 1386182 14589.99 465560.9 891632.3 8257764 1928463 2292404 10550168 4.00 2015-16 1663463 66209.35 1597254 15450.66 501826 989833.7 9015077 2180740 2602538 11617615 4.00 2016-17 1335266 71142.19 1264124 21091.12 544127 1396741 10109983 1900485 2681957 12791940 4.00 2017-18 1829348 69635.3 1759712 23906.65 565525 1483712 10695255 2418779 3267331 13962587 4.00 2018-19 2136770 84561.06 2052209 31741.92 601969 1626512 11721603 2770481 3710464 15432067 4.00 2019-20 2447312 97563.14 2349748 38507.17 543888 1737692 12674016 3029707 4125948 16799963 4.00 2020-21 2853763 101934.8 2751828 47350.79 698867 1995120 14050278 3599981 4794299 18844578 3.00 2021-22 3133716 98027.64 3035689 58444.11 876726.2 2212992 15186605 4068887 5307125 20493729 3.50 a. Calculate and plot the value of currency ratio (M3) for the period 2012-2021. Comment on the trend of the currency ratio over the last ten years. [1.5M] b. Calculate and plot the value of excess reserve ratio (M3) for the period 2000-2018. Comment on the trend of the excess reserve ratio over the last ten years. [2.5M] c. Given the required reserve ratio (use CRR as a measures of required reserves ratio), currency ratio, and excess reserve ratio, calculate and plot the value of money multiplier (M3) for the period 2012-2021. Comment on the trend of the money multiplier over the last ten years. Given the recent trends in money multiplier, should money multiplier be used to influence the monetary policy. [3M] Note: Your comments and analysis for the above questions should have special mention of events like demonetization and Covid-19. Sol:
Money Currency Required Excess ER RR Multiplier Ratio Reserves Reserves Ratio Ratio - M3
0.157 315904.598 54681.062 0.0075 0.044 5.548
0.151 330784.06 154173.480 0.0186 0.040 5.498 0.152 365975.852 161715.708 0.0177 0.040 5.505 0.160 400196.428 167838.922 0.0168 0.040 5.358 0.110 460268.96 155000.230 0.0135 0.040 6.795 0.144 487158.68 148001.620 0.0122 0.040 5.820 0.154 533924.6 152605.460 0.0114 0.040 5.623 0.163 576468.32 64982.820 0.0045 0.040 5.604 0.172 481361.94 319439.860 0.0199 0.030 5.291 0.174 608985.895 365767.945 0.0210 0.035 5.096 a. Currency Ratio = Currency with Public / (Demand Deposit + Time Deposit) -Trend on currency ratio – your explanations mostly cover the factors which led to change in the ratio over these period (financial innovation leads to decline, Covid-19 crisis and inflation will lead to increase, and demonetization will lead to significant decline. Post- demonetization, currency ratio is trying to get back to its previous level, despite surge in digital payments). 1M for calculation and 0.5M for explanation. b. Excess Reserves = Total Reserves – Required Reserves = Cash with Banks + Banker’s Deposit with the RBI – Required Reserves (reserve ratio * demand deposit and time deposit) ER Ratio = Excess Reserves / (Demand Deposit + Time Deposit)
-Trend on excess reserves ratio – your explanations mostly cover the factors which lead to change in the ratio over these periods (increase during the Covid-19 period, decline during demonetization etc). 2M for calculation and 1M for explanation.
c. Money Multiplier – M3 = (1+Currency Ratio) / (Currency Ratio + ER Ratio + RR Ratio)
Trend on money multiplier ratio – Money multiplier trend fluctuating (unstable) over the given period. The reasons could be changes in currency ratio, excess reserve ratio and required reserves ratio (due to financial innovation, inflation, demonetization, covid-19 etc.). As we know, Money Supply (M1 or M3) = Money multiplier*Monetary Base (M0) For effective monetary policy, the instrument of MP should be able to control money supply completely. For this, the value of money multiplier should be stable over the period of time. If it’s not stable, money supply can’t be control by using monetary base and multiplier. 1.5M for calculating and plotting money multiplier and 0.5M for analyzing the trend and 1M for explanation of using multiplier as an effective monetary policy. Please note that the value of multiplier can’t go below 1 (Many student’s calculations of multiplier is coming out to be less than 1 which is a blunder. In those cases, you won’t get any marks).
