Friday, January 10, 2014


Course Code: ECO - 09
Course Title: Money, Banking and Financial Institutions
Assignment Code: ECO – 09/TMA/2015-16
Coverage: All Blocks
Maximum Marks: 100
Attempt all the questions.
1. Why is money demanded? How is the Keynesian approach different from the classical approach in this regard? (20)
2. Explain the establishment, structure and functions of the State Bank of India.                (20)
3. What is meant by money market? Discuss the significance of money market in a modern economy.    (20)
4. Describe the working of the IMF. How does it help member countries in dealing with their temporary balance of payments problems?                     (20)
5. Write short notes on the following:                                    (4×5)
(a) General Leading Principal of World Bank
(b) Regional Rural Banks
(c) Economic Significance of Banking
(d) Branch Banking                                         

Answer of Question No.1.
Demand for Money: Classical view of demand for money contributes that money can not satisfy the holder directly. It is demanded for its purchasing power or its use as medium of buying goods and services which satisfy the holder of money. It is therefore obvious that the demand for money arises from the demand for goods and services to meet the society's requirements. Hence demand for money may be termed as 'derived demand'. The demand for money in a country depend on the volume of transactions taken place in the country; more specially, depends upon the supply of goods and services available in the market. The larger the amount of tradable goods and services in the economy, large is the volume of demand for money.

Comparative analysis of Classical theory and Keynesian approach
Classical theory: The classical theory of demand for money is presented in the classical quantity theory of money and has two approaches: the Fisherman approach and the Cambridge approach.
1. Fisherian Approach: To the classical economists, the demand for money is transactions demand for money. Money is demanded by the people not for its own sake, but as a medium of exchange. Thus, the demand for money is essentially to spend or for carrying on transactions and thus is determined by the total quantity of goods and services to be transacted during a given period.
2. Cambridge Approach: While Fisher's transactions approach emphasized the medium of exchange function of money, the Cambridge cash-balance approach is based on the store of value function of money. According to the Cambridge economists, the demand for money comes from those who want to hold it for various motives and not from those who want to exchange it for goods and services. This amounts to the same thing as saying that the real demand for houses comes from those who want to live in them, and not from those who simply want to construct and sell them. Thus, in the Cambridge approach, the demand for money implies demand for cash balances.
In the end, the classical theory of demand for money may be summarised as under:
(i) Money is only a medium of exchange.
(ii) The ratio of desired money balances to nominal income is assumed to be constant at its minimum, or, in other words, velocity of money is constant at its maximum (because K = 1/V).
(iii) The public holds a constant fraction of its nominal income in non-interest-earning cash balances for transactions and precautionary motives.
(iv) Hoarding, i.e., holding money above the minimum desired for transaction purposes, is considered irrational because money in itself has no value.
(v) Quantity of money demanded is directly related to the price level.
Keynesian theory of Money demand: The modem concept of demand for money is associated with the Keynesian analysis of the demand for money. In his General Theory of Employment, Interest and Money (1936), J.M. Keynes expounded his theory of demand for money. Essentially, Keynes' theory of demand for money is an extension of the Cambridge cash-balances approach and stresses the asset role (i.e., the store of value function) of money. In contrast to the Fisherian view of what people 'have to hold', the Keynesian view stated that the demand for money is determined by what people 'want to hold'. To Keynes, demand for money does not mean the actual money balances held by the people, but what amount of money balances they want to hold. Keynes states that the demand for money means demand for money to hold the demand for cash balances.
Money is not just meant for spending. It can be held as a form of wealth or asset which commands other forms of wealth in exchange, all the time. Thus, money being the most liquid asset, can serve as an efficient store of value; so it is demanded for its own sake. In this sense, the demand for money is the inverse of the velocity of circulation. In short, the Keynesian approach to the demand for money stresses the public's need for cash or money balances as a store of value at a particular point of time.
In this context, it involves evidently the reason for the people's preference to hold liquid cash or money, rather than other assets, as a store of value. This desire for money is described by Keynes as liquidity preference. Thus, the demand for money, in the Keynesian sense, is a demand for liquidity or "liquidity preference." Hence the modern approach to the demand for money has been designated as the cash balance or liquidity preference approach. Keynes distinguished three such motives which induce people to hold money. These are: (1) the transactions motive; (2) the precautionary motive, and (3) the speculative motive.
He further holds that, the total demand for money implies total cash balances. Analytically, total cash balances may be classified into two parts: (i) Active Cash Balances; and (ii) Idle Cash Balances.
Answer of Question No.2.
Establishment of State Bank of India: State Bank of India (SBI), state-owned commercial bank and financial services company, nationalized by the Indian government in 1955. SBI maintains thousands of branches throughout India and offices in dozens of countries throughout the world. The bank’s headquarters are in Mumbai. The oldest commercial bank in India, SBI originated in 1806 as the Bank of Calcutta. Three years later the bank was issued a royal charter and renamed the Bank of Bengal. Along with the Bank of Bombay (founded 1840) and the Bank of Madras (founded 1843), it was one of three so-called presidency banks, each of which was jointly owned by the provincial government and private subscribers. In 1921 the presidency banks were merged to form the Imperial Bank of India (IBI), which then became the largest commercial enterprise in the country.
In 1955 the government of India and the country’s central bank, the Reserve Bank of India (founded 1935), assumed joint ownership of IBI, which was renamed the State Bank of India. Four years later, by the State Bank of India (Subsidiary Banks) Act, banks earlier operated by individual princely states became subsidiaries of SBI. The Reserve Bank’s share of SBI was transferred to the government in 2007. Since nationalization, SBI has served the needs of Indian economic development through rural-development initiatives and microcredit programs and by financing major agricultural and industrial projects and raising loans for the government.
Organisational Structure: The organisational structure of the State Bank of India is somewhat different from the other nationalized banks. It has a well defined system of decentralisation of authority. The whole country has been divided into nine circles for administrative control purposes The Head Offices of each circle is known as Local Head Office with a Local Board of Directors which has a statutory status. Each circle has been further divided into a number of Regions. There is a Chief General Manager (formerly known as the Secretary and Treasurer) for each Circle He is the Chief Executive for his circle and has under him Regional Managers for the different regions in his circle.
The Chief General Manager enjoys vast powers for control over branches and has also extensive discretionary powers regarding loans and advances. All this has resulted in taking the operational control nearer to the area of operation. The Bank is further trying to strengthen the Regional Offices so as to reduce the span of control of the controlling authority (i.e., the Chief General Manager), leading to further decentralisation.
Functions of SBI: The functions of SBI can be grouped under two categories, viz., the Central Banking functions and ordinary banking functions.
A. Central Banking Functions: The SBI acts as agent of the RBI at the places where the RBI has no branch. Accord­ingly, it renders the following functions:
(1) Banker to the Government: The SBI functions as the banker to the central and state governments. It receives and pays money on behalf of the governments. Especially it ren­ders the following functions as directed by the RBI in this regard.
(a) Collection of charges on behalf of the government e.g. collection of tax and other payments
(b) Grants loans and advances to the governments
(c) provides advises to the government regarding economic conditions, etc.
(2) Banker's Bank: Commercial Banks have accounts with SBI. When the banks face financial shortage, the SBI provides assistance to them as it is considered a big brother in the banking industry. It discounts the bills of the other commercial banks. Due to the functions on this line the SBI is considered in a limited sense as the banker's bank.
(3) Currency Chest: The RBI maintains currency chests at its own offices. But RBI Of­fices are situated only in big cities. SBI, buy its wide network of branches operate in urban as well as rural areas. RBI therefore, in such places keeps money at currency chests with SBI. Whenever needs arise, the currency is withdrawn from these chests under proper accounting and reporting to RBI. Presently RBI entrust currency chest to other Public Sector Banks and a few Private Sector Banks also.
(4) Acts as Clearing House: In all the places, where RBI has no branch, the SBI renders the functions of clearing house. Thus, it facilitates the inter bank settlements. Since, all the banks in such places have accounts with SBI; it is easy for the SBI, to act as clearing house.
(5) Renders Promotional Functions: State Bank of India also renders various promotional functions. It provides various facilities to the following priority sectors: (i) Agriculture (ii) Small - Scale Industries (iii) Weaker sections of the society (iv) Co-operative sectors (v) Small – traders (vi) Unemployed Youth (vii) Others. In this respect SBI is like any other commercial bank.
B. General Banking Functions: Besides the above specialized functions, the SBI renders the following functions under Section 33 of the Act.
1. Accepting deposits from the public under current, savings, fixed and recurring deposit accounts.
2. Advancing and lending money and opening cash credits upon the security of stocks, securities, etc.
3. Drawing, accepting, discounting, buying and selling of bills of exchange and other negotiable instruments.
4. Investing funds, in specified kinds of securities.
5. Advancing and lending money to court of wards with the previous approval of State Government.
6. Issuing and circulating letters of credit.
7. Offering remittance facilities such as, demand drafts, mail transfers telegraphic transfers, etc.
Answer of Question No.3.
Meaning of Money Market: The financial system of any country is the backbone of the economy of that country. The financial systems of all economies are broadly sub-divided into money market, capital market, gilt-edged securities market and foreign exchange market. The money market, capital market and the gilt securities market   provides avenues to the surplus sector such as household institutions in the economy to deploy their funds to the deficit sector such as corporate and government sectors to mobilize funds for their requirements. The operations in the money market are generally short-term (upto 1 year) in nature, in capital market short-term to long term and in gilt securities market generally long-term. However, in an integrated financial system, the occurrence of an event in one market of the financial system will have an impact on the other market system.
The Indian money market is a market for short-term money and financial asset that are close substitutes for money, which are close substitute for money, with the short-term in the Indian context being for 1 year. The important feature of the money market instruments is that it is liquid and can be turned quickly at low cost. The money market is not a well-defined place where the business is transacted as in the case of capital markets where all business is transacted at a formal place, i.e. stock exchange. The money market is basically a telephone market and all the transactions are done through oral communication and are subsequently confirmed by written communication and exchange of relative instruments.
 The money market consist of many sub-market such as the inter-bank call money, bill discounting, treasury bills, Certificate of deposits (CDs), Commercial paper (CPs), Repurchase Options/Ready Forward (REPO or RF), Inter-Bank participation certificates (IBPCs), Securitized Debts, Options, Financial Futures, Forward Rate Agreement (FRAs), etc. which collectively constitute the money market.
Role and Functions of Money Market
A well-developed money market is essential for a modern economy. Though, historically, money market has developed as a result of industrial and commercial progress, it also has important role to play in the process of industrialization and economic development of a country. Importance of a developed money market and its various functions are discussed below:
1. Financing Trade: Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade.
2. Financing Industry: Money market contributes to the growth of industries in two ways:
(a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc.
(b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market.
3. Profitable Investment: Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity.
4. Self-Sufficiency of Commercial Bank: Developed money market helps the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market.
5. Help to Central Bank: Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank. Money market helps the central bank in two ways:
(a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy,
(b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy.

Answer of Question No.4.
Introduction of IMF
The International Monetary Fund (IMF) is an international organization created for the purpose of standardizing global financial relations and exchange rates. The IMF generally monitors the global economy, and its core goal is to economically strengthen its member countries. The work of the IMF is of three main types. Surveillance involves the monitoring of economic and financial developments, and the provision of policy advice, aimed especially at crisis-prevention. The IMF also lends to countries with balance of payments difficulties, to provide temporary financing and to support policies aimed at correcting the underlying problems; loans to low-income countries are also aimed especially at poverty reduction. Third, the IMF provides countries with technical assistance and training in its areas of expertise. Supporting all three of these activities is IMF work in economic research and statistics.
In recent years, as part of its efforts to strengthen the international financial system, and to enhance its effectiveness at preventing and resolving crises, the IMF has applied both its surveillance and technical assistance work to the development of standards and codes of good practice in its areas of responsibility, and to the strengthening of financial sectors. The IMF also plays an important role in the fight against money-laundering and terrorism
Balance of payments and IMF helps it members in dealing with this problem
Bad luck, inappropriate policies, or a combination of the two may create balance of payments difficulties in a country—that is, a situation where sufficient financing on affordable terms cannot be obtained to meet international payment obligations. In the worst case, the difficulties can build into a crisis. The country's currency may be forced to depreciate rapidly, making international goods and capital more expensive, and the domestic economy may experience a painful disruption. These problems may also spread to other countries.
The causes of such difficulties are often varied and complex. Key factors have included weak domestic financial systems; large and persistent fiscal deficits; high levels of external and/or public debt; exchange rates fixed at inappropriate levels; natural disasters; or armed conflicts or a sudden and strong increase in the price of key commodities such as food and fuel. Some of these factors can directly affect a country's trade account, reducing exports or increasing imports. Others may reduce the financing available for international transactions; for example, investors may lose confidence in a country's prospects leading to massive asset sales, or "capital flight." In case, diagnoses of, and responses to, crises are complicated by linkages between various sectors of the economy. Imbalances in one sector can quickly spread to other sectors, leading to widespread economic disruption.
How IMF lending helps
IMF lending aims to give countries breathing room to implement adjustment policies and reforms that will restore conditions for strong and sustainable growth, employment, and social investment. These policies will vary depending upon the country's circumstances, including the causes of the problems. For instance, a country facing a sudden drop in the price of a key export may simply need financial assistance to tide it over until prices recover and to help ease the pain of an otherwise sudden and sharp adjustment. A country suffering from capital flight needs to address the problems that led to the loss of investor confidence: perhaps interest rates that are too low, a large government budget deficit and debt stock that is growing too fast, or an inefficient, poorly regulated domestic banking system.
Before a member country can receive a loan, the country's authorities and the IMF must agree on a program of economic policies. A country's commitments to undertake certain policy actions are an integral part of IMF lending. They are designed to ensure that the funds will be used to resolve balance of payments problems. They would also help to restore or create access to support from other creditors and donors. A country's return to economic and financial health allows the IMF to be repaid, making the funds available to other members.
In the absence of IMF financing, the adjustment process for the country would be more difficult. For example, if investors become unwilling to provide new financing, the country has no choice but to adjust—often though a painful compression of imports and economic activity. IMF financing can facilitate a more gradual and carefully considered adjustment.
IMF loan programs are tailored to the specific circumstances of individual countries. In recent years, the largest number of loans has been made through the Poverty Reduction and Growth Facility (PRGF), which provides funds at a concessional interest rate to low-income countries to address protracted balance of payments problems. However, the largest amount of funds is provided through Stand-By Arrangements (SBA), which charges market-based interest rates on loans to assist with short-term balance of payments problems. The IMF also provides other types of loans including emergency assistance to countries that have experienced a natural disaster or are emerging from armed conflict.
Globalization has vastly increased the size of private capital flows relative to official flows and IMF quotas, albeit unevenly so. Many emerging market countries currently see an unmet need for insurance against large and volatile capital flows. In recent years, the IMF has been re-examining its instruments that help prevent and respond to crises to ensure they continue to meet emerging-market members’ needs. Low-income countries have differing needs. Some require debt relief, and others concessional financing. Meanwhile, some no longer need financing, but seek the reassurance of policy support and signaling.

Answer of Question No.5.
(a) General Leading Principles of World Bank
The World Bank has formulated certain principles for advancing loans, either directly or indirectly, which are to be fulfilled. These conditions as incorporated in the Article III of the Articles of Agreements are as follows:
(i) The World Bank usually advances loan to the Government of its member country and also satisfies itself about the repaying capacity of the borrowing of its member country.
(ii) The competent committee of the Bank reports favorably on the project.
(iii) The Bank is satisfied on the issue that the borrower is almost unable to obtain the loan otherwise on reasonable terms.
(iv) The Bank should look into the feasibility of the project for which the loan is sought by the member country.
(v) The World Bank should see that the rate of interest and other charges are reasonable and along with it should see that such rate, charges and the schedule of repayment are quite appropriate to the project.
(vi) The World Bank may guarantee a loan made by other investors and accordingly the Bank must receive suitable compensation for such risk beared by it.
(vii) The Bank should also insist upon a guarantee from the government of the country to which the loan is extended by the Bank.

(b) Regional Rural Banks
Regional Rural Banks were established under the provisions of an Ordinance promulgated on the 26thSeptember 1975 and the RRB Act, 1976 with an objective to ensure sufficient institutional credit for agriculture and other rural sectors. The RRBs mobilize financial resources from rural / semi-urban areas and grant loans and advances mostly to small and marginal farmers, agricultural laborers and rural artisans. The area of operation of RRBs is limited to the area as notified by Government of India covering one or more districts in the State. The Regional Rural Banks (RRBs) have been set up to supplement the efforts of cooperative and commercial banks to provide credit to rural sector. The following were the reasons or need set up the RRBs:
1. To free the rural poor, small and marginal farmers from the clutches of money lenders
2. To provide credit to small farmers, marginal farmers, rural artisans, landless laborers who do not fulfill the criterion of creditworthiness as per the banking principles.
3. To provide banking services to the rural community at a relatively lower cost by adopting a different staffing pattern, wage structure and banking policies.

(c) Economic Significance of banking
Banks play an important role in the economic growth of a country. In the modern set up, banks are not to be considered dealers in money but as the leaders of development. The importance of bank for a country’s economy can be explained in following ways:
a)      Banks by playing attractive interest rate on deposits try to promote thrift and savings in an economy.
b)      The investment of these savings in productive channel results in capital formation.
c)       The scattered small savings in the country can be put to optimum use by commercial banks. Banks utilize this amount by giving loans to industrial houses and the government. By providing funds to the entrepreneurs, bank help in increasing productivity of capital.
d)      Banks help in remitting money from one place to another. The cheque, bank draft, letter of credit, bills, hundies enable traders to transfer large sums of money from one place to another.
e)      By their ability to create credit, the banks have placed at the disposal of the nation a large amount of money. The bank can increase the supply of money through credit creation.
f)       With the growth of banking activity, employment opportunity in the country has increased to a considerable extent.
g)      The banks help in capital formation in the country. A high rate of saving and investment promote capital formation.
h)      Money deposited in the bank and other precious items are now absolutely safe. For keeping valuables, banks are providing locker facilities. Now people are free from any type of risks.

(d) Branch Banking
Branch banking is the act of doing one's banking business at a location that is separate from the bank's central business location. Many large and small banks use branch banking in order to extend the reach of their services to different locations in a community, state, or country. Smaller branches are also less expensive to operate, and often easier for customers to access, while providing all of the features of a larger bank. Historically, branch banks were part of a larger building, often found in strip malls or even in grocery stores or discount stores, sharing the location with another business. Today, however, branch banking can take place at a number of different locations, and many banks build individual branch locations that are independent of other businesses. Each type of location is still considered a branch bank.
In general, most of the services offered at a large bank can be completed at a branch banking location. Locations found in grocery and discount stores often do not have as many options as other branch services; it is often not possible to "drive-through" at these locations, because the bank is located inside the store. In addition, though deposits can be made at this type of bank branch, safe deposit boxes are typically never available, because the security is simply not high enough. Otherwise, these locations typically offer all other services, and generally include an automated teller machine (ATM).