Question 1

Read the following statements carefully : Statement 1 : The government may reduce the repo rate, to control deflationary gap prevailing in the economy. Statement 2 : The government may reduce the deflationary gap, by selling off government securities (G-Sec) in the open market. In the light of the given statements, choose the correct option from the following :

Accepted Answer

(D) Both Statements 1 and 2 are false.

Question 2

(a) Elaborate the process of Credit Creation using a suitable numerical example. (b) Read the following text carefully : "This function of money provides different items to be evaluated against a common standard. It allows comparison of prices and keeping financial records." (i) On the basis of the given text, identify the indicated function of money. (ii) List any other two functions of money.

Accepted Answer

(a) Credit Creation Process:

Numerical Example:
Initial Deposit = Rs. 1,000 crore
Reserve Ratio (LRR) = 20%

Round 1:
Bank receives deposit of Rs. 1,000 crore
Keeps 20% (Rs. 200 crore) as reserve
Lends Rs. 800 crore

Round 2:
Rs. 800 crore deposited back
Keeps 20% (Rs. 160 crore) as reserve
Lends Rs. 640 crore

...continuing this process:

Total Deposits = Initial Deposit × Money Multiplier
Money Multiplier = 1/0.20 = 5
Total Deposits = 1,000 × 5 = Rs. 5,000 crore

(b) Money as measure of standard of deferred payments:

1. Money provides common unit for measuring debt
2. Future payments expressed in money terms
3. Loans and borrowings denominated in money
4. Interest payments calculated in money
5. Enables credit system to function
6. Facilitates long-term contracts

Question 3

If in an economy Bank rate is increased, how will it affect the demand for credit ? Explain.

Accepted Answer

When Bank Rate is increased, the demand for credit decreases.

Explanation:
1. Bank Rate is the rate at which central bank lends to commercial banks for long-term needs
2. Increase in Bank Rate increases cost of borrowing for commercial banks
3. Commercial banks increase their lending rates to maintain profit margins
4. Higher lending rates discourage borrowers from taking loans
5. This reduces the demand for credit in the economy

The transmission mechanism:
Bank Rate ↑ → Cost of funds for banks ↑ → Lending rates ↑ → Borrowing becomes expensive → Demand for credit ↓

Banking

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