Q.No.

Answer Marking
Q1.a. ENDOGENOUS AND EXOGENOUS MONEY SUPPLY 4 Marks for
A variable is designated endogenous if it is determined within or by the model. explaining
In contrast, an exogenous variable is determined outside the model by external difference.
forces. 1 Mark for
Bayes and Jansen define money supply (M) as: each figure.
(4+1+1)

Where:
cd = desired currency to deposit ratio
rr = required reserve to deposit ratio
ed = desired excess reserve ratio
MB = monetary base

Endogenous money supply curve

For structuralists money supply is endogenous, so that Cd and ed do not remain
constant, but vary with economic conditions. For example, there is said to be
an inverse relationship between interest rates, and on the one hand, and ed and
Cd, on the other. Banks are said to decrease their excess reserves with increases
in the interest rates, and to be able to lend out additional funds at the higher
rates. Similarly, many depositors are said to hold less currency and more
interest-bearing instruments to earn greater interest income. Thus, the money
multiplier is said to be an increasing function of interest rates and not a
constant. This gives rise to a money supply curve which is endogenous and
upward sloping (Bayes & Jansen) depicted by Figure:
FIGURE: ENDOGENOUS MONEY SUPPLY

The money supply curve slopes upwards because as interest rates rise, excess
reserves fall and the amount of money in the economy increases - the money
multiplier effect. This effect also takes place via the currency to deposit ratio,
Cd, which drops as interest rates rise. Thus, higher interest rates lead to higher
money supply, when money supply is endogenous. This is the basis of the
structuralist argument against neo-liberal economists, that it is inappropriate to
consider the effect of exogenous changes in Cd or ed on the money supply, since
they are functions of the interest rate
graphed on the vertical axis of figure. Whereas the functional relationship
between interest rates, on the one hand, and Cd and ed, on the other, gives an
upward money supply curve, changes in required reserves, rr, or the monetary
base, MB, shift the money supply curve, just as in the case of an exogenous
money supply curve and in the same direction. An increase in rr shifts the
money supply curve to the left, while decreases in rr, lead to rightward shifts,
as reflected by figure. Also changes in MB lead to an opposite effect compared
to those in rr. Increases in MB shift the
money supply curve to the right, resulting in a higher stock of money at each
interest rate; while decreases in MB shift the money curve to the left, thereby
reducing the money stock at each interest rate.

Exogenous money supply curve

When the money supply in the economy is exogenous, it is said to be
determined by the banks' preferences for excess reserves, ed, and the
depositors' preferences for holding cash, and these preferences are not
affected by economic variables like interest rates. Consequently, the money
multiplier is constant and the amount of money supplied, M, does not vary with
changes in interest rates (Baye & . Jansen, 1995 :483). This gives rise to the
vertical exogenous money supply curve reflected in following Figure:
FIGURE: EXOGENOUS MONEY SUPPLY CURVE

Increases in Cd, ed and rr shift the money supply curve to the left since such
increases reduce the money multiplier and thus the money supply. Decreases
in any of these variables have the opposite effect. The effect of MB is a direct
one, shifting the money supply curve to the right or left with
increases or decreases, respectively, in MB.
i Rise in excess reserves holdings of banks leads to contraction in money supply. 2 Mark for
Exogenous money supply curve: Leftward shift each subpart.
Endogenous money supply curve: Downward Movement along the curve (2+2+2=6)

Increase in use of digital mode of payments leads to fall in currency deposit

ii. ratio and expansion in money supply.
Exogenous money supply curve: Rightward shift
Endogenous money supply curve: Upward Movement along the curve

Reduction in the required reserve ratio leads to expansion in money supply.

iii. Exogenous money supply curve: Rightward shift
Endogenous money supply curve: Rightward shift

The free-rider problem means that private producers of information will not
b. obtain the full benefit of their information-producing activities, and so less
information will be produced. 6.75
This means that there will be less information collected to screen out good
from bad risks, making adverse selection problems worse, and that there will
be less monitoring of borrowers, increasing the moral hazard problem.

As described in Mishkin on page 189, one partial solution to the problem of

lenders (purchasers of securities) having less information than borrowers of
funds are to have private companies collect and produce information that helps
lenders distinguish between good and bad firms selling securities. The free
rider problem arises here when some people purchase the information about
firms and the people that do not purchase it take advantage of the information
the others have paid for. Lenders who have purchased information will
purchase securities from high quality, undervalued firms and in doing so will
reveal to free-riding investors which firms are the ones they should invest in. If
many investors free ride, this will push up the price of good firms’ securities
and make it less profitable to purchase information in the first place. If many
investors find it unprofitable to purchase information, then it may not be
gathered and produced by private firms: “The weakened ability of private firms
to profit from selling information will mean that less information is produced in
the marketplace, and so adverse selection (the lemons problem) will still
interfere with the efficient functioning of securities markets” (Mishkin, p. 189).

As described in Mishkin on page 194, free riding can also aggravate the moral
hazard problem. The principle-agent problem is a problem of moral hazard
that occurs because managers have more information about their activities and
actual profits than stockholders do. Stockholders can partially overcome this
problem by spending time and money on frequent audits of the firms they have
invested in and closely monitoring what management is doing. Similar to the
adverse selection case, free riding can reduce the amount of information about
management and firm activities produced by stockholders through costly audits
or other forms of monitoring. Each stockholder will be unwilling to invest in
monitoring activities, preferring to free ride on the monitoring expenditures of
 other stockholders. If all stockholders think this way, however, none of them
will invest in monitoring and little or no information about management and
firm activities will be produced. Less information for stockholders means the
moral hazard problem will be aggravated.

Asset Securitization is the procedure where an issuer designs a marketable 8

Q.2.a. financial instrument by merging or pooling various financial assets into one
group. The issuer then sells this group of repackaged assets to investors.
Securitization offers opportunities for investors and frees up capital for
originators, both of which promote liquidity in the marketplace.

Beginning in the 1980s the banking system underwent significant

transformations, none of which bear resemblance to traditional banking. Both
the traditional banking and banking with asset securitization systems match
lenders and borrowers and use short-term, liquid funding to supply long-term
loans that are less liquid. The latter system includes many more steps and often
involves several institutions. (Explanation)

b. Marginal Cost of Fund Based Lending Rate (MCLR) 10.75

The Marginal Cost of Fund based Lending Rate refers to the minimum interest
rate a bank must charge for lending. The bank cannot grant any loan below that
rate, except in certain cases permitted by the Reserve Bank of India (RBI).

The MCLR now serves as a benchmark and was introduced to counter the base
rate system. It has been in effect since April 1, 2016, for all the categories of
domestic rupee loans. The MCLR is determined by the current cost of funds, in
contrast to the base rate, which is governed by the average cost of funds. The
MCLR was introduced by the RBI because rates based on this system are more
receptive to the changes in the policy rates. This also ensures that the country’s
monetary policy is implemented effectively across all spheres.

As a result, the MCLR ensures that the lending rates of banks reflect the policy
rates. Moreover, it also provides transparency in the procedure followed by
banks to arrive at interest rates on advances.

Factors that Determine the MCLR

In economics, the term ‘marginal’ refers to a specific change in quantity in its
current state. Hence, the MCLR takes into account the current cost or
incremental cost of funds. Based on this concept, following are the factors
which determine the MCLR:

Base Rate
Before the implementation of the MCLR, loans in every category fell under the
purview of the base rate. Just like the MCLR, the base rate is the minimum
interest rate below which a bank cannot lend. Here as well, exceptions exist in
certain cases allowed by the RBI.
 Base Rate Calculation
Just like the MCLR, the base rate is calculated keeping certain factors in mind.
Each bank is free to determine their own base rate, based on the norms
provided by the RBI. According to the bank, the base rate must be determined
by considering the following factors:

The Outcome of MCLR implementation

Previously, when RBI reduced the repo rate, banks took a long time to reflect it
in the lending rates for the borrowers.

Under the MCLR regime, banks must adjust their interest rates as soon as the
repo rate changes. The implementation aims at improving the openness in the
structure followed by the banks to calculate the interest rate on advances. It
also improved the monetary transmission mechanism.

Q.3.a.
2+2+2+2+2+2
=12
b. Baye and Jansen Chapter 19 Page 680. 6.75

Q.4.a.i. Preffered Habitat Hypothesis (Baye and Jansen chapter 10, page 322-327) 2+2.25+2
ii.

iii.

b. 2.5+2.5+2.5+
2.5+2.5=12.5

If underlying stock price is Rs 690 option will not be exercised, loss of Rs 20.
 If underlying stock price is Rs 710 option will be exercised, loss of Rs 10.

Q.5.a. Reading by A. Vasudevan, Reflections on analytical issues in Monetary Policy. 10.75

Issues in flexible inflation targeting: Issues such as the framework’s rationale,
the medium-term inflation target, the meaning of real interest rate in the
Indian context, the realism in respect of inflation expectations and of the
inferred logic of the yield curve, the implications for economic inequalities,
flexible inflation targeting and Tinbergen Rule in India and Taylor rule in action.

b.
The enhancements of Basel III over Basel II come primarily in four areas: 2+2+2+2=8

(i) augmentation in the level and quality of capital;

(ii) introduction of liquidity standards;
(iii) modifications in provisioning norms;

and (iv) better and more comprehensive disclosures.

Reading by M Y Khan Pg. 9.29-9.30. 9.5+9.25

Q.6.a.

b. Reading by N Jadhav Section 2.3 pg. 39-42.

c. Reading by Sengupta and Vardhan.

Several policy actions have been implemented. Balance sheet troubles for
banks started as early as 2011–12. When the first signs of trouble surfaced, the
RBI as the banking regulator took recourse to regulatory forbearance. For
example, the RBI initiated several restructuring programmes (such as Corporate
Debt Restructuring, Strategic Debt Restructuring, 5/25 scheme, Joint Lenders
Forum, etc) to enable the banks to resolve the stressed asset problem.
However, these programmes helped the banks to hide the actual extent of the
stress on their balance sheets instead of solving the underlying problems.

The government initiated the Indradhanush programme in August 2015 to

revamp the PSU banks. It is a seven-pronged plan, which also includes
recapitalisation or infusion of capital into the banks.

There has been considerable debate in the public policy domain about the pros
and cons of using the resources of the government, to recapitalise banks.
Committees such as the Narasimham Committee II (1998) and the P J Nayak
Committee (set up under the chairmanship of P J Nayak and report submitted
in 2014), for example, were against such capital infusion operations.
Recapitalisation imposes a significant fiscal cost on the government.

Another action taken by the government under the Indradhanush programme

has been to set up a Banks Board Bureau (BBB) to facilitate the appointment of
top officials at the PSU banks. However, the progress made by the BBB has
been slow since it began functioning in April 2016.

While in 2015, the RBI started the Asset Quality Review (AQR) to force banks to
recognise their NPAs and provision accordingly, it may be argued that the AQR
should have been done much earlier in order to prevent the accumulation of
losses in the banking system over multiple years.

The steps adopted so far to address the ongoing bank balance sheet problem
have arguably been small fixes and incremental changes. The need of the hour
is a transformative reform initiative so that the next time around the NPA
problem of banks does not become as big.