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Bachelor’s Degree Programme (BDP)
ASSIGNMENT (2019-20)
Elective Course in Commerce
ECO – 09: Money, Banking and Financial Institutions
For July 2019 and January 2020 admission cycle
School of Management Studies
Indira Gandhi National Open University
Maidan Garhi, New Delhi -110068
Dear Students,
As explained in the Programme Guide, you have to do one Tutor Marked Assignment in this Course.
Assignment is given 30% weightage in the final assessment. To be eligible to appear in the Term-end examination, it is compulsory for you to submit the assignment as per the schedule. Before attempting the assignments, you should carefully read the instructions given in the Programme Guide.
This assignment is valid for two admission cycles (July 2019 and January 2020). The validity is given below:
1) Those who are enrolled in July 2019, it is valid up to June 2020.
2) Those who are enrolled in January 2020, it is valid up to December 2020.
You have to submit the assignment of all the courses to The Coordinator of your Study Centre. For appearing in June Term-End Examination, you must submit assignment to the Coordinator of your study centre latest by 15th March. Similarly for appearing in December Term-End Examination, you must submit assignments to the Coordinator of your study centre latest by 15th September.
TUTOR MARKED ASSIGNMENT
Course Code : ECO - 09
Course Title : Money, Banking and Financial Institutions
Assignment Code : ECO - 09 /TMA/2019-20
Coverage : All Blocks
Maximum Marks: 100
Attempt all the questions
1. Explain the Fisher’s equation of exchange. How is the cash balances equation an improvement over Fisher’s equation? (20)
Ans: For Complete Solution, Download Our Mobile Application
The Cambridge cash balances approach to the quantity theory of money is superior to Fisher’s transaction approach in many respects. They are discussed as under:
1. Basis of Liquidity Preference Theory of Interest:- The cash balances approach emphasizes the importance of holding cash balances rather than the supply of money which is given at a point of time. It thus led Keynes to propound his theory of liquidity preference and of the rate of interest, and to the integration of monetary theory of value and output.
2. Complete Theory:- The cash balances version of quantity theory is superior to the transactions version because the former determines the value of money in terms of the demand and supply of money. Thus it is a complete theory. But in the transactions approach, the determination of value of money is artificially divorced from the theory of value.
3. Discards the Concept of Velocity of Circulation:- The cash balances approach is superior to the transactions approach because it altogether discards the concept of the velocity of circulation of money which ‘obscures the motives and decisions of people behind it.
4. Related to the Short Period:- Again the cash balances version is more realistic than the transactions version of the quantity theory, because it is related to the short period while the latter is related to the long period. As pointed out b Keynes, “In the long run we may all be dead.” So the study of the relationship between quantity of money and price level during the long run is unrealistic.
5. Simple Equations:- In the cash balances equations, transactions relating to final goods only are included where P refers to the level of final goods. On the other hand, in the transactions equation P includes all types of transactions. This creates difficulties in determining the true price level. Thus the former equations are simpler and realistic than the latter.
6. New Formulation in the Monetary Theory:- Further, the Cambridge equation regards the cash balances held by the people as a function of the level of income. The introduction of income (Y or R or T or O) in this equation as against V (the velocity of circulation of money) in the transaction equation has made the cash balances equation realistic and led to new formulations in monetary theory. “It points out that changes in the level of money income can come about through changes in the price level, through changes in real output or through both at once.”
7. Explains Trade Cycles:- Hansen regards K in the Cambridge equation superior to V in Fisher’s equation for understanding cyclical fluctuations. According to him, “Drastic and sudden shifts in the desire to hold money, reflected in a change in K, may produce large and quickly moving changes in the level of income and prices. Shifts in the public psychology, in expectations must be taken into account not less than changes in the money supply. In the Cambridge analysis, a shift in K may start an upward or downward movement.” For instance, when K (the fraction of total real income that people wish to hold in cash balances) increases because of low business expectation, the price level falls, and vice versa.
8. Study of Subjective Factors:- As a corollary to the above, V in Fisher’s equation is mechanistic while K in the Cambridge equation is realistic. The subjective factors behind variations in K have led to the study of such factors as expectations, uncertainty, motives for liquidity, and the rate of interest in modern monetary theory. In this sense, it can be justifiably said that, “the Cambridge equation moves us on from the tautology represented by the equation of exchange to a study of economic behavior.”
9. Applicable under AH Circumstances:- Fisher’s transactions approach holds true only under full employment. But the cash balances approach holds under all circumstances whether there is full employment or less than full employment.
10. Based on Micro Factors:- The Cambridge version is superior to the Fisherian version because it is based on micro factors like individual decisions and behaviours. On the other hand, the Fisherian version is based on macro factors like T, total velocity of circulation, etc..
2. Explain the concept of ‘Unit Banking’. What are the merits and demerits of unit banking system? Suggest measures to overcome the demerits of unit banking system. (20)
Ans: Unit Bank is a type of bank under which the banking operations are carried by a single branch with a single office and they limit their operations to a limited area. Normally, unit banks may not have any branch or it may have one or two branches. This unit banking system has its origin in United State of America (USA) and each unit bank has its own shareholders and board of management.
According to Shapiro, Soloman and White,” An independent unit bank is a corporation that operates one office and that is not related to other banks through either ownership or control.”
Advantages of Unit Banking: Unit banking system has the following advantages:
1. Easy Management: The management and control of unit banks is much easier and effective due to the small size and operations of the banks. There are less chances of fraud and irregularities in the financial management of the unit banks.
2. Localised Banking: Unit banking is localized banking. The unit bank has the specialised knowledge of the local problems and serves the requirements of the local people in a better manner than branch banking. Since the bank officers of a unit bank are fully acquainted with the local needs, they cannot neglect the requirements of local development.
3. Quick Decision: A great advantage of unit banking is that there is no delay of any kind in taking decisions on important problems concerning the unit bank.
4. No Monopolistic Tendencies: Unit banks are generally of small size. Thus, there is no possibility of generating monopolistic tendencies under unit banking system.
5. Promotes Regional Balance: Under unit banking system, there is no transfer of resources from rural and backward areas to the big industrial commercial centres. This tends to reduce regional in balance.
6. Initiative in Banking Business: Unit banks have full knowledge of and greater involvement in the local problems. They are in a position to take initiative to tackle these problems through financial help.
7. Flexibility in operation: The unit banks are more flexible. The manager of the unit bank can use his discretion and arrive at quick decision.
8. No Inefficient Branches: Under unit banking system, weak and inefficient branches are automatically eliminated. No protection is provided to such banks.
9. No diseconomies of Large Scale Operations: Unit banking is free from the diseconomies and problems of large-scale operations which are generally experienced by the branch banks.
Disadvantages of Unit Banking: The following are the disadvantages of unit banking system:
1. Limited Scope: The scope of unit banking is limited. They do not get the benefits of large scale operations.
2. No. Distribution of Risks: Under unit banking, the bank operations are highly localised. Therefore, there is little possibility of distribution and diversification of risks in various areas and industries.
3. Inability to Face Crisis: Limited resources of the unit banks also restrict their ability to face financial crisis. These banks are not in a position to stand a sudden rush of withdrawals.
4. Lack of Specialization: Unit banks, because of their small size, are not able to introduce, and get advantages of, division of labor and specialization. Such banks cannot afford to employ highly trained and specialized staff.
5. Operates only in urban areas and big towns: Unit banks, because of their limits resources, cannot afford to open uneconomic banking business is smaller towns and rural area. As such, these areas remain unbanked.
6. Costly Remittance of Funds: A unit bank has no branches at other place. As a result, it has to depend upon the correspondent banks for transfer of funds which is very expensive.
7. Difference in Interest Rates: Since easy and cheap movement of does not exist under the unit banking system, interest rates vary considerably at different places.
8. Local Pressures: Since unit banks are highly localised in their business, local pressures and interferences generally disrupt their normal functioning.
9. Undesirable Competition: Unit banks are independently run by different managements. This results in undesirable competition among different unit banks.
Measures to overcome demerits of Unit Banking System
Unit banking suffers from various limitations which are stated below. In order to overcome the demerits of unit banking system, branch banking system is to be promoted because branch banking system can overcome the limitations of unit banking system. Some benefits of unit banking system are listed below:
1. Benefits of large Scale Production: Due to large scale production, the cost per unit of operation is very low in case of this system.
2. Distribution of Risks: There is a distribution of risks because the losses incurred by one branch are made up by the profits earned by other branches.
3. Effective Central Bank control: Due to presence of few big banks in the banking system, the RBI can effectively and easily regulate the activities of banks.
4. Public Confidence: Branch banking system gains greater public confidence because of its large scale operations and huge financial resources.
5. Easy transfer of funds: Since the branches of bank under branch banking are spread all over the country, it is easier and cheaper, for it to transfer funds from one place to another.
5. Write short notes on the following :
a) Cambridge equation of Exchange
b) Money market
c) Nationalization of Commercial Banks
d) Inflationary gap (4×5)
Ans: a) Cambridge equation of Exchange:- The Cambridge equation formally represents the Cambridge cash-balance theory, an alternative approach to the classical quantity theory of money. Both quantity theories, Cambridge and classical, attempt to express a relationship among the amount of goods produced, the price level, amounts of money, and how money moves. The Cambridge equation focuses on money demand instead of money supply. The theories also differ in explaining the movement of money: In the classical version, associated with Irving Fisher, money moves at a fixed rate and serves only as a medium of exchange while in the Cambridge approach money acts as a store of value and its movement depends on the desirability of holding cash. Economists associated with Cambridge University, including Alfred Marshall, A.C. Pigou, and John Maynard Keynes (before he developed his own, eponymous school of thought) contributed to a quantity theory of money that paid more attention to money demand than the supply-oriented classical version. The Cambridge economists argued that a certain portion of the money supply will not be used for transactions, instead, it will be held for the convenience and security of having cash on hand. This portion of cash is commonly represented as k, a portion of nominal income (the product of the price level and real income) P.Y). The Cambridge economists also thought wealth would play a equation for simplicity. The Cambridge equation is thus: Md = k. P. Y. Assuming that the economy is at equilibrium (Md = M), Y is exogenous, and k is fixed in the short run, the Cambridge equation is equivalent to the equation of exchange with velocity equal to the inverse of k. M . 1/k = P . Y
b) Money Market: Money market is a market for short term funds meant for use for a period upto one year. Generally money market is the source of finance for working capital. Money market is not a fixed geographical area but it constitutes all organisations and institutions which deal with short term debts such as banks, RBI, mutual funds etc. According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders.”
Features of Money Market:
(a) It is a collection of market for following instruments: Call money, notice money, repos, term money, treasury bills, commercial bills, certificate of deposits, commercial papers.
(b) Market for short term: It is a market for short term funds.
(c) No fixed geographical area: It has no fixed geographical location.
(d) Participants: It constitutes all organisations and institutions which deal with short term debts such as banks, RBI, mutual funds etc.
(e) Activities in the money market tend to concentrate in some centre, which serves a region or an area.
Functions of Money Market
The major functions of money market are given below:
(a) To maintain monetary equilibrium.
(b) To promote economic growth.
(c) To provide help to Trade and Industry.
(d) To help in implementing Monetary Policy.
(e) To help in Capital Formation.
(f) Money market provides non-inflationary sources of finance to government.
c) Nationalisation: Nationalisation of Banks refers to transfer of ownership and management of banks from private individuals and shareholders to the public authorities. In 1969, 14 banks were nationalized. Again in 1980, 6 more banks were nationalized. In 1993, New bank is merged will Punjab National Bank. So, there are 19 nationalized banks in our country at present.
Objectives of Nationalisation:
a) Preventing concentration of economic powers in the hands of few.
b) Provide banking facilities in rural areas.
c) Mobilization of savings of rural areas.
d) Help to the agriculture industry.
e) Balanced regional development of the country
f) Provide adequate financial assistance to the public and private sector industry whether big or small.
g) Greater stability and control in banking sector by reserve bank of India.
Achievements of nationalisation:
a) Expansion of Bank branches: There has been a rapid increase of bank branches after nationalization. Till the end of March, 2014 number of bank branches increases to 97,010.
b) Growth of deposit: After nationalization the deposit occupied by banks was increased due to various branches in Rural, Semi-urban and urban areas.
c) Advances to priority sectors: Priority sector includes Agriculture, small business, small scale industry etc. There has been greater emphasis on those sectors now.
d) Correction of regional imbalances: After nationalization, steps have been taken to improve banking services in less developed states.
e) Advance to Agriculture: The nationalized banks have given particular importance in providing credit to agriculturists.
d) Inflationary Gap:- An inflationary gap is a macroeconomic concept that describes the difference between the current level of real gross domestic product (GDP) and the anticipated GDP that would be experienced if an economy is at full employment. This is also referred to as the potential GDP. For the gap to be considered inflationary, the current real GDP Must be the higher of the two metrics. The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The inflationary gap is so named because the relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run. Due to the higher number of funds available within the economy, consumers are more inclined to purchase goods and services. As the demand for goods and services increases but production has not yet compensated for the shift, prices rise to restore market equilibrium. When the potential GDP is higher than the real GDP, the gap is referred to as a deflationary gap. According to macroeconomic theory, the goods market determines the level of real GDP, which is shown in the following relationship: Y = C + I G+ NX
Where:
Y = real GDP
C = consumption expenditure
I = investment
G = government expenditure
NX = net exports
An increase in consumption expenditure, investments, government expenditure or net exports causes real GDP to rise in the short run. Real GDP provides a measure of economic growth while compensating for the effects of inflation or deflation. This produces a result that accounts for the difference between actual economic growth and a simple shift in the prices of goods or services within the economy.
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