BECE 146 Indian Economy II Solved Question Paper June 2026 TEE for BA General Economics (BAG)

The monetary base, high powered money and the RBI's quantitative tools

Question 1: What is meant by the "monetary base" of an economy? Does "high powered money" influence credit creation? How? Discuss the various "quantitative measures" of monetary policy adopted by the RBI. (20)

The monetary base is the stock of money created directly by the Reserve Bank of India. It is also called reserve money, M0 or high powered money (H). In the accounts of the RBI it has three parts: currency in circulation, bankers' deposits with the RBI and "other" deposits with the RBI.

On the sources side, reserve money moves when the RBI changes its own assets: net RBI credit to the government, RBI credit to banks and the commercial sector, and net foreign exchange assets. When the RBI buys dollars or government bonds, it pays with rupees it creates, and the monetary base rises.

Does high powered money influence credit creation?

Yes. It is called high powered because every rupee of it can support several rupees of deposits and bank credit. Banks keep only a fraction of deposits as reserves and lend the rest, and those loans return to the banking system as fresh deposits that can be lent again.

The link is the money multiplier:

M = m × H,   where m = (1 + c) / (c + r)

Here c is the currency-deposit ratio of the public and r is the reserve-deposit ratio of banks, which includes the CRR and any excess reserves.

Worked example. Suppose c = 0.2 and r = 0.1. Then m = 1.2 / 0.3 = 4, so a rise of ₹100 crore in high powered money can support up to ₹400 crore of broad money. A cut in the CRR lowers r and raises m, so credit expands even if H itself does not change.

The multiplier is not mechanical. If people hold more cash, if banks keep excess reserves or if loan demand is weak, credit grows less than the formula suggests. Under the liquidity adjustment facility the RBI also supplies reserves at the policy rate, so credit demand partly pulls H along with it.

Quantitative measures of monetary policy used by the RBI

Quantitative or general measures act on the total volume and cost of credit rather than on particular sectors.

• Policy repo rate: the rate at which the RBI lends overnight to banks against government securities under the liquidity adjustment facility (LAF). Since 2016 it is set by the six-member Monetary Policy Committee and is the main signal of the policy stance.
• Standing Deposit Facility (SDF): introduced in April 2022, it lets the RBI absorb surplus funds from banks without giving collateral and forms the floor of the policy corridor.
• Marginal Standing Facility (MSF): introduced in 2011, it lets banks borrow overnight at a rate above the repo rate by dipping into their SLR holdings. It forms the ceiling of the corridor.
• Bank Rate: the rate at which the RBI rediscounts bills or lends for longer periods. It is now aligned with the MSF rate and is mainly used to set penal rates.
• Cash Reserve Ratio (CRR): a share of the net demand and time liabilities (NDTL) of banks kept as cash with the RBI, earning no interest. A higher CRR drains liquidity and lowers the multiplier.
• Statutory Liquidity Ratio (SLR): a share of NDTL that banks must hold in safe liquid assets such as government securities, cash and gold. Raising it leaves less money for loans.
• Open Market Operations (OMOs): outright purchase or sale of government securities. Purchases inject lasting liquidity and sales absorb it, while variable rate repo and reverse repo auctions fine-tune daily liquidity.
• Market Stabilisation Scheme (MSS): started in 2004 to sterilise large capital inflows by issuing government securities, so that foreign exchange purchases do not swell the money supply.

Conclusion. Since the Monetary Policy Framework Agreement of February 2015 and the 2016 amendment to the RBI Act, these tools serve flexible inflation targeting: CPI inflation of 4 per cent within a band of 2 to 6 per cent. Rate tools give the signal, while CRR, OMOs and the LAF keep liquidity in line with it.

Fiscal policy instruments, the fiscal deficit and the FRBM Act 2003

Question 2: State the instruments of fiscal policy. Why is it important to keep the level of fiscal deficit low? With what objective was the FRBM Act 2003 enacted? (20)

Fiscal policy is the use of taxation, public spending and borrowing by the government to influence output, employment, prices and the distribution of income. In India it is announced mainly through the Union Budget, the Annual Financial Statement laid before Parliament under Article 112 of the Constitution.

Instruments of fiscal policy

• Taxation: direct taxes such as income tax and corporation tax, and indirect taxes, mainly GST since July 2017. Changing rates alters disposable income and spending.
• Public expenditure: revenue spending (salaries, subsidies, interest) and capital spending (roads, railways, irrigation). Capital spending adds more to future growth.
• Public borrowing: market loans, small savings and external loans fill the gap between spending and receipts.
• Size of the deficit: the planned revenue, fiscal and primary deficit is itself a policy choice that sets the overall push or pull on demand.
• Transfers and subsidies: food, fertiliser and LPG subsidies and direct cash transfers redistribute income towards poorer households.

Why the fiscal deficit should be kept low

Fiscal deficit is total expenditure minus revenue receipts and non-debt capital receipts. It equals the total borrowing the government needs for the year. A persistently high level causes several problems.

• Crowding out: heavy government borrowing absorbs household savings and pushes up interest rates, so private investment falls.
• Debt trap: borrowing today means interest tomorrow. When interest takes a large share of revenue receipts, the government ends up borrowing to pay interest.
• Inflation: if a deficit is financed by creating money, demand rises faster than output and prices climb.
• Twin deficits: excess demand spills into imports and widens the current account deficit, as happened before the 1991 balance of payments crisis.
• Credibility: rating agencies and foreign investors watch the deficit, and a high deficit raises the cost of borrowing for the whole country.
• Fairness across generations: today's deficit becomes tomorrow's tax burden.

A low deficit does not mean no deficit. Borrowing to build capital assets that raise future output is easier to justify than borrowing to pay salaries and subsidies, which is why the revenue deficit is watched so closely.

Objective of the FRBM Act 2003

The Fiscal Responsibility and Budget Management Act was passed in August 2003 and its rules came into force in July 2004. Its objective was intergenerational equity in fiscal management and long-term macroeconomic stability, by limiting borrowing, debt and deficits, removing fiscal hurdles to monetary policy and making budgets more transparent.

• Eliminate the revenue deficit and bring the fiscal deficit down to 3 per cent of GDP by March 2008, a deadline later moved to March 2009.
• Cut the fiscal deficit by at least 0.3 per cent of GDP and the revenue deficit by at least 0.5 per cent of GDP every year.
• Place three statements with each budget: the Medium-term Fiscal Policy Statement, the Fiscal Policy Strategy Statement and the Macroeconomic Framework Statement.
• Stop the Centre borrowing from the RBI in primary issues of government securities from April 2006, except through ways and means advances.
• Cap new government guarantees at 0.5 per cent of GDP a year and review receipts and spending every quarter before Parliament.

The targets were paused after the 2008 global crisis. A 2018 amendment, following the N.K. Singh committee, made debt the main anchor, with general government debt at 60 per cent of GDP and 40 per cent for the Centre, and allowed an escape clause of up to 0.5 per cent of GDP.

Conclusion. Fiscal instruments shape demand and growth, a low fiscal deficit protects private investment and price stability, and the FRBM Act 2003 turned fiscal discipline from a promise into a legal rule.