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Week 8 : NBFI, The Classical System, The Neutrality of Money

I. Non-Banking Financial Intermediaries (NBFI)

  • Definition: An institution that collects funds to place in financial assets (deposits, bonds) and lends to needy people/institutions1.

  • Regulation: Must be registered under the Company Act and approved by the RBI2.

2. Key Features

  • Scale: Small entities; less capital intensive compared to banks3.

  • Flexibility: Offer easy loan availability and loan rescheduling (converting short-term to long-term)4.

  • Independence: Conduct activities independently5.

  • Risk: Involves risk regarding the recovery of loans6.

3. Classification of NBFIs

  • Organized NBFIs:

    • Development Banks, Investment Banks, Post Offices, Specialized Investment Banks, Provident/Pension Funds, Chit Funds 7.

  • Unorganized NBFIs:

    • Finance Companies, Private Investment Companies 8.

4. Difference Between Banks & NBFIs (Crucial for MCQs)

  • Demand Deposits: NBFIs cannot accept demand deposits9.

  • Payment System: They are not part of the payment/settlement system; cannot issue cheques drawn on themselves10.

  • Insurance: DICGC (Deposit Insurance and Credit Guarantee Corporation) facility is not available to NBFI depositors11.

5. Challenges Faced by NBFIs

  • Risk Weights: In 2023, RBI increased risk weights, making bank borrowing more expensive12.

  • Funding Crunch: Bank funding to NBFIs dropped from 22% to 15% (April 2024)13.

  • Bond Market: Indian debt market is shallow and lacks liquidity14.

  • Regulatory Caps: SEBI caps the issuance of ISIN (International Securities Identification Number)15.

  • Rising Costs: Credit costs projected to rise to 4% by 202516.

II. The Classical System

1. Core Theory

  • Money & Variables: Changes in money supply affect Nominal Variables only (Money wages, Nominal GNP), not Real Variables (Real GNP, Employment, Real Wage) 17.

  • Real Output: Determined by quantity/productivity of labor and capital, not money supply18.

2. Key Assumptions

  • Full Employment: The economy naturally operates at full employment; deviations are temporary19.

  • Flexible Prices: Prices adjust upwards with increased money supply (inflation) to balance supply/demand, without increasing real output 20.

  • Flexible Wages: Wages adjust quickly to labor demand; workers accept lower wages to stay employed, ensuring the labor market always clears 21.

3. Demerits (Criticisms)

  • Short-Term Failure: Cannot explain recessions or persistent high unemployment22.

  • Sticky Wages/Prices: In reality, wages are inflexible (sticky) due to contracts or fairness expectations23.

  • Unrealistic Rationality: Real agents have bounded rationality and biases (proven by Behavioral Economics)24.

  • Long-Run Fallacy: Critics (Keynes) argue economies can face prolonged underemployment25.

III. The Neutrality of Money

1. Origin & Definition

  • Origin: Coined by F.A. Hayek (1931), but roots traced to David Hume (1700s)26.

  • Definition: An increase in money supply leads only to an increase in Prices, leaving real economic variables (output/employment) unchanged27.

2. Evolution of Views

  • Classical View: Money is neutral; affects variables only in the long run (modern interpretation)28.

  • Keynesian View: Rejected neutrality in both short and long term29.

  • Post-Keynesian View: Reject neutrality; citing studies that money supply affects relative prices over long periods30.

3. Criticisms of Neutrality

  • Value of Money: Increased supply decreases the value of money31.

  • Short-Term Impact: Money supply changes definitely impact inflation in the short term32.

  • GDP Growth: Increased supply boosts consumption, leading to an increase in GDP33.

  • Resource Allocation: More money leads to resource allocation in real estate and production units.