Prelims Revision -Indian Economy

Prelims Revision -Indian Economy: Key Terms

Fixed Rate System vs Floating Rate System

  • If government or RBI fix the exchange rate of a currency (and does not allow any variations according to demand and supply forces in market), such a system is called Fixed Rate system.
  • It is also called Bretton Woods system or Pegged Currency System. India was following this kind of system till 1975 and partial controls till 1993.
  • Since this currency valuation mechanism is artificial, most of the countries including India changed to Floating Rate System where currency market determines the value of a currency.

Rupee Devaluation vs Rupee Depreciation

  • The term devaluation is used when the government reduces the value of a currency under Fixed Rate System. When the value of currency fall under Floating Rate System, it is called depreciation. 
  • Revaluation is a term which is used when there is a rise of currency to the relation with a foreign currency in a fixed exchange rate.
  • In floating exchange rate correct term would be appreciation.
  • Altering the face value of a currency without changing its foreign exchange rate is a redenomination, not a revaluation.

Exports vs Falling in Indian Rupee Value : The local currency effect

  • A devaluation means that more local currency is needed to purchase imports and exporters get more local currency when they convert the export proceeds (the foreign exchange that they get for their exports).
  • In other words: imports become more expensive – and exporters earn more money. This is supposed to discourage imports – and to encourage exports and, in turn, to reduce trade deficits. Clear,uh?
    That was an explanation giving stress to the local currency angle. Let’s see the same case analyzing the volume effect.

Government Budgeting:

The term ‘Budget’ is not mentioned in Indian Constitution. The related term mentioned is ‘Annual Financial Statement’.

  1. Article 265: provides that ‘no tax shall be levied or collected except by authority of law’. [ie. Taxation needs approval of Parliament.]
  2. Article 266: provides that ‘no expenditure can be incurred except with the authorisation of the Legislature’ [ie. Expenditure needs approval of Parliament.]
  3. Article 112: President shall, in respect of every financial year, cause to be laid before Parliament, Annual Financial Statement.

Railway Budget: (Now Merged: So very vcry important)

  • The Budget of the Indian Railways is presented separately to Parliament and dealt with separately. But the receipts and expenditure of the Railways form part of the Consolidated Fund of India and the figures relating to them are included in the ‘Annual Financial Statement’.

Vote on Account

  • The discussion on the Budget begins a few days after its presentation. Since Parliament is not able to vote the entire budget before the commencement of the new financial year (ie. within 1 month or so), the necessity to keep enough finance at the disposal of Government in order to allow it to run the administration of the country remains. A special provision is, therefore, made for “Vote on Account” by which Government obtains the Vote of Parliament for a sum sufficient to incur expenditure on various items for a part of the year.
  • Vote on Account is a special provision in every budget (and not only in an interim budget) by which Government obtains the Vote of Parliament for a sum sufficient to incur expenditure on various items for a part of the year, usually two months. Vote on Account deals only with expenditure part. But interim budget as well as full budget has both receipt and expenditure side.
  • So presentation and passing of vote on account is the first stage in the budget passing process. Vote on Account is necessary for the working of the government till the period the full budget is passed.

Cut Motions: Policy Cut, Economy Cut, and Token Cut

  • You might have noticed about the Demand for Grants while going through Indian Budget.
  • These are demands usually made in respect of the grant proposed for each Ministry.
  • But Parliament being the authority to check the expenditure of the government, it may not approve all demands. Cut motions are motions in the parliament moved to reduce the amount of a demand.

Cut motions

A motion may be moved to reduce the amount of a demand in any of the following ways:-

1. Disapproval of Policy Cut Motions

  • A Disapproval of Policy Cut motion is moved so that the amount of the demand be reduced to Re.1.
  • It represents the disapproval of the policy underlying the demand.
  • A member giving notice of such a motion shall indicate in precise terms the particulars of the policy which he proposes to discuss.
  • The discussion shall be confined to the specific point or points mentioned in the notice and it shall be open to members to advocate an alternative policy.

2. Economy Cut Motions

  • An Economy Cut motion is moved so that the amount of the demand be reduced by a specified amount.
  • It represents the economy that can be effected.
  • Such specified amount may be either a lump sum reduction in the demand or omission or reduction of an item in the demand.
  • The notice shall indicate briefly and precisely the particular matter on which discussion is sought to be raised and speeches shall be confined to the discussion as to how economy can be effected.

3. Token Cut Motions

  • A Token Cut motion is moved so that that the amount of the demand be reduced by Rs.100.
  • This is to ventilate a specific grievance which is within the sphere of the responsibility of the Government of India.
  • The discussion thereon shall be confined to the particular grievance specified in the motion.

Speaker to decide admissibility

  • The Speaker shall decide whether a cut motion is or is not admissible under these rules and may disallow any cut motion when in his opinion it is an abuse of the right of moving cut motions or is calculated to obstruct or prejudicially affect the procedure of the House or is in contravention of these rules.

Notice of cut motions

  • If notice of a motion to reduce any demand for grant has not been given one day previous to the day on which the demand is under consideration, any member may object to the moving of the motion, and such objection shall prevail, unless the Speaker allows the motion to be made.

Tax Expenditure:

  • Tax Expenditure corresponds to relaxations given when tax burden becomes difficult for the sustainability of a particular sector.
  • Tax exemptions or incentives are given in the form of lower rates of tax relative to normal rates.
  • Tax expenditures are revenue losses attributable to tax provisions that often result from the use of the tax system to promote social goals without incurring direct expenditures. 
  • Normally these exemptions are generated for particular purposes as tax incentives.

Tax Expenditure and its importance in Indian Economy

  • The term ‘tax expenditure’ is associated with budget. Though many are familiar with the concept of subsidies and its impact on Indian Economy, it seems not every one know the details of tax-expenditure. Tax-expenditure more or less has the same impact as subsidies as a necessary evil.
  • Tax expenditures can take many forms. Some result from tax provisions that reduce the present value of taxable income through deferral allowances, or special exclusions, exemptions, or deductions from gross income. Others affect a household’s after-tax income more directly through tax credits or preferential rates for specific activities.

Tax Exemptions given are called Tax Expenditure?

  • If government didn’t give any tax exemptions, this deducted amount would have belonged to government itself. Though Tax Expenditure are not direct spending by government, the concept of tax expenditure is that, government is giving back money to achieve certain social goals, like strengthening housing sector or industrial sector.
  • But in actual sense, Government is not collecting money to be re-distributed later, but gives away tax exemptions.

Tax Expenditure Budget

  • The tax expenditure budget comprises the estimated revenue losses attributable to various exclusions, exemptions, deductions, nonrefundable credits, deferrals, and preferential rates in the tax code.
  • These provisions reduce the income tax liabilities of individuals or businesses that undertake certain types of activities.

What is Fiscal Deficit?

The fiscal deficit is the difference between the government’s total expenditure and its total receipts (excluding borrowing). Fiscal deficit in layman’s terms corresponds to the borrowings and liabilities of the government. As per the technical definition, Fiscal Deficit = Budgetary Deficit + Borrowings and Other Liabilities of the government.

  • Note: Deficit differs from debt, which is an accumulation of yearly deficits. The elements of the fiscal deficit are revenue deficit and capital expenditure.
  • Note: Revenue deficit is the difference between the government’s revenue expenditure and total revenue receipts.

What is Current Account Deficit (CAD)?

  • Current Account is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid).
  • The right way to fill the gap is by increasing the exports and decreasing the imports, which is a step easier said than done.

Sectors of Economy: Primary, Secondary, Tertiary, Quaternary and Quinary:

Primary activities:

  • Primary activities are directly dependent on environment as these refer to utilisation of earth’s resources such as land, water, vegetation, building materials and minerals. It, thus includes, hunting and gathering, pastoral activities, fishing, forestry, agriculture, and mining and quarrying.
  • People engaged in primary activities are called red-collar workers due to the outdoor nature of their work.

Secondary activities:

  • Secondary activities add value to natural resources by transforming raw materials into valuable products. Secondary activities, therefore, are concerned with manufacturing, processing and construction (infrastructure) industries.
  • People engaged in secondary activities are called blue collar workers.

Tertiary activities

  • Tertiary activities include both production and exchange. The production involves the ‘provision’ of services that are ‘consumed. Exchange, involves trade, transport and communication facilities that are used to overcome distance.
  • Tertiary jobs = White collar jobs.

Quaternary activities

  • Quaternary activities are specialized tertairy activities in the ‘Knowledge Sector’ which demands a separate classification. There has been a very high growth in demand for and consumption of information based services from mutual fund managers to tax consultants, software developers and statisticians. Personnel working in office buildings, elementary schools and university classrooms, hospitals and doctors’ offices, theatres, accounting and brokerage firms all belong to this category of services. Like some of the tertiary functions, quaternary activities can also be outsourced. They are not tied to resources, affected by the environment, or necessarily localised by market.

Quinary activities

  • Quinary activities are services that focus on the creation, re-arrangement and interpretation of new and existing ideas; data interpretation and the use and evaluation of new technologies. Often referred to as ‘gold collar’ professions, they represent another subdivision of the tertiary sector representing special and highly paid skills of senior business executives, government officials, research scientists, financial and legal consultants, etc. Their importance in the structure of advanced economies far outweighs their numbers.The highest level of decision makers or policy makers perform quinary activities.
  • Quinary = Gold collar professions.

Financial Market

  • Financial market is the market that facilitates transfer of funds between investors/ lenders and borrowers/ users. Financial market may be defined as ‘a transmission mechanism between investors (or lenders) and the borrowers (or users) through which transfer of funds is facilitated’. It consists of individual investors, financial institutions and other intermediaries who are linked by a formal trading rules and communication network for trading the various financial assets and credit instruments. It deals in financial instruments (like bills of exchange, shares, debentures, bonds, etc).

Main functions of financial market

Let us now see the main functions of financial market.
(a) It provides facilities for interaction between the investors and the borrowers.
(b) It provides pricing information resulting from the interaction between buyers and sellers in the market when they trade the financial assets.
(c) It provides security to dealings in financial assets.
(d) It ensures liquidity by providing a mechanism for an investor to sell the financial assets.
(e) It ensures low cost of transactions and information.

Classification of Financial Market

A financial market consists of two major segments: (a) Money Market; and (b) Capital Market. While the money market deals in short-term credit, the capital market handles the medium term and long-term credit.

Financial Market Classification

    1. Money Market.
      1. Call Money.
      2. Treasury Bill.
      3. Commercial Paper.
      4. Certificate of Deposit.
      5. Trade bill.
    2. Capital Market.
      1. Securities Market
        1. Primary Market : IPOs, Book Building, Private Placements.
        2. Secondary Market : Equity Market, Debt Market, Commodity Market, Futures and Options Market. (Secondary Market can be basically divided into two – spot market and forward market. Forward market has two divisions – futures and options/derivatives. Again, there are two types of options – put option and call option.)
      2. Non-Securities Market
        1. Mutual Funds.
        2. Fixed Deposits, Savings Deposits, Post Office savings.
        3. Insurance.

Money Market

  • The money market is a market for short-term funds, which deals in financial assets whose period of maturity is upto one year. It should be noted that money market does not deal in cash or money as such but simply provides a market for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc. These financial instruments are close substitute of money. These instruments help the business units, other organisations and the Government to borrow the funds to meet their short-term requirement.
  • The Indian money market consists of Reserve Bank of India, Commercial banks, Co-operative banks, and other specialised financial institutions. The Reserve Bank of India is the leader of the money market in India. Some Non-Banking Financial Companies (NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.

Capital Market

  • Capital Market is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares, debentures, bonds, etc. The securities market has two different segments namely primary and secondary market.
  • Primary Market vs Secondary Market : The primary market consists of arrangements for procurement of long-term funds by companies by fresh issue of shares and debentures. The secondary market or stock exchange provides a ready market for existing long term securities. Stock exchange is the secondary market, which provides a place for regular sale and purchase of different types of securities like shares, debentures, bonds & government securities. It is an organised market where all transactions are regulated by the rules and laws of the concerned stock exchanges.
  • Secondary Markets or Stock Exchanges : The functions of a stock exchanges are to provide ready and continuous market for securities, information about prices and sales, safety to dealings and investment, helps mobilisation of savings and capital formation. It acts as a barometer of economic and business conditions and helps in better allocation of funds. Stock exchanges provide many benefits to companies, investors and the society as a whole. But they also suffer from limitations like exclusive speculation and fluctuation in prices due to rumours and unpredictable events. There are 21 stock exchanges in India presently, including BSE, NSE and OTCEI. Stock Exchanges are regulated by the Securities Contracts (Regulation) Act and by SEBI. SEBI has initiated a number of reforms in the primary and secondary market to regulate the stock market. Documentary and procedural requirements for listing and trading have been made stricter and foolproof to protect investors’ interest.
  • The secondary market has further two components. First, the spot market where securities are traded for immediate delivery and payment. The other is forward market where the securities are traded for future delivery and payment. This forward market is further divided into Futures and Options Market (Derivatives Markets). In futures Market the securities are traded for conditional future delivery whereas in option market, two types of options are traded. A put option gives right but not an obligation to the owner to sell a security to the writer of the option at a predetermined price before a certain date, while a call option gives right but not an obligation to the buyer to purchase a security from the writer of the option at a particular price before a certain date.

Money Market:

Bill of exchange

  • A bill of exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to or to the order of a certain person, or to the bearer of the instrument. In a bill of exchange there are three parties the drawer, the drawee and the payee.

Promissory Note

  • A promissory note is an instrument in writing (not being a bank note or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to or to the order of a certain person or to the bearer of the instrument. In a promissory note there are two parties the maker of the note and the payee.
  • NB : In a promissory note there is a promise to make the payment whereas in a bill of exchange there is an order for making the payment. Also, a promissory note requires no acceptance as it is signed by the person who is liable to pay. The drawer of a bill of exchange is generally the creditor of the drawee and therefore it must be accepted by the drawee before it can be presented for payment.

Important Money Market Instruments or Securities

  • There are various securities in Money Market as well as in Capital Market. Following are some of the important money market instruments or securities :

Call Money

  • Call money is mainly used by the banks to meet their temporary requirement of cash. They borrow and lend money from each other normally on a daily basis. It is repayable on demand and its maturity period varies in between one day to a fortnight. The rate of interest paid on call money loan is known as call rate.

Treasury Bill

  • A treasury bill is a promissory note issued by the RBI to meet the short-term requirement of funds. Treasury bills are highly liquid instruments, that means, at any time the holder of treasury bills can transfer of or get it discounted from RBI. These bills are normally issued at a price less than their face value; and redeemed at face value. So the difference between the issue price and the face value of the treasury bill represents the interest on the investment. These bills are secured instruments and are issued for a period of not exceeding 364 days. Banks, Financial institutions and corporations normally play major role in the Treasury bill market.

Commercial Paper

  • Commercial paper (CP) is a popular instrument for financing working capital requirements of companies. The CP is an unsecured instrument issued in the form of promissory note. This instrument was introduced in 1990 to enable the corporate borrowers to raise short-term funds. It can be issued for period ranging from 15 days to one year. Commercial papers are transferable by endorsement and delivery. The highly reputed companies (Blue Chip companies) are the major player of commercial paper market.

Certificate of Deposit

  • Certificate of Deposit (CDs) are short-term instruments issued by Commercial Banks and Special Financial Institutions (SFIs), which are freely transferable from one party to another. The maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, co-operatives and companies.

Trade Bill

  • Normally the traders buy goods from the wholesalers or manufactures on credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or in immediate need of money he/she can draw a bill of exchange in favour of the buyer. When buyer accepts the bill it becomes a negotiable instrument and is termed as bill of exchange or trade bill. This trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.

Capital Market

1) Debt Market

  • The Wholesale Debt Market (WDM) segment of the National Stock Exchange provides a trading platform for a wide range of fixed income securities that includes central government securities, treasury bills (T-bills), state development loans (SDLs), bonds issued by public sector undertakings (PSUs), floating rate bonds (FRBs), zero coupon bonds (ZCBs), index bonds, commercial papers (CPs), certificates of deposit (CDs), corporate debentures, SLR and non-SLR bonds issued by financial institutions (FIs), bonds issued by foreign institutions and units of mutual funds (MFs). (This means that debt market deals not only with capital market securities, but also with money market securities).
  • Debt Instruments : Debt instrument represents a contract whereby one party lends money to another on pre-determined terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower to the lender. Bonds and debentures are the major debt instruments.
  • Bonds and Debentures as debt instruments: A Bond is a loan given by the buyer to the issuer of the instrument. Companies, financial institutions, or even the government can issue bonds. Over and above the scheduled interest payments as and when applicable, the holder of a bond is entitled to receive the par value of the instrument at the specified maturity date. Bonds can be broadly classified into: Tax-Saving Bonds Regular Income Bonds. Also, note the below points which explains the difference between bonds and debentures.
  • Debentures are bonds which have no collateral.
  • Bonds are more secure than debentures, but the rate of interest is lower.
  • Debentures are unsecured loans but carries a higher rate of interest.
  • In bankruptcy, bondholders are paid first, but liability towards debenture holders is less.
  • Debenture holders get periodical interest.
  • Bond holders receive accrued payment upon completion of the term.
  • In the Indian securities markets, the term ‘bond’ is used for debt instruments issued by the Central and State governments and public sector organizations and the term ‘debenture’ is used for instruments issued by private corporate sector.2) Derivative Market [Financial Derivatives + Commodity Derivatives]Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines “derivative” to include –
    • A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
    • A contract, which derives its value from the prices, or index of prices, of underlying securities.
    • Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products.
    • The following three broad categories of participants – hedgers, speculators, and arbitrageurs trade in the derivatives market.
    • Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps.

3) Commodity Market [Commodity Derivatives]

  • Commodity derivatives work almost the same way as financial derivatives, however with some differences. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying is concerned.

4) Equity Market

  • Equity, also called shares or scripts, is the basic building blocks of a company. A company’s ownership is determined on the basis of its shareholding. The BSE Sensex is the most popular index that tracks the movements of shares of 30 blue-chip companies on a weighted average basis. The rise and fall in the value of the Sensex, measured in points, broadly indicates the price-movement of the value of shares. SEBI is the regulator of equity market in India.

Non-Securities Market

Mutual funds, Bank Deposits, Provident Fund, Post – office savings, Insurance etc. forms part of non-securities market.

What is a Mutual Fund?

  • A Mutual Fund is a body corporate registered with SEBI (Securities Exchange Board of India) that pools money from individuals/corporate investors and invests the same in a variety of different financial instruments or securities such as equity shares, Government securities, Bonds, debentures, commercial paper etc. Mutual funds can thus be considered as financial intermediaries in the investment business that collect funds from the public and invest on behalf of the investors. Mutual funds issue units to the investors. The appreciation of the portfolio or securities in which the mutual fund has invested the money leads to an appreciation in the value of the units held by investors.

Forex Reserves

  • Forex reserves are external assets in the form of gold, SDRs (special drawing rights of the IMF) and foreign currency assets accumulated by India and controlled by the RBI.
  • The International Monetary Fund says official foreign exchange reserves are held in support of a range of objectives like supporting and maintaining confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency.
  • It also limits external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.
  • The RBI uses its forex kitty for the orderly movement of the rupee. It sells the dollar when the rupee weakens and buys the dollar when the rupee strengthens. Of late, the RBI has been buying dollars from the market to shore up the forex reserves.
  • When the RBI mops up dollars, it releases an equal amount in rupees. This excess liquidity is sterilised through the issue of bonds and securities and LAF operations.

The Foreign exchange reserves of India consists of below four categories:

  • Foreign Currency Assets
  • Gold
  • Special Drawing Rights (SDRs)
  • Reserve Tranche Position


  • Bitcoin is a type of digital currency that enables instant payments to anyone.
  • Bitcoin was introduced in 2009. Bitcoin is based on an open source protocol and is not issued by any central authority.
  • Bitcoin is a peer-to-peer currency.
  • Peer-to-peer means that no central authority issues new money or tracks transactions.
  • These tasks are managed collectively by the network.

“Bitcoin”, capitalized, refers to the protocol and transaction network whereas “bitcoin”, lowercase, refers to the currency itself. So, having learned that bitcoins correspond to a virtual currency, let’s sum up.

  • Bitcoin is the first decentralized digital currency.
  • Bitcoins are digital coins you can send through the Internet.
  • Compared to other alternatives, Bitcoins have a number of advantages.
  • Bitcoins are transferred directly from person to person via the net without going through a bank or clearinghouse. (This means that the fees are much lower, you can use them in every country, your account cannot be frozen and there are no prerequisites or arbitrary limits.)
  • Bitcoins are sent easily through the Internet, without needing to trust any third party.
  • Bitcoin uses public-key cryptography, peer-to-peer networking, and proof-of-work to process and verify payments.
  • Bitcoins are sent (or signed over) from one address to another with each user potentially having many, many addresses.
  • Each payment transaction is broadcast to the network and included in the blockchain so that the included bitcoins cannot be spent twice.
  • After an hour or two, each transaction is locked in time by the massive amount of processing power that continues to extend the blockchain. (Bitcoin blockchain is a database which holds information about all transactions.)
  • Using these techniques, Bitcoin provides a fast and extremely reliable payment network that anyone can use.

Special Drawing Right (SDR)

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves.

The value of the SDR is based on a basket of five currencies—the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling.

The role of the SDR

  • The SDR was created as a supplementary international reserve asset in the context of the Bretton Woods fixed exchange rate system.
  • The collapse of Bretton Woods system in 1973 and the shift of major currencies to floating exchange rate regimes lessened the reliance on the SDR as a global reserve asset.
  • Nonetheless, SDR allocations can play a role in providing liquidity and supplementing member countries’ official reserves, as was the case amid the global financial crisis.
  • The SDR serves as the unit of account of the IMF and some other international organizations.
  • The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. SDRs can be exchanged for these currencies.

Currencies included in the SDR basket have to meet two criteria:

  • the export criterion and the freely usable criterion. A currency meets the export criterion if its issuer is an IMF member or a monetary union that includes IMF members, and is also one of the top five world exporters.
  • For a currency to be determined “freely usable” by the IMF, it has to be widely used to make payments for international transactions and widely traded in the principal exchange markets. Freely usable currencies can be used in Fund financial transactions.
  • The SDR basket is reviewed every five years, or earlier if warranted, to ensure that the basket reflects the relative importance of currencies in the world’s trading and financial systems.
  • The reviews cover the key elements of the SDR method of valuation, including criteria and indicators used in selecting SDR basket currencies and the initial currency weights used in determining the amounts (number of units) of each currency in the SDR basket.
  • These currency amounts remain fixed over the five-year SDR valuation period but the actual weights of currencies in the basket fluctuate as cross-exchange rates among the basket currencies move. The value of the SDR is determined daily based on market exchange rates.
  • The reviews are also used to assess the appropriateness of the financial instruments comprising the SDR interest rate (SDRi) basket.

The SDR interest rate (SDRi)

  • The SDRi provides the basis for calculating the interest rate charged to members on their non-concessional borrowing from the IMF and paid to members for their remunerated creditor positions in the IMF.
  • It is also the interest paid to members on their SDR holdings and charged on their SDR allocation.

Reserve tranche or gold tranche

  • Reserve tranche is the component of a member country’s quota with the IMF that is in the form of gold or foreign currency.
  • For any member country, out of the total quota, 25% should be paid in the form of foreign currency or gold.
  • Hence this is called as reserve tranche or gold tranche.
  • The remaining 75% can be in domestic currencies and it is called credit tranche.

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