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The following points highlight the two main views on the role of NBFIs in creating liquidity. The views are: 1. The Radcliffe Committee View 2. The Gurley-Shaw View.
1. The Radcliffe Committee View: Radcliffe – Savers Thesis:
The Radcliffe Committee in its report did not accept the monetarist view that there was any direct link between money supply and national income. This is because money is a close substitute for other financial assets, particularly those issued by NBFIs.
If the central bank wanted to follow a constructional monetary policy by selling securities in the open market, NBFIs would be able to release idle demand deposits and currency. In this way, they would offset the restriction of money supply, and leave aggregate demand unchanged. Thus it held the view that “changes in rates of interest only very exceptionally have direct effects on the level of demand.” It also did not find any indirect relation between money supply and national income.
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According to the Radcliffe Committee, it is liquidity that influences total effective demand for goods and services rather than the supply of money The Committee pointed out that the “decisions to spend on goods and services, the decisions that determine the level of total demand, are influenced by the liquidity of the spenders. The spending is not limited by the amount of money in existence; but it is related to the amount of money people think they can get hold of, whether by receipt of income (for instance, from sales), by disposal of capital assets or by borrowing”. Thus liquidity consists of the amount of money people can get hold of from income, sales, disposal of capital assets or borrowing. Suppose if liquidity is reduced, expenditures would decline to the extent they exceed current income and vice versa.
The second element by which the monetary authority can influence the level of overall liquidity and hence the level of aggregate expenditures is the interest rate. It is by manipulating the structure of interest rates which affects the overall liquidity structure.
A movement of interest rates means significant changes in the capital values of many assets held by individuals and financial institutions. When interest rates rise, they reduce liquidity because they reduce the capital value of assets held by the latter. Financial institutions, in turn, reduce the supply of loanable funds. Since individuals and businesses cannot procure funds, they reduce their expenditures.
On the other hand, a fall in the interest rate “strengthens balance sheets and encourages lenders to seek new business”. In this monetary mechanism, the commercial banks hold a special position in the Committee’s view, because they are the most convenient institutional source of funds for most borrowers for short-term purposes.
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On the basis of this transmission mechanism, the Committee concluded that monetary policy performed a “background function”. It thought that business investment was insensitive to changes in short-term interest rates. But it was influenced by long-term interest rates.
Therefore, it was undesirable to cause long-term interest rates to fluctuate sharply because sharp fluctuations would undermine the strength and stability of financial institutions. In fact, financial institutions are accustomed to stable interest rates and they plan their lending policies accordingly. The monetary authority should, therefore, try to hold long-term interest rates at the level which maintained approximate balance between saving and investment in the economy.
The Committee did not favour reliance on monetary policy alone in severe deflationary or severe inflationary conditions. Apart from the removal of credit control and a possible effect of lower long-term interest rates on house-building activity during a slump, monetary policy was thought to be of not much help. Rather, the use of monetary measures to raise the economy from a slump carried the danger of flooding the financial system with liquidity.
It would be difficult to control it later on when business activity expanded during the upswing. Thus in the Committee’s view, “in general, the potentialities of monetary policy alone in the face of a severe slump are well represented by the proverb that you can take a horse to water but you cannot make him drink.”
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Similarly, it was against any restriction on the money supply during severe inflation. It advocated measures to strike directly and rapidly at the liquidity of spenders through control of capital issues, bank advances and consumer credit. But it did not favour control over the lending power of the non- bank financial intermediaries because it entailed additional administrative burdens. More so because new financial institutions would be coming up which would make it difficult for the monetary authority to control the situation.
Thus the Radcliffe Committee suggested “liquidity controls” through changes in long-term interest rates. According to it, “monetary measures cannot alone be relied upon to keep in nice balance an economy subject to major strains from without and within. Monetary measures can help but that is all”. It, therefore, recommended reliance on fiscal policy in normal times which should be supplemented with monetary policy during severe inflations.
Its Criticisms:
The views of the Radcliffe Committee have been severely criticised on the following grounds:
1. Economists have criticised it for advocating the control of overall liquidity of the economy rather than the money supply.
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2. It did not precisely define liquidity or liquid assets. This makes the whole approach to liquidity as haphazard.
3. Prof. Gurley in his review of the Radcliffe Report found “confusion every where in the role of money supply, in the concept of liquidity, and in money to satisfy the liquidity desire of the public.”
4. Other economists characterised the Report as “an utterly muddled one, indicating a stock-flow muddle, a liquidity muddle, and an interest rate muddle.”
2. The Gurley-Shaw View:
According to Gurley and Shaw, it is the NBFIs that provide liquidity and safety to financial assets and help in transferring funds from ultimate lenders to ultimate borrowers for productive purposes. They increase capital formation and consequently lead to economic growth.
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By buying primary securities from the ultimate borrowers and selling indirect securities to the ultimate lenders, the intermediaries influence the availability of credit and the structure and level of interest rates. They create credit different from commercial banks. But they create new assets and liabilities which tend to influence the supply of money and thus hinder the operation of an effective monetary policy.
According to them, the savings deposits of NBFIs resemble the demand deposits of commercial banks because it is not difficult for NBFIs to convert their savings deposits into cash. These savings deposits, whether of commercial banks or of NBFIs, are for all practical purposes as liquid as demand deposits. Such savings deposits held by NBFIs are known as near moneys. Since the demand deposits are not controlled by the central bank, it follows that the savings deposits held by NBFIs will hinder the successful operation of a successful monetary policy.
If the central bank wishes to control excess liquidity in the economy only through the reduction in money supply, it will not be successful because the savings deposits of NBFIs can be converted into cash. Similarly, if the central bank tries to control lending by commercial banks, it will not be successful if the lending of all other FIs are not under its control, as is the case.
According to Gurley and Shaw, this problem arises especially when the central bank adopts an anti-inflationary monetary policy. Suppose the central bank reduces the money supply in order to control inflation. Among other effects, the interest rates on market securities rise in anticipation of higher yields and profits. NBFIs will raise the interest rates on their savings deposits to attract more funds in order to invest them in higher yielding securities.
Persons already holding securities find that their prices have fallen because of the rise in interest rates on present securities. They will, therefore, sell them and deposit their funds with intermediaries in order to earn higher interest rates on savings deposits. In the meantime, attracted by higher interest rates, others holding idle cash balances will also deposit them with intermediaries.
So when NBFIs raise the interest rates on their savings deposits, the public reduces its demand for money which, in turn, reduces the market rate of interest. Thus NBFIs make tight monetary policy less successful or effective. Similarly, NBFIs can make an expansionary monetary policy ineffective by reducing liquidity.
But unlike the Radcliffe Report, Gurley and Shaw argue that the central bank’s control over NBFIs should be extended for an effective monetary policy. This is because the NBFIs create more near-money assets and thereby affect the overall liquidity which, in turn, influences aggregate demand and economic activity.
Its Criticisms:
The view of Gurley and Shaw has been criticised on the following grounds:
1. Prof. Johnson does not agree with Gurley and Shaw. He observes that there seems to be no empirical case for empowering the central bank to extend its control over financial intermediaries similar to that exercised over the commercial banks. According to him, there is little reason for believing that the central bank’s control is weakened by the presence of financial intermediaries.
Moreover, so long as the public does not switch easily from bank deposits into indirect securities of intermediaries, the presence of intermediaries may increase the leverage of the central bank on economic activity.
It implies that it is not possible for the interest rates to settle back at their old levels even by the operation of non-bank financial intermediaries. Rather, interest rates would tend to rise further. The money supply will remain tight and its influence on spending would be restrictive.
2. Further, the rapid growth of NBFIs has helped to strengthen the effectiveness of monetary policy rather than weaken it where the NBFIs have been controlled. But Gurley and Shaw do not elaborate how they should be controlled.
Conclusion:
Despite the weaknesses of both Radcliffe Report and Gurley-Shaw views, they highlight the role of NBFIs in creating liquidity which affects aggregate demand and economic activity. They emphasise that the success of monetary policy depends not in controlling the money supply but general liquidity. Thus the liquidity theory of money provides a new and realistic dimension to monetary policy.
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