In this article we will discuss about:- 1. Objectives / Goals of Monetary Policy 2. Trade-Off in Objectives of Monetary Policy 3. Targets 4. Indicators 5. Instruments 6. Types 7. Role in a Developing Economy 8. Limitations in LDCs.
- Objectives / Goals of Monetary Policy
- Trade-Off in Objectives of Monetary Policy
- Targets of Monetary Policy
- Indicators of Monetary Policy
- Instruments of Monetary Policy
- Types of Monetary Policy
- Role of Monetary Policy in a Developing Economy
- Limitations of Monetary Policy in LDCs
1. Objectives / Goals of Monetary Policy:
The following are the principal objectives of monetary policy:
The objectives of monetary policy are:
(1) Full employment;
(2) Price stability which also includes controlling economic fluctuations (though some writers mention the latter separately);
(3) Economic growth; and
(4) Maintaining balance of payments equilibrium.
1. Full Employment:
Full employment has been ranked among the foremost objectives of monetary policy. It is an important goal not only because unemployment leads to wastage of potential output, but also because of the loss of social standing and self-respect. Moreover, it breeds poverty.
According to Keynes, full employment means the absence of involuntary unemployment. In other words, full employment is a situation in which everybody who wants to work, gets work. Full employment so defined is consistent with frictional and voluntary unemployment. To achieve full employment, Keynes advocated increase in effective demand to bring about reduction in real wages.
Thus the problem of full employment is one of maintaining adequate effective demand. Keynes gave an alternative definition of full employment at another place in his General Theory thus: “It is a situation in which aggregate employment is inelastic in response to an increase in which aggregate employment is inelastic in response to an increase in the effective demand for its output.”
It means that the test of full employment is when any further increase in effective demand is not accompanied by any increase in output. Since the supply of output becomes inelastic at the full employment level, any further increase in effective demand will lead to inflation in the economy.
The Keynesian concept of full employment involves three conditions:
(i) Reduction in the real wage rate;
(ii) Increase in effective demand; and
(iii) Inelastic supply of output at the level of full employment.
According to Prof. W. W. Hart, attempting to define full employment raises many people’s blood pressure. Rightly so, because there is hardly any economist who does not define it in his own way. Lord Beveridge in his book Full Employment in a Free Society defined it as a situation where there were more vacant jobs than unemployed men so that the normal lag between losing one job and finding another will be very short. By full employment he does not mean zero unemployment which means that full employment is not always full.
There is always a certain amount of frictional unemployment in the economy even when there is full employment. He estimated frictional unemployment of 3% in a full employment situation for England. But his pleading for more vacant jobs than the unemployed cannot be accepted as the full employment level.
According to the American Economic Association Committee, “Full employment is a situation where all qualified persons, who want jobs at current wage rate, find full time jobs.” It does not mean unemployment is zero. Here again, like Beveridge, the Committee considered full employment to be consistent with some amount of unemployment.
Individual economists may, however, continue to differ over the definition of full employment, but the majority has veered round the view expressed by the U.N. Experts on National and International Measures for Full Employment that “full employment may be considered as a situation in which employment cannot be increased by an increase in effective demand and unemployment does not exceed the minimum allowances that must be made for the effects of frictional and seasonal factors.” This definition is in keeping with the Keynesian and Beveridgian views on full employment. It is now agreed that full employment stands for 96 to 97 per cent employment, with 3 to 4 per cent unemployment existing in the economy due to frictional factors. Full employment can be achieved in an economy by following an expansionary monetary policy.
2. Price Stability:
One of the policy objectives of monetary policy is to stabilise the price level. Both economists and laymen favour this policy because fluctuations in prices bring uncertainty and instability to the economy. Rising and falling prices are both bad because they bring unnecessary loss to some and undue advantage to others.
Again, they are associated with business cycles. So a policy of price stability keeps the value of money stable, eliminates cyclical fluctuations, brings economic stability, helps in reducing inequalities of income and wealth, secures social justice and promotes economic welfare.
However, there are certain difficulties in pursuing a policy of stable price level. The first problem relates to the type of price level to be stabilized. Should the relative or general price level be stabilized, the wholesale or retail, of consumer goods or producer goods? There is no specific criteria with regard to the choice of a price level.
Halm suggests, “The compromise solution would be to try to stabilise a price level which would include consumers’ goods prices as well as wages.” But this will necessitate increase in the quantity of money but not by as much as is implied in the stabilisation of consumers goods price. Second, innovations may reduce the cost of production but a policy of stable prices may bring larger profits to producers at the cost of consumers and wage earners.
Again, in an open economy which imports raw materials and other intermediate products at high prices, the cost of production of domestic goods will rise. But a policy of stable prices will reduce profits and retard further investment. Under the circumstances, a policy of stable prices is not only inequitable but also conflicts with economic progress.
Despite these drawbacks, the majority of economists favour a policy of stable prices. But the problem is one of defining price stability. Price stability does not mean that prices remain unchanged indefinitely. “Comparative prices will change as fluctuating tastes alter the composition of demand, as new products are developed and as cost reducing technologies are introduced. Differential price changes are essential for allocating resources in the market economy.
Since modern economies tend to exhibit fairly rigid downward inflexibility of prices, differential price changes can only be attained by gradual increases in the aggregate price level over the long-run. Further, prices may have to be changed if costs of imported goods increase or if taxation policy leads to rise in the domestic cost of production.
As pointed out by Dasgupta and Hagger, price stability means “stability of some appropriate price index in the sense that we can detect no definite upward trend in the index after making proper allowance for the upward bias inherent in all price indexes.” Price stability can be maintained by following a counter-cyclical monetary policy, that is easy monetary policy during a recession and dear monetary policy during a boom.
3. Economic Growth:
One of the most important objectives of monetary policy in recent years has been the rapid economic growth of an economy. Economic growth is defined as “the process whereby the real per capita income of a country increases over a long period of time.” Economic growth is measured by increase in the quantity of goods and services produced in a country. A growing economy produces more goods and services in each successive time period.
Thus, growth occurs when an economy’s productive capacity increases which, in turn, is used to produce more goods and services. In its wider aspect, economic growth implies raising the standard of living of the people, and reducing inequalities of income distribution. All agree that economic growth is a desirable goal for a country. But there is no agreement over “the magic number,” viz., the annual growth rate which an economy should attain.
Generally, economists believe in the possibility of continual growth. This belief is based on the presumption that innovations tend to increase productive technologies of both capital and labour over time. But there is very likelihood that an economy might not grow despite technological innovations.
Production might not increase further due to lack of demand which may retard the growth of the productive capacity of the economy. The economy may not grow further if there is no improvement in the quality of labour in keeping with the new technologies.
However, policy makers do not take into consideration the cost of growth. Growth is not limitless because resources are scarce in every economy. All factors have opportunity cost. To produce more of one particular product will mean reduction in that of the other.
New technologies lead to the replacement of old machines which become obsolete. Workers are also displaced because they cannot be fitted in the new technological set up immediately. Moreover, rapid growth leads to urbanisation and industrialisation with their adverse effects on the pattern of living and environment. People have to live in squalor and slums.
The environment becomes polluted. Social tensions develop. “But growth has other more basic effect on our environment, and, today, people are not so sure that unrestricted growth is worth all its costs, since the price in terms of change in, deterioration of, or even destruction of the environment is not yet fully known. What does seem clear, however, is that growth is not going to be halted because of environmental problems and that mankind must learn to cope with the problem or face the consequences.”
The main problem is to what extent monetary policy can lead to the growth of the economy? It is difficult to say anything definite on this issue. The monetary authority may influence growth by controlling the real interest rate through its effect on the level of investment.
By following an easy credit policy and lowering interest rates, the level of investment can be raised which promotes economic growth. Monetary policy may also contribute towards growth by helping to maintain stability of income and prices.
By moderating economic fluctuations and avoiding deep depressions, monetary policy helps in achieving the growth objective. Since rapid and variable rates of inflation discourage investment and adversely affect growth, monetary policy helps in controlling hyper-inflation. Similarly, by a judicious monetary policy which encourages investment, growth can be promoted.
For example, tight monetary policy affects small firms more than large firms, and higher interest rates have a greater impact on small investments than on large industrial investments. So monetary policy should be such that encourages investment and at the same time controls hyperinflation so as to promote growth and control economic fluctuations.
4. Balance of Payments:
Another objective of monetary policy since the 1950s has been to maintain equilibrium in the balance of payments. The achievement of this goal has been necessitated by the phenomenal growth in the world trade as against the growth of international liquidity. It is also recognised that deficit in the balance of payments will retard the attainment of other objectives.
This is because a deficit in the balance of payments leads to a sizeable outflow of gold. But “it is not clear what constitutes a satisfactory balance of payments position. Clearly a country with a net debt must be at a surplus to repay the debt over a reasonably short period of time.
Once any debt has been repaid and an adequate reserve attained, a zero balance maintained over time would meet the policy objective. But how is this satisfactory balance to be achieved on the trading account or on the capital account?… The capital account must be looked upon as fulfilling merely a short-term emergency role in times of crises.”
Again, another problem relates to the question: What is the balance of payments target of a country? It is where imports equal exports. But, in practice, a country whose current reserves of foreign exchange are inadequate will have a mild export surplus as its balance of payments target. But when its reserves become satisfactory, it will aim at the equality of imports and exports. This is because an export surplus means that the country is accumulating foreign exchange and it is producing more than it is consuming: This will lead to low standard of living of the people.
But this cannot last long because some other country must be having import surplus and in order to avoid it, it would impose trade restrictions on the export surplus country. So the attainment of a balance of payments equilibrium becomes an imperative goal of monetary policy in a country.
How can monetary policy achieve it? A balance of payments deficit is defined as equal to the excess of money supply through domestic credit creation over extra money demand based on increased demand for cash balances.
Thus a balance of payments deficit reflects excessive money supply in the economy. As a result, people exchange their excess money holdings for foreign goods and securities. Under a system of fixed exchange rates, the central bank will have to sell foreign exchange reserves and buy the domestic currency for eliminating excess supply of domestic currency. This is how equilibrium will be restored in the balance of payments.
On the other hand, if the money supply is below the existing demand for money at the given exchange rate, there will be a surplus in the balance of payments. Consequently, people acquire the domestic currency by selling goods and securities to foreigners.
They will also seek to acquire additional money balances by restricting their expenditure relatively to their income. The central bank, on its part will buy excess foreign currency in exchange for domestic currency in order to eliminate the shortage of domestic currency.
2. Trade-Off in Objectives of Monetary Policy:
The four objectives of monetary policy discussed above are not complementary to each other. Rather, they conflict with one another. If a government tries to fulfill one goal, some other goal moves away. It has to sacrifice one in order to attain the other. It is, therefore, not possible to fulfill all these objectives simultaneously. We discuss below conflicts or trade-offs between different objectives.
1. Full Employment and Economic Growth:
The majority of economists hold the view that there is no inherent conflict between full employment and economic growth. Full employment is consistent with 4 per cent unemployment in the economy. So the relationship between full employment and economic growth boils down to a trade-off between unemployment and growth. Periods of high growth are associated with low level of unemployment, and periods of low growth with rising unemployment.
In 1961, Aurther Okun established a relationship between real GNP and changes in the unemployment rate. This relationship has come to be known as Okun’s Law. This law states that for every three percentage points growth in real GNP, unemployment rate declines by one percentage point every year.
This is illustrated in Fig. 1 where the curve U represents unemployment and curve G the real growth of an economy for a few years. To begin with, the economy is growing at 3 per cent with an unemployment rate of 4 per cent. During the year 1970, when the real GNP increases by 4.5 per cent (from 3 per cent to 7.5 per cent), the unemployment rate falls by 1.5 per cent (from 4 per cent to 2.5 per cent). In the next year 1971, the growth rate of the economy falls to zero and the unemployment rate rises to 5 per cent. In the subsequent year 1972, the real growth rate increases to 3 per cent and the unemployment rate declines to 4 per cent.
However, certain economists argue that the unemployment rate increases as the growth rate rises. Economic growth leads to reallocation of resources in the economy whereby there is change in the type and quantity of labour demanded. There is shift in the demand for labour from one sector of the economy to the other. As workers are trained for specific jobs, they are displaced when the demand for the products of a particular industries falls.
This creates unemployment. This is particularly so when growth is the result of technological innovations which are labour-saving and require more qualified and skilled workers. Thus unskilled workers are the worst sufferers because they are thrown out of jobs with automation. Employment can, however, increase with growth if demand is increasing at 3 per cent per annum and the productivity is increasing at 4 per cent per year, the output will expand but employment will decline. Under the circumstances, the government should adopt such monetary policy which should increase the overall demand in the economy.
2. Economic Growth and Price Stability:
There is conflict between the goals of economic growth and price stability. The rise in prices is inherent in the growth process. The demand for goods and services rises as a result of stepping up of investments on a large scale and consequent increase in income. This leads to inflationary rise in prices, especially when the level of full employment is reached.
In the long run, when new resources are developed and growth leads to the production of more commodities, the inflationary rise in prices will be checked. But the rise in prices will be there with the growth of the economy and it will be moderate and gradual.
3. Full Employment and Price Stability:
One of the objectives of monetary policy in the 1950s was to have full employment with price stability. But the studies of Philips, Samuelson, Solow and others in the 1960s established a conflict between the two objectives. These findings are explained in terms of the Philips curve.
They suggest that full employment can be attained by having more inflation and that price stability can be achieved by having unemployment to the extent of 5 to 6 per cent. Economists do not find any conflict between unemployment and price stability. They hold that so long as there are unemployed resources, there will be price stability. Prices start rising only when there is full employment of resources.
This is illustrated in Fig. 2 where the percentage of resources unutilized (or unemployed) are taken on the horizontal axis and the percentage change in price level is taken on the vertical axis. Thus each point indicates the percentage of resources unemployed along with the price level. According to this theory, so long as resources (U1, U2 and (J3 are unemployed the price level remains constant at Po. It is only when the economy reaches the full employment level F, prices rise from Po to P1 to P2 to P3 with successive increases in demand.
Thus there is no conflict between unemployment and stable prices, as shown by the shaded area of the figure. However, the policy implications of such a relationship are that there can be no conflict between full employment and price stability so long as the economy is in the shaded area.
This is because when there is full employment, resources are not in excess supply and if the government controls the excess demand through appropriate monetary policy, there will be stability of the price level. But if the economy happens to be at point P, which may be taken to be a point on the Phillips curve, there will be conflict between the objectives of full employment and price stability.
4. Full Employment and Balance of Payments:
There is a major policy conflict between full employment and balance of payments. Full employment is always related to balance of payments deficit. In fact, the problem is one of maintaining either internal balance or external balance. If there is a balance of payments deficit, then a policy of reducing expenditure will reduce imports but it will lead to increase in unemployment in the country.
If the government raises aggregate expenditure in order to increase employment, it will increase the demand for imports thereby creating disequilibrium in the balance of payments. It is only when the government adopts expenditure-switching policies such as devaluation that this conflict can be avoided but that too temporarily.
5. Price Stability and Balance of Payments:
There appears to be no conflict between the objectives of price stability and balance of payments in a country. Monetary policy aims at controlling inflation to discourage imports and encourage exports and thus it helps in attaining balance of payments equilibrium.
However, if the government tries to remove unemployment and allows some inflation within the economy, there appears a conflict between these two objectives. For a rise in the price level will discourage exports and encourage imports, thereby leading to disequilibrium in the balance of payments. But this may not happen if prices also rise by the same rate in other countries of the world.
3. Targets of Monetary Policy:
The choice of a target for monetary policy is determined by the mechanism through which money effects growth, employment and prices. Since none of the monetary authority’s policy tools works directly on these policy variables, the policy makers rely on intermediate targets that they feel they can control tolerably well with the instruments at their disposal, and that are closely linked through transmission mechanism to the ultimate targets of production, employment and price level. There are three target variables for monetary policy. They are the money supply, availability of credit, and interest rates.
1. Money Supply:
So far as money supply is concerned, the central bank cannot directly control output and prices. So it selects the growth rate of money .supply as an intermediate target. If fact, it selects an “operating target” which it considers to be closely linked to its “intermediate target”.
Friedman suggests that the money supply should be allowed to grow steadily at the rate of 3 to 4 per cent per year for a smooth growth of the economy and to avoid inflationary and recessionary tendencies.
2. Availability of Credit and Interest Rates:
Availability of credit and interest rates are the other two target variables of monetary policy. Economists call them as “money market conditions” which refer to short-term interest rates and the banking system’s “free reserves” (i.e. excess reserves minus borrowed reserves). The monetary authority can influence the short-term interest rates.
It can change credit conditions and affect economic activity by rationing of credit or other means. The monetary authority influences economic activity by following an easy or expansionary monetary policy through low and/or falling short-term interest rates and a tight or contractionary monetary policy through high and/or rising short-term interest rates.
The use of interest rates and credit availability as target variables are beset with a number of difficulties:
1. No doubt interest rates and the supply of credit influence spending, but it cannot be predicted with definiteness about the size and timing of the effects of any change in them.
2. So far as interest rates are concerned, it is the real interest rate that matters and not the nominal interest rate.
It is possible to control and observe the movements in the nominal interest rate and not in the real interest rate because it is difficult to measure the expected rate of price inflation. When the monetary authority raises the nominal interest rate, the real interest rate will also rise, other things being equal. But this does not happen always because when money interest rates are raised, the expectations of price inflation are growing. Under such circumstances, a rise in the nominal interest rate may be associated with a fall in the expected real rate. Thus the nominal interest rate is not a good target of monetary policy.
3. The use of credit availability as a monetary target is not helpful in monetary policy. Suppose there is a reduction in the availability of credit, it may be offset by credit flows through NBFIs. Moreover, it is difficult to predict the amount of reduction/increase in the availability of credit.
3. Intermediate Targets:
Money supply and interest rate are intermediate targets of monetary policy. In fact, they are competing targets. The central bank can either aim at a certain rate of increase in the money supply or at a certain level of interest rate. It cannot adopt both the targets at the same time.
The money supply target means loss of control over the interest rate, while the interest rate target means loss of control over the money supply. Let us assume in Fig. 3 that the target money supply fixed by the central bank is MS and the demand for money function is MD.
They intersect at E and determine the interest rate R. With the increase in the demand for money, the MD curve shifts upwards to MD which intersects the MS curve at E1, and determines the higher interest rate R1 .On the contrary, a fall in the demand for money shifts the curve downwards to MD2 so as to reduce the interest rate to R2 .Thus with the money supply fixed by the central bank, the interest rate changes with fluctuations in the demand for money between R1 and R2.
Now assume in Fig. 4 that R is the target interest rate when MS and MD are the original money supply and money demand curves. If the demand for money shifts upwards from MD to MD1 the central bank will have to increase the money supply from MS to M1 S1 to match the money demand to maintain the target interest rate R. Contrariwise, it will have to decrease the money supply to M2S2, in case of a fall in the demand for money MD2 so that the interest rate is stabilized at R. Therefore, to maintain the target interest rate, the central bank has to relinquish control over the money supply.
Of the two targets relating to money supply and interest rate, the monetarists prefer a monetary target for various reasons. First, the money supply is measurable, while there are a variety of interest rates. It is, therefore, difficult to adjust nominal interest rates to real interest rates. Second, the money supply linkage with nominal GNP is more direct and predictable than the interest linkage with nominal GNP.
4. Market Yield on Equity:
Tobin suggests the market yield on equity as a target variable for monetary policy. According to him, the monetary authority should try to equate this yield with the real return expected from investment in physical capital. When the real rate of return on equity rises, the value of existing capital equipment falls which discourages the purchase of new capital equipment. Contrariwise, investment is encouraged when the cost of production of new capital is less than its market value.
Thus the valuation of investment goods relative to their cost is the proper target of monetary policy. This target is superior to other targets because the market value of equity capital can be observed easily and an index of market value can be compared with a price index of investment goods.
Despite this, it is difficult to compare the value of existing assets with those of newly produced assets. Moreover, it is not possible to link investments with changes in stock market prices. So it is not advisable to adopt market yield on equity as the sole target of monetary policy.
Of the various targets of monetary policy, it is advisable for the monetary authority not to rely on any single target. It should select the targets according to the prevailing economic and financial conditions. The interest rate is more suitable during the short run. But in the long run, the credit availability and the money supply should be relied upon by the monetary authority. The target of market yield on equity is unacceptable by economists.
4. Indicators of Monetary Policy:
Money supply, bank credit and interest rate which serve as targets are also employed as indicators of monetary policy.
1. Money Supply:
If the central bank is solely responsible for changes in the money supply, it is a good indicator of monetary policy. But if the money supply changes regardless of the central bank policy, it is hardly an indicator. According to the monetarists, it is open market operations and changes in reserve requirements that are the main cause of movements in the money supply.
It is the money supply which is the most important determinant of both the level of output and the price level in the short run and of the price level and the nominal aggregate demand in the long run. The changes in money supply affect aggregate demand through effects on a wide range of assets. The Keynesians involve a narrow transmission mechanism between money supply and changes in aggregate demand.
When the money supply increases it will be spent on bonds, thereby lowering interest rates and ultimately leading to an increase in investment. But according to the monetarists, an increase in money supply will lead to spending on a much broader range of assets than on bonds only. The excess money supply balances will be used to bring not only financial assets but also real assets. Even if the demand for financial assets expands, interest rates will fall but only temporarily.
If GNP rises, interest rates will also rise because there is a greater need for day-to-day cash transactions to carry out the expanding business activity. Firms will, therefore, borrow to raise more cash and interest rates will rise. Interest rates will also rise when an expansionary monetary policy generates inflationary expectations.
Thus interest rates may be either lower or higher after an expansionary monetary policy, depending on the speed and strength of the change in GNP and on the expectations regarding prices. Similarly, interest rates may either be higher or lower after a contractionary monetary policy begins, depending on the same factors.
2. Bank Credit and Interest Rate:
So far as interest rate as an indicator of monetary policy is concerned, there are vast differences in the views of the Keynesians and the monetarists. The monetarists downgrade interest rate as indicator of monetary policy because it is not under the firm control of the central bank.
The same view is held by the Keynesians. But the differences arise in the transmission mechanisms. According to the Keynesians, the increase in money supply reduces the interest rate provided the demand for money does not become perfectly elastic (the liquidity trap case). Second, the reduction in the interest rate increases investment provided it is not inelastic to the interest rate. Interest rates will stay down so long as the money supply continues to increase.
The monetarists do not agree with this view. To them, the increase in money supply affects interest rate in the following manner. Suppose the money supply increases through open market purchases of securities by the central bank. This will bring down interest rate by increasing the reserves of commercial banks which will expand their loans.
This is the liquidity effect which causes a short-run reduction in interest rate. The low interest rate will encourage investment in new capital formation, inventories, construction activities, etc. As a result, prices of investment goods will rise and the demand for financial and real assets will increase and raise their prices.
The rise in production and demand for money will bid up the interest rate. This is the output effect. Finally, there is the price expectation effect because lenders expect prices to rise and they buy interest-bearing securities and other goods. Thus after the initial fall, interest rate will rise again and settle at a new rate.
The new rate will depend on the rate of inflation generated by the increase in money supply. So interest rate as an indicator of monetary policy shows that when increase in the money supply leads to increase in interest rate, this will be like an expansionary easy money policy. Friedman, therefore, argues that the monetary authority should concentrate on controlling the money supply rather than manipulating the interest rate.
Economists do not agree over the use of money supply, bank credit and interest rate as indicators of monetary policy. Brunner and Metzler are of the view that both the money supply and interest rate would have identical effects on the economy. It is changes in the real interest rate that affect economic activity. But in reality, it is only changes in nominal interest rate that are measured.
The measurement of real interest rate depends on expected price changes. This is both conceptually and empirically a difficult process and subject to errors. Thus to evaluate monetary policy during inflation or deflation by looking at nominal interest rate is misleading. But this problem does not arise in the case of the money supply because it is nominal value of money which influence nominal value of economic activity. Therefore, interest rate is not a reliable and predictable indicator of monetary policy whereas the money supply is.
To select an appropriate indicator of monetary policy requires certain issues which are to be tackled. The first issue concerns the nature of money supply and its control. Friedman includes M2, that is currency, and demand and time deposits in the money supply. But the problem is to what extent the money supply will respond to changes in a predictable manner. The second issue concerns the extent to which the money supply affects economic activity. Third, there is the important issue of “the proposed indicator’s exogeneity with respect to the economic variables that policy makers are attempting to influence”.
5. Instruments of Monetary Policy:
The instruments of monetary policy are of two types: first, quantitative, general or indirect; and second, qualitative, selective or direct. The affect the level of aggregate demand through the supply of money, cost of money and availability of credit.
Of the two types of instruments, the first category includes bank rate variations, open market operations and changing reserve requirements. They are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit. We discuss them as under.
1. Bank Rate Policy:
The bank rate is the minimum lending rate of the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. When the central bank finds that inflationary pressures have started emerging within the economy, it raises the bank rate.
Borrowing from the central bank becomes costly and commercial banks borrow less from it. The commercial banks, in turn, raise their lending rates to the business community and borrowers borrow less from the commercial banks.
There is contraction of credit and prices are checked from rising further. On the contrary, when prices are depressed, the central bank lower the bank rate. It is cheap to borrow from the central bank on the part of commercial banks. The latter also lowers their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged. Output, employment, income and demand start rising and the downward movement of prices is checked.
2. Open Market Operations:
Open market operations refer to sale and purchase of securities in the money market by the central bank. When prices are rising and there is need to control them, the central bank sells securities. The reserves of commercial banks are reduced and they are not in a position to lend more to the business community.
Further investment is discouraged and the rise in prices is checked. Contrariwise, when recessionary forces start in the economy, the central bank buys securities. The reserves of commercial banks are raised. They lend more. Investment, output, employment, income and demand rise, and fall in price is checked.
3. Changes in Reserve Ratios:
This weapon was suggested by Keynes in his Treatise on Money and the USA was the first to adopt it as a monetary device. Every bank is required by law to keep a certain percentage of its total deposits in the form of a reserve fund in its vaults and also a certain percentage with the central bank. When prices are rising, the central bank raises the reserve ratio. Banks are required to keep more with the central bank. Their reserves are reduced and they lend less.
The volume of investment, output and employment are adversely affected. In the opposite case, when the reserve ratio is lowered, the reserves of commercial banks are raised. They lend more and the economic activity is favourably affected.
4. Selective Credit Controls:
Selective credit controls are used to influence specific types of credit for particular purposes. They usually take the form of changing margin requirements to control speculative activities within the economy. When there is brisk speculative activity in the economy or in particular sectors in certain commodities, and prices start rising, the central bank raises the margin requirement on them.
The result is that the borrowers are given less money in loans against specified securities. For instance, raising the margin requirement to 60% means that the pledger of securities of the value of Rs.10,000 will be given 40% of their value, i.e. Rs4,000 as loan. In case of recession in’ a particular sector, the central bank encourages borrowing by lowering margin requirements.
For an effective anti-cyclical monetary policy, bank rate, open market operations, reserve ratio and selective control measures are required to be adopted simultaneously. But it has been accepted by all monetary theorists that (i) the success of monetary policy is nil in a depression when business confidence is at its lowest ebb; and (ii) it is successful against inflation. The monetarists contend that as against fiscal policy, monetary policy possesses greater flexibility and it can be implemented rapidly.
6. Types of Monetary Policy:
1. Expansionary Monetary Policy:
An expansionary (or easy) monetary policy is used to overcome a recession or a depression or a deflationary gap. When there is a fall in consumer demand for goods and services, and in business demand for investment goods, a deflationary gap emerges.
The central bank starts an expansionary monetary policy that eases the credit market conditions and leads to an upward shift in aggregate demand. For this purpose, the central bank purchases government securities in the open market, lowers the reserve requirements of member banks, lowers the discount rate and encourages consumer and business credit through selective credit measures. By such measures, it decreases the cost and availability of credit in the money market, and improves the economy.
The expansionary monetary policy is explained in terms of Fig. 1 (A) and (B) where the initial recession equilibrium is at R, Y, P and Q. At the interest rate R in Panel (A) of the figure, there is already an excess money supply in the economy. Suppose the central bank credit policy results in an increase in the money supply in the economy.
This leads to a rightward shift of the LM curve to LM1. This increases income from OY to OY1, and aggregate demand expands and the demand curve D shifts upwards to D, in Panel (B). With increase in the demand for goods and services, output increases from OQ to OQ1 at a higher price level P1If the expansionary monetary policy operates smoothly, the equilibrium at E1can be at the full employment level.
But this is not likely to be attained because of the following limitations:
Its Scope and Limitations:
During the 1930s and 1940s, it was believed that the success of monetary policy in stimulating recovery from a depression was severely limited than in controlling a boom and inflation. This view emerged from the experiences of the Great Depression and the appearance of Keynes’s General Theory.
The monetarists hold that during a depression the central bank can increase the reserves of commercial banks through a cheap money policy. They can do so by buying securities and reducing the interest rate. As a result, their ability to extend credit facilities to borrowers increases. But the experience of the Great Depression tells us that in a serious depression when there is pessimism among businessmen, the success of such a policy is practically nil.
In such a situation, banks are helpless in bringing about a revival. Since business activity is almost at a standstill, businessmen do not have any inclination to borrow to build up inventories even when the rate of interest is very low. Rather, they want to reduce their inventories by “repaying loans already drawn from the banks. Moreover, the question of borrowing for long-term capital needs does not arise in a depression when the business activity is already at a very low level.
The same is the case with consumers who faced with unemployment and reduced incomes do not like to purchase any durable goods through bank loan. Thus all that the banks can do is to make credit available but they cannot force businessmen and consumers to accept it. In the 1930s, very low interest rates and the piling up of unused reserves with the banks did not have any significant impact on the depressed economies of the world.
“This is not to say that an easy monetary policy in times of severe contraction will be without beneficial effect, its effect will be largely that of preventing a bad situation from getting worse. But a restrictive monetary policy combined with a business downturn would surely aggravate the downturnâ€”the classical example of this was the monetary policy in 1931 that contributed to the deepening of the Great Depression… On the other hand, if credit is readily available on favourable terms, it clearly has a stabilising effect. By meeting the liquidity requirements of business, it can slow and perhaps reduce the extent of the downturn.”
But what led to the decline of monetary policy in the 1930s and 1940s? In addition to the sad and disillusioning experiences during and after the Great Depression, it was Keynes’s General Theory that led to a decline in monetary policy as an instrument of economic stabilisation. Keynes pointed out that a highly elastic liquidity preference schedule (liquidity trap) renders monetary policy impotent in time of severe depression.
2. Restrictive Monetary Policy:
A monetary policy designed to curtail aggregate demand is called restrictive (or dear) monetary policy. It.is used to overcome an inflationary gap. The economy experiences inflationary pressures due to rising consumers’ demand for goods and services and there is also boom in business investment. The central bank starts a restrictive monetary policy in order to lower aggregate consumption and investment by increasing the cost and availability of bank credit.
It might do so by selling government securities in the open market, by raising reserve requirements of member banks, by raising the discount rate, and controlling consumer and business credit through selective measures. By such measures, the central bank increases the cost and availability of credit in the money market and thereby controls inflationary pressures.
Its Scope and Limitations:
But the scope of monetary policy is severely limited in controlling inflation.
The following are its limitations:
1. Increase in the Velocity of Money:
One of the important limitations on the effectiveness of monetary policy in controlling inflation is increase in the velocity of money held by the public. The central bank can control the money supply and the cost of money by a tight monetary policy but it does not possess any power to control the velocity of money. The public can make an effective use of the money supply held by them thereby making a restrictive monetary policy ineffective. This can be done in a number of ways.
(a) Commercial Bank Portfolio Adjustments:
In the face of a restrictive monetary policy, commercial banks meet the borrowers demand for loans by selling government securities to the central bank. Such a policy simply converts idle deposits held by the banks in the form of securities into active deposits. Government securities lying in the bank’s portfolios are substituted for loans. But there is no change in either the total deposits or the money supply with the banks. However, this leads to increase in total spending when the banks lend money to borrowers. Thus the restrictive monetary policy of the central bank becomes ineffective.
Moreover, when the banks sell government securities to the central bank, their prices fall and the interest on them rises in the market. This will raise the general interest rate structure in the market. But the fall in the prices of securities brings capital losses to the banks and they may be reluctant to bear them. This depends upon whether they expect the fall in security prices (or rise in interest rate) to be short-lived or continue overtime.
If the fall in security prices is expected to be short-lived, the banks will prefer to keep securities rather than sell them at a capital loss. On the other hand, if they expect it to continue for sometime, they will sell securities for giving loans to customers at higher interest rates, thereby recouping the capital loss on the sale of securities through higher interest rates on loans.
But once the demand for loans subsides, the banks can buy back government securities now at prices lower than at which they sold, and again gain in the transaction. Thus the commercial banks’ policy of portfolio adjustment raises the velocity of total money supply even in the face of a tight monetary policy thereby making the latter ineffective.
(b) The Role of Non-Bank Financial Intermediaries:
NBFIs act as a restraint on the effectiveness of monetary policy to restrict the money supply in two ways. First, they sell securities for advancing loans, and thus increase velocity in the same manner as commercial banks do, as explained above. Second, as interest rates on securities rise in a tight monetary policy, financial intermediaries raise the interest rates on deposits with them to attract more funds from savers. This induces savers to shift more idle money to the intermediaries which increase their lending power further. In this way, they are able to raise the velocity of money thereby making tight restrictive monetary policy ineffective.
(c) Methods to Make Better Use of Available Money Supply:
The private sector has evolved many ways to make better use of available supply of money which make a restrictive monetary policy ineffective. Some of the methods are the evolvement of improved methods of collecting funds by sales finance companies, borrowing funds by companies from the public at higher rates than offered by commercial banks, etc. By getting funds from sources other than the commercial banks, such institutions are able to increase the velocity of the available supply of money even under restrictive monetary policy.
A restrictive monetary policy is discriminatory in its effects on particular sectors of the economy. It is argued that firms that depend upon internal sources of financing are not affected by a restrictive monetary policy. On the other hand, only those firms are affected that depend for funds on the banking system. In particular, a tight monetary policy “is thought to work against small businessmen, because they are poorer credit risks, and against residential construction and some types of state and local government spending, because they are most sensitive to changes in credit cost.” It may slow down or even halt spending by them.
3. Threat to Credit Market:
If the central bank rigorously tightens the credit market and investors expect continued increase in interest rates, this may lead to drying up of loanable funds to the credit market. As a result, securities may not be sold and the credit market may cease to function.
4. Threatens Solvency of NBFIs:
A vigorous restrictive monetary policy by swiftly raising interest rates may threaten the solvency of such NBFIs as savings banks, and savings and loan associations. This is because unlike the commercial banks, they are not in a position to adjust themselves to rapidly increasing interest rates.
5. Alter Expectations of Borrowers and Lenders:
A very tight monetary policy may alter the expectations of borrowers and lenders. So they bring irreversible changes in credit market conditions. A rapid rise in interest rates may so change expectations that even when this policy is abandoned and an expansionary policy is started, lenders may be reluctant to make long-term loans in anticipation of rise in interest rates again. On the other hand, borrowers may borrow long-term funds even if they do not need them immediately in anticipation of rise in interest rates in the future.
6. Time Lags:
Another important limitation of a tight monetary policy is the existence of time lags which are related to the need of action, its recognition, and the decision and operation of actions in time. As the monetary authority is not able to adopt restrictive monetary measures in time due to these time lags, monetary policy works very slowly and hence it is not very effective in controlling inflation.
7. Role of Monetary Policy in a Developing Economy:
Monetary policy in an underdeveloped country plays an important role in increasing the growth rate of the economy by influencing the cost and availability of credit, by controlling inflation and maintaining equilibrium in the balance of payments. So the principal objectives of monetary policy in such a country are to control credit for controlling inflation and to stabilise the price level, to stabilise the exchange rate, to achieve equilibrium in the balance of payments and to promote economic development.
1. To Control Inflationary Pressure:
To control inflationary pressure arising in the process of development, monetary policy requires the use of both quantitative and qualitative methods of credit control. Of the instruments of monetary policy, the open market operations are not successful in controlling inflation in underdeveloped countries because the bill market is small and undeveloped. Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete.
They are also reluctant to invest in government securities due to their relatively low interest rates. Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of rediscounting or borrowing from the central bank.
The bank rate policy is also not so effective in such countries due to:
(i) Lack of bills of discount;
(ii) Narrow size of the bill market;
(iii) A large non-monetized sector where barter transactions take place;
(iv) Existence of indigenous banks which do not discount bills with the central bank;
(v) The habit of the commercial banks to keep large cash reserves; and
(vi) The existence of a large unorganised money market.
The use of variable reserve ratio as an instrument of monetary policy is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open market operations are not successful.
But a rise or fall in the variable reserve ratio by the Central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities. Again, the commercial banks keep large cash reserves which cannot be reduced by an increase in bank rate or sale of securities by the central bank.
But raising the cash reserve ratio reduces liquidity with the banks. The use of variable reserve ratio has certain limitations in LDCs. The non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are more affected than those who maintain it.
The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In LDCs, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive channels available in agriculture, mining, plantations and industry.
The selective credit controls are more appropriate for controlling and limiting credit facilities for such unproductive purposes. They are beneficial in controlling speculative activities in food grains and raw materials. They prove more useful in controlling ‘sectional inflations in the economy.
They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency. This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the Central bank in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral, the regulation of consumer credit and the rationing of credit.
2. To Achieve Price Stability:
Monetary policy is an important instrument for achieving price stability. It brings a proper adjustment between the demand for and supply of money. An imbalance between the two will be reflected in the price level. A shortage of money supply will retard growth while an excess of it will lead to inflation.
As the economy develops, the demand for money increases due to gradual monetization of the non- monetized sector, and increase in agricultural and industrial production. These will lead to increase in the demand for transactions and speculative motives. So the monetary authority will have to raise the money supply more than proportionate to the demand for money in order to avoid inflation.
3. To bridge BOP Deficit:
Monetary policy in the form of interest rate policy plays an important role in bridging the balance of payments deficit. Underdeveloped countries develop serious balance of payments difficulties to fulfill the planned targets of development. To establish infrastructure like power, irrigation, transport, etc. and directly productive activities like iron and steel, chemicals, electrical, fertilisers, etc., underdeveloped countries have to import capital equipment, machinery, raw materials, spares and components thereby raising their imports. But exports are almost stagnant.
They are high-priced due to inflation. As a result, an imbalance is created between imports and exports which leads to disequilibrium in the balance of payments. Monetary policy can help in narrowing the balance of payments deficit through high rate of interest. A high interest rate attracts the inflow of foreign investments and helps in bridging the balance of payments gap.
4. Interest Rate Policy:
A policy of high interest rate in an underdeveloped country also acts as an incentive to higher savings, develops banking habits and speeds up the monetization of the economy which are essential for capital formation and economic growth.
A high interest rate policy is also anti-inflationary in nature, for it discourages borrowing and investment for speculative purposes, and in foreign currencies. Further, it promotes the allocation of scarce capital resources in more productive channels.
Certain economists favour a low interest rate policy in such countries because high interest rates discourage investment. But empirical evidence suggests that investment in business and industry is interest-inelastic in underdeveloped countries because interest forms a very low proportion of the total cost of investment. Despite these opposite views, it is advisable for the monetary authority to follow a policy of discriminatory interest rateâ€”charging high interest rates for nonessential and unproductive uses and low interest rates for productive uses.
5. To Create Banking and Financial Institutions:
One of the objectives of monetary policy in an underdeveloped country is to create and develop banking and financial institutions in order to encourage, mobilise and channelize savings for capital formation. The monetary authority should encourage the establishment of branch banking in rural and urban areas.
Such a policy will help in monetizing the non-monetized sector and encourage saving and investment for capital formation. It should also organise and develop money and capital market. These are essential for the success of a development-oriented monetary policy which also includes debt management.
6. Debt Management:
Debt management is one of the important functions of monetary policy in an underdeveloped country. It aims at proper timing and issuing of government bonds, stabilising their prices and minimising the cost of servicing the public debt. The primary aim of debt management is to create conditions in which public borrowing can increase from year to year.
Public borrowing is essential in such countries in order to finance development programmes and to control the money supply. But public borrowing must be at cheap rates. Low interest rates raise the price of government bonds and make them more attractive to the public. They also keep the burden of the debt low.
Thus an appropriate monetary policy, as outlined above, helps in controlling inflation, bridging balance of payments gap, encouraging capital formation and promoting economic growth.
8. Limitations of Monetary Policy in LDCs:
The experience of underdeveloped countries reveals that monetary policy plays a limited role in such countries.
The following arguments are given in support of this view:
1. Large Non-monetized Sector:
There is a large non-monetized sector which hinders the success of monetary policy in such countries. People mostly live in rural areas where barter is practiced. Consequently, monetary policy fails to influence this large segment of the economy.
2. Undeveloped Money and Capital Markets:
The money and capital markets are undeveloped. These markets lack in bills, stocks and shares which limit the success of monetary policy.
3. Large Number of NBFIs:
Non-bank financial intermediaries like the indigenous bankers operate on a large scale in such countries but they are not under the control of the monetary authority. This factor limits the effectiveness of monetary policy in such countries.
4. High Liquidity:
The majority of commercial banks possess high liquidity so that they are not influenced by the credit policy of the central bank. This also makes monetary policy less effective.
5. Foreign Banks:
In almost every underdeveloped country foreign owned commercial banks exist. They also render monetary policy less effective by selling foreign assets and drawing money from their head offices when the Central bank of the country is following a tight monetary policy.
6. Small Bank Money:
Monetary policy is also not successful in such countries because bank money comprises a small proportion of the total money supply in the country. As a result, the Central bank is not in a position to control credit effectively.
7. Money not deposited with Banks:
The well-to-do people do not deposit money with banks but use it in buying jewellery, gold, real estate, in speculation, in conspicuous consumption, etc. Such activities encourage inflationary pressures because they lie outside the control of the monetary authority. On account of these limitations of monetary policy in an under-developed country, economists advocate the use of fiscal policy along with it.