Monetary Policy in an Economy: Meaning, Objectives and Limitations

Let us study about Monetary Policy in an Economy. After reading this article you will learn about: 1. Meaning of Monetary Policy 2. Objectives of Monetary Policy 3. Limitations 4. Conclusion.

Meaning of Monetary Policy:

Monetary policy may be defined as the use of money supply by the appropriate authority (i.e. central bank) to achieve certain economic goals. Whenever there is a change in money supply there occurs a change in the rate of interest. Thus, monetary policy influences interest rate or cost and availability of credit.

When the central bank attempts to contract money supply through various credit control instruments so as to restrain the economy, the situation is then called tight monetary policy. Oppositely, an easy monetary policy is employed to boost the economy by increasing money supply through its credit control instruments.

Though monetary policy influences other variables, control of quantity of money is considered to be the key variable in the monetary policy.

Anyway, monetary policy is defined as the central bank’s use of control of money supply or interest rates (i.e., the price of money) or the rationing of credit sanctioned by banks to influence the level of economic activity.

Monetary authority employs monetary policy to influence aggregate demand in order to achieve higher levels of income and employment. The mechanism—called money transmission mechanism—that influences aggregate demand follows the following course.

An increase in money supply by the central bank will mean more money in the pockets of firms and households. Faced with more money, people will buy more financial assets, such as bonds. Consequently, bond prices will go up and interest rates will decline. This will stimulate consumption and investment spending, thereby raising aggregate demand and, hence, level of income and employment.

Thus, monetary policy, according to G. K. Shaw, refers to any deliberate and conscious action undertaken by the central monetary authority “to change the quantity, availa­bility or cost (interest rate) of money.

A broader definition must also take into account action designed to influence the composition and age profile of the national debt, as, for example, open market operations geared to the purchase of short term dated securities and sale of long term bonds.”

Thus, monetary policy includes debt management —an important element of fiscal policy. For our present purpose, we will restrict ourselves to its narrow definition. In the words of Harry Johnson, monetary policy may be defined as a policy employing the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy.

Attitude towards Monetary Policy during the 20th Century:

To the classical economists, monetary policy was important. And fiscal policy was unknown at that time. But, Keynesian theory —introduced out of the Great Depression of 1930s—made a great damage to this key policy management of the economy. As the monetary policy collapsed under the impact of the Great Depression, Keynes-suggested ‘fiscal policy’ became all-important.

Monetary authorities put the monetary policy into the cold storage till the end of the Second World War. Fiscal policy was then yielding some sort of diminishing returns. No longer fiscal policy was seen as the only weapon for the management of the economy. Monetary policy was called in the 1950s and stood as an instrument of macroeconomic management up to the end of the 1960s.

The early 1970s saw the twin problems of inflation and unemployment—more popularly called stagflation (stagnation + inflation). Fiscal policy, however, could not combat these problems. To combat inflation and unemploy­ment, monetarists suggested control of the growth of money supply. However, Keynesian economists did not subscribe to this view.

This debate over the importance of monetary policy/fiscal policy created two schools of thought: Keynesians and monetarists. In the 1980s, monetarists again scored a good mark when all over the world it was agreed that price level stability was to be ensured through tight monetary policy.

Thus, any macroeconomic management policy of an economy is subject to debates and controversies. In view of the debates, supply-side economics emerged in the early 1980s. Margaret Thatcher and Ronald Regan applied the supply-side theory. Since supply- side economics is beyond our overview, we limit our discussion here.

Objectives of Monetary Policy:

Monetary policy is regarded as one of the most important tools of macroeconomic management.

An appropriate monetary policy should have the following objectives since monetary policy is, strictly speaking, part of the broader sphere of economic policy:

(i) Maintaining internal and external stability;

(ii) High employment;

(iii) Economic growth;

(iv) Fiscal objectives; and

(v) Social objectives.

(i) Maintaining Price Stability:

By price stability, we mean both internal and external stability in the price level. Price fluctuations of a larger degree are always unwelcome.

Sustained increase in price level has a destabilizing effect on the economy. A falling price level has more destabilizing influence on the economy. In other words, both inflation and depression must be controlled so that benefits of economic development are reaped. Price stability prevents not only economic fluctuations but also helps in the attainment of a steady growth of an economy.

Monetary policy also has the objective of upholding external stability in prices. External instability hampers the smooth flow of trade between nations. It also erodes the confidence of the currency. Thus, what is needed is a stable exchange rate.

It is to be posited out here that a conflict may arise between internal stability and external stability. Further, maintenance of external stability is no longer considered the main monetary policy objective. A monetary policy must aim at preventing or correcting internal price movements.

(ii) High Employment:

Though it is difficult to give a precise definition of full employment, monetary policy during the 1930s aimed at achieving and maintaining full employment. Further, full employment, though theoretically conceivable, is difficult to attain in market-driven economies.

A country must aim at attaining at least near full employment situation. By pushing up aggregate demand (C + I + G), a country can prevent wastes of labour. And, aggregate demand gets to be stimulated by applying appropriate monetary policy instruments.

But A.W. Phillips has shown that the objectives of controlling inflation and unemployment are conflicting in nature. One objective can be fulfilled only at the expense of the other. This dilemma seems to be a block for monetary policy effectiveness. In view of this, this objective may be translated into ‘high employment’ objective.

No doubt this goal is desirable, but how high should it be?

Answer is – ”The goal for high employment should therefore be not to seek an unemployment level of zero but rather a level of above zero consistent with full employment at which the demand for labour equals the supply of labour. This level is called the natural rate of unemployment.”

(iii) Economic Growth:

Growth should be the predominant aim of monetary policy. An appropriate monetary policy by adjusting money supply to the needs of growth, directing the flow of funds in keeping with the overall economic priorities, and providing institutional facilities for credit in specific areas of economic activity—all combined creates a favourable climate for economic growth.

By economic growth we mean an increase in per capita output. In a market economy, economic growth is conditioned by the productive capacity or capital stock of the economy. Economic growth requires an increase in saving and investment. Monetary policy can contribute towards economic growth by raising saving-income ratio.

There are various ways of raising the aggregate saving rate. A high rate of interest is conducive to higher saving propensities. However, a high rate of interest discourages investment. Further, a high rate of interest may encourage inflation to develop. Thus, a high rate of interest may not necessarily increase aggregate saving rate.

But monetary policy can boost aggregate saving rate by expanding banking facilities in under-banked and unbanked areas. Commercial banks can mobilize savings of the people in such a way that savings are channelized into productive investment.

For productive investment, bank funds are invested in government securities so that the government can finance its planned investment programme. Banks also provide a great deal of monetary funds to meet the credit needs of various economic sectors of the economy.

However, generation of savings and its investment is not enough for boosting economic growth. What is needed is the allocation of funds in proper direction. Monetary policy has to be designed in such a way that scarce resources are invested only in productive lines.

Since monetary policy can influence the rate of interest, investment, and the availability of credit, it can direct aggregate savings in the most productive channels of the economy. Thus, monetary policy contributes greatly in pushing the growth rate of the economy by raising both saving-income ratio and investment-income ratio.

But the promotion of economic growth is often hampered due to the appearance of inflationary tendencies. Underdeveloped countries are inflation-sensitive countries. Benefits of higher economic growth are eaten by excessive price rise. In other words, there exists a conflict between economic growth and economic stability.

In view of this conflicting objective, it is now generally accepted that the main objective of monetary policy should be the promotion of economic growth with reasonable price stability. That is to say, monetary policy has to be directed towards attaining a high rate of economic growth, while maintaining reasonable stability of the internal purchasing power of money.

Truly speaking, the objective of monetary policy is twofold. It has to facilitate the flow of an adequate volume of bank credit to industry, agriculture and trade to meet their genuine needs and provide selective encouragement to sectors which stand in need of special assistance such as the weaker sections of the community and the neglected sectors and areas in the economy.

At the same time, to keep inflationary pressures under check, it has to restrain undue credit expansion and also ensure that credit is not directed towards undesirable purposes.

(iv) Fiscal Objectives:

The most important fiscal objective which monetary policy has to pursue is that of facilitating government borrowing and the management of public debt. In the interest of a sound debt management policy, monetary policy is employed so that an orderly condition in the security market is established.

It is to be remembered here that, in practice, both the fiscal and monetary policy objectives are likely to be mixed up. In reality, it becomes difficult to draw a line of demarcation of one objective from that of another.

(v) Social Objectives:

Monetary policy is often used to attain some social ends or social welfare. By raising or lowering price level, monetary policy can produce far-reaching social effects of redistribution of wealth. One of the most important objectives of the pursuit of monetary stability is to maintain the social status quo.

Thus, monetary policy has had variety of objectives. Some of these objectives are conflicting and some of them are compatible. In the case of conflicting objectives, what is needed is to give priority to the immediate or short run problems.

But that does not mean that long run problems are to be given less importance. Thus, the monetary authority must make a choice and should aim at attaining an optimal combination so that the country’s needs are served better.

Limitations of Monetary Policy:

Through its credit control instruments like CRR, OMOs, bank rate, etc., a central bank-aims to control the broad monetary base and broad liquidity. But sometimes serious problems arise. This makes monetary policy an ineffective weapon.

Usually, commercial banks hold cash in excess of the CRR. Faced with an excess cash reserve, banks need not reduce the volume of credit; they can simply reduce their cash ratios towards the minimum.

Further, massive growth of uncontrolled institutions has also greatly reduced the efficacy of monetary policy. Usually, uncontrolled non-banking financial insti­tutions are not subject to cash reserve requirement imposed by the central bank.

These institutions now provide huge lendable resources in the economy. Because of restrictive monetary policy applied by the central bank, some sort of disintermediation—switching off business away from the banks which are subject to control—takes place.

Banks often induce customers to take loan in a foreign currency from one of their overseas branches and then convert the currency into rupees. In the absence of foreign exchange control, this practice is followed by banks. Anyway, lending continues in the midst of restrictive monetary policy. These problems, therefore, seriously restrict the efficacy of monetary policy.

Monetary policy is less effective in controlling cost-push variety of inflation. Today, an administered price-wage system conduces cost-push inflation. Price hike of, say, petroleum products, and salary revision of government employees are considered to be the most important sources of inflation in India.

Such administered wage-price system is not subject to central bank’s credit control instruments. Again, black money is another source of inflation. Monetary policy, in fact, cannot combat black money. However, for this the central bank must not be blamed.

In government-run industries, govern­ment is the supplier of lendable resources. These industries may not be handicapped by the shortage of money. Thus, contractionary monetary policy pursued by the central bank loses much of its effectiveness when government provides funds for its industries.

In view of this, it is said that a government committed to a sustained reduction in the growth of money supply will find this very difficult unless it restricts the size of the public sector deficit.

But it is difficult to control the volume of deficit since the government is rather hesitant in raising tax rates and in cutting government expenditure. Consequently, demand for money and supply of money increase—thereby frustrating the effectiveness of monetary policy.

Because of this problem, an expert argues in the following way:

“And as fiscal consolidation is a prerequisite for the operation of monetary policy, its success does not solely depend on its design and use. Monetary policy is, however, going through a process of ‘trial and error’ and there is a long way to go before an efficient policy can be designed.”

One of the important problems of monetary policy is that it does not produce immediate effects, but operates only after some time lag. In policy making, one observes decision lags and implementation lags. Decision lags arise because of bureaucracy. Further, policy­makers are rather cautious in changing policy.

Implementation lags arise because policy changes take time to impact on economic behaviour. Lipsey and Chrystal argue that the long and unpredictably variable implemen­tation lag “makes monetary fine-tuning difficult and possibly destabilising. This is because the impact of the policy is felt much later than the time the policy decision is made, and circumstances may have changed in the meantime.”

Conclusion to Monetary Policy:

In order to stabilize the economy, the government can use either monetary policy or fiscal policy. But neither monetary policy nor fiscal policy should be considered as a precise means of controlling aggregate demand.

Each policy has its own strengths and weaknesses. In view of this, both monetary and fiscal policies are simul­taneously employed in every economy. However Samuelson and Nordhaus have argued that the USA now ‘relies almost completely upon monetary policy’.