Role of Monetary Policy to Accelerate Economic Stability

The role of monetary policy to accelerate economic stability and full employment is restricted and even secondary in less developing countries.

The basic reason is that the various weapons of monetary policy are not much conducive to the environment and smooth functioning of these economies.

However, scarcity of financial institutions, large existence of non-monetized sector, and immaturity of money and capital markets are the basic characteristic of underdeveloped countries, that result in the limited application of monetary tools.

High proportion of investments made in unproductive channels further impairs its true spirit of effectiveness. The entire system should be modified and any pitfall in money market should also be rectified.

There must be early credit facilities for rural sector involving small and marginal cultivators, businessmen and shopkeepers etc. In short, old and traditional monetary policy may be reoriented according to the needs of developing countries. Similarly, debt and asset management policy must also be redefined. Monetary authority under these circumstances should raise itself to the occasion and should affirm effective policy measures to step up the economy on sound footing.

In this case, monetary policy may perform the under-noted functions:

1. Adjustment between Demand for and Supply of Money.

The monetary policy plays key role in the development of underdeveloped countries by controlling price fluctuations and general economic activities. This is done by making proper adjustment between demand for money and the supply of money. As the economy develops, there is continuous increase in demand for money. So, central authority takes measures to increase the money supply proportionate to the increase in demand for money in order to avoid inflation.

On the contrary, fall in price level adversely affects the pace of development by bringing downward spiral of prices and output. Under both circumstances, monetary authorities take steps by adopting appropriate monetary policy to control the use of money and credit. It also controls speculative activities through direct physical controls. Therefore, monetary authority is conscious of controlling fluctuations in prices so that it may not adversely affect the investment and production in an economy.

2. Price Stability:

Generally, underdeveloped countries face the problem of inflationary pressures due to a variety of structural rigidities and imbalances. Inflationary pressures adversely affect the propensity to save and divert investible resources into unproductive channels. Sometimes, it has been noticed that inflationary increase leads to frequent devaluation of the domestic currency and fluctuating exchange rate also creates chaos in the internal trade. Consequently, it applies to the rate of economic growth.

So, monetary authority keeps a vigil on the movements of prices and takes steps to control the same accordingly. It also tries to maintain exchange stability. In other words, monetary authority takes qualitative and quantitative methods of credit control to check inflationary trend in the economy and further to gear the process of economic growth.

3. Monetization of the Economy:

Non-monetized sector is common in many of the under-developed economies. In many countries of Africa and Asia, monetization ratio is relatively less. In other words, barter system largely prevails. Monetary policy, expands the area of monetization and replaces barter system by monetary exchange system. Consequently the possibility of investible surplus or increase in real saving becomes great.

(i) On account of monetization of barter transaction, demand for money increases more than income. As a result means of equivalent value come to the market. Increase in money stock of the people, in a sense, increases in their real saving. Monetary authority or government, issuing money makes use of this real saving for increasing investment,

(ii) With the advent of money, difficulties of barter system are removed and the production and trade goes up. It also leads to increase in saving and investment and

(iii) With the advent of money, there is increase in division of labour and specialization. Consequently total production increases. Increased production leads to more saving and investment and this in turn accelerates the rate of economic growth.

4. Development of Capital Market:

A developed capital market help the people to invest their savings directly or indirectly in productive activities. They make direct investment by purchasing themselves shares of public enterprises or they make indirect investment by investing their saving in the shares of mutual funds.

As a result of developed capital market adequate investment is made in productive activities. Further more proper control over share market by stock exchange reduces the risk element of the people and they feel encouraged to invest their savings in shares. Enterprises succeed in getting long-term loans on reasonable rate of interest for capital formation from the capital market. In this way, monetary policy plays a significant role in economic development by establishing organised capital market.

5. Creation and Expansion of Financial Institutions:

In underdeveloped countries, monetary policy can work to accelerate the process of economic development by improving the currency and credit system of the country. For this purpose, more banks and financial institutions should be established to mobilize large resources into the productive channel.

Generally, financial institutions are situated in big cities which provide loan facilities to big industrial concerns while small and medium businessmen and cultivators are deprived of these facilities. Therefore, it is the dire need of the underdeveloped countries that banking facilities should be extended to rural areas. In the absence of these facilities, village money lender is the last source who charges high interest rates.

Therefore, central authority should pay special attention to this problem and take measures to expand financial institutions in the rural and backward areas. In this regard, network of cooperative credit societies with apex banks financed by central bank is useful instrument in providing the credit facilities to rural masses.

These institutions can also be helpful to the business and industry to a greater extent. Moreover, central authority can act as a fiscal agent of the government and manage public debt. They can also organize and set up a stock securities market and bill market. Another act is also done by the central bank as of guardian of the money market. Therefore, according to Prof. Meier and Baldwin “Central bank’s control of commercial banks is the chief weapon of monetary policy.”

6. Credit Control:

In order to boost up the economic development, monetary policy comes forward to influence the pattern of investment and production in a country. To control the inflationary forces, it adopts both qualitative and quantitative methods of credit control.

But, its success entirely depends on the range of credit institutions found in the country and on forms of credit controls that are employed by the central bank. Unfortunately, in underdeveloped countries, financial institutions are not fully organised and developed. In fact, quantitative measures which include open market operations, bank rate policy and variable reserve ratio are not much successful in less developed countries.

At the same time, qualitative methods are, however, more effective in influencing the allocation of credit. So, they should be adopted to change the character and pattern of investment and production by differentiating between the cost and a variability of credit to different sectors. But in underdeveloped countries, there is a strong tendency to invest into unproductive channels instead of productive channels.

Therefore, this system has a bottleneck of making discrimination between essential and non-essential use of bank credit. Under these circumstances, selective credit controls are more appropriate and suitable for limiting credit facilities for such unproductive purpose. They are useful in controlling the speculative activities, and thus beneficial in controlling. ‘Sectional inflation’ without affecting the pattern of investment and production adversely. If this is done in a proper manner, it will certainly quicken the pace of economic development in a country.

7. Favourable and Suitable Interest Rate Structure:

For the purpose of development in an economy, investment on a gigantic scale is the most essential. To some extent, cheap money policy favours as it makes public borrowing easily available at a lower cost which in turn stimulates investment in private as well as in public sector. Therefore, a policy of lower rate of interest is recommended as an incentive to economic development.

On the contrary, some other economists also argue in favour of high interest rate policy as it restricts borrowings for speculative and undesirable purposes. Thus, it works as an anti-inflationary measure. Moreover, it also secures allocation of resources into most needed productive channel. Monetary authority, in such a critical situation, plays an active role by adopting suitable interest rate policy which promotes economic development and retards superfluous spending’s in the economy.

8. Debt Management:

In underdeveloped countries, the government has to borrow on a large scale to implement the various schemes for economic development. Therefore, monetary authority has the primary aim to manage the public debt effectively. Prof. J.D. Sethi who has laid the emphasis on this objective says, Debt Management is to create conditions in which public borrowing can increase from year to year and on a big scale without giving any jolt to the system. And this must be cheap rate to keep the burden of the debt low. On the basis of above argument, one can say that monetary policy has manifold aims in a developing economy to stimulate economic development.

9. Exchange Stability:

Economic development of under-developed countries requires that the balance of payments of the country should either be in equilibrium or favourable. To achieve economic development, the objective of the monetary policy is to attain exchange stability.

The methods of achieving exchange stability are:

(i) Control over Supply of Money:

If the imports of a country exceed its exports, it should reduce the supply of money. It will bring down the prices, which, in turn, will encourage exports and discourage imports. But if exports exceed its imports, then the supply of money should be increased. As a result, price-level in the country will rise that, in turn, will lower the exports and raise the imports. The balance of payments will be in balance and exchange rate will remain stable.

(ii) Change in the Cost of Money or in the Rate of Interest:

If the exchange rate is unstable due to fall in exports and rise in imports, then to control it, domestic rate of interest should be reduced. Consequently price-level will fall, exports increase and imports decrease. On the other hand, rate of interest on foreign loans should be raised so as to encourage the inflow of foreign capital. Thus, the deficit of balance of payments will be covered. When imports are less than exports, domestic rate of interest should be raised and rate of interest on foreign loans be reduced.

(iii) Control over Availability of Money:

In order to check instability in the rate of interest, availability of money must be controlled. In case of the low rate of exchange, exports should be increased by giving liberal Credit facilities to foreign trade. More credit should be given at low rate of interest to foreign trade. On the contrary, in case of high rate of exchange, credit facilities offered to foreign trade should be contracted.