Monetary Policy: Concept, Instruments and Objectives | Trade Cycle Control

Let us make an in-depth study of Monetary Policy:- 1. Concept of Monetary Policy 2. Instruments of Monetary Policy 3. Objectives 4. Monetary Policy during Depression 5. Monetary Policy during Inflation 6. Increasing the Effectiveness of Monetary Policy.

Concept of Monetary Policy:

Monetary policy seeks to influence the rate of aggregate spending by varying the degree of liquidity of various constituents of the economy including banks, firms, business houses and households.

In a recession, monetary policy raises the level of expenditure by increasing the amount of cash and other liquid assets (e.g., short and long-term government securities) at the disposal of the community and by making borrowing conditions easier through lower rates of interest.

In an inflationary situation monetary policy seeks to restrict aggregate spending by reducing the total amount of liquid assets with the community and by making borrowing more costly.

Instruments of Monetary Policy:

The instruments of monetary policy are the same as instruments of credit control at the disposal of a central bank. These are bank rate, open market operations and changes in reserve requirements usually referred to as quantitative credit controls. The second categories of credit controls consists of consumer credit control, margin requirements and are known as qualitative controls.

The quantitative instruments are so called because they regulate the total quantity of money and qualitative so called because they are employed to limit the amount of money available for certain specific purposes.

Until recently quantitative instruments of monetary policy were used for causing changes in the whole structure of interest rates, for it was thought that changes in interest rates would affect the amount of saving and investment.

It was considered desirable to raise the interest rate in inflation as it would encourage saving and reduce it in deflation as that would discourage saving and encourage investment. Lately, monetary theorists seem to have lost their faith in interest rate changes as a means of regulating total spending in the economy.

They argue that the MEC and other psychological factors rather than the rate of interest affect the amount and direction of investment in periods of inflation and deflation. Further, to the extent that investment is made possible by the retained profits of business enterprises, the amount of investment may be decided irrespective of the considerations of the rate of interest.

According to Friedman, the most important development in the post-war years in the field of policy has been a shift from credit policy to monetary policy. This distinction is important. By credit policy we mean the effect of the actions of the monetary authorities on rates of interest, terms of lending and other conditions in the credit markets.

By monetary policy we mean the effect of the action of monetary authorities on the stock of money on the number of currency notes in people’s pockets or the quantity of deposits on the books of banks.

This distinction between credit policy and monetary policy is of fundamental importance for the policy makers in every country because monetary policy is and must be much more a matter of opportunities, of day to day adjustment, of meeting the economic problems of our time.

Objectives of Monetary Policy:

Important objectives of monetary policy are:

1. Stability of Exchange Rates.

2. Maintaining Price Stability.

3. Obtaining satisfactory rate of economic growth by controlling business cycles.

4. Full Employment.

We study these objectives in brief.

1. Exchange Stability:

The traditional objective of monetary policy has been the achievement of stable exchange rates. This objective was primary, while stability of prices and output was secondary owing to the paramount importance of international trade in the leading economies of England, Denmark, Japan etc. For them, maintenance and proper conduct of the gold standard was considered to be the primary function of the monetary authorities. This way, minor changes in exchange rates were easily noticed.

These led to a lot of speculation and consequent dislocation of economies. This imposed on them problems of inflation and deflation. This objective is now considered to be of secondary importance except in case of countries like Japan and England, whose prosperity still depends upon foreign trade.

However, in under-developed countries the relationship between economic growth and exchange stability is of special importance because an under-developed country has to import materials and equipment for planned industrial development besides making heavy borrowings from abroad. Therefore, the exchange rate has to be so adjusted that the balance of payments position does not worsen.

2. Price Stability:

In the thirties, during and after the great depression (1929-33), price stability and control of business cycles became important objectives of monetary policy. Fluctuations in prices in the upward direction and more so in the downward direction create difficult problems of production and distribution, besides great economic unrest and political upheavals. Stability of the price level, thus, became the chief aim of monetary policy. But this objective of monetary policy proved to be short lived on the ground that it was difficult to determine a satisfactory price level at which the general price level should be stabilized.

Price stabilisation policy is beset with many difficulties: one, it may remove indirect business incentives which come through a rise in prices. Moreover, the prices of different sectors and groups in the economy vary considerably and show different trends. Again, stability of prices does not lead to stability of business conditions. Keeping in view the great stress laid by transactions and cash balance theorists upon the evil consequences of inflation and deflation, some tried to enquire into the relationship of the full employment objective with that of the objectives of price stability.

3. Objectives of Full Employment and Economic Growth:

The objective of price stabilisation is good but it is not always desirable. We happen to live in an age of welfare states and full employment policies. There was a time, when exchange and price stabilities were considered important objectives of monetary policy, but in recent years both price and exchange stabilities have been relegated to the background and full employment—its attainment and maintenance—has assumed greater importance as the goal of monetary policy. It is argued now that achievement of full employment also results in price and exchange stabilities.

Economies like those of the U.K. and the U.S.A. may normally work near the full employment level; the real problem in such economies is how to maintain full employment. On the other hand, the main problem of an underdeveloped country is how to achieve full employment.

Such an economy has to overcome underemployment of the entire agricultural population and has to remove unemployment of a large number of people who are without jobs.

Hence, a monetary policy designed to promote full employment through increased investment shall have to be followed. Such a policy is cheap money policy which lowers the rate of interest so as to stimulate borrowing for investment.

Once the level of full employment has been achieved, monetary policy tries to maintain it. It is, therefore, clear that the maintenance of full employment will imply stable cost-price structure as also stable exchange rates. For full employment is a very delicate situation which might be upset by changes in exchange rates.

Monetary Policy during Depression:

Depression is characterised by falling prices, incomes, output and employment. It is a period of low interest rates and unusually high liquidity preference. The objectives of monetary policy during depression are to offset the decline in velocity of money, to satisfy through additional money supply demands for precautionary and speculative motives; to strengthen the cash position of banks and non-bank groups.

Monetary policy is oriented to stimulating lending for investment and consumption purposes bringing down the structure of interest rates with a view to encouraging investments. The cheap money policy is followed with a view to increasing aggregate demand, using excessive saving for development, stimulating the prices of securities to increase confidence in tire security market.

Lowering of interest rate is easier than wage reduction: it also stimulates consumption by encouraging hire-purchase or installment buying.

It has been argued that monetary policy during depression has little scope, for it encounters practical difficulties. Policy makers find that rates of interest are already very low during depression and cannot be depressed further.

Injections of cash and other liquid securities into the economy are absorbed by firms, banks and individuals in strengthening their liquidity position. They frustrate monetary policy by changing from risky and liquid assets to less risky and more liquid ones under the general wave of pessimism and business uncertainty.

In these circumstances, businessmen are scared away by the rapidly depleting profit margins. Even if the central bank is able to lower the rate of interest, the effect on investment may be negligible because the marginal efficiency of capital continues to be low. Businessmen borrow only when business is expanding. Merely low rates of interest cannot make unwilling and nervous borrowers to borrow.

One can take a horse to water but cannot make it drink. Even if a lowering of interest rate encourages investment, there is a limit beyond which rate of interest cannot be lowered by increased money supply. Thus, monetary policy, if pursued during depression, is rendered ineffective.

However, it would be a mistake to dispense with monetary policy as irrelevant for curing depression, for cheap credit policy does affect private investment and household demand for durable consumer goods. Monetary policy is a necessary adjunct to other measures for maintaining full employment.

In this connection, Prof. K. Kurihara remarks :

“Thus, in the industrially and financially less developed countries credit and banking policies are much more than a more brake on undue credit inflation.”

Even in industrially advanced countries there is scope for effective anti-depression credit (monetary) policy as long as real estate credit, consumer instalment credit and other particular types of credit remain restricted by high interest rates.

Even if credit policy is incapable by itself of turning the tide of depression, it can increase overall liquidity via open market operations and other conventional methods, thereby creating the monetary atmosphere necessary for the successful operations of more effective measures of fiscal and other policies.

Monetary Policy during Inflation:

Inflation is characterised by rising prices, income output and employment. There is a general wave of optimism as a result of which business activities expand rapidly. In response, more cash is released by banks making additions to consumers’ income and outlay.

Traders, faced with reduced stocks of goods and continuously rising demand, make frantic efforts for producing and holding additional stocks they consider appropriate. The improved prospects of business and the high values of securities in the stock exchanges make the banking authorities willing to expand credit which is used in making additions to plant and machinery.

One might expect that this goes on forever. Unfortunately, this does not happen. When consumer spending and investment spending reach a high pitch, banks find it difficult to cope with the increased demand for credit.

Under inflation the aims of monetary policy are to slow down the rate of expansion of money, to reduce the volume of liquid assets, to reduce consumption by means of high interest rates. Such a monetary policy during inflation is necessary to achieve stabilisation and also to avoid a sudden collapse. The idea is to check inflation and to level off the boom conditions.

It is believed that the effectiveness of monetary policy during inflation is much greater. It is easier to raise interest rates than to lower them, and the can be raised as high as the monetary authorities wish. This is followed by open market operations in order to curtail the liquidity of banks and non-bank financial institutions thereby further reducing lending for investment.

Moreover, margin requirements and consumer credit conditions may also be tightened.

Even then, if consumption and investment spending are not reduced to the desired extent, there remains the power to raise reserve requirements. Thus, some believed that monetary policy can be fairly effective, if applied quickly and continuously, in preventing booms from developing into inflation. However, experience has shown that monetary policy has not been very successful or mitigating inflationary pressures.

The effectiveness of monetary policy during inflation would depend upon changes in the velocity of circulation of money, because these changes may sometimes completely neutralise the restrictions imposed by the central bank on the supply and cost of money.

Further, growth of financial intermediaries has weakened the conventional monetary controls of the central banks. These financial institutions include insurance companies, housing societies, savings and loan associations, financial houses which mobilise savings from the public and advance loans.

Moreover, the central bank’s debt-management operations have discriminatory effects on different sectors of the economy. It is impossible for the policy makers to ignore the differential effects of a tight money policy on different sectors of the economy. All these limitations account for the practical ineffectiveness of monetary policy during inflation.

Increasing the Effectiveness of Monetary Policy:

In order to make monetary policy more effective, no time should be lost between the need for action and the action taken. Similarly, there should be no time gap between the need for taking action and recognition of the need for taking action. But in actual practice the actions of monetary authorities are not so prompt and some time elapses between the need for action, its recognition and the actual action taken.

Recognition lag implies the passage of time to recognise that the economy has changed in such a way as to require a change in the existing policy. Even if the need for a change in policy is recognised, some time must elapse before suitable action is taken. The action lag may again depend upon a number of factors.

The sum of recognition lag and action lag is called the inside lag. The inside lag is influenced by policy trade-offs and priorities as well as by the speed of data collection and analysis for administrative action.

Once the policy is changed, some time must elapse before the changes in the policy work their way through the system to become effective in changing aggregate output or employment. There is no agreement amongst economists about the optimum duration of these lags.