BBA The Major Role of Monetary Policy in a Development Economy

question: The Major Role of Monetary Policy in a Development Economy

Answer:

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 the balance of payments.

So the principal objectives of monetary policy in such a country are to control credit for controlling inflation and to stabilize the price level, to stabilize the exchange rate, to achieve equilibrium in the balance of payments and to promote economic development.

To Control Inflationary Pressures:

To control inflationary pressures 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 underdevelopment 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 redics counting or borrowing from the central bank.

The bank rate policy is also not so effective in such countries due to: (i) the lack of bills of discount; (ii) the narrow size of the bill market; (iii) a large non-monetised sector where barter transactions take place; (iv) the 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 changes 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.

To Achieve Price Stability:

Monetary policy is an important instrument for achieving price stability k 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 the gradual monetization of the non-monetized sector, and the 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.

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-price due to inflation. As a result, an imbalance is created between imports and exports which lead to disequilibrium in the balance in 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.

Interest Rate Policy:

A policy to 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 rate-charging high interest rates for non-essential and unproductive uses and low interest rates for productive uses.

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 channelise 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 an capital market. These are essential for the success of a development oriented monetary policy which also includes debt management.

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.