Monetary Policy in Developing Countries: The Way Forward

1. Introduction


Monetary Policy is concerned with the changes in the supply of money and credit. It refers to the policy measures undertaken by the government or the central bank to influence the availability, cost and use of money and credit with the help of monetary techniques to achieve specific objectives. Monetary policy aims at influencing the economic activity in the economy mainly through two major variables i.e. (a) money or credit supply and (b) the rate of interest.  

According to A.J. Shapiro, "Monetary Policy is the exercise of the central bank's control over the money supply as an instrument for achieving their objectives of economic policy."

Monetary Policy is not an end in itself, but a means to an end. It involves the management of money and credit for the furtherance of the general economic policy of the government to achieve the predetermined objectives like Neutrality of money, price and exchange rate stability, full employment and economic growth.

 

2. Monetary Policy Influence in the Market


Monetary policy influences economic activities in two ways:

         i.            Directly through Money Supply

Money Supply is directly related to the level of economic activity. An increase in money supply increases economic activity by enabling people to purchase more goods and services and vice versa.

       ii.            Indirectly through Rate of interest

A change in money supply influences economic activity through its impact on rate of interest and investment. Increase in money supply reduces the rate of interest, which in turn, increase in investment, and hence promotes economic activity, and vice versa.

3. The Relationship between money supply and interest rate



Fig: Money supply and interest rate 

 

Higher money supply puts downward pressure on interest rates.

Lower interest rates will also tend to reduce the value of the currency. If UK interest rates fall relative to elsewhere, it becomes less attractive to save money in UK banks. We will see an outflow of ‘hot money’ as investors move to countries with higher interest rates. This will put downward pressure on the currency as people sell Pounds to buy other currency.

There is an inverse relationship between interest rate and money supply. Basically banks increase money supply through credit creation. The liquid cash amount usually remains more or less constant unless more money is printed through deficit financing. But deficit finance if resorted beyond specific limit increases inflationary pressure for which it is kept within tolerable limit by the Govt.To regulate money supply through bank credit interest rate is used as a mechanism by the Central Bank. If it wants to pursue a cheap money policy it reduces rate of interest so that bank credit is expanded and money supply is increased leading to expansion of economy through investment, if the Central Bank wants to contain inflation it increases interest rate so that people are encouraged to save instead of spending more money.

3. Limited Scope of Monetary Policy in the underdeveloped countries


The monetary policy has the limited scope in the underdeveloped countries because of the following reasons.

·         There exists a large non-monetized sector in most of the underdeveloped countries which act as a great hurdle in the successful working of the monetary policy.

·         Small-sized and unorganized money market and limited array of financial assets in underdeveloped countries also hinder the effectiveness of monetary policy.

·         In most of the underdeveloped countries, total money supply mainly consists of currency in circulation and bank money forms a very small portion of it. This limits the operation of central bank's monetary policy which basically works through its impact on bank money.

·         The growth of nonbank financial institutions also restricts the effective implementation of monetary policy because these institutions fall outside the direct control of the central bank.

·         In the underdeveloped countries (e.g., in Libya), many commercial banks possess high level of liquidity (i.e., funds in cash form). In these cases, the changes in monetary policy cannot significantly influence the credit policies of such banks.

·         Foreign based commercial banks can easily neutralize the restrictive effects of tight monetary policy because these banks can replenish their resources by selling foreign assests and can also receive help from international capital market.

·         The scope of monetary policy is also limited by the structural and institutional realities of the underdeveloped countries, weak linkage between interest rate, investment and output, particularly due to structural supply rigidities. When investment is increased as a result of a fall in the rate of interest, increased investment may not expand output due to the structural supply constraints, such as inadequate management, lack of essential intermediate products, bureaucratic rigidities, licensing restrictions, lack of interdependence within industrial sector. Thus, higher investment, instead of increasing output, may generate inflationary pressures by raising prices.

 

4. Conclusion


The Monetary Policy in an economy works through two main economic variables, i.e., money supply and the rate of interest. The efficient working of the monetary policy, however, requires the fulfillment of three basic conditions (a) The country must have highly organized, economically independent and efficiently functioning money and capital markets which enable the monetary authority to make changes in money supply and the rate of interest as and when needed. (b) Interest rates can be regulated both by administrative controls and by market forces so that consistency and uniformity exits in interest rates of different sectors of the economy. (c) There exists a direct link between interest rates, investment and output so that a reduction in the interest rate leads to an increase in investment and an expansion in output without any restriction. The developed countries largely satisfy all the necessary prerequisites for the efficient functioning of the monetary policy, whereas the developing or underdeveloped economies normally lack these requirements.

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