Monetary policy

Economic strategy chosen by a government in deciding expansion or contraction in the country's money-supply. Applied usually through the central bank, a monetary policy employs three major tools: (1) buying or selling national debt, (2) changing credit restrictions, and (3) changing the interest rates by changing reserve requirements. Monetary policy plays the dominant role in control of the aggregate-demand and, by extension, of inflation in an economy. Also called monetary regime.

Objectives of Monetary Policy

The monetary policy in developed economies has to serve the function of stabilization and maintaining proper equilibrium in the economic system. But in case of underdeveloped countries, the monetary policy has to be more dynamic so as to meet the requirements of an expanding economy by creating suitable conditions for economic progress. It is now widely recognized that monetary policy can be a powerful tool of economic transformation.

As the objective of monetary policy varies from country to country and from time to time, a brief description of the same has been as following:

(i) Neutrality of money

(ii) Stability of exchange rates

(iii) Price stability

(iv) Full Employment

(v) Economic Growth

(vi) Equilibrium in the Balance of Payments.

1. Neutrality of Money:

Economists like Wicksteed, Hayek and Robertson are the chief exponents of neutral money. They hold the view that monetary authority should aim at neutrality of money in the economy. Any monetary change is the root cause of all economic fluctuations. According to neutralists, the monetary change causes distortion and disturbances in the proper operation of the economic system of the country.

They are of the confirmed view that if somehow neutral monetary policy is followed, there will be no cyclical fluctuations, no trade cycle, no inflation and no deflation in the economy. Under this system, money is kept stable by the monetary authority. Thus the main aim of the monetary authority is not to deviate from the neutrality of money. It means that quantity of money should be perfectly stable. It is not expected to influence or discourage consumption and production in the economy.

2. Exchange Stability:

Exchange stability was the traditional objective of monetary authority. This was the main objective under Gold Standard among different countries. When there was disequilibrium in the balance of payments of the country, it was automatically corrected by movements. It was popularly known, “Expand Currency and Credit when gold is coming in; contract currency and credit when gold is going out.” This system will correct the disequilibrium in the balance of payments and exchange stability will be maintained.

It must be noted that if there is instability in the exchange rates, it would result in outflow or inflow of gold resulting in unfavorable balance of payments. Therefore, stable exchange rates play a key role in international trade. Thus, it is clear from this fact that: the main objective of monetary policy is to maintain stability in the external equilibrium of the country. In other words, they should try to eliminate those adverse forces which tend to bring instability in exchange rates.

(i) It leads to violent fluctuations resulting in encouragement to speculative activities in the market.

(ii) Heavy fluctuations lead to loss of confidence on the part of domestic and foreign capitalists resulting in adverse impact in capital outflow which may also result in capital formation and growth.

(iii) Fluctuations in exchange rates bring repercussions in the internal price level.

3. Price Stability:

The objective of price stability has been highlighted during the twenties and thirties of the present century. In fact, economists like Crustar Cassels and Keynes suggested price stabilization as a main objective of monetary policy. Price stability is considered the most genuine objective of monetary policy. Stable prices repose public confidence because cyclical fluctuations are totally eliminated.

It promotes business activity and ensures equitable distribution of income and wealth. As a consequence, there is general wave of prosperity and welfare in the community. Price stability also impedes economic progress as there is no incentive left with the business community to increase production of qualitative goods.

It discourages exports and encourages imports. But it is admitted that price stability does not mean ‘price rigidity’ or price stagnation’. A mild increase in the price level provides a tonic for economic growth. It keeps all virtues of a stable price.

4. Full Employment:

During world depression, the problem of unemployment had increased rapidly. It was regarded as socially dangerous, economically wasteful and morally deplorable. Thus, full employment assumed as the main goal of monetary policy. In recent times, it is argued that the achievement of full employment automatically includes prices and exchange stability.

However, with the publication of Keynes’ General Theory of Employment, Interest and Money in 1936, the objective of full employment gained full support as the chief objective of monetary policy. Prof. Crowther is of the view that the main objective of monetary policy of a country is to bring about equilibrium between saving and investment at full employment level.

Similarly, Prof. Halm has also favoured Keynes’ view. Prof. Gardner Ackley regards that the concept of full employment is ‘slippery’. Classical economists believed in the existence of full employment which is the normal feature of an economy. Full employment, thus, exists when all those who are ready to work at the existing wage rate get work. Voluntary, frictional and seasonal unemployed are also called employed.

According to their version, full employment means absence of involuntary unemployment. Therefore, it implies not only employment of all types of labourers but also includes the employment of all economic resources. It is not an end in itself rather a pre-condition for maximum social and economic welfare.

Keynes equation of income, Y = C + I throws light as to how full employment can be secured with monetary policy. He argues that to increase income, output and employment, it is necessary to increase consumption expenditure and investment expenditure simultaneously. This indirectly solves the problem of unemployment in the economy. Since the consumption function is more or less stable in the short period, the monetary policy should aim at raising investment expenditure.

As monetary policy is the government policy regarding currency and credit, in this way, government measures of currency and credit can easily overcome the problem of trade fluctuations in the economy. On the other side, when the economy is facing the problem of depression and unemployment, private investment can be stimulated by adopting ‘cheap money policy’ by the monetary authority.

Therefore, this policy will serve as an effective and ideal stimulant to private investment as there is pessimism all round in the economy. Further, the objective of full-employment must be integrated with other objectives, like price and exchange stabilization.

The advanced countries like U.S.A. and U.K. are normally working at full employment level as their main concern is how to maintain full employment and avoid fluctuations in the level of employment and production. While, on the contrary, the main problem in underdeveloped country is as to how to achieve full employment.

Therefore, in such economies, monetary policy can be designed to meet with the problem of under employment and disguised unemployment and by further creating new opportunities for employment. The most suitable and favourable monetary policy should be followed to promote full-employment through increased investment, which in turn having multiplier and acceleration effects.

After achieving the objective of full-employment, monetary policy should aim at exchange and price stability. In short, the policy of full employment has the far-reaching beneficial effects.

(a) Keeping in view the present situation of unemployment and disguised unemployment particularly in more growing populated countries, the said objective of monetary policy is most suitable.

(b) On humanitarian grounds, the policy can go a long way to solve the acute problem of unemployment.

(c) It is useful tool to provide economic and social welfare of the community.

(d) To a greater extent, this policy solves the problem of business fluctuations.

5. Economic Growth:

In recent years, economic growth is the basic issue to be discussed among economists and statesmen throughout the world. Prof. Meier defined “Economic growth as the process whereby the real per capita income of a country increases over a long period of time.” It implies an increase in the total physical or real output, production of goods for the satisfaction of human wants.

In other words, it means utilization of all the productive natural, human and capital resources in such a manner as to ensure a sustained increase in national and per capita income over time.

Therefore, monetary policy promotes sustained and continuous economic growth by maintaining equilibrium between the total demand for money and total production capacity and further creating favourable conditions for saving and investment. For bringing equality between demand and supply, flexible monetary policy is the best course.

In other words, monetary authority should follow an easy or tight monetary policy to suit the requirements of growth. Again, monetary policy in a growing economy, has to satisfy the growing demand for money. Thus, it is the responsibility of the monetary authority to circulate the proper quantity and quality of money.

6. Equilibrium in the Balance of Payments:

Equilibrium in the balance of payments is another objective of monetary policy which emerged significant in the post war years. This is simply due to the problem of international liquidity on account of the growth of world trade at a more faster speed than the world liquidity.

It was felt that increasing of deficit in the balance of payments reduces, the ability of an economy to achieve other objectives. As a result, many less developed countries have to curtail their imports which adversely effects development activities. Therefore, monetary authority makes efforts that equilibrium should be maintained in the balance of payments.