CHAPTER

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Polic olicy Monetary Policy in Dev Economic Development
MEANING AND IMPORTANCE
Monetary policy refers to the policy of the monetary authority of a country with regard to monetary matters. It may be defined as that policy which deals with: (a) the controls of financial institutions; (b) active purchases and sales of paper assets by the monetary authority as adeliberate attempt to effect changes in money conditions; and (c) passive purchases and sales of paper assets resulting from the maintenance of a particular interest rates structure, the stability of security prices or meeting other obligations and commitments.1 Monetary policy in an underdeveloped country plays an important role in accelerating development by influencing the cost and availability of credit, by controlling inflation, and by maintaining balance of payments equilibrium. As development gains momentum, an appropriate monetary policy is all the more essential to provide an elastic credit supply to meet the requirements of a growing volume of trade, a rapidly increasing population, and an expanding monetized sector. MAIN FEATURES OF MONETARY POLICY According to Dr. J.D. Sethi, monetary policy can be taken to function in the following directions: (i) To have and also to make use of a most suitable interest rate structure, (ii) To achieve a
1. J. D Sethi, Problems of Monetary Policy in an Underdeveloped Country.

correct balance between the demand and supply of money. (iii) The provision of proper credit facilities for a growing economy and stopping its undue expansion; and also the channeling of credit to users as consistent with pre-planned investment, (iv) The creation, working and expansion of financial institutions, (v) Debt management.2 These features of monetary policy in an underdeveloped country are discussed below: 1. Creation and Expansion of Financial Institutions. One of the aims of monetary policy in an underdeveloped country is to improve its currency and credit system. More banks and financial institutions should be set up to provide larger credit facilities and to divert voluntary savings into productive channels. Financial institutions are localised in big cities in underdeveloped countries and provide credit facilities to estates, plantations, big industrial and commercial houses. In order to remedy this, branch banking and unit banking should be extended to rural areas to make credit available to peasants, small businessmen and traders. For an effective monetary policy, however, the existence of a strong and powerful central bank is a necessary condition. In underdeveloped countries, the commercial banks provide only short-term loans. Credit facilities in rural areas are mostly non-existent. The only source is the village moneylender who charges exhorbitant interest rates. Besides, there are no properly organised and developed stocks and security markets. To remove these shortcomings, the central bank should play a dominant role in shaping a countrys monetary policy. The Central bank acts as the fiscal agent of the government and thus manages the public debt. It issues government bonds and securities itself and through other commercial banks in the country. Since there is no well-established bill market in an underdeveloped country, it is the central bank which can set up and organise a stocks and securities market. The hold of the village money-lender in rural areas can only be slackened if new institutional arrangements are made by the central bank in providing short-term, medium-term and longterm credit at lower interest rates to the cultivators. A network of co-operative credit societies with apex banks financed by the central bank can help solve the problem. With the vast resources at its command, the central bank can also help in establishing industrial banks and financial corporations in order to finance large and small industries. Lastly, the central bank acts as the guardian of the money market. It has sufficient powers to control commercial banks as it desires. Central bank control of commercial banks is a chief weapon of monetary policy.3 It can induce banks to make provide medium and long-term loans by providing rediscounting facilities. But monetary and financial institutions in themselves cannot be expected to be the primary and active movers of development in credit sense. Given the fundamental stimulus which comes from enterprise and entrepreneurship, the monetary system must then be sufficiently responsive to the stimuli that arise as development gains momentum.4 2. A Suitable Interest Rate Policy. In an underdeveloped country the interest rate structure stands at a very high level. There are also vast disparities between long-term and short-term interest rates and between interest rates and different sectors of the economy. The existence of high interest rates acts as an obstacle to the growth of both private and public investment in an underdeveloped economy. A low interest rate is, therefore, essential for encouraging private investment in agriculture and industry. Since in an underdeveloped country businessmen have little savings out of undistributed profits, they have to borrow from the banks or from the
2. Ibid., p. 94. 3. Ibid., p. 103. 4. Meier and Baldwin, op. cit., p. 395.

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capital market for purposes of investment and they would borrow only if the interest rate is low. A low interest rate policy is also essential for encouraging public investment. A low interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low, and thus helps in financing economic development. Even from the point of view of foreign investors, the availability of cheaper money for complimentary funds encourages private foreign investments. But a low interest policy is not an unmixed blessing in an underdeveloped country. It has certain disadvantages. It encourages borrowing and investment for speculative purposes and thus hinders the financing of productive investments. A low interest rate on government bonds makes them unattractive to the investors who are solely guided by the profit motive. A low interest rate also adversely affects the growth of saving in the economy. In order to discourage the flow of resources into speculative borrowing and investment, the Central bank should follow a policy of discriminatory interest rates, charging high rates for non-essential and unproductive loans and low rates for productive loans. But this does not imply that savings are interest-elastic in an underdeveloped economy. Since the level of income is low in such economies, a high rate of interest is not likely to raise the propensity to save. In the context of economic growth, as the economy develops, a progressive rise in the price level is inevitable. The value of money falls and the propensity to save declines further. Money conditions become tight and there is a tendency for the rate of interest to rise automatically. This would result in inflation. In such a situation any effort to control inflation by raising the rate of interest would be disastrous. Cheap money policy may thus lead to inflation if it is not accompanied by strict physical control. A stable price level is, therefore, essential for the success of a low interest rate policy.5 3. 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, stabilizing their prices and minimizing the cost of servicing public debt. It is the central bank which undertakes the selling and buying of government bonds and making timely changes in the structure and composition of public debt. The primary aim of 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 on cheap rates to keep the burden of the debt low.6 In order to strengthen and stabilize the market for government bonds, the policy of low interest rates is essential. For, a low rate of interest raises the price of government bonds, thereby making them more attractive to the public and giving an impetus to the public borrowing programmes of the government. The maintenance of structure of low interest rates is also called for minimizing the cost of servicing the national debt. Further, it encourages funding of debt by private firms. Dr. Sethi opines that to make the rate of interest play an active and useful role in any single market, the government should offer a wide range of securities. He maintains that if there is no demand for them, as is the case in an underdeveloped country, then the basic function of debt management policies is to create their demand. However, the success of debt management, as an instrument of monetary policy, would depend upon the existence of well-developed money and capital markets in which wide range of securities exist both for short and long periods. To the extent these factors are absent, debt
5. J.D. Sethi, op. cit., pp. 94-97. 6. Ibid., pp. 106-107.

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management becomes an Herculean task in an underdeveloped country. 4. Proper Adjustment between Demand for and Supply of Money. Monetary policy is an important instrument in bringing about a proper adjustment between demand for and supply of money. An imbalance between the two will be reflected in the price level. A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the economy develops, the demand for money is likely to go up due to gradual monetization of the nonmonetized sector, the increase in agricultural and industrial production and prices. The demand for money for transaction and speculative motives will also rise. So the increase in money supply will have to be more than proportionate to the increase in the demand for money in order to avoid inflation. There is, however, the likelihood of increased money supply being used for speculative purposes, thereby inhibiting growth and causing inflation. The monetary authorities should control the use of money and credit by an appropriate monetary policy and control speculative activities through direct physical controls. Thus in an underdeveloped economy, the supply of money and credit should be controlled in such a way that the price level is prevented from rising without affecting investment and production adversely. 5. Credit Control. Monetary policy should also aim at controlling credit in order to influence the patterns of investment and production in a developing economy. Its main objective is to control inflationary pressure arising in the process of development. This requires the use of both quantitative and qualitative methods of credit control. Open market operations are not successful in controlling inflation in underdeveloped countries. The success of open market operations depends on: (a) the existence of a well-organised bill market; (b) the maintenance of fixed cash reserve ratios by the commercial banks; and (c) the absence of rediscounting facilities from the Central bank. But these factors do not operate in such economies. The bill market is small and under-developed. Commercial banks keep an elastic cash ratio because the central banks 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 reserve in liquid form such as gold, foreign exchange and cash. Only the last condition is operative because commercial banks are not in the habit of rediscounting or borrowing from the central bank. In underdeveloped countries, the bank rate policy is also not so effective due to lack of bills of discount and the habit of the commercial banks to keep large cash reserves. Where the central bank is more powerful, it is able to influence the market rates by appropriate changes in the bank rate. The use of the variable reserve ratio as a method of credit control is more effective than the open market operations and the bank rate policy. Commercial banks are able to create more credit in underdeveloped countries as they keep large cash reserves. The Central bank can check this expansion by raising the compulsory reserve ratio. 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 underdeveloped countries, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive channels 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 foodgrains 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

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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. Of the various quantitative and qualitative methods of credit control, the latter are more effective than the former. But reliance on any one method would not suffice. Therefore, alongwith the qualitative methods of credit control not only such methods as: (a) direct control of plant and equipment; (b) control of capital issues; (c) discriminatory taxes, and (d) control over imports and exports etc., will have to be instituted, but direct physical controls over commodity markets will have to be brought into make the general control policy a success.7 Conclusion. To conclude with Dr. Baljit Singh, Development of banking facilities and savings institutions, reorganization of agricultural and industrial credit, integration and improvement of the money market, growth of a sound central banking, closing of free markets in gold and silver, replacement of hoards and above all currency reforms are urgently needed. It is only after these deficiencies are made good that the monetary apparatus of economically backward countries can prove effective in aiding construction and development. If a country fails in this task it would either go slow, even stagnate or be compelled to switch over its economic system to overall planning and reallocation of resources through direct state control.8

7. Op. cit., p. 102, Italics mine. 8. Baljit Singh, Federal Finance and Underdeveloped Economy, p. 70.