In this article we will discuss about the role of monetary policy in controlling inflation in developing countries.
Monetary policy refers to that branch of economic policy which attempts to achieve the broad objects of policy — stability of employment and prices, economic growth and balance in external payments — through control of the monetary system and by operating on such monetary magnitudes as the supply of money, the level and structure of interest rates and other conditions affecting the availability of credit. Like fiscal policy, monetary policy operates ultimately through its influence on expenditure flows.
In the 1960s and earlier, policy aimed to influence spending through the level of interest rates, which determines whether funds for capital expenditure are dear or cheap. At that time interest rate policy, regarded as only moderately effective, was frequently backed up by direct control — credit ceilings and the like — on bank lending and hire purchase finance.
In the 1970s, for a variety of reasons, of which the influence of monetarism is only one, relatively more weight has come to be attached to control of monetary aggregates, i.e., the money supply in one or other of its definitions.
In fact, this is a matter of emphasis since, given the size and growth of the Indian national debt, interest rate policy is a vital ingredient of controlling growth in the money supply and, through it inflation.
The essence of monetary policy is to control the release of central bank reserves to commercial banks in a manner which stimulates bank lending and investing in support of consumer and business spending, as well as government outlays in order to foster economic growth without contributing to inflationary pressures. Consequently, it has the capacity to exert an enormous impact on the level of employment, the value of output and the rate of inflation and serves a major tool for influencing economic activity.
Changes in interest rates, through the effects on the quantity of money are a central bank instrument of monetary policy. In the Keynesian model, a rise in the level of interest rates will first, by encouraging saving, reduce consumption, and secondly, by increasing the cost on finance, reduce investment.
Increases in interest rates will, though a ‘multiplier effect’, reduce the pressure of aggregate demand, and exert a downward effect on inflation. Such a policy was used in advanced countries at various times in the 1950s and 1960s. However, interest rate, as an instrument of monetary control, does not prove to be very much effective in developing countries like India having underdeveloped money and capital markets.
This is why the traditional (quantitative) instruments of credit control, viz., the bank (discount) rate, open market operations and variable reserve ratio do not succeed much in controlling inflation. In such countries, more reliance is placed on qualitative or selective credit control measures.
For instance, the main thrust of the RBI’s monetary policy has been on restricting bank credit against inflation-sensitive items (such as food grains, cotton, jute, oilseeds and oil, sugar and textiles) as also to influence the cost and availability of commercial bank credit by periodically changing the bank rate and raising the cash reserve ratio (CRR) of member banks. The RBI relies more on selective credit control (SCC) rather than general credit control measures so as to discourage speculative hoarding.
Monetary policy in developing countries like India is directed essentially and consistently toward preventing any excess increase in money supply and at the same time to ensure that the genuine credit requirements of the priority sectors of the economy, such as agriculture, industry and infrastructure (especially coal, power and transport), are adequately met.
For reducing money supply, the CRR is normally raised. Another important instrument of monetary control is the bank rate. Central bank funds represent reserve deposits of commercial banks. These balances typically are purchased by banks short of reserves and are sold mainly by banks with an excess of such funds.
It is the key rate in the money market. It has an important influence on the cost of funds (credit) to banks and other borrowers in the money market and, in its turn, tends to affect lending rates in much of the credit and securities market.
For example, by increasing the bank rate and eventually tightening bank reserve positions sufficiently to maintain this new bank rate, the central bank can reduce monetary growth and thus, limit the banking system’s ability to expand credit and deposits.
By raising the CRR and the bank rates central banks of developing countries have largely succeeded in mopping up excess liquidity in the economy, moderating monetary and credit expansion and consequently helped in bringing down the rate of price inflation.
As a general rule, throughout the plan period, the RBI has used its monetary policy to achieve a pragmatic compromise between the growth of GDP and control of the general price level. As the growth rate in GDP was targeted 5.5% during 1997-98, it set its necessary supply growth rate within 15.5% and aimed at keeping inflation with the safe limit of 8%. During this period, RBI controlled growth of money supply by raising CRR and sale of government securities to people, as part of its open market operations.
Selective Credit Control (SCC):
However, in developing countries, the stress has all along been on SCC.
And, the RBI uses three kinds of SCC:
(a) Imposition of ceiling on the volume of credit for certain purposes;
(b) Imposition of minimum margins for lending against specific securities;
(c) Differential rates of interest on different types of loans.
Selective controls are normally imposed on credit to traders for financing inventories (for purposes of hoarding and speculation). This is necessary to keep the rising prices under check. At the same time, the RBI ensures that sufficient bank credit flows to the genuine productive sectors of the economy — industry, transportation and exports.
This is why RBI’s monetary policy is one of ‘controlled expansion’, which implies that monetary policy has two aims — growth of the economy through expansion of bank credit to industry and trade, and control of inflationary pressure by using both quantitative (general credit restraint) and selective credit control, so that the making of loans and advances by the commercial banks for speculative purposes is held in check.
However, monetary policy alone cannot enable an economy achieve price stability. In view of seasonal fluctuations in agricultural prices in India, there is also need for supply management policies for controlling inflationary pressures.
This is why the Chakravarty Committee has suggested a two-pronged strategy for achieving price stability:
(a) raising output levels by the adoption of supply management policies through central government directive, and
(b) controlling the expansion in reserve money and money supply by the RBI.
In this context, we have to realise the relationship among money supply, output and prices. In the last two decades, the increase in reserve money and in money supply has been largely due to a rise in the level of RBI credit to government.
Monetisation of debt refers to the process whereby government debt is rapid on maturity, or is, for policy reasons, ‘bought in’ without a counterbalancing issue of new non-monetary debt, so that the money supply increases.
This situation may arise in consequence of difficulties of debt management, or as a result of a policy to stabilise interest rates which imposes on the government obligations to buy in all its own debt offered to it, at a constant price. It may also arise as a direct consequence of paying off the national debt as part of a political programme, which disapproved of public indebtedness.
In this context, two recommendations may be made. First, following the monetarists, rules should replace discretions. This means that the target for an increase in money supply, in a broad sense, during a year should be announced in advance. As suggested by Chakravarty Committee, “the target should be in terms of a range, based on anticipated growth in output and in the light of the price situation”.
The target can, of course, be modified from time to time, but it is vitally important to announce in advance the circumstances under which the modification is being made. This policy of monetary targeting is expected to help the RBI in the use of its monetary policy instruments for controlling inflation and stabilising the general price level.
Secondly, it is very important for the government to impose monetary discipline on itself. This can be achieved by restricting its recourse to RBI at pre-determined levels so as to restrict monetisation of debt. To achieve this, it is absolutely essential to raise the yield rate of dated government securities and Treasury bills so that these because as attractive as private bonds and debentures.
It appears that if the yield rate is 2% per annum in real term’s (ignoring the effects of inflation) the government will be able to attract lenders from outside the traditional market consisting of banks and insurance companies.
In other words, the government must raise the needed financial resources by tapping the savings of the people or by increasing tax revenues or by incurring budget deficit financed by borrowing from sources other than RBI. It is gratifying to note that, in the past few years the Government of India has borrowed more and more from the open market at market rates of interest. This is known as market borrowing.
Another important point to note here is that the RBI’s monetary instruments and its power are such that they affect only the organised sector, viz., commercial banks and cooperative banks. As Datt and Sundharam have rightly commented in this context: “To the extent inflationary pressure is the result of bank finance, the RBI’s general and selective controls will have positive effect. But if inflationary pressure is really brought about by deficit financing and shortage of goods, the RBI’s control may not have any effect at all”.
This is exactly what is really happening in developing countries like India in recent years. Furthermore, it should not be missed that the RBI’s area of influence does not extend to non-banking financial institutions as well as indigenous bankers who compete closely with banks for attracting public deposits and cause a parallel expansion of money supply by playing a major role in financing trade and industry.
In no way, can a steep or even moderate rate of inflation be stopped if monetary policy allows bank credit and money-supply growth to fully accommodate price excesses. By the same token, monetary policy alone cannot effectively dampen inflationary excesses.
In reality, various non-monetary forces operating in the economy contribute heavily to the behaviour of prices. For this reason, the fight against inflation requires, along with a tight monetary policy, restraint through the central government’s fiscal operations sufficient to help curtail excessive demand pressures in the economy.
Furthermore, an effective anti-inflation policy requires longer-term efforts at breaking rigidities and imperfections on the supply side, including productivity-enhancing measures and moves to combat monopolistic pricing practices.