In this article we will discuss about the role of monetary policy in economic growth.

Economic growth implies the expansion in productive capacity or capital stock in the economy so that increases in real national output or income are attained. As is well known, economic growth can be speeded up by accelerating the rate of savings and investment in the economy.

This requires the following steps:

(a) Increase in the aggregate rate of savings in the economy;


(b) Mobilisation of these savings so that they are made available for the purpose of investment and production;

(c) Increase in the rate of investment; and

(d) Allocation of investment funds for productive purposes and priority sectors of the economy.

Proper monetary policy can help in producing favourable effects on the above requirements of economic growth.

Monetary Policy and Savings:


Several monetary measures can be adopted to raise the aggregate rate of saving. First, a high interest rate policy can promote savings. In the fifties and sixties of the 20th century, it was widely believed that interest rate reflected the price of capital and since capital was scarce in developing countries, the real interest rates should be kept at higher levels to promote saving so that capital accumulation is speeded up. However, this argument in favour of higher real interest rates in developing countries was based upon the belief that savings were positively elastic or sensitive to the interest rate.

It is worthwhile to mention an opposite viewpoint regarding interest rate policy which has gained large support in recent years. According to this view (emphasised by Keynes in his monetary theory), rate of interest represents the cost of investment, and lower the lending rate of interest, the greater will be inducement to invest. However, Keynes was of the view that investment was not much sensitive or elastic to lower rate of interest and easy or cheap monetary policy was ineffective to revive the economy from depression. Dr. K.N. Raj argued that since investment is an important factor determining economic growth in developing countries, it should be promoted by lowering the interest rates.

However, this is not fully correct. This is because whereas inducement to invest may be promoted by lowering the interest rates, the adequate amount of savings or resources needed to finance larger investment may not be forthcoming at lower interest rates. Further, a low interest rate policy in developing countries like India is likely to promote more investment in inventories and luxury consumer goods such as cars, air conditioners, luxury houses rather than that in fixed capital goods.

In our view therefore in a developing economy a reasonably positive real interest rate policy should be pursued to provide incentives for more savings so that large sources are made available for investment in fixed capital stock. If monetary policy in a developing country is to promote economic growth it must aim at raising the rate of saving. It may be recalled that real rate of interest is nominal rate of interest minus rate of inflation. In our view, real rate of interest should be positive and preferably should not be allowed to fall below 5 per cent per annum, if it is to provide reasonable rate of return on savings.


Therefore, with the rise in rate of inflation nominal rate of interest should also be raised to keep incentives for saving intact. It may be noted that in recent years (2011-12 and 2012-13) in India low deposit rates offered to the public by banks have prompted the people to invest their savings in unproductive assets such as gold, jewellery and real estate. This led to the fall in financial saving required for productive investment. This led the Finance Minister, Mr. Chidambaram, in his budget for 2013-14 to announce issuing of inflation-indexed bonds on which nominal interest rate will automatically rise with the increase in inflation rate.

Besides, the monetary policy can play a strategic role in increasing national savings by promoting the expansion of banking facilities and other financial intermediaries in the developing countries, especially in their rural areas. With more bank branches in under-banked and underdeveloped regions, the people who consume away their surplus incomes will be induced to save them in the form of bank deposits which are quite safe as a store of value. The commercial banking encourages thrift or propensity to save by offering a return on savings in the form of interest rate on bank deposits.

It also induces more savings by providing outlets for mutual funds which can be equity linked and other saving schemes for fruitful investment of the savings by the people who would have otherwise put them to unproductive or wasteful uses such as buying land, real estate, gold and jewellery. But to tap and raise savings sufficiently and to prevent its unproductive use, banks and other financial institutions need to be numerous and dispersed throughout the economy in both the urban and rural areas. Speaking from the development experience of various countries, Prof. Lewis, a development economist, has emphasised that the volume of savings depends partly upon how widespread banking and other financial institutions are. To quote him, “If the saving institutions are placed under the individual’s nose, people save more than if the nearest saving institutions is some distance away.”

Thus growth in saving in the form of bank deposits will be greater, if a reasonable real rate of interest policy is pursued. Similarly, with the expansion of other financial institutions, the people will feel induced to save more for buying financial assets. It is generally agreed that the rapid expansion of banking facilities after the nationalisation of major commercial banks in 1969 promoted by the Reserve Bank of India has contributed considerably to the growth of aggregate savings.

While the aggregate saving rate has gone up from 16.5 per cent in 1969-70 to 22.7 per cent in 1982-83, bank deposits, which accounted for 8.7 per cent of total domestic savings in 1969-70, accounted for 22.5 per cent of these savings in 1982-83. The number of commercial banks’ offices increased from 8,262 in July 1969 to 44,521 in 1984 and to 62,350 in 1995. Although it is difficult to establish a precise quantitative relationship between expansion of bank branches and savings in the form of bank deposits, its significant contribution to the promotion of savings cannot be denied. Therefore, the future branch expansion policy must fully take into account the untapped saving potential of under-banked and underdeveloped regions.

It may be noted that in order to facilitate mobilisation of an increasing proportion of savings by the banking system, it is essential to maintain a reasonable price stability. Dr. Manmohan Singh, when he was Governor of Reserve Bank of India, pointed out, “It is only under conditions of reasonable price stability that people will have less attraction for savings in the form of physical assets such as gold, real estate and excessive accumulation of inventories.” Further, if banks are to mobilise adequate amount of savings in the form of bank deposits, interest rates on bank deposits must remain positive in real terms. That is, the rate of interest be maintained at a higher level than the rate of inflation. If through excessive rise in prices real rate of interest becomes negative, people will be discouraged to save.

Monetary Policy and Investment:

Monetary policy has an important role to play in boosting up the level of investment by making available savings or resources mobilised by banks for purposes of investment and production. The banks fulfill this task by offering bank credit for investment to business and industry.

Cost of Credit:

It may be noted that Keynesian theory of monetary policy emphasises that the effect of a change in the supply of money on the level of production and investment operates through the changes in the rate of interest. The increase in the supply of money by the monetary authority will cause the market rate of interest to fall. At lower rate of interest, the entrepreneurs will be induced to invest more.


Accordingly, Keynesian monetary theory has been described as “cost of credit” theory. However, Keynes himself and several economists after him believed that this effect of changes in money supply on investment which operates through rate of interest is not very vigorous. It has been asserted that investment in fixed capital is interest inelastic. That is why Keynes did not have much faith in the effectiveness of monetary policy and instead emphasised the role of fiscal policy in influencing the level of economic activity. However, it is now generally believed by the economists that since interest is an important cost of investment, investment demand is fairly interest elastic. Therefore, to promote investment, the easy monetary policy should be adopted.

It may be noted that in the post-economic reforms period from 1996 to 2003 easy or low interest rate policy was adopted to promote private investment so as to revive the industrial sector whose growth slowed down from 1996-97 to 2002-03. Following the soft-interest rate policy of Reserve Bank of India prime lending rates of interest of commercial banks, which varied between 15 and 16 per cent prior to 1996, were reduced over a period of time to 9 to 10 per cent in 2003.

Again when in September 2008 global financial crisis occurred as a result of bust of housing bubble in the US, there was worldwide (including India) economic slowdown, Reserve Bank of India in October 2008 reduced its repo interest rate from 9 per cent in July 2008 to 7 per cent in October 2008 and further to 4.75 per cent on March 4, 2009, to promote private investment so as to prevent sharp economic slowdown in India.

However, the soft interest rate policy does not always, especially during recession, achieve much success in stimulating private investment. This is because when there are sluggish demand conditions, the existing fixed capital is underutilised, it is not profitable to make more investment for expanding fixed capital stock, and private enterprises are therefore not willing to make further investment despite lower interest rates. It is for such economic conditions that it has been said that ‘you can bring the horse to water but you cannot make it drink’.


Therefore, in our view, the favourable effect of lower interest rate on investment has been exaggerated. As Keynes emphasised, it is the prospective yield from investment which plays a crucial role in determining investment. Unless the private business class expects to earn sufficient profits, they will not increase their investment. Unless the expectations of the business class about profit making are raised or what Keynes called animal spirits’ of entrepreneurs are revived, investment will not increase. The profit expectations can be raised by government increasing its expenditure, especially on infrastructural projects which through its multiplier will raise the aggregate demand for goods and services.

Besides, through its fiscal policy the government can provide liberal depreciation allowance against taxation. This will raise the internal rate of return. However, the profit expectations of businessmen depend on the demand for goods produced by the capital assets they plan to invest. Thus, “the only way in which businessmen can be persuaded to invest more is if they genuinely believe that the demand for the output of the assets will be there when they have been acquired. Consequently, the best way of increasing prospective yield is to increase demand either by increasing consumption or by increasing government expenditure”.

Availability of Credit:

It is noteworthy that in the recent times monetary theory emphasises the credit-availability effect on investment of the changes in the supply of money. According to this, an increase in the supply of money causing expansion in the reserve money with the banks directly enlarges the availability of bank credit for investment purposes and thereby raises the level of investment in the economy.


On the contrary, contraction in money supply will directly reduce the availability of credit and hence tend to decrease investment in the economy. The credit availability of banks can be increased by RBI by lowering cash reserve ratio (CRR) and statutory liquidity ratio (SLR) of banks. Note that statutory liquidity ratio (SLR) of the banks is the proportion of their deposits which the banks have to invest in government securities. The reduction in CRR and SLR releases resources for the banks to lend to the private businessmen for investment.

Further, in this context it is noteworthy that in developing countries, government or public investment plays a crucial role in the development of their economies. Therefore, monetary policy requires promoting not only private investment but also public investment by making available adequate amount of credit for it.

Monetary Policy and Private Investment:

If the private sector plays an important role in the development process, as it does in India after economic reforms undertaken since 1991, monetary policy has also to ensure that the needs for bank credit for investment and production in the private sector are fully met. The banks must provide adequate bank credit to meet at least essential working capital requirements of industry and agriculture. Both large-scale and medium industries require funds for investment in fixed capital, working capital and for maintaining inventories.

Subject to appropriate norms fixed for inventory holdings, the credit needs of the private sector should be met if existing capacities in the private sector are to be fully used and also more productive capacity is to be built up. In India banks have been asked by the Reserve Bank of India to give specific percentage of loans at concessional rates of interest to some priority sectors such as agriculture and small and medium enterprises.

Monetary Policy and Public Investment:


Let us first explain the promotion of the public investment through monetary policy. Monetary policy has to ensure that the banking system contributes to the financing of the planned public investment. For this, a good part of bank deposits mobilised by the banks should be invested in Government and other approved securities so that the government should be able to finance its planned investment, especially in infrastructure. At present in India, there is lack of infrastructure such as power, roads, highways, ports, irrigation facilities which is obstructing economic growth.

Besides, when industry faces demand recession, public investment is an ideal tool to develop infrastructure and to increase the demand for industrial products through the operation of multiplier. This will stimulate private investment. Therefore, in our view, policy of raising public investment will crowd in private investment rather than crowding it out. In India a new technique of monetary policy has been designed to secure larger resources from the banking system for financing public investment.

This technique has been described as Statutory Liquidity Ratio (SLR). According to this, in addition to cash reserve requirements banks in India are required to keep a minimum proportion of their total demand and time deposits in the form of specified liquid assets. And the most important specified liquid asset for this purpose is the investment in government and other securities. To raise the lendable resources of the banks, cash reserve ratio of the banks must be kept at low level.

Allocation of Investment Funds:

Mobilisation of savings alone would not do proper canalisation of these into suitable directions of investment is or perhaps more important than mobilisation itself. The monetary policy should restrict the growth of wasteful lines of investment which are inimical to economic growth. It should be able to direct investment in productive channels. In this regard, the monetary policy has to play a selective or qualitative role in so far as it is possible through its operations to discriminate between productive and unproductive outlays. It should give a fillip to the former and stint the growth of the latter.

Further, it has to be so designed as to influence the specific sectors and industries which are most significant to affect the growth of the economy. In fact, the particularised application of credit can greatly activise the process of economic growth. Therefore, it is necessary to operate the selective credit rationing with a view to influence the pattern of investment. However, in the gamut of monetary policy, there are selective credit control measures of both general and specific nature. In the general category, measures such as voluntary credit restriction and moral suasion are included. In the category of specific measures there exist measures to control credit institutions.


For the purpose of regulating the individual credit institutions, the method of varying the reserve requirements is quite effective. On the other hand, in order to divert the financial resources into desired channels, the method of credit rationing should be used by the Central Bank. This may be done by fixation of a ceiling on the aggregate portfolio of the commercial banks, thereby making it incumbent that loans and advances do not exceed the fixed ceiling.

Alternatively, it may be done by directly allocating funds that can be granted and used. Besides, policies such as the selective rediscount policy, prior deposit requirement policy and the fixation of deposit requirement policy can also be adopted to achieve similar goals. However, it may be pointed out that the potency of credit planning depends upon the extent of the area over which it operates. The developing economies must strive for an extension of credit planning over wider areas.

Credit control measures such as noted above promote growth by directing the stream of domestic savings into the desired lines of investment. Measures such as lengthening the periods of repayment, lowering of margin requirements, providing rediscounting facilities at rates below the bank rate, provision of special loans by commercial banks to be used for specific purposes or the setting up of special investment institutions such as Industrial Development Bank can provide the required inducement to channelise savings in the desired directions.

In the indirect sense, these measures may prove conducive to growth in two ways. First, the qualitative credit control measures prevent the savings from being wasted in unproductive channels. Through their application it becomes possible to deny or discourage certain lines of investment that are inimical to the growth of the economy. However, the extent to which such measures can help providing resources for investment in the desired directions depends on the extent to which the flow of credit towards the undesirable channels can be prevented.

Secondly, such measures may go a long way in galvanising the process of growth by restraining inflation and its adverse effects. When inflationary tendencies set in, generally the bank advances to businessmen tend to rise. In this way, certain undesirable and unproductive enterprises may grow and flourish. For instance, activities such as speculative demand for building up inventories, accumulation of precious metals for purchase of foreign exchange and real estate get a fillip. Growth of these and such other unproductive activities can be held in check by raising the margin requirements for the blackballed collaterals. Further, the monetary authority can fix a ceiling by holding the loans and advances of the value of the collateral. Thus, it serves the dual purpose of curbing inflation and protecting certain essential productive forms of investment from being restricted.

In the context of the planned development of the underdeveloped countries, the use of methods of selective credit controls and credit rationing is not only necessary but also essential. They greatly widen the horizons of development along predetermined and desired directions. They are not only helpful in preventing inflation but also act as a positive means of directing the process of economic development on the desired lines. Furthermore, the policy of selective credit controls is especially suited to the needs of underdeveloped countries where the orthodox monetary techniques have limited applicability. As it is, the structure of these economies is not very conducive to the general methods of credit control.


The huge investment expenditure made by the government in the public sector in its endeavour to accelerate the process of growth is not amenable to control by the monetary authority. The monetary authority is, in fact, subversive to the wishes of the government in the matter of providing resources for development. Further, in order to help government borrowings, the bank rate policy of the Reserve Bank tends to become more or less inflexible. Besides, for the sake of supporting government loans, the institutions such as SEBI (Stock Exchange Board of India) is also required to stabilise the securities market.

Monetary Policy to Control Inflation in Developing Countries:

The developing countries are prone to the emergence of inflationary pressures in the economy.

This is because in developing countries the government often spends more to raise public investment and as a result often experience fiscal deficit which they finance:

(1) By borrowing by issuing bonds (which are generally purchased by banks, insurance companies, mutual funds, pension funds etc.) and

(2) By creating new printed money.

They result in excess demand conditions in the economy and therefore generate inflation. Monetary policy is an important tool of demand management in the economy and therefore of checking inflation. In what follows, we explain the role and limitations of monetary policy in controlling with special reference to India.


Monetary policy refers to the adoption of suitable policy regarding interest rate and the availability of credit. Monetary policy is important measure for reducing aggregate demand to control inflation. As an instrument of demand management, monetary policy can work in two ways. First, it can affect the cost of credit and second, it can influence the credit availability for private business firms. Let us first consider the cost of credit.

The higher the rate of interest, the greater would be the cost of borrowing from the banks by the business firms. As anti-inflationary measure, the rate of interest has to be raised to discourage businessmen to borrow more so that less bank credit is created. The cheap credit policy (i.e., lower interest rates) is recommended on the ground that lower rate of interest will promote more private investment which is an important factor determining economic growth. Keeping in view this consideration, cheap money policy was adopted in India up to 1972 and accordingly bank rate was kept low.

The dear money policy (that is, higher interest rate policy) has often been used in India to curb the inflationary pressures in the Indian economy. In India, bank rate has not been generally used to check inflation. Instruments like repo rate and reverse repo rate have often been used to manage aggregate demand. Repo rate is the interest rate at which Reserve Bank of India lends funds to the commercial banks for a short period. To curb inflation repo rate is raised.

Hike in repo rate raises the cost of funds for the banks which will, if they do not have excess reserves, raise their lending rates. The higher lending rates will lower the demand for bank credit for investment and for purchases of cars (auto loans) and housing (housing loans). Under these circumstances to mobilise funds banks raise their deposit rates. The higher rate of interest on saving and fixed deposits will induce more savings by the households and help in cutting down aggregate consumption expenditure. Besides, higher rates of interest will discourage more investment in inventories and consumer durables and will help in reducing aggregate demand.

However, rise in repo rate will lead to the decline in credit growth if monetary transmission mechanism works. This will happen only if banks are short of liquid funds. If the banks have excess liquid reserves with them they would not raise their lending rates when the RBI raises repo rate. Therefore, for monetary transmission mechanism to work liquidity with the banks must be curtailed. This can be done by the RBI by raising cash reserve ratio (CRR) and by open market operation through sale of government securities.

It is noteworthy that a recent monetary theory emphasizes that it is changes in the credit availability rather than cost of credit (i. e., rate of interest) that is a more effective instrument of regulating aggregate demand. There are several methods by which credit availability can be reduced. Firstly, it is through open market operations that the central bank of a country can reduce the availability of credit in the economy.

Under open market operations, the Reserve Bank sells government securities. Those, especially banks, who buy these securities, will make payment for them in terms of cash reserves. With their reduced cash reserves, their capacity to lend money to the business firms will be curtailed. This will tend to reduce the supply of credit or loanable funds by the banks which in turn would tend to reduce aggregate demand.

However, in the past in India open market operations did not play a significant role as an instrument of credit control to fight against inflationary situation. This was because market for government securities was narrow as well as captive. However, with financial reforms this is no more the situation. At present RBI often uses open market operations to influence liquidity of the banking system.

General public do not buy more than a fraction of government securities. It is the institutions such as commercial banks, LIC, GIC and Provident Funds which are required by law to invest a certain proportion of their funds in buying government securities. The RBI can reduce the liquidity with the banks by selling government securities to them through open market operations.

In India, it is the cash reserve ratio (CRR) which can be effectively used to curb inflation. By law banks have to keep a certain proportion of cash money as reserves against their demand and time deposits. This is called cash reserve ratio. To reduce liquidity with the banks and thereby to contract credit availability Reserve Bank can raise this ratio. In recent years to squeeze credit for checking inflation, cash reserve ratio in India has been raised from time to time.

Statutory Liquidity Ratio (SLR):

Another instrument with Reserve Bank of India for affecting credit availability is the statutory liquidity ratio. In addition to CRR, banks have to keep a certain minimum proportion of their deposits in the form of specified liquid assets. And the most important specified liquid asset for this purpose is the government securities. To mop up extra liquid assets with banks which may lead to undue expansion in credit availability for the business class, the Reserve Bank has often raised statutory liquidity ratio.

Limitations of Tight Monetary Policy:

However, tight monetary policy for controlling inflation is not without its limitations. First, monetary transmission mechanism may be weak and raising of short-term interest rates by the RBI may not actually lead to the restriction of bank credit. This can happen when the banks may have surplus liquidity (i.e., cash reserves) with them and therefore they may not follow tight monetary policy and raise their lending rates. As a result, supply of credit by banks will not be restricted. Secondly, if the economic environment is such that boom conditions prevail in the economy and aggregate demand for products is quite high, demand for credit may not be much affected by higher lending rates.

As emphasized by J.M. Keynes, investment is determined more by marginal efficiency of capital (that is, expected rate of return) rather than rate of interest. Thirdly, at present in India corporate firms are more easily able to borrow from foreign capital markets (i.e., external commercial borrowing, ECB) especially when rates of interest in the US, European zone and Japan are extremely low. Therefore, unless this debt-capital inflow (i.e., ECB) is checked RBI’s monetary policy may not be effective to check the supply of credit to control inflation in the economy.

Thirdly, when the stock market prices are rising and aggregate demand is quite high, the corporate sector is able to raise funds itself more easily from the capital market. This will also offset the impact of tight monetary policy of the RBI to control inflation. Fourthly, if adequate internal funds are available with the corporate firms as a result of retained profit earnings by the companies they can use them to finance their expansion plans and thereby add to the aggregate expenditure or demand. This will also nullify the tight monetary policy of the RBI to curb inflation.

It may be noted that in recent years to control inflation the Reserve Bank of India raised its repo rate 13 times from March 2010 to November 2011 (from 4.75% in March 2010 to 8.50% in November 2011) but inflation as measured by the WPI remained at an elevated level. It was estimated at 10 per cent (YoY) in September 2011, 9.73% in October 2011 and 9.11 per cent in November 2011.

After November 2011, WPI inflation declined because of dip in food inflation due partly to the base effect and partly to easing of supply position of some food articles. Thus tight monetary policy failed to check inflation despite 3.75 percentage points increase in repo rate. The RBI explained failure of its tight monetary policy to curb inflation by blaming the large fiscal deficit of the government in 2011 -12.

Due to large fiscal deficit, aggregate demand was increasing which was feeding inflation in the Indian economy. According to the RBI, unless fiscal deficit is brought down by the government, tight monetary policy alone will not succeed in checking inflation. Besides, the RBI blamed supply-side factors responsible for food inflation which has contributed to overall rise in WPI inflation.

Lastly, if inflation in the economy has originated from the supply-side factors, for example, if production of food-grains and other essential food articles such as milk, vegetables, fruits etc. in a year declines or does not increase adequately to meet the growing demand for them due to certain supply-side bottlenecks, this will cause the demand-supply imbalances leading to the rise in inflation. Such supply-side inflation cannot be checked by raising interest rates under the tight monetary policy.

This happened in 2009-10 when due to the shortage of monsoon rainfall, drop in agricultural production was expected, and inflationary pressures emerged in the Indian economy raising food inflation to around 20 per cent in December 2009. This food inflation continued to prevail at double digit level till November 2010. Tight monetary policy which is aimed at management of aggregate demand rather than augmentation of supply is ineffective in tackling this supply-side inflation as in case of food inflation in 2010. Likewise, in 2010-11 and 2011 -12 shortage of protein-based food products such as pulses, milk, fruits and vegetables, eggs, meat and fish contributed a good deal to the persistence of food inflation.

It is only after October 2011 when there was a drop in food inflation, the WPI inflation also declined. Similarly, supply-side inflation arises when prices of petroleum products rise which is passed on to the domestic consumers and cannot be tackled with use of tight monetary policy. In addition to fuel, if output growth in core industries such as steel, cement, coal declined as they did during 2011-12 in India, they create supply-side bottlenecks in various industries leading to supply-side inflation.

Now to control food inflation what is required is to take long-term measures to augment supply of food-grains and other food articles by raising agricultural productivity by undertaking appropriate technological changes and land reform measures. In the short run to control food inflation what is needed is to release food stocks through public distribution system (PDS) which should be properly monitored to check black market. Besides, to control rise in food prices in the short run release of food stocks for sale in the open market should be made. However, this presupposes enough food stocks with the government. Further, to check food inflation, food-grains, pulses, oilseeds and other feed articles in short supply can be imported.

It may however be noted that when inflationary expectations arise as a result of emergence of shortage of supply of some essential commodities, there is tendency on the part of traders to hoard stocks of goods in short supply for speculative purposes. To discourage such speculative hoarding of goods in short supply monetary policy of high interest rates can be helpful. Besides, as explained above, selective credit controls of monetary policy can also be used to check excessive hoarding.

The Policy of Quantitative Easing (QE) and Developing Countries:

We have explained above the conventional monetary policy to bring stability in the economy. Now, in 2008 there was a severe economic crisis caused by bursting of housing bubble. Prior to 2008, when the prices of houses were rising the Americans had made excessive investment in houses financed by sub-prime housing loans given on a large scale by the American banks at low rates of interests. The American banks sold these sub-prime mortgaged housing loans to other financial institutions which converted them into securities that were traded in the market.

Now in 2007-08 when the prices of houses declined sharply, the people who had got the sub-prime housing loans from the banks started defaulting on paying interest and the principal amount. This caused serious financial crisis as the prices of securities based on sub-prime mortgage housing loans fell almost to zero. As a result, the banks and financial institutions such as Lehman Brothers, Citi Bank which had made large investment in them came to the brink of bankruptcy. In July 2008, Lehman brothers declared itself bankrupt. This caused great panics which ultimately result in severe recession in the US economy which had world-wide repercussion. The recession in the US economy was so severe that its growth rate came down to almost zero and unemployment shot up to 10 per cent of labour force.

It is to tackle such severe recessionary conditions the non-conventional monetary policy of quantitative easing (QE) was adopted by the Federal Reserve (which is the Central Bank of the US). The interest rates were then so low that the conventional monetary policy of lowering interest rates had lost its ability to stimulate the economy. Therefore, non-conventional monetary policy of quantitative easing (QE) was adopted by the Federal Reserve keeping near zero rate of interest under the quantitative easing (QE) the Federal Reserve purchased bonds (both treasury bonds and private corporate bonds) and other financial assets on a large scale and to purchase them created new money. In this way, the Federal Reserve pumped a large liquidity (i.e., cash) in the banking system and has continued this policy for several years now since 2008, though the scale of purchase of bonds has slowed down in recent years.

Now, selling bonds and other financial assets to Federal Reserve and getting a lot of cash allowed American Commercial banks to provide loans to business firms and investors at low rate of interest to make more investment and thus increasing spending in the economy. It was hoped that more investment and spending would help the economy to get out of recession. Thus, quantitative easing (QE) was expected to stimulate the US economy and recover from recessionary conditions.

It may be noted that with the Federal Reserve purchasing bonds from the market on a large scale, their supply in the market was reduced which driven up the bond prices. Higher bond prices mean the yield from them declined and therefore investors were discouraged to buy them. The investors or business firms which got loans from the banks not only invested some money in building new factories or expanding their existing capacities but also used them to buy back their own stock or shares with the intention to shore up their prices.

Since return on more investment in the US was very low, a good amount of US dollars created through quantitative easing also flowed into the emerging economies, especially India and China where returns from investment in shares and bonds were quite high. The inflows of capital (i.e., US dollars) in India and China caused share prices in these countries to shoot up. In this way, American foreign institutional investors (Flls) made a good amount of profits in investing in India and China.

With the policy of pumping a lot of liquidity in the banks which gave liberal loans at very low interest rates has succeeded in reviving the American economy whose annual GDP growth has on average reached 2.5 per cent and unemployment rate has also declined to 5 per cent labour force (June 2015). However, the recovery of the American economy is fragile. The Federal Reserve has quite often decided to withdraw completely the quantitative easing policy and raise of interest but each time it has postponed the implementation of its decision.

It may be noted that when quantitative easing (QE) policy is completely withdrawn and rates of interest raised by the Federal Reserve, there will be outflows of capital (i.e., dollars) by FIIs from India. When this happens the share prices in India will fall sharply, the Indian rupee would depreciate and thus creating a lot of economic instability in the Indian economy. This economic instability will also be seen in other emerging economies.