Some of the major limitations of monetary policy in under-developed countries are as follows:
(1) Under-developed Money Market:
The money market in developing countries is highly under-developed. Due to the unorganized nature of the money market and lack of its integration with the central bank, the traditional methods of credit control like bank rate policy, open market operations and variations in the reserve ratio etc., have got limited effect.
The central bank extends its control only to the organised sector and not to the unorganized sector. This creates several complicated problems for the central bank when it tries to control the money market of the country. The money market is also conspicuous by the absence of a well-developed bill market.
(2) Non-Monetized Sector:
Due to the existence of an extensive non-monetized sector, changes in the money supply of the country or the changes in the interest rates do not have any effect on the level of economic activity. It is because money does not enter into this sector and all the transactions conducted therein are merely barter exchanges. Therefore, non-monetized sector creates many problems in the smooth working of the monetary policy.
(3) Lack of Integrated Interest Rate Structure:
The various types of interest rates prevalent in the money market do not bear any definite relationship with the bank rate of the country. Any changes affected in the bank rate do not produce proportional changes in the other interest rates. The result is that the central bank of the country is unable to control the money market in an effective manner and monetary policy fails in its operation.
(4) Proportion of Credit to Money:
The proportion of credit to money in the monetized sector is very small. Nearly 70-75% money supply consists of currency in active circulation. The bank deposits in such an economy form only a small and insignificant portion of the total money supply. This seriously limits the working of monetary policy.
(5) Shortage of Real Factors:
Another problem in developing countries exists that there is a shortage of real factors like capital, entrepreneurial ability etc., therefore, monetary policy can do nothing about it.
(6) Lack of Banking Facilities:
In a developing economy, adequate banking facilities are not available specially to those areas in the country which are either un-banked or under-banked. The idle savings of the people cannot be mobilized. Moreover, sometimes commercial banks do not cooperate with the central bank. Thus lack of banking facilities creates number of problems in the way of monetary policy.
(7) Existence of Inflation:
A developing economy is highly sensitive to inflationary pressures. Government incurs huge expenditure on various types of development projects. It increases the effective demand much more than the output of consumer goods. The result is a sharp rise in the internal price level. Moreover during the course of hyper inflation, tools of monetary policy fail to work properly.
(8) Black Money:
In underdeveloped countries, large quantity of black money exists due to political and economic factors. Black money is used for activities such as hoarding and speculative motives etc. As a result, it hinders the true spirit of the various objectives of monetary policy.
(9) Non-Banking Financial Institutions:
According to Gurley and Shaw, non-banking financial institutions like “Life Insurance Corporation, State Financial Institutions and other Credit Financial Institutions, greatly hamper to achieve the objectives of monetary policy in a less developed country.
(10) Deficit Financing:
In the modern world, deficit financing is the main source of financing development activities. But heavy doses of deficit financing has proved inoperative to achieve the objectives of monetary policy. For example, monetary authority wants to check the supply of money while deficit financing helps to increase its supply. Thus how both factors can operate simultaneously?
(11) Only Persuasive Policy:
Generally monetary policy in underdeveloped countries is soft, lenient, persuasive and this leads to ineffectiveness. As its role is not compulsive but permissive only which creates serious limit on the efficacy of monetary policy.
(12) Lack of Honesty:
In underdeveloped countries administrative honesty and firmness are not very rigorous. This leads to the problem of tax evasion, antisocial elements, black money etc. This parallel economy helps speculations and illegal trading and thereby reduce the efficiency of monetary policy.
(13) Disequilibrium in Balance of Payments:
In less developed countries, monetary expansion generally leads to increased imports and unfavorable balance of payments. This puts a limitation on the monetary policy.
(14) Investment in Unproductive Channels:
The well-to-do people do not deposit money with banks but use this money in buying jewellery, gold, real estate, and in conspicuous consumption etc. In other words, investment is made in unproductive channels instead of productive channel and as a result, it retards the economic development of underdeveloped countries.
(15) Limited Application of Weapons of Credit Control:
In the developing economies, people mostly rely on currency in circulation and bank deposits which forms only a small proportion of money supply. This being the case, weapons of credit control have only limited application.