Read this article to learn about the meaning, instruments and limitations of monetary policy in a modern welfare state.


Macroeconomic policy has come to play a very vital role as a policy instrument in a modern welfare state.

It aims at bringing about the desired charges in income and employment in the economy.

Maintaining price stability, providing full employment, rapid economic growth, maintaining exchange rates are amongst the important social and economic objectives of the state.


In order to attain these objectives the governments adopt suitable macroeconomic policies.

The use of macroeconomic policy for promoting economic growth with stability and social justice involves the framing of appropriate economic policies which also aim at reducing income and wealth inequalities in the economic system.

As a matter of fact, the objectives of such a macroeconomic policy are many and varied, important ingredients of a macroeconomic policy for rapid economic growth with stability are the monetary, fiscal, income and other measures. All these are used as complementary policy instruments in a macroeconomic policy to attain the social and economic objectives.

There is now widespread agreement that only governments are capable of pursuing consistent full employment policies, for no other organisation possesses the power and resources necessary for the task. Attainment and the maintenance of a state of full employment in the economy has become one of the major aims of every government at the present time. Since the publication of Keynes’ ‘General Theory’, governments are taking keen interest in stabilizing economic activities at full employment.


All measures at full employment aim at maintaining aggregate demand at a level sufficient to ensure full employment. In order to achieve and maintain full employment, expenditures on consumption and investment have to be maintained at sufficiently high levels.

The simple income equation Y = C + I, given by Keynes, underlines even the most tough employment policy. Adequate expenditure to maintain full employment can be ensured only if we can stimulate either consumption or investment expenditure or both to the required level, choice depending on cyclical or secular nature of the unemployment in question.

Consumption function being stable in the short-run, efforts has to be made to promote investment to counteract trade cycles or cyclical fluctuations. In the long-run, however, consumption expenditures have to be manipulated.

It is clear, therefore, that for continuous full employment monetary expenditures on both consumption and investment must be stimulated and kept under control for as excess of these expenditures leads to inflation and a deficiency to depression. We take up the monetary measures here: Monetary policy seeks to influence the rate of aggregate spending by varying the degree of liquidity of various constituents of the economy including banks, firms, business houses and households.


Monetary policy raises the level of expenditure by increasing the amount of cash and other liquid assets (e.g., short and long-term government securities) at the disposal of the community and by making borrowing conditions easier through lower rates of interest. Again, monetary policy seeks to restrict aggregate spending in the country by reducing the total amount of liquid assets with the community and by making borrowing more costly and difficult. Therefore, whether the central bank will follow a ‘cheap money policy’ or a ‘tight money policy’ depends on the economic conditions prevailing in the economy.

Instruments of Monetary Policy:

Monetary policy refers to measures designed to influence the cost and availability of money for the purpose of influencing the working of the economy. In other words, monetary policy consists of all those measures which help the central banking authorities of a country to manipulate the various instruments of credit control.

The instruments of monetary policy are the same as instruments of credit control at the disposal of a central bank, like the bank rate, open market operations, changes in reserve requirements usually referred to as quantitative credit controls.

Second category consists of consumer credit control, margin requirements, etc., known as qualitative controls. The quantitative instruments are so called because they regulate the total quantity of money and qualitative because they are employed to limit the amount of money available for certain specific purposes even though plenty of money may be available for other purposes.

Until recently quantitative instruments of monetary policy were used for causing changes in the whole structure of interest rates, for it was thought that changes in interest rates would, in turn, affect saving and investment. It was considered desirable to raise interest rate in inflation as it would encourage saving and lower it in deflation as it would discourage savings and encourage investment. Lately, monetary theorists seem to lose their respect for interest rate changes as a means of regulating the total spending in the economy.

It is argued that the MEC and other psychological factors rather than the rate of interest affect the amount and direction of investment in periods of inflation and deflation. Further, to the extent that investment is made possible by the retained profits of business enterprises, it may be decided irrespective of the considerations of the rate of interest. R.P. defines monetary policy as, “the management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment.”

According to G.K. Shaw, “By monetary policy we mean any conscious action undertaken by the monetary authorities to change the quantity, availability or cost (interest) of money” H.G. Johnson defines monetary policy as a policy of central bank’s control of the supply of money for achieving the objectives of general macroeconomic policy.

Thus, policy of handling control of credit is called monetary policy; it is so called because it is the policy adopted by the central bank, the final monetary authority. Broadly speaking, monetary policy can be conceived to embrace all measures undertaken by a government to affect the expenditure or use of money by the public, whereas in the narrow sense it refers to the regulation of the supply of money (currency and bank deposits) through discretionary actions of the central banking authorities.

According to Friedman the most important development in the post-war years in the field of policy has been a shift from credit policy to monetary policy. This distinction though highly important yet remained neglected. By Credit Policy we mean the effect of the actions of the monetary authorities on rates of interest, terms of lending and conditions in the credit markets. By monetary policy we mean the effect of the action of monetary authorities on the stock of money—on the number of pieces of paper in people’s pockets or the quantity of deposits on the books of banks.


This distinction between credit policy and monetary policy is of fundamental importance for the policy-makers in every country because monetary policy is and must be much more a matter of opportunities, of day-do-day adjustment, of meeting the particular problems of our time. Friedman laments the fact that those who are entrusted with the task of laying down monetary policy (for USA) are still wedded to old theories prevalent 20 years ago.

Limitations of Monetary Policy:

Monetary policy alone cannot generate full employment and promote economic stability. More measures, unless supported by other government measures, may not even be able to achieve a specific price level, leave alone the stabilization of economic activity. Prof. Halm remarks. “It is highly doubtful that even the best conceivable monetary policy could eliminate cyclical fluctuations of a money economy. Such a policy would not only have to prevent disturbing influences from the monetary side itself but also to counter-balance disturbing influences from other sources. Experiences in recent years have at least shown that general fluctuations of business are continuing and that the instruments at the disposal of monetary authorities are certainly not capable, at least as they are now being used, of extricating the economy from conditions of under-employment and of leading it into permanent prosperity. The cyclical fluctuation of the money economy itself is partly the reason for the failure of the instruments of monetary policy to work more satisfactorily.”

Prior to 1920 or so, when quantity theory of money held away, there was little doubt as to the efficacy of monetary policy. Monetary policy, however, failed to control the unheard of hyper-inflation of Germany. It could not generate a revival of business activity during the depression of 1929-33. It was in this context that Keynes openly questioned the efficacy of monetary policy. He advocated fiscal policy to bring about economic stability and full employment.

There is nothing inconsistent in arguing that ‘money matters’ while simultaneously maintaining that monetary policy as defined is ineffective either because it is countered by induced changes elsewhere (velocity changes), or because it takes effect with too long a delay. According to Friedman, time lags make the implementation of monetary policy potentially hazardous and as such he would like to abandon countercyclical stabilization monetary policy altogether. Monetary policy will be a destabilizer rather than a stabilizer on account of the effects of time lags. The best stabilization policy is no stabilization policy at all.


What Friedman proposes instead is that the Federal Reserve (or any central bank) be instructed to follow a fixed long-run rule: Increase the money supply at a steady and inflexible rate, month in and month out, year in and year out regardless of the economic conditions. Set the money supply on automatic pilot and then leave it alone. Although Friedman’s position is based on statistical evidence produced by Friedmanites, yet very little is really known about the length and variability of the time lags. Such evidence as there is, and there is not much, is extremely mixed.

Serious research on the subject is still in its infancy and no consensus is possible so far amongst economists who have worked in this area. However, Brian Tew has brought out certain implications of Friedman’s approach. He says if the money supply could indeed be shown to be the crucial determinant of the pressure of demand, the authorities would be faced with a task which may be well beyond their powers. For restricting the growth of bank deposits is not in our economies the equivalent of turning off a tap, it is rather equivalent of fighting a flood.

In the 1950s, opinions changed again in favour of monetary policy. Countries; raised rediscount rates, sold securities and tightened the money markets in their effort to regulate and control post-war inflation. Rad-cliffy Committee expressed the opinion that monetary policy consisting of the bank rate and selective credit controls may be quite effective in checking an inflationary situation but it cannot be expected to act quickly enough or alone to bring-about a complete recovery during a slump.

Prof. R.S. Sayers stated that the debate still goes on with respect to the virtues of monetary policy. However, it may be concluded that a suitable combination of monetary policy, fiscal policy and debt management can end cyclical fluctuations and generate full employment.


Thus, monetary authorities are fully justified in stating that the objectives of economic stability and full employment cannot be attained by monetary policy alone, but these goals should be sought through proper co-ordination of monetary and other major policies of the government which affect business activity. In contrast to traditional monetary policy which had emphasized the cost of credit to the investor, the new policy stressed the availability of funds for new investment.

Many critics who condemned the monetary policy as being virtually useless in the years of depression now became advocates of the new monetary policy during an age of inflation. While still conceding the Keynesian position that favourable expectations were the major influence on the will to invest, and while still maintaining the general interest inelasticity of the investment demand schedule, it was now recognized that; investment could not be undertaken if investible funds simply could not be obtained. The 1950s through 1970s therefore, witnessed something of a partial resurgence in the efficacy of monetary policy.