Role of Monetary Policy to Promote Economic Growth!

1. 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 or assumption that savings were positively elastic or sensitive to the interest rate. It is worthwhile to mention an opposite view point regarding interest rate policy which has gained large support in recent years. According to this view (emphasized by Keynes’ in his monetary theory), rate of interest represents the cost of investment, and lower the 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 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 not be allowed to fall below 5 per cent per annum, if it is to provide reasonable rate of return on savings. Actually for past some years in India, rate of interest on bank deposits (which are main assets in which people keep their savings) is negative.

For three years fixed deposits rate of interest is around 9 per cent or even 8.5 per cent in some banks, whereas rate of inflation as measured by consumer price index (CPI) has been around 10 per cent in past some years. (It was 9.52 per cent y-on-year basis in Aug. 2013). This means real rate of interest which people are getting is negative, that is, keeping money in banks fixed deposits is eating into your savings.

It is not surprising that people are prompted to invest their savings in gold and jewellery, real estate which are socially unproductive assets. 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, real estate, accumulation of inventories. This led to the fall in financial saving required for productive investment.


This has 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 India, especially in their rural areas. With more bank branches in under-banked and under-developed 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 emphasized 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 nationalization 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 increased 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 under-developed 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 mobilize adequate amount of savings in the form of bank deposits, interest rates on bank deposits must remain positive in real terms. That is, the nominal rate of interest should 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.

2. 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 mobilized by banks for purposes of investment and production. The banks fulfill this task by offering bank credit for investment to business and industry.

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 need 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.

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-was reform period from 1996 to 2003 easy or low interest rate policy 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 underutilized, it is not profitable to make more investment for expanding fixed capital stock, 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’. However, in normal circumstances cheap interest rate policy promotes private investment and therefore helps to achieve higher economic growth.


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.

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 to promote not only private investment but also public investment by making available adequate amount of credit for it.

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 mobilized 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 its total demand and time deposits in the form of specified liquid assets.

And the most important specified liquid asset for this purposes 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.

3. Allocation of Investment Funds: Credit Rating:

Mobilisation of savings alone would not do. Proper canalization 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 designed as to influence the specific sectors and industries which are most significant to affect the growth of the economy. In fact, the particularized 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 are included measures such as voluntary credit restriction and moral suasion. 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 channelize savings in the desired directions.


In the indirect sense, these measures may prove conducive to growth in two ways. Firstly, 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 prevented.

Secondly, such measures may go a long way in galvanizing the process of growth by restraining inflation and it: 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 are 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 endeavor 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.