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Unit 13: Macro Economic Policies: Monetary Policy

external demand and exchange rate shocks. This, in turn, has enhanced the possibility of significant Notes
changes in trade and other current account flows in a short span of time.
A more serious challenge to conduct of monetary policy emerges from the capital account.
A distinctive feature of capital flows is the greater volatility vis-à-vis the trade flows. Capital
flows in gross terms are much higher than those in net terms. Global capital flows impact the
conduct of monetary policy on a daily basis, imparting volatility to monetary conditions.
Along with the explosion in financial innovations and the information technology revolution,
this has led to the swift transmission of market impulses across countries and a structural change
in the process of financial intermediation. All this has fundamentally altered not only the
environment of monetary policy formulation but also its instrumentality and operating
framework.
Typically, central banks attempt to overcome the policy dilemma by undertaking a variety of
operations such as open market sales of government/own bonds to neutralise the expansionary
monetary effect arising out of their market purchases. Such sterilisation operations, in turn,
have their own limitations and involve costs, especially if external flows are persistent.
Globalisation, thus, transforms the environment in which monetary policy operates, throwing
up a number of challenges. The foremost challenge is the progressive loss of discretion in the
conduct of monetary policy.

Self Assessment

Fill in the blanks:
9. The supply of money is determined by the product of stock of money and its .....................
10. An increase in money supply will .............................. the price level.
11. According to the Keynesian theory, monetary policy does not affect the price level but the
level of ...................................
12. A perfectly elastic liquidity preference over a range is referred to as a ..............................
13. An economy that is not free to trade with the other economies is called .............................
economy.

13.4 Effectiveness of Monetary Policy

Different methods of monetary policy seem to be quite simple but its implementation is a
complex task. Let us evaluate the effectiveness of monetary policy as below:
Changes in Velocity: Changes in velocity of money greatly influence the effectiveness of
monetary policy. In case, regulatory authority reduces the supply of money with a view of
reducing credit but at the same time, people make more use of money that is, increase in
velocity, then supply of money instead of diminishing, may increase. Again, if speculative
demand also declines due to a fall in the prices of bonds, this type of decrease in demand
for money also results in increasing the velocity of circumstances. Under these
circumstances, effectiveness of monetary policy does not prove to be much effective.
Non-banking Financial Institutions: The policy adopted by non-banking financial
institutions also affects the effectiveness of monetary policy to a greater extent. If the
working of these institutions is not in accordance of monetary policy, then it can get much
success. However, Professor Gurley and Shaw attached much more significance to these
institutions, which sometimes limit the smooth working of monetary policy.

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