Page 248 - DECO402_Macro Economics

Unit-27: Monetary Policy

Use of Variable Reserve Ratio in form of a tool of monetary policy in LDCs is more effective Notes
in comparison to bank rate policy and open market operations. Since market of securities
is very small hence open market operations are not successful. But increase or decrease
in variable reserve ratio by the central bank increases or decreases cash available with
commercial banks without having an unfavourable influence on prices of securities. Again,
commercial banks keep huge cash reserves with cannot be reduced by the central bank. But
by increasing variable reserve ratio, liquidity of banks is reduced. There are some limitations
of use of variable reserve ratio in LDCs- first, since non-banking financial intermediaries
do not keep deposits with central banks that is why they are not influence by it. Secondly,
those banks which do not keep extra liquidity, in comparison to them, those who keep it
are influenced more.
But in influencing the allocation of credit and consequently in influencing the procedure
of investment qualitative measures of credit control are more effective in comparison to
quantitative measures. In LDCS strong tendency is found to invest in gold, jewellery,
inventories, tangible assets etc in comparison to optional productive sources available in
agriculture, mining, plantation and industries. For controlling and limiting credit facilities for
such unproductive objectives qualitative credit control is more appropriate. They are useful
in limiting speculative activities in matter of larders and raw materials. They are more useful
in stopping sectional inflation in the economy. They cut the demand for import by making
it compulsory for importers to deposit advance amount equivalent of foreign exchange.
It also has this influence that reserve rates of banks reduce so much so that in this process
their deposits are transferred to the central bank. Selective credit control measures may be
in form of change in limit requirement instead of definite type of security, consumer credit
regulation and rationing of credit.
2. To Achieve Price Stability: Monetary policy is an important tool to attain price stability. It
brings appropriate adjustment in money demand and supply. Imbalance in both of these
will be reflected in price level. Decrease in money supply stops growth, while it excess
will bring inflation. When economy is marching towards development then by increase in
agricultural and industrial production and by slowly changing of non-monetised areas to
monetised areas, demand for money rises slowly. By it demand for money for exchange and
speculation objectives will also increase. Hence monetary officer, for stabilising prices and
stopping inflation, will have to increase supply of money more than the ratio of demand
for money.
3. To Bridge BOP Deficit: In form of interest rate policy, monetary policy does a very important
task for bridging the BOP deficit. For achieving the planned target of development developing
economies have to face serious Balance of Payment difficulties. For establishing foundational
structures like electricity, irrigation, transportation etc and for directly productive activities
like iron and steel, fertilizers, chemical etc such countries have to import capital equipments,
machinery, raw material, parts and furniture. Because of which there is an increase in their
export. But their exports are stagnant and because of inflation prices of export are also
very high. As a result difference in import and export is created because of which balance
of payment is imbalanced. Monetary policy through high interest rates may be helpful in
bridging the deficit of balance of payment. High interest rates are helpful in reducing the
difference in balance of payment by motivating inflow of investment.
4. Interest Rate Policy: For a developing economy high interest rate policy encourages more
savings, develops banking habits and provides strength to monetization of the economy,
which is necessary for capitalization and economic development. High interest rate policy
also removes inflation because it discourages borrowing and investment of speculation and
investment. Then this policy encourages allotment of scarce capital resources towards more
productive sources. Some economists are supporter of low interest rates in such countries

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