Page 261 - DECO502_INDIAN_ECONOMIC_POLICY_ENGLISH

Unit 20: Indian Financial System: Money Market and Monetary Policy

(ii) Change in Lending Margins : The banks advance money more often than not against the mortgage Notes
of some asset or property—-land, building, jewelry, share, stock of goods, and so on. The banks
provide loans only up to a certain percentage of the value of the mortgaged property. The gap
between the value of the mortgaged property and amount advanced is called ‘lending margin.’ For
example, if value of stock is Rs. 10 million and the amount advanced is only Rs. 6 million, the
lending margin is 40 percent. Since 1956, the RBI has made an extensive use of this method with a
view to preventing speculation in scarce agricultural products, namely, food grains, cotton, oil seeds,
vegetable oil (vanaspati), sugar, Khandsari and gur, and cotton textiles and yarns. The speculative rise
in the price of scarce agricultural products had taken place because high price of such goods could
secure higher loans through mortgaging. Higher loans provided more funds to buy and accumulate
the stock of the scarce agricultural commodities to be mortgaged for further borrowing. This created
a kind of artificial scarcity which pushed the prices further up. By increasing the lending margin,
the RBI could curb this kind of speculative borrowing. This method is no more used widely India.

The central bank is empowered to increase the lending margin with a view to
decreasing the bank credit. This method was used for the first time by the RBI in
1949 with the objective of controlling speculative activity in the stock market.

(iii) Moral Suasion : The moral suasion is a method of persuading and convincing the commercial
banks to advance credit in accordance with the directives of the central bank in overall economic
interest of the country. This method is adopted in addition to quantitative and other qualitative
methods, particularly when effectiveness of other methods is doubtful. Besides, quantitative
and qualitative methods are, in fact, ineffective in the underdeveloped countries with
underdeveloped money and credit markets. Under this method, the central bank writes letter
to and hold meetings with the banks on money and credit matters.
(iv) Direct Controls : When all other methods prove ineffective, the monetary authorities resort to
direct control measures with clear directive to carry out their lending activity in a specified
manner. There are, however, rare instances of use of direct control measures.
The Limitations and Effectiveness of Monetary Policy
The effectiveness of monetary policy, in practice, depends on the following factors, knows as the
limiting factors of monetary policy.
(i) The Time Lag : The first and the most important limitation in effective working of monetary
policy is the time lag, i.e., the time taken in chalking out the policy action, its implementation
and response time. The time lag is divided in two parts : (i) ‘inside lag’ or preparatory lag, and
(ii) ‘outside lag’ or response lag. The inside lag refers to the time lost in (a) identifying the
nature of the problem, (b) identifying the sources of the problem, (c) assessing the magnitude of
the problem, (d) choice of appropriate policy action, and (d) implementation of policy actions.
The outside lag refers to the time taken by the households and the firms to react to the policy
action taken by the monetary authorities.
If preparatory and operational lags are long, not only the nature and the magnitude of the
problem may change rendering the policy ineffective, but also it may worsen the situation. It
has been the experience of many countries including developed ones that both inside and outside
lags have been unduly long, making monetary policy less effective than expected. The time lag
of monetary policy, particularly its response lag, has been found to be generally longer than the
time lag of fiscal policy. However, the issue of time lag in case of monetary policy is controversial.
Friedman and Schwartz find an average time lag of 18 months between peaks (troughs) of
money supply and peaks (troughs) of business cycle. Their findings have been questioned by
the findings of other economists. However, ‘the evidence from several sources suggest that the
lag associated with monetary policy is long and possibly variable’ and ‘the consensus seems to
be that the lag is about 12 to 16 months long.’
(ii) Problems in Forecasting : The formulation of an appropriate monetary policy requires that the
magnitude of the problem—recession or inflation—is correctly assessed, as it helps in
determining the dose of the medicine. What is more important is to forecast the effects of

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