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Unit 13: Macro Economic Policies: Monetary Policy

If there is an exogenous increase in money supply from M to M , then, given the demand for Notes
1 2
money (liquidity preference), the rate of interest is reduced. With a reduction in the rate of
interest, from r to r , the investment demand is stimulated. As investment increases, from I to
1 2 1
I , the level of real income increases from Y to Y through the multiplier effect.
2 1 2
Exactly in the same way, a decrease in money supply is followed by a rise in the rate of interest—
a fall in investment expenditure and therefore, a fall in real income. In order that this mechanism
works, we need to assume (a) the absence of ‘liquidity trap’, (b) the interest elasticity of investment
and (c) the operation of ‘multiplier effect’. If the economy is caught in the ‘liquidity trap’ (i.e., a
perfectly elastic liquidity preference over a range), a given change in money supply cannot just
induce any change in the rate of interest; the interest rate gets so rigidly pegged to an institutional
minimum that it does not change. As if, a horse is taken to the water (money supply is changed),
but he does not drink water (it has no influence on the rate of interest in the money market).
Interest rate may be insensitive to monetary policy also because of a simultaneous shift in the
liquidity preference curve when there is a change in the quantity of money exogenously
determined. Even if interest rate is responsive to money supply, there is no guarantee that the
level of investment (demand for capital) will be interest elastic. If interest charges do not account
for a major part of the total costs of investment or if investment activity is determined by factors
other than costs (factors such as the size of market, location, government patronage, expected
returns, etc.), then it is possible that investment becomes interest inelastic. In fact, empirical
observation suggests such interest inelasticity of investment.
Finally, even if interest is money sensitive and investment is interest elastic, monetary policy
may not generate income changes because the so-called investment multiplier may not operate.

Example: If the economy is characterised by full employment and absence of excess
capacity or if the marginal propensity to consume is very high, multiplier mechanism may not
work; in that case, a rise in investment may increase only prices but not real income. Excess
investment may generate demand-pull inflation and to that extent the expansion in real income
(following cheap money policy) may suffer.

13.3.1 Monetary Policy in Developing Economy

Developments in monetary policy closely mirror the changes in overall economic policy. The
decade of 1990s has seen far reaching changes in India’s economic policy. In developed countries,
after decades of eclipse, monetary policy re-emerged as a potent instrument of economic policy,
in the fight against inflation in the 1980s. The relative importance of growth and price stability
as the objective of monetary policy as well as the appropriate intermediate target of monetary
policy became the focus of attention.
A similar trend regarding monetary policy is discernible in developing economies as well.
Much of the early literature on development economics focused on real factors such as savings,
investment and technology as mainsprings of growth. Very little attention was paid to the
financial system as a contributory factor to economic growth even though attention was paid to
develop financial institutions which provide short term and long term credit. In fact, many
writers felt that inflation was endemic in the process of economic growth and it was accordingly
treated more as a consequence of structural imbalance than as a monetary phenomenon. However,
with the accumulated evidence, it became clear that any process of economic growth in which
monetary expansion was disregarded led to inflationary pressures with a consequent impact on
economic growth. Accordingly, the importance of price stability and, therefore, the need to use
monetary policy for that purpose also assumed importance in developing economies.
Nonetheless, the debate on the extent to which price stability should be deemed to be the
overriding objective of monetary policy in such economies continues.

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