Monetary policy refers to policy formulated and implemented for achieving the following objectives:
i. Regulating the supply of money including credit money and adjusting it to the needs of the economy
ii. To control the cost of money by regulating the rates of interest.
iii. Directing the supply of money to the required channels in accordance with the plan of priorities prepared by the planning authority.
According to A.G. Hart "A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy."
From the above discussion, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives.
Objectives of Monetary Policy: The objectives of a monetary policy in India are similar to the objectives of its five year plans. In a nutshell planning in India aims at growth, stability and social justice. After the Keynesian revolution in economics, many people accepted significance of monetary policy in attaining following objectives.
a) Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth.
b) Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities.
c) Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate.
d) Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.
e) Full Employment: Full Employment refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment.
f) Equal Income Distribution: Many economists used to justify the role of the fiscal policy are maintaining economic equality. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attaining an economic equality.
Importance of monetary policy
A modern economy is a money economy. All transactions are effected with the help of and through the medium of money. The prices of goods, services and factors are fixed in terms of money. People earn their income in the form of money and spend it in the form of money. So the supply of money creates money income in the hands of the community and expenditure of money generates the demand for different goods and services.
The monetary authority has to maintain a perfect balance between increase in the production of goods and services and increase in the supply of money. If increase in the supply of money exceeds increase in the production of goods and services the result is inflation. On the other hand, if the production of goods and services increases at a fast rate and the supply of money increases at a slow rate the result is recession and maybe depression. Hence the monetary authority has to monitor the growth in production very closely and adjust the money supply to it.
In India the monetary policy is formulated and implemented by the Reserve Bank of India which is an autonomous financial institution. It is expected that the RBI would use professional expertise to control the supply of money to the benefit of the community.
Limitations of Monetary Policy
Through the monetary policy is useful in attaining many goals of economic policy, it is not free from certain limitations. Its scope is limited by certain peculiarities, in developing countries such as India. Some of the important limitations of the monetary policy are given below.
a) There exists a Non-Monetized Sector: In many developing countries, there is an existence of non-monetized economy in large extent. People live in rural areas where many of the transactions are of the barter type and not monetary type. Similarly, due to non-monetized sector the progress of commercial banks is not up to the mark. This creates a major bottleneck in the implementation of the monetary policy.
b) Excess Non-Banking Financial Institutions (NBFI): As the economy launch itself into a higher orbit of economic growth and development, the financial sector comes up with great speed. As a result many Non-Banking Financial Institutions (NBFIs) come up. These NBFIs also provide credit in the economy. However, the NBFIs do not come under the purview of a monetary policy and thus nullify the effect of a monetary policy.
c) Existence of Unorganized Financial Markets: The financial markets help in implementing the monetary policy. In many developing countries the financial markets especially the money markets are of an unorganized nature and in backward conditions. In many places people like money lenders, traders, and businessman actively take part in money lending. But unfortunately they do not come under the purview of a monetary policy and creates hurdle in the success of a monetary policy.
d) Higher Liquidity Hinders Monetary Policy: In rapidly growing economy the deposit base of many commercial banks is expanded. This creates excess liquidity in the system. Under this circumstances even if the monetary policy increases the CRR or SLR, it does not deter commercial banks from credit creation. So the existence of excess liquidity due to high deposit base is a hindrance in the way of successful monetary policy.
e) Money not appearing in an Economy: Large percentage of money never comes in the mainstream economy. Rich people, traders, businessmen and other people prefer to spend rather than to deposit money in the bank. This shadow money is used for buying precious metals like gold, silver, ornaments, and land and in speculation. This type of lavish spending give rise to inflationary trend in mainstream economy and the monetary policy fails to control it.
f) Time Lag Affects Success of Monetary Policy: The success of the monetary policy depends on timely implementation of it. However, in many cases unnecessary delay is found in implementation of the monetary policy. Or many times timely directives are not issued by the central bank, then the impact of the monetary policy is wiped out.
g) Monetary & Fiscal Policy Lacks Coordination: In order to attain a maximum of the above objectives it is unnecessary that both the fiscal and monetary policies should go hand in hand. As both these policies are prepared and implemented by two different authorities, there is a possibility of non-coordination between these two policies. This can harm the interest of the overall economic policy.
These are major obstacles in implementation of monetary policy. If these factors are controlled or kept within limit, then the monetary policy can give expected results. Thus though the monetary policy suffers from these limitations, still it has an immense significance in influencing the process of economic growth and development.