Monday, August 24, 2009

“Monetary Policy Can Back a Boom, but it Cannot Deal with Recession.”

Monetary policy embraces banking and credit policy relating to loans and interest rates as well as the monetary standard and public debt and its management. It influences the volume of credit base and through it the volume of bank credit and thus the general level of prices and economic activity. We know the usual methods through which monetary policy works. By way of recapitulation the important ones among such methods are manipulation of bank rate and open market operations. When boom conditions are developing bank rate is raised and thus credit is contracted with the consequent brake upon the undue expansions of business activity. In a depression, a policy of cheap money may be adopted to stimulate business investment and thus assist recovery.

The bank credit policy involves two types of controls the quantitative and qualitative. The quantitative control is aimed at general toghening or easing of credit system as the situation may demand. It is exercised by influencing the reserves of banks. The qualitative control seeks to regulate particular types of credit. It’s object to stimulate, restrict or stabilize bank advances for specific business schemes.

Obviously monetary policy has much to command itself and was therefore rightly regarded, till three decades back as the best anticyclical instrument. But there are limitations of the policy relating to the bank rate and open market operations. Its resources will depend on how far certain assumptions are true. For example, how far the various members of the banking system are prepared to accept the lead given by the central banks, how far the banks can make their borrowers use their credits for purposes for which such credits have actually been created; further, how far monetary causes are responsible for the economic fluctuations, and still further and most important whether the business community will adjust their investment exactly in accordance with the altered rates of interest.

Thus since these assumptions are only partially true, it is understandable that monetary management can claim only limited efficacy. The most serious limitation of monetary policy is in period of depression when the business community is so completely in the grip of pessimism that even a substantantial reduction of the interest rates does not make them embark upon expansion of production and new investment. The horse may be taken to water, but it may refuse to drink. The monetary authority can only encourage business enterprises. The above discussed points reveal that can back a boom, but it cannot deal with recession.

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