Monetary and Credit System

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Chapter 12

Monetary and Credit System

Dr. Gopalakrishna B.V.Faculty in MBA,

SDM, Mangalore.


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The economy does not always work smoothly, they oftenoccur fluctuations in the level of economic activity.

At the time of recession level of national income,output and employment are below their full potentiallevels.

While on the other hand in times of boom/peak higher level of income, employment and output .

Thus, in a free market economy there is a lot ofeconomic instability.

During the 1930s world depression and post of secondworld war Keynes become popular with the public ofGeneral Theory in 1936.

Keynes argued economic instability depression andinflation can be eliminated with help of macro-economicpolicy such as monetary policy and fiscal policy.


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Monetary Policy

Central bank of a country which formulates andimplements the monetary policy in a country.

Monetary policy is concerned with changing the supply ofmoney stock and rate of interest which stabilizing in theeconomy.

At times of recession monetary policy increase the

money supply and lower interest rates to stimulateaggregate demand in the country cheap monetarypolicy.

At times of inflation/boom monetary policy reducedmoney supply and increases interest rate adoptingtight monetary policy.

The country like India, achieving equilibrium of fullemployment to encourage economic growth such asagriculture, industry and service sectors.


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Objectives of monetary policy

Objectives of monetary policy will be changing fromtime to time and from country to country depending

upon the needs and requirements of the nation. Classical economic thinkers keen interested to

ensure exchange rate satiability as a objective ofmonetary policy.

During period of World Great Depression in 1930s full employment is the main objectives of monetarypolicy which is shifted from unemployment to fullemployment.

Post world war period economic growth & rapidstrides is considered to be the main objective ofmonetary policy.


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The major objectives of the monetary

policy can be set in the following ways

1. Stability of foreign exchange rate

2. Price stability3. Economic stability

4. Full employment

5. Economic growth with stability


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1. Stability of Foreign exchange rate

Stability of foreign exchange rate is considered to be oneof the oldest and traditional objectives of monetarypolicy.

The government of every country is faced with theproblem of fluctuating foreign exchange rates.

It is a question of choosing between a stable domesticprice level and a stable foreign exchange rate.

For countries depending mainly on foreign trade, theimportance of a stable exchange rate need not be

stressed. For example UK, Japan etc. Changes in the rate of exchange will lead to a number of

difficulties they give rise to speculative activities inforeign exchange market.


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2. Price stability During, Great Depression of 1930s many economists

and administrators realize the importance of pricestability were the main objective of monetary policy.

The countries of the world were worst hit during thegreat depression of 1930s with price falling to the rock

bottom level. Similarly the countries had equally experienced the

unpleasant adverse effects due to soaring prices at thetime of world war.

A rising price level creates problems and hardships tothe small savers and fixed income groups.

Fluctuation of increasing and decreasing prices are alsoimpact on level of income and employment.


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3. Economic stability

As we studied the causes and consequences of

business cycle, many economic thinkers stronglybelieves that economic stability is the mainobjectives of monetary policy.

They advocate strict control over supply of

money (including banking credits) in order toavoid economic instability during boom banking sector should contract credit andregulate the supply of money.

During depression expand credit to stimulateeconomic activity.

Thus fighting against economic fluctuation wasconsidered to be the goal of monetary policy.


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4. Full employment With the publication of Keynesian General Theory, full

employment has been advocated as the important goalof monetary policy.

Keynes himself has said the objective of the monetarypolicy should be to reduce the trade cycle and bringabout equilibrium between saving and investment.

Keynes also pointed out the monetary policy should beaimed at solving the unemployment problem byexpanding consumption and investment expenditure.

Monetary policy in the short period follow up the cheap

and dear monetary policy during the period of depressionand boom.

He also stress that during full employment level all theavailable resources efficiently and effectively utilised.


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5. Economic growth with Stability

Economic growth with stability was the main objectivesof monetary policy (modern welfare economists).

To achieving full employment level is not enough but thestandard of living of the people should be go up toaccelerate pace of economy.

Economic growth implies - increases in the volume of

goods and services produced in the economy. It signifies the sustained increase in the per capita real

income of the people.

For this two things are essential 1. Productive capacity should increase.

2. increase in demand for goods and services.

Growth with Stability has become the new objectiveof developing economy therefore regulating moneysupply in one hand and encourage productive activities

and regulate speculative activities on the other hand.


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Tools of monetary policy


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Inflation The term Inflation in an economy denotes a situation

where the general prices of goods and services continuously increases.

Inflation is a persistent rise in the general price levelrather than a once for all rise in it.

On the other hand, deflation represents persistently

falling prices. These days all the economies of the world, under

developed as well as developed, suffer from inflation.

Some countries rate of inflation has been touches 20

30 percent per annum during the last few years. During 70s & 80s higher rate of inflation associated with

high rate of unemployment which is know asStagflation/ Slumpflation.


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Degrees of Inflation

Three important types of inflation can be

distinguished

1. Creeping inflation

2. Walking inflation

3. Running inflation4. Galloping inflation/hyper inflation


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Cause of inflation

1. Currency inflation2. Budgetary inflation

3. Cost-push inflation

4. Demand pull inflation

5. Profit-push inflation

6. Excess demand inflation

7. Speculative inflation

8. Imported inflation

9. Over-investment inflation


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1. Cost push inflation According to this theory, inflation may be the

result of rising cost of production rather than

production. Normally, cost push is associated with wage

push inflation one of the major cause for costpush inflation. Due to high pressures puts by

trade unions claiming for excessive increase inwages. Recently, due to enormous increase in the

prices of petroleum fuel, the cost of productionhas increased manifold.

Increases in the profit margin by the firm undermonopolistic and oligopolistic market conditions.

Increases the prices of material goods alsocauses for cost push inflation.


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Aggregate Output

PriceL

evel

P2

P1

Y2 Y1

AD

AD

AS2

AS2

AS1

AS1

Cost Push Inflation


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2. Demand Pull Inflation Increases in a aggregate demand for goods and

services either from the government orentrepreneurs or households.

Demand pull inflation caused by a situationwhereby the pressure of aggregate demand forgoods and services exceeds the available

supply of output. In such a situation, rise in price level is the

natural consequences. Aggregate demand generated by

1. Consumers spending on consumer goods andservices

2. Government expenditure on consumer goods andservices

3. Entrepreneurs on net investment


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Government uses cheap monetary policy anddeficit financing.

JM Keynes in his booklet How to pay for theWar, published during second world war explained inflation in terms of excess of demandfor goods relative to the aggregate supply ofoutput.

His notion of the inflationary gap representedexcess of aggregate demand over fullemployment level.

This results prices rises rather than output.

Since beyond full employment level of aggregatesupply of output cannot increase in response toincrease in demand this result in rise in pricesunder pressure of excess demand.


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AS

AD1

AD2

AD3

AD4

O X

Y

Y1 Y2 YF

P1

P2

P3

P4

Aggregate Demand and Supply

Price

L e

vel


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3. Structural Inflation

Inflation rate in developing countries is different fromdeveloped countries.

Of course investment expenditure and increase moneysupply causes inflation it is all about proximate notultimate factors responsible for inflation.

The well known economist, Myrdal and Streeten have

proposed inflation in the developing countries in terms ofstructural features of their economies.

The Latin America and SAARC countries such as India due to existence of market imperfections and structuralrigidities (imbalances).

The supply of output cannot be equated with AD due tounder-utilisation of resources.

They mention various sectoral constraints or bottleneckswhich generate the sectoral imbalances and lead to rise

in prices


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1. Agricultural bottlenecks agricultural

products inelastic.

1. Disparities is land ownership.

2. Defective land tenure system

3. Excessive population growth.

2. Resources constrains/budget constraint

3. Foreign exchange bottleneck.

4. Physical infrastructural bottleneck


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Control of Credit

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Monetary and Credit System

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