MONEY AND BANKING PART 07
TYPES OF MONETARY POLICY Monetary policy are of 2 different types. 1. EXPANSIONARY MONETARY POLICY 2. CONTRACTIONARY MONETARY POLICY
EXPANSIONARY MONETARY POLICY The expansionary monetary policy is adopted when the economy is in a recession, and the unemployment is the problem. The aim is to increase the aggregate demand by cutting the interest rates and increasing the supply of money in the economy. The money supply can be increased by buying the government bonds, lowering the interest rates and the reserve ratio. The consumer spending increases, the private sector borrowings increases, unemployment reduces and the overall economy grows. It is also called as "easy monetary policy"
RISKS OF EXPANSIONARY MONETARY POLICY Although the expansionary monetary policy is useful during the slow period in a business cycle, it comes with several risks. Such as the economist must know when the money supply should be expanded so as to avoid its side effects like inflation. There is often a time lag between the time the policy is made and the time it is implemented across the economy, so up-to-the-minute analysis of the policy is quite difficult or impossible. Also, the central bank and legislators must know when to stop the supply of money in the economy and apply a Contractionary Policy.
CONTRACTIONARY MONETARY POLICY The Contractionary Monetary policy is applied when the inflation is a problem and economy needs to be slow down by curtailing the supply of money. The inflation is characterized by increased money supply and increased consumer spending. The aim is to decrease the money supply and the spendings in the economy. This is done by increasing the interest rates so that the borrowing becomes expensive.
OBSTACLES The central bank of a country faces certain obstacles in the implementation of the monetary policy Such as: 1. EXISTENCE OF A NON MONETIZED SECTOR In many developing countries like India, there exists a non monetized sector. These are rural and backward areas which does not have any proper banking facility 2. CORRUPTION : There exists a high degree of corruption and red tapism in the administration and government department for the monetary policy to function effectively
3. LACK OF KNOWLEDGE: In many rural areas, the people dont have the adequate knowledge of this monetary policy. Many citizens do not deposit cash in commercial bank. Fue to this, the central bank finds it difficult to employ traditional tools of monetary policy. Hence, the monetary policy instruments do not work in their favour. 4. NO DIRECT LINKAGE : There is no direct link between lower interest rate and higher investment. The investment decisions are not based on the interest rate rather on the business expectations which makes it difficult to employ monetary policy.
5. EXCESS OF NBFIs : There are many Non Banking Financial Institutions providing credit facilities. However, they do not come under the purview of the monetary policy and thus, become nullify its effect. 6. LACK OF MARKETS : The lack of developed money market and capital market are a hurdle to the success of the monetary policy. With such disorganization of the markets, the implementation of certain instruments become difficult.
7. INAPPROPRIATE USE OF INSTRUMENT: At times, a problem arises in the economy and the central bank does not know which is the best instrument to be applied. This often leads to wrong implementation and disturbance in the economy 8. VOLATILITY OF EXCHANGE RATE: The floating exchange rate system implies openness and globalizatiorn which affects their exchange rate on a day to day basis. This type of volatility means that the central bank has to come up with an effective instrument quickly
9. MONEY DOES NOT APPEAR IN THE ECONOMY: The rich traders and businessmen prefer to spend their money and purchase gold, silver etc. They do not wish to deposit their money in a commerical bank. Thus, a large amount of money does not appear in the circulation of credit. 10. TIME LAG : A monetary policy is effective if it is implemented on a timely basis. But the time involved in doing so is a lot, which often leads to a delay in it.