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SPECIAL ARTICLES tole of Monetary Policy C Rangarajan What should be the objectives of monetary policy? Does the objective of
arm of economic policy. As is well known in economic policy, there should be as many instruments as there are objectives if a
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SPECIAL ARTICLES tole of Monetary Policy C Rangarajan What should be the objectives of monetary policy? Does the objective of price stability conflict with the goal of achieving faster economic growth? Can monetary policy by itself ensure price stability? What should be the interrmediate target of monetary policy? What are the respective roles of direct and indirect instruments of monetary control? This paper addresses these issues against the backdrop of theoretical developments as well as empirical evidence on the impact of mone tary policy in India and elsewhere in the world importantto recognise is that all the objectives cannot be effectively pursued by any single am of economic policy. As is well known in economic policy, there should be as many instruments as there are objectives if all objectives are to be fulfilled. Faced with multiple objectives that are equally relevant and desirable, there is always the problem of assigning to each instrument the most appropriate target or objective. Itisclear from both the theoretical literature and empirical findings that among various policy objectives, monetary policy is best suited to achieving the goal of price stability in the economy. It has also been recognised that, in the long run, the objective of price stability and growth do not necessarily conflict with each other. Rather in today's altered economic context, a low and stable price environment is being increasingly regarded as an essential condition for improving the growth and productive potential of the economy. As a noted monetary economist had once observed Friedman 1968) The first and the foremost lesson that history teaches about what monetary policy can do -and it is a lesson of most profound importance is that monetary policy can prevent money itself from being a major source of economic disturbance provide a stable background for the economy and lag between the time a monetary change is contribute to offsetting major disturbances initiated and the time its ultimate impact on in the economic system arising from other prices and output is felt. The length of this IN the context of the economic reforms that INLATION AND MONEY SumY are under way, the role and content of mone tary policy have evoked greater attention. In fact this increased attention is not unique to India. World over there has been a renewed interest in the conduct of monetary policy, with more and more countries committing themselves to maintain a low and stable rate Ina monetary economy, where cach single transaction is valued in terms of the unit of national currency, it is nothing but a truism to say that money supply has a role in determining the price level in the economy Analytically viewed, in the short run, with output fixed, the price level is essentially determined by the excess demand condition in the economy, which depends on the level of demand for and supply of real money balances. It is thus natural that once the real money balance is increased above what is demanded by people the pressure would be felt on the demand for goods and services or assets, leading to an increase in their prices. Although thisexposition of the money and price relationship is familiar to all of us, there is no denying the fact that changes in the price level can be caused by several other internal and external shocks, which influence the cost structure of firms. However, a continuous pressure on prices, which is what inflation is all about, cannot be sustained, if there is no accommodating increase in money supply.It is in this sense that inflation is a monetary phenomenon. There are. however, three important qualifications to this statement. First, there could be a variable of inflation in their economies. Monetary economics is not a settled science. There are continuing debates on several issues connected with monetary policy. Some of these questions are: what are or should be the objectives of monetary policy? Does the objective of price stability conflict with the goal of achieving faster rate of economic growth? Can monetary policy by itself ensure price stability? What should bethe intermediate target of monetary policy? How should monetary policy be imple- mented? What are the respective roles of direct and indirect instruments of monetary control? This paper addresses these ques- tions against the backdrop of the theoretical developments as well ás empirical evidence on the impact of monetary policy in India and elsewhere in the world. GOALS OF MONETARY PoLICY The first set of questions that needs to be addressed is: what are the objectives of economic policy and should the goals of monetary policy be the same as these objectives ?Shouldall the goals of economic policy be the goals of monetary policy? The issue of objective has become important because of the need to provide clear guidance tomonetary policy-makers. Indeed this aspect hasassumedadded sienificanceinthe.context lag is determined by the inherent dynamics sources Commitment to price stability does not in the real sector and the speed with which mean a blind faith in maintaining a certain level of inflation, without concerm for the need to maintain and accelerate growth. Far from.it In nn.contry in the wnrld has this economic agents adjust to a change in monetary situation. Therefore, a monetary shock may take several months to express itself on nrices and ontrut
arm of economic policy. As is well known in economic policy, there should be as many instruments as there are objectives if all objectives are to be fulfilled. Faced with multiple objectives that are equally relevant and desirable, there is always the problem of assigning to each instrument the most appropriate target or objective. Itisclear from both the theoretical literature and empirical findings that among various In a monetary economy, where each single transaction is valued in terms of the unit of national currency, it is nothing but a truism to say that money supply has a role in determining the price level in the economy Analytically viewed, in the short run, with output fixed, the price level is essentially determined by the excess demand condition in the economy, which depends on the level of demand for and supply of real money balances. It is thus natural that once the real money balance is increased above what is demanded by people the pressure would be felt on the demand for goods and services or assets, leading to an increase in their prices. Although this exposition of the money and price relationship is familiar to all of us, there is no denying the fact that changes in ary policy have evoked greater attention. In fact this increased attention is not unique to India. World over there has been a renewed interest in the conduct of monetary policy, with more and more countries committing themselves to maintain a low and stable rate of inflation in their economies. Monetary economics is not a settled science. There are continuing debates on several issues connected with monetary policy. Some of these questions are: what are or should be the objectives of monetary policy? Does the objective of price stability conflict with the goal of achieving faster rate of economic growth? Can monetary policy by itself ensure price stability? What should be the intermediate target of monetary policy? rHow should monetary policy be imple mented? What are the respective roles of direct and indirect instruments of monetary control? This paper addresses these ques tions against the backdrop of the theoretical developments as well ás empirical evidence on the impact of monetary policy in India and elsewhere in the world. policy objectives, monetary policy is best suited to achieving the goal of price stability in the economy. It has also been recognised that, in the long run, the objective of price stability and growth do not necessarily conflict with each other. Rather in today's altered economic context, a low and stable price environment is being increasingly regarded as an essential condition for the price level can be caused by several other improving the growth and productive internal andexternal shocks, which influence potential of the economy. As a noted the cost structure of firms. However, a monetary economist had once observed continuous pressure on prices, whichis what Friedman 1968) inflation is all about, cannot be sustained if there is no accommodating increase in money supply. It is in this sense that inflation is a monetary phenomenon. There are The first and the foremost lesson that history teaches about what monetary policy can do - and it is a lesson of most profound importance is that monetary policy can however, three important qualifications to GOALS OF MONETARY PoLICY prevent money itself from being a major The first set of questions that needs to be addressed is: what are the objectives of economic policy and should the goals of monetary policy be the same as these objectives 7 Shouldallthe goals of economic policy be the goals of monetary policy? The issue of objective has become important because of the needto provide clear guidance tomonetary policy-makers. Indeed this aspect has assumed added significance inthe context ofthe increasing stress on autonomy of central banks. While autonomy has to go with accountability, accountability itself requires a clear enunciation of goals. Since the inception of development planning, the broad objectives of India's economic policy have been to achieve a faster rate of economic growth, ensure a reasonable degree of price stability in the economy and promote distributive justice. The working of monetary policy in India over the past several decades would reveal that monetary policy has also emphasised these broad objectives of our economic policy. What is. however. source of economic disturbance. provide a this statement. First, there could be a variable lag between the time a monetary change is initiated and the time its ultimate impact on prices and output is felt. The length of this lag is determined by the inherent dynamics stable background for the economy and contribute to offsetting major disturbances in the economic system arising from other sources Commitment to price stability does not in the real sector and the speed with which mean a blind faith in maintaining a certain economic agents adjust to a change in level of inflation, without concern for the monetary situation. Therefore, a monetary need to maintain and accelerate growth. Far shock may take several months to express from it. In no country in the world has this been so. What this commitment implies is Second, it is also essential to differentiate that monetary policy can help the growth between a relative price change and its process vastly by regulating money supply immediate impact on overall price situation towards the direction of maintaining price on the one hand, and the persistent increase stability in the economy and helping the in prices on the other. The former effect can economy to recover from independent be caused by a sudden shock to the cost shocks. Opinions, however, differ when structure of a firm, which may raise the price growth and price stability are seen as two competing objectives of monetary policy. At some reallocation of resources and at the a more fundamental level it is even asked same time raising the overall price level in whether inflation is a monetary phenomenon the economy to some extent. However, given and what would happen if money supply is the size of nominal demand, which is largely increased to boost credit and growth in the economy. itself on prices and output. of its product relative to others, causing determined by the growth of real income and the money supply. a relative price shock Economic and Political Weekly December 27, 1997 3325

Most growth theories are non-monetary in nature. They assume growth to depend on such real factors as capital accumulation. population, technology and innovation. Clearly in this context, money has no role in either initiating or sustaining the growth process. Despite the money neutrality assum- ption in growth theories. economic research and public policy have hardly supported this proposition as true. In fact as Blanchard (1996) observes in the opening remark in his survey paper on money and output, Much of research on economic fluctuations has focused on the effects of nominal money on output. This is not because moncy is the major source of movements in output; it is not. Rather it is because economic theory does not lead us to expect such effects Indeed it holds that with lexible prices money should be approximately neutral, with changes in nominal money being reflected in nominal prices rather than in output The perception regarding the money ncutrality preposition, however, underwent a significant change with the Keynesian the hidden costs of inflation, whileevaluating revolution, which emphasised that nominal wages are relatively more rigid than prices. price stability and output. If all efficiency so that an increase in money supply will costs and welfare costs of inflation were to decrease real wages and bring down be quantified and given due weight, the unemployment. This idea was later given an trade-off would become even more un- empirical justification by A W Phillips through his celebrated Philips curve relationshipbetweenthe wagerate or inflation rate and the unemployment rate. The well known Phillips curve which became the centre of discussion of such a trade-off in the 1950s and 1960s has been theoretically and empirically invalidated in many countries since the onset of a prolonged period of stagflation in the 1970s. Its demise was partly because of the weak theoretical foundation on which it was based, as it ignored the role of expectations in the economic system, and partly because the relationship did not empirically hold good in many countries, including UK and the US in the 1970s and 1980s. This is, however not to say that there is no relation between inflation and growth. The trade-off is seen to exist at best in the short run. Given the slow pace of adjustment between people's expectation about centain events and their The reason central banks persistently focus on inflation, monetary aggregate targets or no, is not that they view inflation as the only significant economic issue facing modern industrial states. Far from it. More reasonably, they take the considered view that what they are unavoidably responsible for-managing primary liquidity and in that crucial sense in creating money- will in the end also be the crucial factor in what happens to inflation, and that good inflation per- formance is a plus for the economy as a whole Third, the effectiveness of monetary policy in causing an impact on the price level also depends on inflation expectations. For example. while the expansionary effect of predominantly negative long-term relation- ship between growth and inflation". The estimates presented by Fischer (1994) show that a 10 percentage point increase in inflation rate results in 0.4 per cent decline in output growth per annum and 0.18 per cent decline in productivity growth. A recent study by Barro (1995) reponed that over a long time period of 30 years, a 10percentage point permanent increase in inflation rate is estimated to bring down the level of real GDP by 4 to 7 per cent. There is, however, some inconclusiveness about the empirical evidence on the short-run relationship between price stability and growth. Not withstanding this, the experience of some of n h n the fastest growing developing countries such as Malaysia, Singapore and Thailand showed fiscal policy will not persist for long without ) an accommodating increase in money supply that their consistent achievement on the growth front in the range of 8 to 9 per cent could come about with an inflation rate of 3to5 per cent. Empirical studies on inflation and growth normally do not take into account the interest rate effect may, however, get sustained, giving rise to inflation expectations, and thereby adversely affecting r t the effectiveness of monetary policy to fight a inflation Giventhe above theoretical backdrop what are the empirical relationships between the short-run or long-run trade-off between inflation and money supply growth in the 1 Indian economy? Many studies have shown that the relationship between prices on the one hand and income and money supply on the other is found to hold reasonably well over a period of time. Averages of price favourable for growth. International evi dences alsosuggest that inflation rate beyond a threshold has significant adverse impli cations for growth. But, what the appropriate inflation threshold beyond which costs tend to exceed benefits is needs to be estimated for each countrry separately. Nevertheless, people worry about even moderate inflation ievels because if not held in check, a little inflation can lead to higher inflation and eventually affect growth. Itisimportant tonote that while an increase in money supply beyond what is consistent withthe growth in real income,could improve the credit availability, reduce the interest cost and promote investment and growth in the short run, the impact cannot be sustained for a long period. The ultimate effect will be a rise in inflation rate. A recent macro- econometric model for the Indian economy for the period 1970-71 and 1993-94 Rangarajan and Mohanty 1997. simulated f changes over a period of four to five years are predicted with reasonable accuracy by these equations and these predictions fall within a range which should be sufficient guide to policy. Seeking to find a direct year f to-year correspondence between changes in money supply and real income and the price level is a simplistic approach to the problem t which overlooks the inherent lags in the functioning of an economy. Apart from my earlier studies in this regard which I had reported in my presidential address to the Indian Economic Association in 1988 (Rangarajan 1989] and the Lakdawala Memorial Lecture in 1994 Rangarajan 1994 the price equation estimatedusing the data forthe period 1972-73 to 1993-94 shows that prices move in tandem with money supply in the long run. 3326 Economic and Political Weekly December 27. 1997
shows that an increase in investment spending financed by money creation has a positive effect on output. But this effect is significant only in the short run. In the long run prices rise at a faster rate. A 10 per cent sustained increase in public investment in the non- agricultural sectoroverthe reference simula- tion financed by an increase in net RBl credit to Government increases the money supply by 5.3 per cent, real capital stock in non agricultural sector by I per cent, price level by 13 per cent and real income by 0.7 per cent, on an average.duringthe first two years of the shock. In a span of 18 years, the average rate of increase in price level accele rates to 18.1 per cent, while output growth averages around 2.7 per cent showing the severe inflationary outcome of this policy option. Morcover, there is al extemal implication of this financing policy. conscious of the hidden costs of inflation Interest rate responds to several factors and the nominal interest rate comprises of threeimportant elements (i) real interest rate, ()inflationexpectations, and (i)adiscount factor for uncertainties. In this sense real and their adverse implications for growth. Perhaps the single most important contribution that monetary policy can make under these conditions is to maintain a low and stable rate of inflation that would provide thenocessary condition for promoting compe- tition, efficiency and growthin the economy. The case for price stability as the dominan objective of monetary policy therefore rests on the assumption that volatility in prices creates uncertainty in decision-making. Rising prices affect adversely savings while they make speculative investments more attractive. The most important contribution of the financial system to an economy is its ability to augment savings and allocate resources more efficiently.A regimeof rising prices vitiates the atmosphere for promotion of savings and allocation of investment. Apant as it leads to a deterioration in the current from all of these, there is also a social toarisein inflation and inflation expectations. dimension. Inflation affects adversely those who have no hedges against inflation and that includes all the poorer sections of the scenario implies is that a high and dispropor community. Of course, a critical question in point to note is that the only enduring way this context is at what level of inflation the adverse consequences begin to set in. In a resource constrained economy like ours, monetary policy would also have to play an active role in ensuring adequate flow of credit to the essential sectors of the interest rate is not an observed variable. Real interest rate is influenced by several long- term factors such as saving and investment balance inthe economy and the rate of return on capital. On an economywide basis this should be equal to real rate of growth. The effectiveness of monetary policy to bring down the nominal interest rate will depend on the impact that this policy will have on inflation expectations and on the perception of uncertainty in the economy. As the experience of many countries has shown, an excessive expansion in money supply to bring down interest rate can lead to the hardening of the nominal interest rate due an adverse This is not to say that interest rate cannot and should not be influenced by monetary policy. It can and will be. But the essential accou
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Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.

The Fed can use four tools to achieve its monetary policy goals: the discount rate, reserve requirements, open market operations, and interest on reserves. All four affect the amount of funds in the banking system.

• The discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans. Federal Reserve lending at the discount rate complements open market operations in achieving the target federal funds rate and serves as a backup source of liquidity for commercial banks. Lowering the discount rate is expansionary because the discount rate influences other interest rates. Lower rates encourage lending and spending by consumers and businesses. Likewise, raising the discount rate is contractionary because the discount rate influences other interest rates. Higher rates discourage lending and spending by consumers and businesses. Discount rate changes are made by Reserve Banks and the Board of Governors.

• Reserve requirements are the portions of deposits that banks must hold in cash, either in their vaults or on deposit at a Reserve Bank. A decrease in reserve requirements is expansionary because it increases the funds available in the banking system to lend to consumers and businesses. An increase in reserve requirements is contractionary because it reduces the funds available in the banking system to lend to consumers and businesses. The Board of Governors has sole authority over changes to reserve requirements. The Fed rarely changes reserve requirements.

• Open market operations, the buying and selling of U.S. government securities, has been a reliable tool. As we learned earlier, this tool is directed by the FOMC and carried out by the Federal Reserve Bank of New York.

• Interest on Reserves is the newest and most frequently used tool given to the Fed by Congress after the Financial Crisis of 2007-2009. Interest on reserves is paid on excess reserves held at Reserve Banks. Remember that the Fed requires banks to hold a percentage of their deposits on reserve. In addition to these reserves banks often hold extra funds on reserve. The current policy of paying interest on reserves allows the Fed to use interest as a monetary policy tool to influence bank lending. For example, if the FOMC wanted to create a greater incentive for banks to lend their excess reserves, it could lower the interest rate it pays on excess reserves. Banks are more likely to lend money rather than hold it in reserve (so they can make more money) creating expansionary policy. In turn, if the FOMC wanted to create an incentive for banks to hold more excess reserves and decrease lending, the FOMC could increase the interest rate paid on reserves, which is contractionary policy.

As the objective of monetary policy varies from country to country and from time to time, a brief description of the same has been as following:

(i) Neutrality of money

(ii) Stability of exchange rates

(iii) Price stability

(iv) Full Employment

(v) Economic Growth

(vi) Equilibrium in the Balance of Payments.

1. Neutrality of Money:

Economists like Wicksteed, Hayek and Robertson are the chief exponents of neutral money. They hold the view that monetary authority should aim at neutrality of money in the economy. Any monetary change is the root cause of all economic fluctuations. According to neutralists, the monetary change causes distortion and disturbances in the proper operation of the economic system of the country.

2. Exchange Stability:

Exchange stability was the traditional objective of monetary authority. This was the main objective under Gold Standard among different countries. When there was disequilibrium in the balance of payments of the country, it was automatically corrected by movements. It was popularly known, “Expand Currency and Credit when gold is coming in; contract currency and credit when gold is going out.” This system will correct the disequilibrium in the balance of payments and exchange stability will be maintained

3. Price Stability:

The objective of price stability has been highlighted during the twenties and thirties of the present century. In fact, economists like Crustar Cassels and Keynes suggested price stabilization as a main objective of monetary policy. Price stability is considered the most genuine objective of monetary policy. Stable prices repose public confidence because cyclical fluctuations are totally eliminated.

4. Full Employment:

During world depression, the problem of unemployment had increased rapidly. It was regarded as socially dangerous, economically wasteful and morally deplorable. Thus, full employment assumed as the main goal of monetary policy. In recent times, it is argued that the achievement of full employment automatically includes prices and exchange stability.

5. Economic Growth:

In recent years, economic growth is the basic issue to be discussed among economists and statesmen throughout the world. Prof. Meier defined “Economic growth as the process whereby the real per capita income of a country increases over a long period of time.” It implies an increase in the total physical or real output, production of goods for the satisfaction of human wants.

In other words, it means utilization of all the productive natural, human and capital resources in such a manner as to ensure a sustained increase in national and per capita income over time.

6. Equilibrium in the Balance of Payments:

Equilibrium in the balance of payments is another objective of monetary policy which emerged significant in the post war years. This is simply due to the problem of international liquidity on account of the growth of world trade at a more faster speed than the world liquidity.

It was felt that increasing of deficit in the balance of payments reduces, the ability of an economy to achieve other objectives. As a result, many less developed countries have to curtail their imports which adversely effects development activities. Therefore, monetary authority makes efforts that equilibrium should be maintained in the balance of payments.

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