An important question in this literature is why the financial sector is so exposed to certain aggregate shocks. For example, if the economy is recovering from recession and is presently approaching full employ­ment with aggregate demand, output, employment and prices all registering a rise, the transac­tions demand for money will increase. On the basis of his study of monetary history of the United States, he contends that faulty decisions regarding changes in money supply, made by the monetary authorities, are responsible for a lot of instability that prevailed during the period of his study. Fiscal policy and monetary policy are importantly different in that they affect interest rates in opposite ways. Stable economic growth. This creates a demand-pull inflation causing rise in prices. The Central Bank may lower the bank rate or what is also called discount rate, which is the rate of interest charged... 3. Thus, when Reserve Bank of India lowers statutory liquidity Ratio (SLR), the, credit availability for the private sector will increase. Regulations, therefore, are important to maintaining a status quo across all states wherein each citizen is guaranteed their rights to life, liberty, and the pursuit of happiness. Monetary and Fiscal Stability Taken together, fiscal and monetary policies create an investment environment. In the long run, monetary policy only has an influence on monetary variables; this means that steering the increase of price levels (i.e. The government needs adequate revenue to fulfill responsibilities.The state cannot fulfill its duties in case of a shortage of money but excessive taxes cannot be imposed for increasing revenue. Given that the velocity of money (V) is unstable or variable, increase in money supply (M), according to this rule, may not ensure growth of aggregate demand (which, according to monetarist theory, is equal to MV) equal to the rate of growth of output in a year which is difficult to predict. Thus this will reduce the availability of credit and also raise its cost. The monetary policy manages the supply of money in the country through the Central Bank. To quote Ritter and Silber, “such a rule would eliminate the major cause of instability in the economy—the capricious and unpredictable impact of counter cyclical monetary policy. Expansionary monetary policy which produces the effect after 6 to 8 months may, therefore, actually intensify the inflationary situation. There is, however, a limit to the amount monetary policy can affect the economy because it hinges upon interest rates and monetary circulation. The expansion in credit or money supply will increase the investment demand which will tend to raise aggregate output and income. However, surprisingly, enough, the most monetarists do not advocate the use of discretion­ary monetary policy, namely, an expansionary or easy money policy, to lift the economy out of recession and tight monetary policy to check inflationary boom and thereby correct the ‘downs’ and ‘ups’ of the business cycles. However, as shall be discussed below, it is the monetarists led by Friedman who do not favour discretionary monetary policy to check cyclical instability. This will have a direct effect on the contraction of money supply in the economy and help in controlling demand-pull inflation. Monetary policy is used to influence the employment situation and to manage inflation. In April 1996, when Reserve Bank lowered the CRR from 14 per cent to 13 per cent, it was estimated that this would release funds equal to Rs. Similarly, if the supply of money does not rise at a more than average rate, any inflationary increase in spending will burn itself out for lack of fuel.”. Further, the effect of increase in investment on output and employment depends on the size of multiplier. Such adjustments can be made quickly, and monetary authorities devote considerable resources to monitoring and analyzing the economy. 29.4 shows that with the rate of interest remaining unchanged at r0, the level of investment does not rise. 2. Monetary policy has great importance. This influence exerted by the policy helps in curbing inflation, increasing employment and most importantly it helps in maintaining a healthy value of the currency. Monetary policy is important in decisions the United States government makes about economic practices and regulations, but equally important are the fiscal policies, which government spending and tax reform are geared toward in stimulating the economy. Professor of Business, Economics, and Public Policy, Fighting Inflation Versus Fighting Unemployment. However, we do not have the tools to manage any desired equity implications of our actions. 4. In countries like India, this is a more effective and direct way of expanding credit and increasing money supply in the economy by the central bank. 29.2 is fairly elastic so that rise in rate of interest from r1 to r2 is sufficient to reduce investment by I2 – I1 or ∆I. With level of investment remaining the same, there is no increase in aggregate demand and the economy remains in a state of depression. According to Keynesian theory, expansion in money supply causes the rate of interest to fall. Besides Cash Reserve Ratio (CRR), the Statutory Li­quidity Ratio (SLR) can also be increased through which excess reserves of the banks are mopped up resulting in contraction in credit. Panel (b) of Fig. 2. The Federal Reserve annually dictates interest rates, liquidity, and currency circulation, which in turn also stimulate the market. Monetary policy is also concerned with maintaining a sustainable rate of economic growth and keeping unemployment low. From his empirical studies Friedman concludes that it takes six months to two years for the changes in money supply to produce a significant effect on nominal income. It will be seen from panel (b) that with this fall in rate of interest, investment increases from I1 to I2. 29.2. A strong currency is considered to be one that is valuable, and this manifests itself when comparing its value to another currency. New Normative Macroeconomic Research Empirical research on monetary-policy rules has recently begun to focus on this important exchange-rate question. What Is Deflation and How Can It Be Prevented? 29.2 shows that at a higher interest rate r2, private investment falls from I2 to This reduction in investment expenditure shifts aggregate demand curve C + I2 + G2 downward to C + I1+ G2 and in this way inflationary gap is closed and equilibrium at full-employment output level YF is once again established. 1. The reverse of this is a contractionary monetary policy. We shall explain how these various tools can be used for formulating a proper monetary policy to influence levels of aggregate output, employment and prices in the economy. Report a Violation, Monetary Policy: Meaning, Objectives and Instruments of Monetary Policy, Monetary Policy of India: Main Elements and Objectives, Public Expenditure: Meaning, Importance, Classification and Other Details. More private investment will cause aggregate demand curve to shift upward. Thus, according to Keynesian economists, policy of monetary rule does not guarantee economic stability and it may itself create economic instability. Monetary policy can be expansionary and contractionary in nature. Monetarists argue that since it is extremely difficult to know the time lag involved in a specific monetary policy measure adopted to tackle the problem, it is impossible to determine when a particular policy measure should be taken and which policy measure, expansionary or tight, is suitable under the given situation. 29.1. This makes the demand for money absolutely elastic at a low rate of interest as is shown in Fig. Thus, in the context of developing countries the following three are the important goals or objectives of monetary policy: (1) To ensure economic stability at full-employment or potential level of output; (2) To achieve price stability by controlling inflation and deflation; and. It does this to influence production, prices, demand, and employment. In times of recession or depression, expansionary monetary policy or what is also called easy money policy is adopted which raises aggregate demand and thus stimulates the economy. The primary objective of monetary policy is Price stability. This increase in transactions demand for money will cause the rate of interest to rise. Monetary policy is often in the hands of bankers, and refers to interest rates, access to credit and inflation rates. In line with the above goals of monetary policy it has often been asserted by Governors of Reserve Bank of India that growth with price stability is the goal of monetary policy of the Reserve Bank of India. Economic Stagflation in a Historical Context, Ph.D., Business Administration, Richard Ivey School of Business, B.A., Economics and Political Science, University of Western Ontario.
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