Monetary Policy in a Developing Economy: Prof. Ragnar Nurkse defines underdeveloped countries as “those which compared with the advanced countries are under-equipped with capital in relation to their population and natural resources.”
Underdeveloped countries do posses plenty of natural and manpower resources but they are unutilized or underutilized. Most of the underdeveloped countries suffer from the problems of low level of real per capita income, business fluctuations, price instability, lack of credit facilities, lack of capital formation, balance of payments disequilibrium,
etc. An effective and proper monetary policy will not only provide adequate financial resources for economic development but also help the underdeveloped countries to set up
and accelerate the rate of output, employment and income. It may also help these countries in containing inflationary pressures and achieving balance of payment equilibrium.
The following are the main objectives of monetary policy in a developing economy:
1. Inducement to Saving: Capital formation which is a prerequisite to economic growth depends upon saving. Monetary policy in an underdeveloped country helps in promoting savings, their mobilization, and their investment in productive activities. Monetary authority has to provide adequate banking institutions, which may later on be utilised for investment purposes. In order to induce savings, the monetary authority has to offer various incentives to the savers in the form of high rate of interest, safety of deposits, etc.
2. Investment of Savings: According to Prof. Meier and Prof. Baldwin, “the problem of inadequate savings cannot be solved merely by creating new institutions, but the problem
can be solved only by saving profitable investment of savings.” The objective of economic growth cannot be achieved unless and until the savings are utilised in productive investment activities. The rate of investment is very low in underdeveloped countries on account of the absence of profitable productive activities, lack of
entrepreneurial ability and low marginal efficiency of capital. The central bank in such a situation can resort to cheap money policy to promote investment activities.
3. Appropriate Policy as regard to Rate of Interest: The structure of the rate of interest is generally not conductive to economic growth in underdeveloped countries—the rates
of interest do not only differ according to different time-schedules but these also differ in different regions and business activities. High rate of interest, as they are generally
witnessed in underdeveloped countries, discourage both public and private investment.
The monetary authority, therefore, is required to formulate such a policy as regards the rate of interest which may induce the investors to go in for more loans and advances from
the commercial banks and other financial institutions.
4. Maintenance and Monetary Equilibrium: Monetary policy in an underdeveloped country should be directed towards achieving equality between demand for money and
supply of money. In the initial stages of economic development there is need to expand credit facilities but once a certain level of growth is achieved credit restrictions of various
kinds must be imposed by the central bank. In practice, however, it is very difficult to say as to when the monetary authority should impose credit restrictions to control the
supply of money.
5. To make Balance of Payment Favorable: Most of the underdeveloped countries
have to import capital goods, machinery, equipments, technical know-how, etc. in the initial stage of their development. Consequently, their imports exceed the exports and
balance of payments becomes unfavorable. Monetary policy should be directed towards maintaining stability in exchange rates and removing disequilibrium in the balance of payments.
6. Price Stability: Internal price stability is an important objective of monetary policy in underdeveloped countries. Violent fluctuations in the internal price level not only disrupt
the smooth working of an economy but these also lead to insecurity and social injustice. While inflation creates enormous hardships for the wage-earners and consumers,
deflation proves disastrous for both entrepreneurs and wage-earners. Increasing cost of labor and material also increases the cost of various projects, which adversely affect the
rate of economic growth.
It should be noted that the effects of price instability are always cumulative in character. Therefore, monetary authority in a developing country should pursue such a monetary policy which may help in maintaining price stability over a long period so that the development activities may go uninterrupted. Different monetary measures can be a
adopted for inflationary and deflationary conditions. If inflationary pressures are
mounting in the economy, the monetary authority can resort to stringent monetary action,
so as to restrict the supply of money and credit in the country. For example, measures like high bank rate, selling of government securities, raising the reserve ratio, raising the
margin requirement, etc., can be adopted to contain inflation. Likewise, a different set of measures like lowering the bank rate, purchasing government securities in open market, lowering reserve ratio, reducing the margin requirements, etc. can be adopted to control
Thus, it is clear that the monetary authority in a developing economy can follow the policy of monetary expansion and monetary contraction to stabilize the internal price
level. We can, therefore, conclude that the ultimate objective of monetary policy in the developing countries is to achieve sustained economic growth with stability.
Limitations of Monetary Policy in Developing Countries: Monetary policy can play a very crucial and significant role in the economic development of developing countries.
However, the success of the monetary policy is limited by certain factors, the more important amongst these are as follows:
1. Underdeveloped Monetary and Capital Market: Most of the developing countries do not have a well-developed and fully-organized money and capital market. In the absence of such developed money markets it is not possible to
effectively implement the various credit control policies by the central bank.
2. Lack of Integrated Structure of Rate of Interest: In the developing countries a sizable proportion of the total financial resources come from the unorganized banking sector. In the absence of an integrated and well-organized structure of
rate of interest the central bank fails to influence the market rate of interest through changes in the bank rate. In fact, any increase or decrease in the bank rate must be reflected in the form of increased or decreased market rate of interest, but it does not happen in the developing countries.
3. Banking Habits of the People: In the developing countries most of the exchange transactions are conducted with the help of money. People very seldom use credit instruments to perform exchange transactions. It is for this reason that the credit
control policy of the central bank does not have desired effect on the business activities.
4. Lack of Co-operation by the Commercial Bank: Commercial banks are the institutions which help in the implementation of the monetary policy pursued by
the central bank. In developing countries, however, the commercial banks fail to provide sufficient co-operation to the central bank and in some cases they also flout the directives given by the central bank. Monetary policy cannot succeed
unless and until there is a proper coordination and co-operation between the central bank and commercial banks.
5. Literacy and Social Obstacles: Most of the developing countries suffer from mass illiteracy, superstitions, dogmatism and other social evils. People do not
understand the significance of banking institutions. Neither they keep their deposits with the banks nor do they avail the opportunities of loans and advances from the banks. The success of monetary policy depends upon the widespread
banking institutions, banking habits of the people, adequate development of credit facilities, adequate quantity of bank deposits, entrepreneurial ability etc.