Essay on the Role of Monetary Policy in Developing Countries

The monetary policy in a developing economy will have to be quite different from that of a developed economy mainly due to different economic conditions and requirements of the two types of economies.

A developed country may adopt full employment or price stabilisation or exchange stability as a goal of the monetary policy.

But in a developing or underdeveloped country, economic growth is the primary and basic necessity. Thus, in a developing economy the monetary policy should aim at promoting economic growth, the monetary authority of a developing economy can play a vital role by adopting such a monetary policy which creates conditions necessary for rapid economic growth. Monetary policy can serve the following developmen­tal requirements of developing economies.

1. Developmental Role:

In a developing economy, the monetary policy can play a significant role in accelerating economic development by influencing the supply and uses of credit, controlling inflation, and maintaining balance of payment.

Once development gains momentum, effective monetary policy can help in meeting the requirements of expanding trade and population by providing elastic supply of credit.

2. Creation and Expansion of Financial Institutions:

The primary aim of the monetary policy in a developing economy must be to improve its currency and credit system. More banks and financial institutions should be set up, particularly in those areas which lack these facilities.

The extension of commercial banks and setting up of other financial institutions like saving banks, cooperative saving societies, mutual societies, etc. will help in increasing credit facilities, mobilising voluntary savings of the people, and channelising them into productive uses.

It is also the responsibility of the monetary authority to ensure that the funds of the institutions are diverted into priority sectors or industries as per requirements of are development plan of the country.

3. Effective Central Banking:

To meet the developmental needs the central bank of an underdeveloped country must function effectively to control and regulate the volume of credit through various monetary instruments, like bank rate, open market operations, cash-reserve ratio etc.

Greater and more effective credit controls will influence the allocation of resources by diverting savings from speculative and unproductive activities to productive uses.

4. Integration of Organised and Unorganised Money Market:

Most underdeveloped countries are characterized by dual monetary system in which a small but highly organised money market on the the one hand and large but unorganised money market on the other hand operate simultaneously.

The unorganised money market remains outside the control of the central bank. By adopting effective measures, the monetary authority should integrate the unorganised and organised sect ors of the money market.

5. Developing Banking Habits:

The monetary authority of a less developed country should take ap­propriate measures to increase the proportion of bank money in the total money supply of the country. This requires increase in the bank deposits by developing the banking habits of the people and popularising the use of credit instruments (e.g, cheques, drafts, etc.).

6. Monetisation of Economy:

An underdeveloped country is also marked by the existence of large non-monetised sector. In this sector, all transactions are made through barter system and changes in money supply and the rate of interest do not influence the economic activity at all. The monetary authority should take measures to monetise this non-monetised sector and bring it under its control.

7. Integrated Interest Rate Structure:

In an underdeveloped economy, there is absence of an integrated interest rate structure. There is wide disparity of interest rates prevailing in the different sectors of the economy and these rates do not respond to the changes in the bank rate, thus making the monetary policy ineffective.

The monetary authority should take effective steps to integrate the interest rate structure of the economy. Moreover, a suitable interest rate structure should be developed which not only encourages savings and investment in the country but also discourages speculative and unproductive loans.

8. Debt Management:

Debt management is another function of monetary policy in a developing country. Debt management aims at (a) deciding proper timing and issuing of government bonds, (b) stabilising their prices, and (c) minimising the cost of servicing public debt.

The monetary authority should conduct the debt management in such a manner that conditions are created “in which public borrowing can increase from year to year and on a big scale without giving any jolt to the system.

And this must be on cheap rates to keep the burden of the debt low.”However, the success of debt management requires the existence of a well- developed money and capital market along with a variety of short- term and long-term securities.

9. Maintaining Equilibrium in Balance of Payments:

The monetary policy in a developing economy should also solve the problem of adverse balance of payments. Such a problem generally arises in the initial stages of economic development when the import of machinery, raw material, etc., increase considerably, but the export may not increase to the same extent.

The monetary authority should adopt direct foreign exchange controls and other measures to correct the adverse balance of payments.

10. Controlling Inflationary Pressures

Developing economies are highly sensitive to inflationary pres­sures. Large expenditures on developmental schemes increase aggregate demand. But, output of consumer’s goods does not increase in the same proportion. This leads to inflationary rise in prices.

Thus, the monetary policy in a developing economy should serve to control inflationary tendencies by increasing savings by the people, checking expansion of credit by the banking system, and discouraging deficit financing by the government.

11. Long-Term Loans for Industrial Development:

Monetary policy can promote industrial development in the underdeveloped countries by promoting facilities of medium-term and long-term loans to the manufac­turing units. The monetary authority should induce these banks to grant long-term loans to the industrial units by providing rediscounting facilities. Other development financial institutions also provide long-term produc­tive loans.

12. Reforming Rural Credit System:

Rural credit system is defective and rural credit facilities are deficient in the underdeveloped countries. Small cultivators are poor, have no finance of their own, and are largely dependent on loans from village money lenders and traders who generally exploit the helplessness, ignorance and necessity of these poor borrowers. The monetary authority can play an important role in providing both short-term and long term credit to the small arrangements, such as the establishment of cooperative credit societies, agricultural banks etc.