Monetary policy influences economic activity in two ways:
1. Directly through Money Supply:
Money supply is directly related to the level of economic activity. An increase in money supply increases economic activity by enabling people to purchase more goods and services, and vice versa.
2. Indirectly through Rate of Interest:
A change in money supply influences economic activity through its impact on rate of interest and investment. Increase in money supply reduces the rate of interest, which in turn, increases investment, and hence promotes economic activity, and vice versa.
The monetary policy in an economy works through two main economic variables, i.e., money supply and the rate of interest. The efficient working of the monetary policy, however, requires the fulfillment of three basic conditions
(a) The country must have highly organised, economically independent and efficiently functioning money and capital markets which enable the monetary authority to make changes in money supply and the rate of interest as and when needed,
(b) Interest rates can be regulated both by administrative controls and by market forces so that consistency and uniformity exists in interest rates of different sectors of the economy,
(c) There exists a direct link between interest rates, investment and output so that a reduction in the interest rate (for example) leads to an increase in investment and an expansion in output without any restriction.
The developed countries largely satisfy all the necessary prerequisites for the efficient functioning of the monetary policy, whereas the developing or underdeveloped economies normally lack these requirements. The monetary policy has the limited scope in the underdeveloped countries because of the following reasons
(i)There exists a large non-monetised sector in most of the underdeveloped countries which as a great hurdle in the successful working of the monetary policy.
(ii)Small-sized and unorganised money market and limited array of financial assets in underdeveloped countries also hinder the effectiveness of monetary policy.
(iii)In most of the underdeveloped countries, total money supply mainly consists of currency in circulation and bank money forms a very small portion of it. This limits the operation of central bank’s monetary policy which basically works through its impact on bank money.
(iv)The growth of nonbank financial institutions also restricts the effective implementation of monetary policy because these institutions fall outside the direct control of the central bank.
(v)In the underdeveloped countries (e.g., in Libya), many commercial banks possess high level of liquidity (i.e, funds in cash form). In these cases, the changes in monetary policy cannot significantly influence the credit policies of such banks.
(vi)Foreign-based commercial banks can easily neutralise the restrictive effects of tight monetary policy because these banks can replenish their resources by selling foreign assets and can also receive help from international capital market.
(vii)The scope of monetary policy is also limited by the structural and institutional realities of the underdeveloped countries, weak linkage between interest rate, investment and output, particularly due to structural supply rigidities.
When investment is increased as a result of a fall in the rate of interest, increased investment may not expand output due to the structural supply constraints, such as inadequate management, lack of essential intermediate products, bureaucratic rigidities, licensing restrictions, lack of interdependence within the industrial sector.
Thus, higher investment, instead of increasing output, may generate inflationary pressures by raising prices.