Relevancy of Monetary Policy in a Developing Nation

Bidur Timalsina

Kathmandu, 11 October. Monetary policy is a major economic policy undertaken by the central bank on behalf of the government to pursue achievement of broad economic goals as defined by country’s general economic policy. It generally aims to fulfill the goals of full employment, price stability, economic growth, reducing economic inequality, exchange rate stability, balance of payment equilibrium, and so on. It works on the basis of various qualitative and quantitative monetary tools that directly or indirectly influence availability of money & credit, interest rate and uses of money. The rational and efficient implementation of monetary policy has empirically proved its significance in several economic crises in the world’s scenario. It plays crucial roles to overcome the problems of two extent reverse economic problems called inflation and depression/deflation. Its implementation as a complementary economic policy in coordination with others can promote favorable economic events by slacking down the undesirable impacts.

The monetary policy in a developing economy needs 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 stabilization or exchange rate 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.

Nepal has adapted a mixed economic system. It is a blend of communist’s centrally planned economic system and capitalist’s open market economy.  Hence, structure of the economic system of our country situates between these two fundamental extents. The phases of business cycle are commonly observed in capitalist economy but they are suppressed with government interference and plans in communist economy. Both the uppermost swing and lowermost swing of business cycle are not desirable from the view point of country’s economic health. During inflationary period, the market prices of goods and services rise excessively where as purchasing power of money gets fallen. To address such problematic situation, a contractionary monetary is to be adapted. It is also called a dear or restrictive monetary policy. It aims to reduce money supply for lowering effective aggregate demand. On contrary, during the period of recession and depression, the market prices of goods and services massively fall down. An expansionary monetary policy is to be adapted to get rid of such situation. An expansionary monetary policy aims to encourage aggregate effective demand by increasing supply of money and credit.

Nepal Rastra Bank (NRB) was established on 14^th Baishak 2013 as the central bank of Nepal under NRB Act 2012. NRB formulates and implements monetary policy in Nepal with the aim of achieving its macroeconomic goals. Recently, monetary policy for the fiscal year 2074/75 is under implementation. It is being operatinalized to meet the targeted economic growth rate of 7.20 %. Recent monetary policy has aimed to limit annual inflation rate within 7 %. The physical, human and financial losses experienced by Nepal due to earthquake few years back and the ongoing political instability are the main hindrances in achieving its targets. Mitigating various challenges, NRB has stepped forward to stabilize the fluctuating interest rate through this policy. Rather than being focused on monetary policy facts, we discuss the roles and relevancy of monetary policy for our nation here in brief.

Prior to economic liberalization, Nepal Rastra Bank followed direct selective monetary instruments such as interest rate, margin rate, Statutory Reserve Requirements (SLR), and so on. However, after economic liberalization, indirect general instruments such as Cash Reserve Ratio (CRR), Open Market Operation (OMO) and bank rate have been used. These instruments first affect the aggregate demand and thereby it affects real macro economic variables such as price level, income, employment, output, and so on. But in Nepalese context, like other policies, monetary policy has not been effective to achieve its goals or objectives because price level is not explained by money supply alone. Besides addressing inflationary and deflationary problems, the relevancy of monetary policy for a developing nation is increasing due to the following facts:

1. 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.
2. 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 banks to grant long-term loans to the industrial units by providing rediscounting facilities. Other developmental financial institutions also provide long-term produc­tive loans.
3. 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.
4. Integration of Organized and Unorganized Money Market: Most underdeveloped countries are characterized by dual monetary system in which a small but highly organized money market on the one hand and large but unorganized money market on the other hand operates simultaneously.

The unorganized money market remains outside the control of the central bank. By adopting effective measures, the monetary authority should integrate the unorganized and organized sectors 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 popularizing the use of credit instruments (e.g., cheques, drafts, etc.).
6. Monetization of Economy: An underdeveloped country is also marked by the existence of large non-monetized sector. In this sector, all transactions are made through barter system. Changes in money supply and the rate of interest do not influence the economic activity at all in this case. The monetary authority should take measures to monetize this non-monetized 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) stabilizing their prices, and (c) minimizing 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 large scale without giving any jolt to the system. 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. 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 by providing elastic supply of credit.
11. 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, mobilizing voluntary savings of the people, and channelizing 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 our development plan of the country.

12. 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.

Monetary policy alone can’t provide solution to one or all burning economic problems. It will get proved to be effective if, it is implemented in close coordination with other economic and financial policies. Hence, it is not competitive but complementary to all other economic plans, policies, directives and decisions of concerned authorities.