Monetary Policy is a set of tools by which the central bank can control inflation and deflation by increasing and decreasing the money supply in the market. But in some cases, it fails to achieve its goals. Developing and Under-Developing countries mostly face the limitation of monetary policy.
In this article, we will see how and why monetary policy fails to achieve its goal. This article will help you to develop your understanding of this topic. This is an important topic for you if you are preparing for UPSC exams.
Limitation of monetary policy
Before we begin the topic I request you ask these questions to yourself. “Why we need monetary policy?” “Can we control inflation or deflation without having monetary policy?” “Is this the only way to control inflation or deflation?” “why monetary policy fails or why monetary policy has limitations?”
I hope you have read all the question. Keep these questions in your mind, now we will try to find out all the answers.
We know that monetary policy helps central banks to increase or decrease loan rates through credit control. This is the most common way to deal with inflation or deflation. It is true if the loan rates are cheaper then people take credit, and practicing these on a large scale will increase the money supply in the market, and in deflation market needs money. So the central banks decrease the monetary rates to curb deflation. The same thing also applied to inflation. In inflation central bank increases the monetary rate and it makes loans costlier. Because of high-interest rates, people hesitate in taking loans from banks and this reduces money in the market.
Now suppose a situation where the central bank of the country cut its monetary rates. From the above concept, we know that due to this cut in rates loans become cheaper. But in developing and under-developing countries this does not happen. To understand why this happens first we have to understand how banks earn.
How Banks Earn Money
There are so many earning sources for banks but here we will talk about the major source of income. Banks accept time and demand deposits from their customers and pay interest to them. Now banks lend this money to lenders and charge interest on the amount. The difference between the interest banks charge from their lenders and bank pay to their depositors is the major source of income for a bank.
Why does monetary policy fail to achieve its goal?
Now come to our point, according to the central banks’ steps bank should cut their interest rates. But in developing and under-developing countries people prefer to hold cash instead of putting that money in banks. Banks have some liabilities like they pay interests to their depositors and salary to their employees etc. To fulfill their needs banks have to earn the required amount of money. This can be done in two ways, by increasing quantity or by increasing rates. If banks receive a huge amount of deposits then banks lend money at discounted rates. But if banks have a limited amount of money to lend then banks charge higher interest rates to fulfill their requirements. Here you clearly understand that in developing and under-developing countries people hold cash and that is why banks have less money to lend so we see a minimum or no change in loan rates.
So here we can understand the first limitation of monetary policy which is monetary policy cannot fully control the money supply in the market.
Along with this their are other factors also. Let us discuss one by one:
- Now think about a situation, you have some amount money and you want to fix it in the bank and for that, you will get 7 percent return. But somehow you come to know that Kisan Vikas Patra which is a government bond offers an 8 percent of return. Now, what will you do? Of course, you will put your money there where the interest rates are high. In this case, banks receive less deposit, so they will not cut their interest rate. If government bonds offer more return than banks then people prefer to invest in government bonds than fixed deposits.
- Now think about a question why Central Banks want banks to cut their lending rates? When the loan interest rates are less, people and corporates take loans and spend as per their requirements. It increases economic activity and boosts the economy. Now think about a situation, you want to purchase a home for that you want a home loan. When you enquire about the interest rate on the home loan, you come to know that the interest rates are continuously decreasing in the last three quarters. Now, what will you do? Will you take the loan or you will wait another quarter in a hope that it will decrease more? Most of the people wait for another quarter. Now in this situation, banks have sufficient funds but there is less costumer. In this situation, maybe banks will cut their interest rate or the bank will invest their money anywhere else (Government Securities). As a conclusion from the above situation, we can say that the purpose of the central bank to boost the economy is not fulfilled here.
- Suppose the central bank eases the policy rates and now banks have more money to lend. Are you thinking banks will lend to borrowers? I also hope they will so, but here is a problem for banks “NPA”. Banks are performing their business and no business wants to lose their money. Suppose, banks think that if they lend they will get 10 percent of interest but there is a risk of NPA. On the other side if they invest their money in government securities they will get 9 percent of interest but there is no risk of NPA. In this situation, banks invest their larger portion in G-Sec. This is also one of the situations where the goal of monetary policy is not fulfilled.
- Investing preference is also one of the cause for monetary failure. People in developing or under-developing country invest their money in gold, property, and other high yeild schemes.
From time to time government or central bank introduces some reforms which help them to achieve their goal through monetary policy. Priority Sector Lending (PSL) and Marginal Cost of Funds based Lending Rate (MCLR) are the examples of such reforms. Lastly, we can conclude that monetary policy unable to achieve its goal or limitation of monetary policy through banks then it is called its failure.