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(D) Effectiveness of the monetary policy: Keynes and his followers have strongly criticized this policy and pointed out several limitations of it. Monetary policy is both inadequate and ineffective to solve fundamental problems of fluctuations and disequilibrium in employment and income levels. Some of the important criticisms are:

i) Monetary policy operates only on the supply side of the economy. It attempts to control the supply of currency and credit. But leaves demand side outside its scope altogether. As a result, such a one-sided approach has no chance of achieving any significant success in solving major issues.

ii) Even on the supply side, the monetary policy faces various difficulties. It is expected that whenever the central bank wants to expand or contract credit supply, the bankers should act accordingly. But this need not be the case. Bankers are likely to be affected by the central bank policies only through their reserve funds positions. But many bankers play safe and are cautious in credit supply activity. They often maintain larger cash reserves than the minimum limits set by the central bank. In such cases bankers can continue to expand or contract credit supply even when the central bank does not desire them to do so.

iii) Bank credit supply activity and investors demand for it depends upon general market conditions. If the central bank reading about the market behavior is not correct then its policy will be a failure. Even when it intends to make credit supply the unwilling investors will wish to utilize credit resources. On the other hand if investors strongly wish to borrow and invest then any attempt to raise bank rate and to make credit dearer will not prevent them to do so.

iv) Monetary policy suffers from time lags. There are usual administrative delays in making the decision. Then it is published and made known to the bankers. Before the bankers take official note of it and make adjustments in their current transactions there may be further time lapses. There is usually 4 to 6 months or even a longer interval of time lag between the original decision of the monetary authority and its final impact. In the meantime the original economic situation might have altered significantly. Therefore the monetary policy then becomes irrelevant.

v) Monetary policy is based on the functioning of the equation of exchange. The equation is based on two basic assumptions. It presumes both the velocity of circulation (V) and the trade volume or level of real income (T) to remain constant, despite changes in the supply of money. But none of these assumptions are realistic. During periods of inflation, when money is losing its value, people show a greater tendency to quickly convert money into stock of real goods. This tends to reduce the value of (V) the velocity of circulation. On the contrary, during a deflationary phase, when the value of money is increasing, people reduce consumption and prefer to hold on to money. This causes a rise in the value of (V) the velocity. The second assumption about constancy of (T) trade volume is also not correct. At the most one can say that the equation of exchange works under full employment conditions. But in reality, the economic conditions are frequently fluctuating. This results in a situation where some resources are kept unemployed or underemployed. So long as the resources are unemployed, the equation of exchange cannot hold good. Variations in the supply of money cannot simply raise or lower the price level. It is incorrect therefore, to believe that money supply has no real effects on the levels of output and employment. In modern times money cannot remain a neutral medium. It does influence real economic activities.


7.1 Fiscal Policy
7.2 Banking

Chapter 8

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