Support the Monkey! Tell All your Friends and Teachers

Help / FAQ

vi) Monetary policy operates only to bring about variations in the fluctuating price level. But this is a highly unsatisfactory approach. Price level is only a superficial part of the deeper economic phenomenon. When price level is in disorder there is something fundamentally wrong with the real economic processes. Therefore mere changes in the supply of money, intending to correct price level, cannot achieve anything substantial. It is more important to detect real causes of disequilibrium on the supply and demand sides of money and to correct them .

vii) Monetary policy attempts to operate through the supply of credit and rate of interest. Keynesian economists agree that higher or lower rates of interest may have some indirect effect on the marginal efficiency of capital (MEC). This may influence investment behavior to some extent. But the ability of monetary policy to alter the rate of interest significantly is itself a matter of doubt. Keynes’ concept of ’liquidity trap shows that rate of interest is always positive and it never falls below a certain minimum level. Therefore monetary policy ceases to be of any effect beyond such a point.

(E) Monetarists’ views

i) Demand for money: The classical viewpoint in opposition to the Keynesian analysis has been put forth in the recent past by the monetarists. After 1954, Professor Milton Friedman and his followers have repeatedly contributed to such monetarist arguments. Their views are significantly modified and more realistic than the traditional rigid outlook. Before arriving at their reaction to monetary policy, it would be appropriate to consider the demand for money.

Demand for money is the opposite of the velocity of circulation of money. It is the reciprocal of velocity in its value. If (V) is velocity and (d) is demand for money then,

This is an obvious relationship. Velocity is speed or frequency of rotating units of money and its value can be increased only by restricting spending. An individual possessing a $100 bill can either spend it or hold a part of it. If he spends $90, he can only hold $10 of it. But if he spends $70 he can hold only $30 in cash. Therefore spending more is demanding less and demanding more is spending less of money possessed.

ii.    Monetarists and monetary policy: The monetarists point out that demand for money, as a proportion of the total income is stable. Therefore during the expansionary phase when a greater amount of money income is received, people tend to spend the surplus income quickly. Such spending causes aggregate or effective demand to increase and the curve to shift upwards. Moreover in the short run some resources may be underutilized or unemployed. In that case such extra expenditure induces some increase in employment. But once the full employment condition is established, there is no further scope for real output and employment to increase. If the expansionary policy persists and monetary expenditure continues to increase, then it will cause a pure inflationary rise in the price level. Thus in the short run monetary policy may have an impact on the real economic activities but in the long run the equation of exchange holds good.

iii) Abuse of monetary policy: Monetarists further argue that it is not monetary policy as such but the abuse of it that is objectionable. Such abuse arises out of rigid and incorrect judgments of monetary authority about market conditions. During the period of the Great Depression, the deflationary policy was pursued; this was a wrong move that had accentuated the crisis.

Moreover, the average man as a consumer or a firm goes by 'expectations' about future changes in the monetary policy. Normally the average annual growth rate of price level is said to be permissible and desirable to the extent of 4 percent. This can compensate for real growth rate of income (GDP). But if people expect higher or lower rate of inflation in the future then their reactions alter and cause disturbances in the economy. Therefore the best thing for the monetary authority to do is to maintain a steady growth rate of money supply and maintain steady rate of inflation. The monetarists believed that the monetary policy should be able to allow for a rise in the growth rate and at the same time not result in either inflation or deflation.



7.1 Fiscal Policy
7.2 Banking

Chapter 8

All Contents Copyright © All rights reserved.
Further Distribution Is Strictly Prohibited.

In Association with