MODULE (FINAL)

LESSON 2

TITLE: MONETARY POLICY AND ITS ROLE IN ECONOMIC DEVELOPMENT

INTRODUCTION

MONETARY POLICY: DEFINITION

(Economics, Concepts, Theories, and Applications, Nebres, Abriel, M, National Bookstore, 2008)
Monetary Policy is a policy of influencing the economy through changes in the banking system’s reserves
that affect the money supply and credit availability in the economy. Monetary and banking regulations are
the countenance of monetary policy because there are influential in controlling the volume of money
available throughout the economic system. Monetary policy is controlled by the Central Bank to affect the
amount, availability, and use of money and credit.
Monetary Policy is the monitoring and control of money supply by a central bank. This is used by the
government to be able to control inflation, and stabilize currency. Monetary Policy is considered to be one
of the two ways that the government can influence the economy – the other one being Fiscal Policy (which
makes use of government spending, and taxes). Monetary Policy is generally the process by which the
central bank, or government controls the supply and availability of money, the cost of money, and the rate of
interest. ([Link]

GOALS OF MONETARY POLICY

1. Controls either the cost of very short-term borrowing¹ of the money supply², often targetting an inflation
rate or interest rate³ to ensure price stability and general trust in the currency.
2. Contribute to the stability of gross domestic product (GDP).
3. Achieve and maintain low unemployment.
4. Maintain predictable exchange rate6

¹Short-term borrowing
Short-term borrowing means all indebtedness in respect of borrowed money maturing on demand or within
one year from the date of creation thereof.

²Money supply
The money supply is the entire stock of currency and other liquid instruments circulating in a country’s
economy as of a particular time. The money supply can include cash, coins and balances held in checking
and savings account.

MONEY SUPPLY INDICATOR

Money supply indicators are often found to contain necessary information for predicting future behavior of
prices and assessing economic activity. Moreover, these are used by economists to confirm their
expectations and help forecast trends in consumer price inflation. One can predict, to a certain extent, the
government's intentions in regulating the economy and the consequences that result from it. For example,
the government may opt to increase money supply to stimulate the economy or the government may opt to
decrease money supply to control a possible mishap in the economy.
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These indicators tell whether to increase or decrease the supply. Measures that include not only money but
other liquid assets are called money aggregates under the name M1, M2, M3, etc.

M1: Narrow Money

M1 includes currency in circulation. It is the base measurement of the money supply and includes cash in
the hands of the public, both bills and coins, plus peso demand deposits, tourists’ checks from non-bank
issuers, and other checkable deposits. Basically, these are funds readily available for spending. Adjusted M1
is calculated by summing all the components mentioned above.

M2: Broad Money

This is termed broad money because M2 includes a broader set of financial assets held principally by
households. This contains all of M1 plus peso saving deposits (money market deposit accounts), time
deposits and balances in retail money market mutual funds.

M3: Broad Money Liabilities Broad Money Liabilities include M2 plus money substitutes such
as promissory notes and commercial papers.

M4: Liquidity Money

These include M3 plus transferable deposits, treasury bills and deposits held in foreign currency deposits.
Almost all short-term, highly liquid assets will be included in this measure.

Implications
If the velocity of M1 and M2 money stock has been low, this indicates that there is a lot of money in the
hands of consumers and money is not changing hands frequently.

Generally, we would expect that when money supply indicators are growing faster than interest rates plus
growth rate or inflation, whichever is higher, interest rates should possibly be increased. This should only
generally apply when broad measures of money supply growth are higher than narrow measures, to rule out
some of the measurement error issues that could emerge.

³Interest Rate
The cost of borrowing money or the amount paid for lending money expressed as a percentage of the
principal.

Interest Rates Determination

1. Supply and Demand.

An increase in the demand for money or credit will raise interest rates, while a decrease in the demand for
credit will decrease them.

2. Inflation
The higher the inflation rate, the more interest rates are like to rise. This occurs because lenders will
demand higher interest rates as compensation for the decrease in purchasing power of the money they are
paid in the future.

3. Government
The government has a say in how interest rates are affected. Government, thru the Central Bank, often
makes announcement about how monetary policy will affect interest rates.

Interest Calculation

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Formula for interest rate is: I = Prt (where I=Interest, P=Principal, r=Interest, and t=time). It can be
calculated in two ways: simple interest or compound interest.

Three Main Types of Interest Rates

There are three main types of interest rates: the nominal interest rate, the effective interest rate and the real
interest rate.

Nominal Interest Rate. Simply the stated rate on which savings or loans accrue over a period of time. For
example, an investment of P10,000, at nominal interest rate of 5% over 1 year, would earn the investor
P500. (I = Prt = P10,000 x 5% x 12/12 = P500)

Effective Interest Rate. Takes into account compounding over the full term of the investment. It is often
used to compare the annual interest rates with different compounding terms (daily, monthly, semi-annually,
annually, etc.).

Formula: Effective Interest Rate (EIR) = (1 + i/n)n - 1

Where:
i = nominal interest rate
n = number of compounding period

Illustration:
Nominal rate = 12% p.a.
Compounding Period = semi-annual

EIR = (1 + 0.12/2)2 - 1
= (1.06)^2 - 1
= 1.1236 - 1
= 12.36%

Real Interest Rate. Considers impact of inflation on nominal interest rate. For example, the nominal
interest rate if 5% and the inflation rate is also 5%, the real interest rate is effectively 0%. (RIR = 5% - 5% =
0%).

Impact of the Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they
borrow from a lender (creditor). It is viewed as a “cost” of borrowing money. Interest-rate targets are a tool
of monetary policy. The quantity of money demanded varies inversely with the interest rate. Central banks
in countries tend to reduce the interest rate when they want to increase investment and consumption in the
economy. However, low interest rates can create an economic bubble where large amounts of investments
are made, but result in large unpaid debts and economic crisis. The interest rate is adjusted to keep inflation,
the demand for money, and the health of the economy in a certain range. Capping or adjusting the interest
rate parallel with economic growth protects the momentum of the economy.

MONETARY POLICY INSTRUMENTS/TOOLS

The central bank influences interest rates by expanding or contracting the monetary base, which consists of
currency in circulation and banks’ reserves on deposit at the central bank. Central banks have three main
instruments or tools of monetary policy: open market operations, the discount rate and the reserve
requirements.

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Open Market Operations

Open market operations (OMO) is an economic monetary policy where central banks purchase or sell bonds
or other government securities on the open market in an effort to regulate the money supply. In other words,
the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors in order to change
the number of outstanding government securities and money available to the economy as a whole.
([Link]

Open Market Operations consist of repurchase and reverse repurchase transactions, outright transactions,
and foreign exchange swaps.

 Repurchase and Reverse Repurchase

This is carried out through the Repurchase Facility and Reverse Purchase Facility of the Bangko Sentral
ng Pilipinas.

In Purchase transactions, the Bangko Sentral buys government securities with a dedication to sell it back
at a specified future date, and at a predetermined interest rate. The BSP's payment increases reserve
balances and expands the monetary supply in the Philippines.

On the other hand, in Reverse Repurchase, the government acts as the seller, and works to decrease the
liquidity of money. These transactions usually have maturities ranging from overnight to one month.

 Outright Transactions
Unlike the repurchase or reverse repurchase, there is no clear intent by the government to reverse the
action of their selling/buying of monetary securities. Thus, this transaction creates a more permanent
effect on our monetary supply. "When the BSP buys securities, it pays for them by directly crediting its
counterparty's Demand Deposit Account with the BSP.” The reverse is done upon the selling of
securities.

 Foreign Exchange Swaps

This refers to the actual exchange of two currencies at a specific date, at a rate agreed upon the deal date
and the reverse exchange of the currencies at a farther ate in the future, also at an interest rate agreed on
deal date.

 Acceptance of Fixed-Term Deposits

To expand its liquidity management, the Bangko Sentral introduced this method in 1998. In the Special
Deposits Account, or SDA, consists fixed terms deposits by banks and institutions affiliated with the
BSP.

Discount Rate

To increase the volume of credit in the financial system, the Bangko Sentral ng Pilipinas extends loans,
discounts, and advances to banking institutions. "Rediscounting is a standing credit facility provided by the
BSP to help banks meet temporary liquidity needs by refinancing the loans they extend to their clients."
There are two types of rediscounting in the BSP: the peso rediscounting facility and the Exporter's dollar and
Yen Rediscount Facility.

Formula: 1 / (1 * (1 + dr)pn))

Where:
dr = discount rate
pn = period number

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Example: discount rate = 10%
Period number = 2

Solution:
Discount Factor = 1 / (1 * (1 + 10%)^2
= 1 / (1 * 1.21)
= 1 / 1.21
= 0.83

Reserve Requirements
The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum amount
of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the
central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial
bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and
stored physically in the bank vault (vault cash), plus the amount of the commercial bank's balance in that
bank's account with the central bank.

In banking institutions, there are required amounts that banks cannot lend out to people. They always need
to maintain a certain balance of money, which are called "reserves". Once these reserve requirements are
changed and are varied, changes in the monetary supply will be observed greatly.

The reserve requirement (or cash reserve ration)—the amount of cash a bank must hold in reserves against
deposits made by customers—is currently at twelve percent (12%) in the Philippines (set in March 2023).

TYPES OF MONETARY POLICY

([Link] )

Depending on its objectives, monetary policies can be expansionary or contractionary.

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by decreasing interest
rates, purchasing government securities by central banks, and lowering the reserve requirements for banks.
An expansionary policy lowers unemployment and stimulates business activities and consumer spending.
The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also
possibly lead to higher inflation.

Expansionary monetary policy tends to encourage economic activity as more funds are made available for
lending by the banks. This, in turn, increases aggregate demand which could eventually fuel inflation
pressures in the domestic economy.
Contractionary Monetary Policy

Contractionary monetary policy tends to decrease the level of liquidity/money supply in the economy.

Contractionary monetary policy tends to limit economic activity as less funds are made available for lending
by banks. This, in turn, lowers aggregate demand which could eventually temper inflation pressures by
economic economy.

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The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be
achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for
banks. The contractionary policy is utilized when the government wants to control inflation levels.

Expansionary Monetary Policy versus Contractionary Monetary Policy

Expansionary policy increases the total supply of money in the economy more rapidly than usual and
contractionary policy expands the supply of money more slowly than normal. Expansionary policy is used to
combat unemployment, while contractionary is used to slow inflation.

SETTING BASE INTEREST RATES

For many borrowers, the factors that determine a bank's interest rate are a mystery. How does a bank decide
what rate of interest to charge? Why does it charge different interest rates to different customers? And why
does the bank charge higher rates for some types of loans, like credit card loans, than for car loans or home
mortgage loans?

Following is a discussion of some concepts lenders use to determine interest rates. It is important to note that
many banks charge fees as well as interest to raise revenue, but for the purpose of our discussion, we will
focus solely on interest and assume that the principles of pricing remain the same if the bank also charges
fees.

Cost-plus loan-pricing model

A very simple loan-pricing model assumes that the rate of interest charged on any loan includes four
components:

1. the funding cost incurred by the bank to raise funds to lend, whether such funds are obtained through
customer deposits or through various money markets;
2. the operating costs of servicing the loan, which include application and payment processing, and the
bank's wages, salaries and occupancy expense;
3. a risk premium to compensate the bank for the degree of default risk inherent in the loan request; and
4. a profit margin on each loan that provides the bank with an adequate return on its capital.

Let's consider a practical example: how this loan-pricing model arrives at an interest rate on a loan request of
$10,000.

 The bank must obtain funds to lend at a cost of 5 percent.

 Overhead costs for servicing the loan are estimated at 2 percent of the requested loan amount and

 a premium of 2 percent is added to compensate the bank for default risk, or the risk that the loan will not
be paid on time or in full.

 The bank has determined that all loans will be assessed a 1 percent profit margin over and above the
financial, operating and risk-related costs.

Adding these four components, the loan request can be extended at a rate of 10 percent (10% loan interest
rate = 5% cost of funds + 2% operating costs + 2% premium for default risk + bank's targeted profit
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margin). As long as losses do not exceed the risk premium, the bank can make more money simply by
increasing the amount of loans on its books.

Price-leadership model

More banks are using a form of price leadership in establishing the cost of credit. A prime or base rate is
established by major banks and is the rate of interest charged to a bank's most creditworthy customers on
short-term working capital loans.

This "price leadership" rate is important because it establishes a benchmark for many other types of loans.
To maintain an adequate business return in the price-leadership model, a banker must keep the funding and
operating costs and the risk premium as competitive as possible. Banks have devised many ways to decrease
funding and operating costs, and those strategies are beyond the scope of this article. But determining the
risk premium, which depends on the characteristics of the individual borrower and the loan, is a different
process.

Credit-scoring systems and risk-based pricing

Credit-scoring systems, which were first developed more than 50 years ago, are sophisticated computer
programs used to evaluate potential borrowers and to underwrite all forms of consumer credit, including
credit cards, installment loans, residential mortgages, home equity loans and even small business lines of
credit. These programs can be developed in-house or purchased from vendors.

Credit scoring is a useful tool in setting an appropriate default premium when determining the rate of
interest charged to a potential borrower. Setting this default premium and finding optimal rates and cutoff
points results in what is commonly referred to as risk-based pricing. Banks that use risk-based pricing can
offer competitive prices on the best loans across all borrower groups and reject or price at a premium those
loans that represent the highest risks.

So, how do credit-scoring models and risk-based pricing benefit the borrower who only wants a loan with
reasonable repayment terms and an appropriate interest rate charge? Since a bank is determining a
reasonable default premium based on past credit history, borrowers with good credit histories are rewarded
for their responsible financial behavior. Using risk-based pricing, the borrower with better credit will get a
reduced price on a loan as a reflection of the expected lower losses the bank will incur. As a result, less risky
borrowers do not subsidize the cost of credit for more risky borrowers.

QUANTITATIVE EASING
([Link] )

Quantitative easing (QE) is a monetary policy of printing money, that is implemented by the Central Bank to
energize the economy. The Central Bank creates money to buy government securities from the market in
order to lower interest rates and increase the money supply. These economic conditions will then trigger
financial institutions to promote increased lending and to make the money supply more liquid.

[Link]

Quantitative easing effectively allows central banks to dramatically increase the size of their balance sheets,
which also increases the amount of credit available to borrowers. To make that happen, a central bank issues
creates new money and uses that to purchase assets from commercial banks. These then become new

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reserves held at these banks. Ideally, the funds the banks receive for the assets will then be loaned to
borrowers at attractive rates. The idea is that by making it easier to obtain loans, interest rates will remain
low and consumers and businesses will borrow, spend, and invest.

According to economic theory, the increased spending leads to increased consumption, which increases the
demand for goods and services, fosters job creation, and, ultimately, creates economic vitality. While this
chain of events appears to be a straightforward process, remember that this is an oversimplification of a
more complex topic.

PHILIPPINE MONETARY/CURRENCY POLICY

Bangko Sentral ng Pilipinas

In accordance with Republic Act No. 265 of June 15, 1948, the Central Bank of the Philippines (CBP) was
created as the central monetary authority of the Republic of the Philippines. In accordance with a provision
in the 1987 Constitution, President Fidel V. Ramos signed into law Republic Act No. 7653, the New Central
Bank Act, on June 14, 1993. The law provides for the establishment of an independent monetary authority to
be known as the Bangko Sentral ng Pilipinas (BSP). On July 3, 1993, the New Cental Bank Act took effect.

BSP provides policy directions in the areas of money, banking and credit and exists to supervise operations
of banks and exercises regulatory powers over non-bank financial institutions. It keeps demand from
growing rapidly with resulting high inflation, or from growing too slowly, resulting in high unemployment.

The primary objective of BSP's monetary policy is to promote price stability because it has the sole ability to
influence the amount of money circulating in the economy. In doing so, other economic goals, such as
promoting financial stability and achieving broad-based, sustainable economic growth, are given
consideration in policy decision-making.

Inflation Targeting

Inflation Targeting requires a public announcement of an inflation rate that a country will target for the
coming years, or in a given period of time. It focuses on maintaining a low level of inflation, that which is
considered to be optimal, or at least would allow the country to have ample economic growth. Its main
desire is to achieve price stability as the ultimate end goal of the monetary policy. The Philippines formally
adopted Inflation Targeting as the framework for Monetary Policy on January 2002.

The Philippines’ inflation target is measured through the Consumer Price Index (CPI). For 2009, inflation
target has been set to be 3.5 percent, having a 1% tolerance level, and 4.5 percent for 2010, also having 1%
tolerance. Also, the Monetary Board of the Philippines announced a target of around 4±1 percent from 2012
to 2014.

The BSP’s latest estimates show that inflation will remain elevated in the coming months to average at 6.1
percent in 2023 before easing to 3.1 percent in 2024. The higher inflation forecast in 2023 is due to the
following: higher-than-expected actual inflation; elevated prices of food, utilities and transport; and
subsequent adjustments on rent and restaurant prices.

Exchange Rate

Exchange rates play a significant role in monetary transmission mechanism and at the same time, it can have
a large impact on inflation rates. Although the BSP has adopted the inflation targeting approach, it may be
tempted to inexplicitly target exchange rate to achieve its low inflation target. The issue here is the extent of

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the exchange rate pass-through or ERPT to domestic prices since higher ERPT would require the BSP to
shift its attention to exchange rate movements to stabilize prices.

Role of Monetary Aggregates

Since the shift to inflation targeting, BSP has already abandoned monetary aggregates because its
information content has apparently declined in the recent years. Moreover, it is also assumed that a shift of
approach was necessary because money aggregates are normally not good indicators of future economic
policy requirements due to unreliability of measurement

Measurement of Inflation and Liquidity Trap

Since inflation targeting leads to lower and stable inflation rates, more improvement should then be given to
the measurement of the consumer price index since few percentage points have greater repercussions when
rates are low. Errors in CPI measurement could lead to ineffective and unsuitable monetary policy response
by the BSP which definitely result to detrimental effects to the economy

Another issue arising from monetary policies is the liquidity trap. This happens when inflation rate declines
too much leading to a threat of deflation. Liquidity trap is defined as a situation in which there are zero
nominal interest rates, persistent deflation and deflation expectations. In the event this occurs, bonds and
money earn the same real rate of return thus making people indifferent to holding bonds or excess money

Budget Deficit and External Debts

Given high budget deficits, the government is concerned about two closely related issues: it does not want to
pay very high interest on its borrowings and it does not want to crowd out the market. Ideally, the
government could raise tax revenues to avoid borrowing huge sums from the market. However, the
government opted to borrow from the international capital market and though rates are low, these have
shorter maturity and country's outstanding external debt has continued to move towards a less ideal position

Fiscal Dominance

According to the fiscal theory of the price level, it is not the non-interest bearing money but the total
nominal liabilities including interest bearing notes and future fiscal surpluses that matter for price-level
determination. In the absence of fiscal discipline, an independent central bank such as the BSP cannot
guarantee a stable nominal anchor. In other words, for the BSP to successfully focus on price stability, there
must be a credible commitment on the part of the National Government to reduce total fiscal deficits by a
meaningful amount.

ROLE OF MONETARY POLICY IN ECONOMIC DEVELOPMENT

Role of monetary policy in the economic development of a country are as follows: 1. Appropriate
Adjustment between Demand for and Supply of Money, 2. Price Stability, 3. Credit Control, 4. Creation and
Expansion of Financial Institutions, 5. Suitable Interest Rate Structure, and 6. Debt Management.

1. Appropriate Adjustment between Demand for and Supply of Money

Economic development results in rising demand for money because the growth of economy and a
corresponding contraction of the subsistence sector greatly increase the transaction demand for money.
Besides, the rise in per capita income and increase in population during the development process also
increases the demand for money to carry out day-to-day transactions. The continuously rising demand for
money makes it imperative for the monetary authority to increase money supply at a rate roughly equal to
the rate of increase in real income, so that prices do not fall consequent upon a rise in national output.

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A falling price level adversely affects the pace of economic growth by initiating a vicious downward spiral
of prices and output. Similarly, if the supply of money is more than needed by the requirements of trade and
industry, it may be used for speculative purposes, thereby inhibiting growth and causing inflation.

The gist of the argument is that a proper control upon the supply of money will prevent economic
fluctuations and pave the ground for rapid development. The monetary policy, therefore, can play a vital role
in the economic development of underdeveloped countries by minimizing fluctuations in prices and general
economic activity by achieving all appropriate balance between the demand for money and the productive
capacity of the economy.

2. Price Stability
Maintenance of stability in the domestic level of prices and exchange rates is an important condition of
economic growth. However, economic development leads to inflationary pressures in under-developed
countries due to a variety of structural rigidities and imbalances.

The inflationary increase in prices adversely affects the propensity to save and diverts invertible resources
into speculative and unproductive investments such as real estate, jewellery, gold, stock-piling of goods etc.
The monetary authority, therefore, should keep a constant vigil on the movement of prices and so regulate
the supply and direction of money and credit that it puts a check on rising prices.

Similarly, inflationary increase in prices leads to the frequent devaluation of the currency. The fluctuating
exchange rates adversely affect international trade and the earning of foreign exchange tails, which could
help in the development of the country.
In short, instability in internal prices and exchange rates impedes the rate of sustained economic growth and
consequently monetary policy should aim at preventing excessive increase in prices and maintaining
exchange stability at some realistic level. This implies the adopting of such monetary policies that will check
inflation and frequent development of the currency.

A developing country generally suffers from balance of payments difficulties because of the high propensity
to import and limited capacity to export. In such a situation, the monetary policy should be directed to
improving the foreign exchange position.

The monetary authority can employ both traditional weapons of control such as bank rate, open market
operations etc., and the direct control over foreign exchange for the correction of adverse balance of
payments.

In under-developed economies, governments have to spend on a gigantic scale under the planning process to
secure growth rate commensurate with the growth rate of population and also to provide social and
economic overheads.

But the rate of saving being low, the government has to resort to large scale borrowing and deficit financing
to cope with the rising investment. Since there is dearth of complementaryresources in such economies and
the supply curve of goods is generally inelastic, the abnormal increasing effective demand generated by
huge government expenditure paves the way for inflation.

The best remedy for fight inflation is to reduce aggregates pending, encourage savings and discourage
hoarding. For this, the Central Bank may raise the bank rate which would reduce the pressure of demand for
bank credit by making borrowing costlier than before and this will discourage borrowing for hoarding and
speculative purposes.

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On the other hand, an increase in the rate of interest will stimulate savings. To reduce the credit creating
capacity of the banks further, the Central Bank may supplement it with the sale of government and banks
securities, raising the serve ratio and by instituting selective credit controls.

Thus the Central Bank by relying on both the quantitative and qualitative instruments of credit control can
limit inflation and help the process of economic development.

3. Credit Control:
With a view to secure an accelerated rate of economic growth, the monetary authority should press into
service its techniques of credit control to influence and shape the character and pattern of investment and
production.

This will, of course, depend on the range of credit institutions that exist in the economy and also on the
forms of credit controls that are employed by the Central Bank. In most of the underdeveloped countries, the
banking system is not fully developed.

The commercial banks, mainly provide short-term credit requirements of businessmen and traders and are
reluctant to provide medium and long-term credit to meet the financial requirements of industry and for
manufacturing in general.

The monetary authority should step in to make appropriate guarantees and provide rediscounting facilities
with a view to induce and encourage banks to provide medium and long-term loans for productive purposes.
Besides joint loans by commercial banks and state owned financial institutions can greatly help in this
direction.

Similarly, selective credit controls should be adopted to influence the pattern of investment and production
by differentiating between the costs and availability of credit to different sectors and industries.

The selective credit control, unlike quantitative credit control makes discrimination between essential and
non-essential use of bank credit and helps the funds to flow into desirable channels and uses without
affecting the economy as a whole.

Thus in an underdeveloped economy, the monetary authority should control the uses of money and credit by
an appropriate monetary policy so that investible resources flow into desirable channels without adversely
affecting investment and production. This will quicken the pace of development.

5. Creation and Expansion of Financial Institutions:

Monetary policy can speed up the process of economic development by improving the currency and credit
system of the country. For this propose more banks and financial institutions need to be established to
provide larger credit facilities and to mobilise saving for productive purpose.

In under-developed countries there is death of financial institutions and banking facilities are available only
to a limited extent. This being the case, the savings of the people cannot be mobilised effectively for
economic development and consequently the rate of growth is very slow.

The monetary authority can help in the expansion of financial institutions by granting subsidies and special
concessions in the form of free remittance and rediscounting facilities to new institutions and by providing
training facilities for their staff.

The Central Bank should pay special attention to the problem of rural credit. A network of cooperative credit
societies with apex banks finances by the Central Bank can go a long way in providing the credit needs of
the ruralites.

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Similarly the Central Bank and financial corporations to provide finance to business and industry. This will
obviously help increase the rate of economic development.

There exists vast non-monetized sector in under-developed economies which is not responsive to changes in
the quantity of money and interest rates and such, this sector remains outside the effective control of the
Central Bank. This being the case all out efforts must be made by the monetary authority to extend the
sphere of the monetized sector to make monetary policy a success.

For the attainment of the objective of growth with stability, the monetary authority of developing
economies, therefore, has to play a positive role in creation, working and expansion of banking and other
financial institutions and extend credit facilities where needed.

5. Suitable Interest Rate Structure:

Economic development requires investment on a gigantic scale both by the public sector and the private
sector. For this cheap money policy should be follow because it make public borrowing cheap, keeps the
cost of serving public debt low and thus stimulates investment both public and private, the financing of very
ambitious programs of economic development in all sectors of the economy demands that credit should be
made available to the private entrepreneurs at as low rates as possible.

Thus a policy of low interest rates serves as an incentive to investment for economic development. As
against this it is pointed out that cheap money policy may induce the traders and speculators to borrow more
from the banks and utilise these funds for hoarding and stockpiling and for other speculative purposes.

But this tendency on the part of private investors can be checked through selective credit control and thereby
directing investment into desirable channels.

However, there are economists who suggest a policy of high interest rates on the following considerations:

a) It will serve as an anti-inflationary measure by restricting borrowing from the banks for speculative
purposes and undesirable investments;
b) It will stimulate savings and thus increase the supply of investible sources.
c) It would secure the allocation of scarce capital into most productive uses and avoid productive and
wasteful use of resources. But these arguments do not carry much weight. The productive and efficient
use of investible resources can be better secured by direct controls and control over capital issues.

Further, qualitative methods of credit control can be used effectively to ensure flow of funds into desirable
channels. So far a stimulus to savings is concerned, it may be mentioned that the volume of savings is more
a function of the level of income rather than the rate of interest.
A higher rate of interest may, however, be used as a shock tactic to curb speculation in goods and securities
when it gets beyond control and other methods have failed to control it. The developing countries, therefore,
should be more pragmatic in their approach and must evolve such a differentiated interest rate policy which
should restrain the superfluous spending, contain the inflationary pressures, promote capital formation and
sustain the investment activity at a level such that the pace of growth is not slowed down.

6. Debt Management:
In developing economies, the government has to borrow on a large scale to implement the programs of
economic development and hence the responsibility of managing public debt effectively and efficiently so as
to serve the requirements of economic growth, lies with monetary authority that is the Central Bank of the
country.

The primary object of debt management “is to create conditions in which public borrowing can increase
from year to year and on a big scale without giving any jolt to the system. And this must be on cheap rates to
keep the burden of the debt low.”

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The policy of low interest rates is desirable for strengthening and stabilizing the market for government
bonds because a low rate о interest raises the price of government bonds and thus makes them more
attractive to the public and ensure the public borrowing programme a success.

Besides, a low structure of interest rates minimizes the burden of public debt. Thus for speeding up the
process of economic development, the monetary policy should aim at the efficient management of public
debt which implies proper timing of the issuing of government bonds, stabilizing their prices and
minimizing the burden of debt.

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