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“From full employment to sustained economic growth as the objective of monetary policy represents a move forward in the direction of establishing a welfare state. If people within a nation have to enjoy a high standard of living, the economy has to grow at the compound rate through time. In America, the Employment Act of 1946 asked the Federal Government to use all practical means with the assistance and cooperation of industry, agriculture, labour and state and local governments to promote maximum employment, production and purchasing power. In achieving this goal of maximum production or economic growth, the monetary policy has been assigned an important role. Read more »

The various instruments of monetary policy which the central bank employs to achieve the goals of economic policy can be classified into the general or quantitative instruments and the selective or qualitative instruments. The general instruments employed by the central bank to carry out its monetary policy are open market operations, changes in the minimum legal cash reserves ratio and changes in the bank or discount rate. All these three monetary policy instruments influence the credit-creating capacity of the commercial banks in the economy by operating directly or indirectly on their excess cash reserves. When the banks grant credit by making loans and purchasing securities their assets and liabilities portfolios are influenced. On the one hand, banks’ assets increase but on the other hand there takes place a corresponding increase in their deposits, primarily demand deposits. Since, apart from keeping operating and safety margin cash reserves, banks are statutorily required to maintain a certain minimum percentage of their total deposits in the form of cash reserves with the central bank, their capacity to make more loans is limited by their excess cash reserves position. If the banks have only sufficient reserves with them to meet their minimum legal reserves requirements against their total deposits, they cannot make any more loans and purchase more securities. In such a situation, when the banks have the total cash reserves which are just adequate to cover their total deposits, further acquisition of earning assets by increasing their deposit liabilities would create a deficiency of cash reserves. Since bulk of the deposits of banks are comprised of the money supply, its rate of growth is under central bank’s control by exercising control over the volume of cash reserves held by the commercial banks by raising the percentage of the minimum legal cash reserves ratio which the banks must maintain against their deposits.

The central bank can influence increase or decrease the commercial banks’ cash reserves through its open market operation. The instrument of open market operations is the most effective instrument which is available to the central bank to carry out its monetary policy. Being flexible, it enables the central bank to change the direction of its open market operations according to circumstances from a policy of increasing the cash reserves of the commercial banks to decreasing their reserves and vice versa. Open market operations are either defensive or dynamic. Defensive operations are those which are taken to offset the other factors that change the volume of banks’ cash reserves. If, for example, gold outflows or increases in treasury deposits at the central bank are tending to reduce commercial banks’ cash reserves, the central bank may make offsetting government security purchases even though it is not trying to ease its credit policy. Conversely, it may buy securities during the tight money periods if other factors are tending to reduce the commercial banks’ cash reserves too fast. Thus, it is impossible to tell from a mere sale or purchase of securities whether the central bank is pursuing a defensive or dynamic open market operations policy without knowing how the other factors are affecting the commercial banks’ cash reserves.

The instrument of variable minimum legal cash reserves ratio requirement affects not the total amount of commercial banks’ reserves but the amount of their excess cash reserves which in turn affects their total ability to lend. Thus, the central bank can carry out its expansionary monetary policy by providing the commercial banks with additional lending or credit-creating power either by increasing their total cash reserves through the open market purchases of securities or, their total cash reserves remaining unchanged, by decreasing the minimum legal cash reserves ratio requirement. As a result of decreasing the minimum legal cash reserves requirement, a part of the existing required cash reserves

Monetary policy has a rich past and in the pre-Keynesian days it was the single established instrument of macroeconomic policy. Before the publication of Keynes’ scholarly work entitled The General Theory of Employment, Interest and Money in 1936, monetary policy was cast in the mould of international gold standard which existed upto 1936. The principal objective of the gold standard countries’ monetary policy was to preserve the international prestige of the nation’s money unit by maintaining its convertibility directly or indirectly through some other country’s currency into gold at the fixed legal parity. In other words, monetary policy aimed at maintaining the fixed exchange rates (although these could move within the limits set by the gold export and gold import points) against other gold standard countries’ currencies. Unlike today, currency convertibility as monetary policy’s objective before 1914 did not mean the avoidance of exchange and direct controls, then virtually unknown, but rather the avoidance of those exchange rate fluctuations which would result from delinking the national currencies from gold. Since currency convertibility at fixed exchange rate was the major objective of monetary policy, the major criterion of policy was the behaviour of the reserves ratio of the central bank as affected by gold flows, by changes in the central bank’s holdings of other legal reserves and by changes in the liabilities of the central bank. A decrease in the cash reserves ratio led to an increase in the discount rate and/or other measures designed to check or reverse the movement. Read more »

According to the international liquidity theory of inflation, the acceleration of inflation rates throughout the world from the late 1960s is due to the excessive increase in the world money supply largely resulting from the US government’s financing of its domestic social programmes and the escalation of the Vietnam war through bank borrowing printing money. This act produced inflation and the balance of payment deficit for the US and the consequential double pressure on the price trends of other countries direct influence from the dominating position in world markets of the inflation-gripped US economy and indirect influence from the increasing domestic money supplies in the other countries as a result of the balance of payments surpluses corresponding to the US balance of payments deficits. Read more »

F.D. Holzman, James S. Duesenberry, Gardner Ackley and some others have ascribed inflation to the practice of the American business corporations to compute costs and then add to these costs a certain mark-up to yield a given “target return” on the invested capital or sales. Mark-up pricing is a type of administered price-fixing and is given as a plausible explanation of the recent inflationary trend in the US economy. According to Gardner Ackley, the mark-up approach “places the emphasis where unions and businessmen place it, not on the level of prices per se, nor on supply and demand, but on the preservation of ‘fair’ relationships between buying prices (including the cost of living), and selling prices (including wage rates)”. In Ackley’s view, Uhen the demand is higher the make-up tends to be higher, about equal to cost increases and less (but not too much) when demand is low and costs are high. An important point made by the mark-up inflation theorists is that what is important is the process by which increases in prices and wages occur and not where the increase in prices initially occurred.

Ratchet inflation emerges in the economy when although the aggregate demand is not excessive, it is so distributed in the economy that it is excessive in certain sectors of the economy and inadequate in others. In an economy with perfectly flexible wages and prices, prices would rise in those sectors where the demand was excessive and fall in those others where the demand was inadequate keeping the general level of prices unchanged. However, due to price “administration” by strong trade unions and oligopolistic industries, prices tend to be rigid in the downward direction. Thus, while prices in the excess demand sectors rise these do not fall in the deficient demand sectors. The net effect is a rise in the overall price level. The excess demand bids up prices while the administered wages and prices provide the ratchet preventing the compensating fall in the prices elsewhere in the economy. Read more »

It has been frequently argued by governments that inflation is not generated domestically but is rather an international phenomenon beyond their control. This view of inflation seeks to ascribe the price rise to international factors. For example, it has been argued by the Canadian government that inflation in that country is the result of international price pressures. This argument is particularly appealing because firstly, Canada is a relatively small economy highly vulnerable to international price pressures (Canada’s total imports constitute around 30 per cent of her GNP) and secondly, international inflation does exist and focusing on it tends to draw attention away from the domestic aspects of inflation. Since 1974, as a result of sudden and perceptible rise in the petroleum and petroleum-based products’ prices many countries have experienced inflation that can be ascribed to international price pressures. While it is true that international forces may contribute to inflationary pressures in any economy, particularly in an economy which is highly dependent on the outside world, at the same time it cannot be denied that inflationary pressures in the economy are chiefly fed by the domestic factors.

Alvin H. Hansen has drawn attention to the need for distinguishing between a major and a minor business cycle. According to him, the full course duration of a major cycle, taking from trough to trough, varies from a minimum of six years to a maximum of thirteen years. Those economic fluctuations that may be termed as minor cycles range in length, measured from trough to trough, from a minimum of two years to a maximum of five years. The length of three years seems to be a model figure. Hansen has made a study of 73-year period (1865-1938) and on the basis of his study has concluded that there were altogether 18 cycles in the USA during this 73-year period; seven of these were major cycles while the rest eleven were minor cycles. Read more »

There are different methods or systems of note-issue which have existed in different countries at different times. The following are the various systems of note-issue which have been practised at different times in different countries.

1. Simple Deposit System.
2. Maximum Fiduciary System.
3. Fixed Fiduciary System.
4. Proportional Reserve System.
5. Minimum Reserve System.
6. Percentage Deposit System.
7. Bonus Deposit System. Read more »

 The problem of note-issue concerns itself basically with two questions: (i) Should note issuing authority be vested in the government or in the banks? And (ii/) If it is vested in the banks should a single bank or several banks be given the right to issue currency notes? So far as the first question is concerned, opinions are divided on the issue. Those who favour the idea of the government vesting itself with the necessary authority to issue notes, argue that the currency issued by the Treasury would enjoy greater prestige and confidence of the public than if it were issued by some bank. The, government is in a position to benefit from the advice of experts whose services are generally not available to private banks. The government can also control the currency system more efficiently since it has the necessary sanction to enact and enforce necessary laws. It is argued by the supporters of government monopoly of note-issue that it is very risky to entrust the control and management of money to private institutions. Read more »