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chapt07

chapt07

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Published by Sukumar Nandi

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Published by: Sukumar Nandi on Mar 14, 2008
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06/16/2009

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SEVENLinkages Between Sectors, Monetary Policy and Transmission Mechanism
 
"All theorizing is simplifying, cutting out the unimportant and leaving what is thought to be important, in the hope that by simplifying we may increase understanding" 
[ Hicks, 1967; p. 156 ]The central banks of the developed countries are keen to exercise theiindependence by formulating suitable monetary policy with the twin objectives of stability of price level and the stability of the exchange rate of the domestic currency.These two objectives are complementary to each other and the central banks study thechannels of transmission of their different policies to have a fair idea about what isknown as
leads
and
lags
of monetary policy. In fact the entity what is known as the`Economy' of a country is hardly compartmentalized and its stylized different sectors arelinked through the dynamic functioning of different economic parameters some of whichare heavily dependent on social conditions. We assume that the social conditions remainfixed or some sort of social stability becomes the ground reality of their assumption.When a person buys a house through the HDFC loans at a specific interest rate, heseldom realizes that the intrinsic value of his property may change by the changes in themarket interest rate, though his property is tied to the contract rate of HDFC. Neither does he realize that his decision may have some impact in the linkages between themoney market and the asset market.The linkages between the sectors are important in the sense that the impact of themonetary policy spreads through the sectors with the help of those linkages. The effects
 
of monetary policy through the linkages in different sectors, what is known as thetransmission mechanism, are also different in the developing countries compared to thedeveloped ones. In the latter, monetary expansion is supposed to affect output in theshort run, even if the effects simply lead to the changes in the price level over a long period of time. But in the developing countries, an expansion in money supply mayinflate the prices immediately and still have little transitional effects on other realvariables. This situation occurs when the credibility of the central bank is low andinflationary expectations are dominant. The situation may be aggravated if the financialmarkets are shallow and volatile, and in this case the effects of the monetary expansionon the real sector becomes difficult to predict. Price stability should be the objective of the monetary policy in this case.In recent literature there has emerged a near-consensus among the economists thatmonetary policy cannot influence the long run growth of the economy, though it canaffect the real sector in the short run. Even the effectiveness of influencing the short runsituations has been under doubt as the lags in recognizing turns in the business cycle,and the subsequent lag effects in the response of the economy to the changes in the policymake it difficult for the policy maker to choose the correct time for the announcement of the policy for fine tuning the business cycle.Price stability has been the principal objective of the monetary policy. Generallyit is agreed that an approximate 3 per cent inflation should be tolerated which can takecare of the difficulties of the measurement and the adjustment of the relative prices thatreflect differential productivity trends in different sectors of the economy.In the developing countries the tolerable limit of inflation should be higher, say 5to 6 per cent as the relative price adjustment will be more significant and pronounced insuch economies because productivity gains in the tradable sector is high and thedifferences of productivity gains in different sectors are high also.The developing countries have another dimension which make it imperative thatmonetary policy should have objectives other than price stability. It is generally seen that
 
the concentration of output occurs in a smaller number of products. Also, the financialmarkets are not developed with relevant expertise lacking. All these may make thedeveloping country more vulnerable to the destabilizing shocks. This necessitates theusefulness of counter cyclical monetary policy. There is another aspect. Since thefinancial system is weak, the apex bank can use monetary policy to direct credit to thesectors considered to be vital for the growth of the economy.Even when price stability is the sole objective of monetary policy, the effects of the latter on the output and employment cannot be neglected when inflation-control becomes the priority of the monetary policy, the pace of deflation will have a contractioneffects on output and employment. It is generally seen that various features of highinflation developing economies, including lack of credibility, the wage-rigidities in themarkets, etc. may create an inflation inertia and this increases the output cost of anti-inflation monetary policy. Considering all these many developing countries followmonetary policy with multiple objectives consistent to their local conditions.
The Transmission Channels of Monetary Policy :
In a modern monetary system four channels of transmission mechanism of monetary policy have been identified. The first is through the direct interest rate effects,and this affects both the cost of credit and the cash flow of debtors and creditors. Thesecond channel is through the impact of monetary policy on domestic asset prices i.e. prices of bond, stocks and real estates. The third channel is through the exchange ratesand the fourth channel is the credit availability. In an economy the nature of thefunctioning of these four channels depends on the structure and macroeconomicenvironment. One recent phenomenon is the globalization and the liberalization. Thishas changed the structure of the domestic financial system and thus the dynamics of thefunctioning of these channels has changed too.
The Interest Rate Channel :
In the traditional Keynesian model of monetary transmission, a policy induced change inthe money supply, for a given money demand, will lead to a change in the interest rate.

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