Monetary Policy in the Era of Globalization

Willingly or unwillingly, the Government of India has come out with a number of measures to control the rising tide of inflation. Among them are the instruments of monetary policy, wielded by the Reserve Bank of India (RBI), country’s central bank. As is known, the RBI has a number of quantitative as well as qualitative instruments to control the volume of money supply in the economy. The former include bank rate, open market operations, cash reserve ratio (CRR) and statutory liquidity ratio (SLR), while the latter consist of moral suasion, warnings and directives. Before the onset of the present era of the Washington consensus-based globalization, these instruments of monetary policy were quite effective in tackling inflation and deflation by regulating the supply of money and credit. There are, however, serious doubts about their efficacy now.

At present, India is faced with an upward trend in the rate of inflation. In the short-run, the rate may dip now and then because of seasonal and random factors, but it will, in all likelihood, maintain an upward trend. After two consecutive weeks, which saw a slight fall, the inflation rate has resumed its upward journey. It climbed to 6.10 per cent during the week ended February 24 from 6.05 per cent in the previous week.

As every student of economics knows, inflation has a number of components. To begin with, there is a core component, which depends solely on the balance of supply and demand of goods and services. This balance can be maintained by increasing the supply and curtailing the demand. The volume of supply in the short-run may be increased by measures like taking recourse to import, dehoarding, and regulating the distribution of available goods and services besides curbing blackmarketeers and profiteers. In case, there is “overheating”, i.e., the aggregate supply falling short of the aggregate demand because of a serious shortage of productive capacity, it will take a long time to tackle inflationary pressure and the people have to endure till new productive capacity is commissioned.

The second component is the quantum of money supply in the economy and the perception about the future. Before the present era of globalization, the RBI could control the quantum of money supply in the economy with various instruments at its disposal. It could raise the bank rate, cash reserve ratio, statutory liquidity ratio, repo rate, reverse repo rate, and rates of interest on various types of deposits and loans; selling government securities in the market; and pressurizing commercial banks to restrain their credit creation activities. By these measures, the RBI may reduce the volume of money in the economy and, consequently, the volume of demand for goods and services. The RBI may not succeed in its mission if the people’s perception about the future is not conducive to it. To give a concrete example, if the people think that prices of the commodities they want to buy may go up in the months to come, they will not postpone their purchases even if the rates of interest go up. 

The claim that raising the rate of interest deters people from borrowing has been termed as the “most prestigious form of fraud, our most elegant escape from reality” by none other than Prof. John Kenneth Galbraith (The Economics of Innocent fraud, p.43). According to him, if there is a threat of inflation, increased cost of borrowing as a result of higher interest rates in pursuance of the steps by the central bank, may not necessarily “restrain business investment and consumer borrowing, counter the excess of optimism, level off prices and thus insure against inflation” (Ibid, p.44). He goes on to add: “Business firms borrow when they can make money and not because interest rates are low” (Ibid, p. 45).

Kenneth Rogoff of the Harvard University who has been intimately connected with the IMF, in a paper presented to a symposium, organized by Fed Reserve Bank of Kansas City, last year, underlined that globalization “is weakening the grip of individual central banks over the trajectory of domestic real interest rates except at relatively short horizons.” His colleague Prof. Benjamin M. Friedman in his paper “The Future of Monetary Policy: The Central Bank as an Army with only a Signal Corps? (International Finance, Nov. 1999) has concluded: “The influence of monetary policy over interest rates, and, via interest rates, over non-financial economic activity, stems from the central bank’s role as a monopolist over the supply of bank reserves. Several trends already visible in the financial markets of many countries today threaten to weaken or even undermine the relevance of that monopoly, and with it the efficacy of monetary policy. These developments include the erosion of the demand for bank-issued money, the proliferation of non-bank credit and aspects of the operation of bank clearing mechanisms. What to make of these threats from a public policy perspective – in particular, whether to undertake potentially aggressive regulatory measures in an effort to forestall them – depends in large part on one’s view of the contribution of monetary policy towards successful economic performance.” Five years ago, Prof. Helmut Wagner of the University of Hagen (Germany) in a paper, “Implications of Globalization for Monetary Policy”. Came to the same conclusion, i.e., the growing ineffectiveness of the monetary policy in controlling inflation.

Stephen King, managing director of economics at HSBC, has recently come out with an article (Independent, February 19) underlining the reasons for growing redundancy of the monetary policy: “The frameworks which have proved reliable in the past appear to be breaking down. One standard approach used by central banks is to consider changes in interest rates against measures of the amount of spare capacity within an economy. The idea is simple. Each economy has a “supply potential”, the point at which resources are used to such a degree that there is a tendency neither for inflation nor deflation. If interest rates can be moved to set demand at a level consistent with “supply potential”, it follows that the central bank will, through time, achieve price stability.     

“Another approach is to think about inflation from the angle of money supply growth. Given that inflation is, in some sense, a monetary phenomenon, a central bank could take the view that accelerating money supply growth might say something about future inflation, even if there is little immediate evidence of inflationary pressures coming from, say, measures of spare capacity.

“At the moment, neither of these approaches is working particularly well. The problem with the first lies with the inability of central banks to be sure about the size of supply potential.”

With the onset of the era of globalization, there are few impediments in the free flow of financial resources. India has made the rupee fully convertible on current account and partially on capital account. The efforts are on to make it fully convertible on capital account. In this situation, if the rates of interest are increased, financial resources may rush in to take advantage and earn higher returns. It is an open secret that a significant component of these resources may be the ill-gotten money of the Indians stored in the banks abroad. It has been coming, after being laundered, via Mauritius and other routes, under the umbrella of FIIs. In case, the interest rates are lowered, financial resources may flow out. In both the cases, monetary policy will fail to achieve its aim.

Lastly, the phenomenon of unaccounted money is very formidable in the country. Its size has been expanding notwithstanding the ostensible measures by the government. It is ever ready to ease the financial resource constraints and reap handsome profits by indulging in hoarding the stocks of essential commodities.

In conclusion, the monetary policy instruments have lost their potency and only the gullible can be deceived by the seeming seriousness to control the upward trend of inflation by deploying them.


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