The role of monetary policy may be explained as follows:
i) Economic Development
In developing countries, the monetary policy should aim at promoting economic development. The monetary policy can play a vital role in acceleration to economic development. It influences the supply and uses of credit, controlling inflation and maintaining equilibrium balance of payment.
ii) Development of Banking and Financial Institutions
| One of the main functions of central bank or primary aim of monetary policy is to establish more banks and financial institutions. Underdeveloped countries lack these facilities. These facilities will help in increasing banking habit, mobilizing voluntary savings of the people, channelizing them into productive uses and raising the rate of capital formation. |
iii) Debt Management
In the developing economy, debt management is one of the main functions of monetary policy. The tools under the aims of debt management are deciding proper timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing the public debt. These tools collect the means and sources of economic development. Monetary policy helps it in goal specific way.
iv) Control Inflation
Monetary policy is an effective measure to control inflation. Increase in government expenditure on developmental schemes increase aggregate demand but aggregate supply of consumer’s goods does not increase in the same proportion. This increases the price level. The monetary policy controls inflationary tendencies by increasing saving, checking expansion of credit by banking system and discouraging deficit financing by the government.
v) Correct the adverse Balance of Payment
Monetary policy in the form of interest rate policy plays as important role in correcting the balance of payments deficit. In the developing countries like Nepal, there is serious balance of payment difficulties to fulfill the planned targets of development. To develop infrastructure such as power, irrigation, transport, etc. and directly productive activities like iron, steel, chemicals, electrical, fertilizers, etc., developing countries have to import capital equipment, machinery, raw materials, spares and components thereby raising their imports.
The exports are almost stagnant. They are high priced due to inflation. As results, an imbalance is created between imports and exports which lead to imbalance in the balance of payments. Monetary policy can help in decreasing the gap between balance of payments deficit through high rate of interest. The high rate of interest attracts the inflow of the foreign investment and help in bridging the balance of payment gap.
vi) Reduction of Economic Inequality
In an underdeveloped economy, there is wide disparity of income and wealth and absence of an integrated interest rate structure. Monetary policy can play a significant role to maintain equal distribution of income and wealth and a suitable rate of interest rate. The central bank should take effective steps that benefit the poor and to integrate the interest rate structure of the economy. For this, low rate of interest should be fixed for the poor and small farmers, and entrepreneurs and subsidy may be given for them. A suitable interest rate structure encourages savings and investment in economy and discourages unproductive loans and speculative.
vii) Adjusting Demand and Supply of Money
Monetary policy can be of great use in these economies for effecting necessary adjustment between the demand for and supply of money. The demand for money is likely to go up on account of increased transactions and gradual disappearance of non-monetized sector combined with increased demand for money on account of precautionary and speculative motives. The use of money and credit for speculative purposes has to be controlled by the monetary authorities through suitable monetary policy and by the government through direct physical controls, falling which inflation is likely to appear, which may stifle growth instead of helping it.
viii) Maintain Economic Growth Rate
Monetary policy can also help growth. The sectoral impacts of such policy in a developing economy are worth nothing. Monetary expansion can be used at least in theory, to change the terms of trade against the agricultural sector, which tends to benefit from increased production in the secondary or tertiary sectors. If the prices of industrial goods can be raised through inflation without affecting the prices of food-stuffs and raw materials, it may be difficult to follow.
Similarly, monetary policy should try to maintain in the economy at most suitable interest rate structure. At present, the interest structure is amendable only in the upward direction and very little in the downward direction, but with the help of monetary policy the structure becomes somewhat manageable in the downward direction also. For a large public debt that has to be raised in poor economies, rates of interest must be kept low.
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