Monetary Policy – Free BBA Notes/ MBA Notes

Limitations of Monetary Policy

Monetary Policy has following limitations:

1. The time lag

The first and the most important factor that delays the effective working of monetary’ policy is the time-lag. Time lag refers to the time taken by policy -makers for chalking out the policy action and its implementation. The time-lag is divided in two parts:

i. Inside lag or Preparatory lag

The ‘inside lag’ refers to the time lost in (a) identifying the nature of the problem. (b) identifying the sources of the problem, (c) assessing the magnitude of the problem, (d) choice of appropriate policy action, and (e) implementation of policy actions.

ii. Outside lag or Response lag

The outside lag’ or the response lag refers to the time taken by the households and the firms to react in response to the policy action taken by the monetary authorities. If inside and outside lags arc long, not only the nature and the magnitude of the problem may change rendering the policy ineffective, but also it may worsen the situation.

It has been the experience of many countries including developed ones that time-lag has been unduly long making monetary policy less effective than expected. The time-lag of monetary policy, particularly its response lag, has been found to be generally longer than the time lag of fiscal policy.

2. Underdeveloped Money and Capital Markets

The money and capital markets are undeveloped. These markets lack in bills, stocks and shares which limit the success of monetary policy.

3. High Liquidity

 The majority of commercial banks posses high liquidity so that they are not influenced by the credit policy of the central bank. This also makes monetary policy less effective.

4. Problem in forecasting

The formulation of an appropriate monetary policy requires a reliable assessment of the nature and magnitude of the problem-recession or inflation. More important is to forecast the effects of monetary actions. Despite advancement in forecasting techniques, reliable forecasting of macroeconomics variables remains an enigma. An inappropriate policy based on guess work is bound to be unsatisfactory effective.

5. Non-banking financial intermediaries

 The structural change in the financial market has also reduced the scope of effectiveness of monetary policy. Non-banking financial institutions have expanded rapidly over time. The proliferation of non-banking financial intermediaries including industrial finance corporations, industrial development banks, mutual saving funds, insurance companies, chits and funds, etc., has reduced the share of the commercial banks in the total credit. Although financial intermediaries cannot create credit through the process of credit multiplier, their huge share in the financial operations reduces the effectiveness of monetary policy.

6. Foreign Banks

In almost every developing country, foreign-owned commercial banks exist. They also render monetary policy less effective by selling foreign assets and drawing money from their head offices when the central bank of the country is following a tight monetary policy.

7. Money Not Deposited with Banks

The well-to-do people do not deposit money with banks but use it in buying jewelry, gold, real estate, in speculation, in conspicuous consumption, etc. Such activities encourage inflationary pressures because they lie outside the control of the monetary authority.

8. Small Bank Money

 Monetary policy is also not successful in developing countries because bank money comprises a small proportion of the total money supply in the country. As a result, the central bank is not in a position to control credit effectively.

Monetary Policy – Free BBA Notes/ MBA Notes

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