Why is monetary policy inefficient in a depression or recession situation?
People don’t have many investment opportunities. Commercial banks are the most popular source of investing money by the common people. Which bank provides various investment facilities to the customers like saving bank account, term deposits which can be fixed as well as recurring, Life Insurance, mutual funds etc. Bullion investment as well as property also falls under this category.
As a result of this the banks retain majority of its deposits from the customers’ money and carry out their financial business with it. However, this situation is slightly different in other countries like the United States where the banks do not retain majority of the money of the population.
The common people there invest money in various avenues other than banks like Mutual Funds, hedge funds, etc. Therefore at any given point of time the banks do not have a large amount of deposit from the customers which who are mostly the common people.
The money market in India is highly unorganised. There are many non-scheduled Financial Institutions that run within the country that are by no means connected to the Reserve Bank of India and hence any kind of financial transaction done by them will not reflect in the positive economy of the country.
These unorganised money markets include private money lenders as well as criminals who carry out nefarious activities of sourcing and transferring money from illegal means. Lack of financial inclusion is also a reason why these unorganized money markets are so popular in India.
These unorganised sectors do not require the involvement of extensive red tape and paperwork which deters the common people from taking loans from the banks. Therefore even if the RBI makes any changes in its monetary policy like changing the interest rates of loans and deposits, it will not directly reflect in the economy of the nation.
Another limitation of the monetary policy is that it does not have direct control over the prices of crude oil and gold which are decided by the international market. Subsequently is the price of crude oil or Gold increases in the international market it will reflect in an increase in the prices of petrol diesel and other fuel within the country.
This will result in the increase in prices of all those commodities which are transported by vehicles running on petrol and diesel because of which there will be widespread inflation and the government will have no other means to prevent it from affecting the common people as well as dilapidated the economy.
The monetary policy also cannot control the wide disparity between the expense and the influx of money in the Indian economy. Every country like India has a particular amount of influx of money from the people as revenue and Taxes. However in India because of various developmental policies these funds are spent almost completely.
Sometimes even more money than the incoming amount is spent on these developmental policies which are announced by the government just for placing the wood bank and not considering its long term implications on the economy.
So a situation developed where the expenditure is more than the income. When this happens a government has to borrow money from other governments and countries.
This results in a cycle of interest and loan that creates inflation in the long run. In this situation, even if the RBI changes with interest rates nothing would be able to revise the economy because the money lost is leaked out from the economy by unscrupulous activities in the form of Black Money which will have no written records of retrieval.
Urjit Patel Committee Recommendations
In order to control the inflation as a result ineffective monetary policy the RBI had formed the Urjit Patel committee which was an expert committee form to revise and strengthen the monetary policy framework.
Earlier the RBI’s main focus was the wholesale price index WPI. However majority of the GDP of the country which is more than 60% comes from the service sector and not from the whole sale sector.
The Urjit Patel committee decided to shift focus to the consumer price index CPI which would be done on and all India level combining rural plus urban people. A target rate of 2% to 6% was kept for taming the inflation. Anything below 2 and above 6 would mean a situation of depression or recession. The actual target CPI was kept at 4% with a 2% relaxation above and below the rate.
A similar model is also followed in various of the developing countries including those of Mexico and Africa
The committee also recommended decentralization of power of deciding the repo rate from the Governor. The Governor was thus relieved of the pressure of deciding all the functioning of the economy single handedly and an expert committee was made to decide upon the repo rate by majority voting system.
However there are certain challenges before the government and the RBI which can damp in their goals of bringing down the inflation with their monetary policy.
These challenges mostly includes natural hindrances like droughts and heavy erratic weather conditions which result in unexpected shortfall of crop production resulting in a natural growth of inflation because of reduced supply.
Geo political problems are another cause which might cause inflation and failure of the revised monetary policy. Today the world is in a very volatile situation with wars being fought many parts of the world including Syria and Iraq. Subsequently is a situation of World War arises, the prices of crude oil will increase invariably which will affect the inflation of products negatively.
Another major problem in India is the indiscriminate announcement of subsidy policies by the political class in order to appease the voters without any knowledge of long-term implication of their promises.
All these play a major role in the economy of a nation and monetary policy alone is not capable of controlling these.