According Stabilization: Prof. Gustav Cassel and Lord Keynes

According to these economists, collectively known as the neutralists, money should not influence economic parameters such as price, output, income and employment nor should it influence the pattern of distribution in society. In other words, money should play a passive role as a medium of exchange and store of value.

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Neutrality of money is often put to severe criticism on the following grounds:

1. It is based on the assumption, implicit in the quantity theory, that a change in money supply causes a direct and proportional change in the price-level. The assumptions, like many other postulates of classical theory were put to severe criticism by the followers of Keynes.

2. It is difficult to implement. Neutrality of money requires that money supply should remain constant and adjustments in it should be made only to accommodate the fundamental changes in the economy.

3. It imparts no guarantee of price-stability. Even when money supply is kept constant, prices may change either due to bottlenecks in production or due to an increase or a decrease in demand caused by a sudden change in tastes, preferences, etc.

4. It is self-contradictory. On one side, neutralists assign a passive role to money while on the other, they prescribe that the monetary authority should maintain constant supply of money through frequent adjustments in it so as to accommodate fundamental changes taking place in the economy.

5. It fails to explain the onset of depression. Prices fall during depression even when money supply is held constant. Also, prices fail to rise even when money supply is increased during depression.

2. Price Stabilization:

Prof. Gustav Cassel and Lord Keynes (during the early period of his career) suggested price stabilization as a desirable objective of the monetary policy.

During the decades of twenties and thirties in the last century, price stabilization as an objective of monetary policy was tried on experimental basis by several countries; but, with the passage of time, it was replaced by a more acceptable objective—the objective of full employment.

Instability of price leads to distortions in the economy. The evils of inflation and deflation disturb the economic relationships among various sections. On the other hand, stability of price eliminates cyclical fluctuations, prevents artificial prosperity, facilitates equitable distribution of income and promotes economic stability and social welfare.

But stabilization of prices should not be interpreted here in its literal sense. It does not imply stability of prices of individual products. Instead, it refers to the stability of the average price, as reflected by the wholesale price index or the consumer price index.

3. Exchange Stabilization:

Another objective of the monetary policy is stabilization of the exchange rate. Under the gold standard, countries followed the system of proportional reserves while issuing the currency. This they did under the compulsion of convertibility of the currency issued into gold. Under the circumstances, supply of money was limited to the stocks of gold the bank of issue possessed. As a result, the countries followed the principle—’expand the currency and the credit when gold comes in and contract them when it goes out’.

Supply of money thus was linked to the stock of bullion reserves with the central bank. Value of a currency in terms of other currencies was more or less stable and so was the exchange rate. But after the Second World War, most of the war-shattered economics came under compulsion to give up the gold standard.

This was necessitated by the problem of reconstruction and rehabilitation as the monetary resource they possessed under the convertible currency system was limited to the stock of gold with the mint and posed, posed serious constraints. The system of minimum reserves came handy as it permitted them to issue unlimited currency with a certain minimum of the bullion reserves with the mint.

This affected the value with of their currency in terms of the other currencies and hence the exchange rate. Ever since the switch over to the system, widespread fluctuations in the exchange rates have been witnessed causing a common concern. Instability of exchange rate poses several problems a few of which may be outlined below:

1. Heavy fluctuations in the exchange rate encourage speculation in foreign exchange markets.

2. Heavy fluctuation in the exchange rate lead to loss of confidence on the part of the foreign investors, who, in consequence, may decide to hold their investments back.

3. Heavy fluctuations in the exchange rate also produce repercussions on the internal price-level of the country concerned.

4. Heavy fluctuations in the exchange rate impart a serious setback to the flow of trade between the countries concerned.

Fluctuations in the exchange rates thus pose serious repercussions, but before getting carried away with them, it is necessary to examine the following arguments often put forth against exchange rate stabilization:

1. Stability of exchange rate is generally achieved at times at the expense of the stability of the internal prices. Price fluctuations hamper the economic progress of a country.

2. Under the stable exchange rates, inflation or deflation prevalent in some countries get transmitted to the trading partners. Inflationary or deflationary movements originating from the inflicted countries to the non-inflicted ones through trade jeopardize the internal stability of the latter through their repercussion effect.

As it is well known International Monetary Fund (IMF) was specifically set up after Second World War to stabilize exchange rates among member-nations. This being so, the individual countries no longer attach much importance to stabilization of the exchange rates as an objective of their monetary policy.

4. Full Employment:

According to J.M. Keynes, the main objective of monetary policy should be maximum utilization of the productive resources in the economy. None of the above objectives, however desirable, can promote full employment of productive resources. Rather it is more likely that the objectives of neutrality of money and stabilization of prices and exchange rates may create deflationary forces and cause unemployment in the economy.

A suitably designed monetary policy can serve the cause of full employment. Recall the Keynesian equation Y = C + I + G, where C is consumption, I is investment and G is government spending. A monetary policy to boost consumption and investment is capable of raising income, output and employment. To demonstrate, suppose government initiates a reduction in the lending rate of interest on housing loans.

This would encourage home loans which in turn would boost demand for housing. In consequence, construction industry would respond by constructing more houses. This would create new job opportunities for masons, architects, brick layers and general labour. All along, demand for building material such as cement, granite, marble, iron, sanitary wares, electrical fittings, etc., too would rise creating fresh job opportunities in all these industries.

House construction is an activity which draws inputs from a number of industries and employs manpower of all the categories—skilled or unskilled, educated or uneducated, trained or untrained—alike. Related industries too experience a boom.

A recent boom in the construction industry in the suburbs of Delhi stands a testimony to the statement. A sizable reduction in the lending rate on home loans propelled housing demand sky-high with the result that construction activities shot up to their highest level in entire National Capital Region.

Even in the related industries investment shot up to new heights to keep pace with the construction activity. This provides enough scope for researchers to study the nature and extent of correlation between lending rate on home loans and consequential investment in construction and related industries.

This may reveal the true nature of the investment function (7 = Ia – hr) as also of the applicability of the Keynesian process of income propagation through investment multiplier in the less developed countries having massive unemployment. Investment in construction industry and the borrower friendly lending rates on home loans have both gone quite well in boosting income propagation in NCR so far.

5. Economic Growth:

As an objective of the monetary policy, emphasis has shifted even from full employment in recent years. It now rests on economic growth. There are mainly three reasons for this shift:

1. With the realization that full employment is not possible without stepping up the economic growth emphasis automatically shifted on economic growth.

2. A rising rate of economic growth is necessitated also by the universal desire to enjoy ever-rising standard of living in the developing and the developed countries.

3. In the modern competitive world, an ever increasing rate of economic growth is treated essential for survival of the developing nations.

Economic growth may be defined as the sustained increase in real income of a country over a long period of time. In the process, money has a very important role to play as a mobilizing agent. Many nations possess abundant human and non-human resources but somehow these resources continue to remain unutilized due to lack of finance. Given adequate monetary support, both types of resources can be put to fuller utilization, leading, in the process, to substantial increase in the size of the real output. Monetary policy can thus be considered as an stimulant of growth.