Refusing to remain as a useful slave, money has often behaved as a tyrant imposing arbitrary redistribution of wealth and income among the various classes of people.
It has therefore been felt that money should be made to behave properly. This raises the question of defining the ideal behaviour of money.
Once we can define this ideal behaviour of money, the problem of defining monetary policy becomes easy.
The term monetary policy is used to denote the policy of the government regarding money matters. The government must determine the objectives of monetary management.
1. Falling Price Level:
Marshall showed a preference for a falling price-level. Periods of rising prices contain within themselves seeds of future disasters. With falling prices, though the businessmen get less, the wage-earners get more.
In a progressing economy, a slowly falling price level may be the ideal monetary policy so that the benefits of economic progress might be enjoyed by all those whose money incomes are fixed by contract or customs.
2. Stable Price Level:
One of the most popular views regarding the aim of monetary policy is that the value of money should be kept stable. If money is a measure of value, it is desirable that like all measures, it should be stable in value.
A policy of stable price level is very simple and easy to grasp. In recent times we have so experienced the evils of instability of prices that to point out the benefits of stable prices seems to be superfluous.
Rising prices and falling prices are both bad and therefore the stable prices are the best. Since money is a store of value, variations in its value cause unnecessary loss or confer unfair advantages both of which are against the principle of natural justice?
Lastly, stable price would secure social justice; it would ensure justice between debtors and creditors and between wage earners and employers.
But a policy of stable prices would not guarantee the absence of inflation and deflation. In an economy where improvements in industrial techniques are made, prices should fall pari passu with the increase in productivity or decrease in cost.
But if prices are kept stable, this would give rise to profit inflation leading to over-investment and collapse. This actually happened in the USA in pre-1929 years.
The Federal Reserve Board kept the prices more or less stable during that period. But productivity was rapidly rising in the USA leading to abnormal profits, the stock exchange boom and the ultimate collapse.
3. Generally Rising Price Level:
The case in favour of a slowly rising price level rests on the fact that it acts as a great incentive to enterprise. When prices rise, the expenses of businessmen do not rise as much as prices. Hence during such periods, businessmen can make huge profits. Prospects of profits would stimulate them to increase production.
Thus rising prices would secure full employment of workers than could otherwise be obtained. In a community characterised by varying degrees of unemployment, a slowly rising price level may be, as Keynes observed, a better monetary policy than mere price stability.
According to Robertson, the industrial progress in the nineteenth century has been made possible because of the stimulus given by rising prices.
Rising prices conflict with the principle of social justice. Periods of rising prices lower the real value of money incomes of wage earners and the investing classes.
It is not desirable that wage earners should be made to suffer in order to provide incentive to businessmen. Moreover, rising price m.ght lead to over-investment, speculative boom and ultimate collapse.
4. Neutral Money:
In view of the defects of stable prices, Prof. Hayek has proposed that the ideal monetary policy is that which interferes as little as possible with the operation of nonmonetary forces. When there is no money and the barter system prevails, ratios of exchange would be established between different goods.
The aim of monetary policy is to see that the same ratios of exchange prevail even under money economy. The introduction of money should not “distort” the situation that should have obtained under barter.
In other words, money should be neutral in its effects on prices. This could be secured not by stability of prices but by the stability in the quantity of money in circulation.
If the supply of effective money is kept constant then there can be no distortion of the real ratios of exchange through changes in the quantity of money. The price level would then vary inversely with productive power.
But this policy will be faced with the most serious practical difficulties. In order to keep the effective supply of money constant, the quantity of money has to be changed as its velocity of circulation is altered. But how is the central bank to know when and in what degree the velocity of circulation has changed?
Another practical difficulty arises when we consider the case of increasing productivity. Under such a policy, prices would fall as cost reductions are affected.
But if some prices are monopoly controlled and are thus prevented from falling, then other prices must fall by greater degree in order that average prices should correspond to the average costs. These other industries would be then subjected to a prolonged period of depression.
Hansen has rightly criticised that the basic assumptions of the policy do not correspond with reality under modern development of cartels and other semi-monopolistic organisations.
5. Avoidance of Cyclical Fluctuations:
Many economists are of opinion that business fluctuations are caused by monetary factors and can be remedied by monetary weapons. Bank credit can be regulated by the Central Bank by variation of bank rate, open market operations etc.
Through these weapons the central bank can restrict credit to choke off a boom and expand credit to avoid recessions.
But according to Keynes, business cycles are not caused by monetary factors and hence purely monetary weapons cannot prevent them. However, monetary policy can reduce the range of business fluctuations—make booms and slumps less severe.
6. Stability of External Value of Currency:
The monetary policy of a country must aim at securing stability of the rate of foreign exchange. Stable exchange rates are highly important for countries like UK whose economic prosperity depends upon foreign trade.
The pre-war gold standard was managed for the purpose of securing exchange stability. Stability of exchange rates secured large benefits for the world. It facilitated large scale movements of goods from one country to another.
It also fostered the growth in the volume of international investment. But stability in the rate of foreign exchange at the cost of internal price stability is not desirable.
Nowadays exchange stability is secured through exchange control. Exchange stability is not inconsistent with internal price stability. The external and internal values of money are two aspects of the same thing. There is no reason why both cannot be kept stable by efficient management.
7. Full Employment and High Rate of Economic Growth:
The objective of monetary policy should be full employment of all available resources and a high rate of economic growth.
If private expenditure is not adequate to achieve and maintain full employment, the deficiency must be made up by public expenditure. There will be no inflation so long as there are unemployed resources.