Monetary policy, however, plays a more limited role in developing countries for a number of reasons;
- Commercial banks in developing countries are less sensitive to changes in their cash base partly because many banks find themselves with excess liquidity because of the scarcity of viable projects and credit-worthy borrowers. Thus, if commercial banks have a higher level of liquidity than the legal minimum liquidity ratio, a reduction in their reserve assets need not bring any response in terms of a reduction in credit. This limits the effectiveness of open market operations and the cash ratio as instruments of monetary policy in developing countries.
- Markets and financial institutions in many developing countries are highly disorganized with many developing countries operating under a dual monetary policy system with a small organized money market catering to the financial requirements of middle- and upper-class individuals, and a large disorganized and uncontrolled money market to which most low-income individuals are forced to turn in times of financial need. Due to the lack of developed money market and capital markets and the limited quantity and range of financial assets the use of instruments like Open Market Operations for economic management is severely limited.
- Commercial banks in developing countries are merely overseas branches of major private banking institutions in developed countries. Thus, foreign commercial banks can turn to parent organizations for liquid funds in the event of having their base squeezed by local monetary authorities.
- In developing countries, there is no direct linkage between lower interest rates, higher investment and expanded output. This is because investment decisions are rarely sensitive to interest rate movement with business expectations being a much more important variable determining investment. In addition, because of inflation, many developing countries experience negative real rates of interest
- The ability to develop country governments to regulate national money supply is constrained by the openness of their economies and by the fact that the accumulation of foreign currency is significant but a highly variable source of their domestic financial resources.
- Many people in developing countries do not deposit their money with commercial banks. It is therefore much more difficult for the central bank to use the traditional instruments of monetary policy to control the money supply.
- Lack of knowledge about the operation of monetary policy instruments like open market operations and selective credit controls makes them less effective in developing countries.
- Corruption in some developing countries also makes instruments like selective credit control ineffective.
- Monetary instruments are sometimes used inappropriately and do not address the problem effectively. The policy mix is very important since the problem at hand may require fiscal rather than monetary policy. In general, monetary policy is considered more appropriate for an external problem like the balance of payment deficit while fiscal policy is more appropriate for internal problems like unemployment and recession
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