Maintenance of economic stability is perhaps the most important task entrusted to the government in all the advanced countries of the world. Fluctuations in economic activity, as we know, are an integral part of a laissez-faire capitalist economy. Alternate periods of prosperity and depression in business activity have been occurring in these countries more or less regularly. The horrors of depression, which brings along with it, unemployment and misery for the millions, can be overcome only if the government regulated economic activity in such a manner that it moves on smoothly. A suitable monetary policy has to be adopted to prevent the recurrence of booms and depressions economic stability and ensuring full employment and a high level of national income.
stability in general level of prices is an important objective of government economic policy. Violent fluctuation in price level causes innumerable economic and social problems. For example, steeply rising prices or inflation, adversely affect and fixed income groups and causes a decline in their living standards. But, such a situation might prove a boon for the business classes who can always charge more from the consumers when the prices go up. Thus, inflation works against the fixed income group, the labor and the poor people, but it benefits the richer sections of society, the businessmen and the capitalist class.
Continuously falling prices or deflation, on the other hand, may be temporarily beneficial to the fixed income group, particularly the workers, because they can now buy more of goods and services with their given money income. But, the business community facing shrinking profits may soon be obliged to reduce their production levels or close down their factories, thus throwing may people out of employment. Hence, both inflation and deflation adversely affect the common masses and upset the working of the economic system. The monetary policy should, therefore, strive at achieving a reasonable amount of price stability to ensure smooth working of the economy.
The traditional objective of the monetary policy was to control, credit creation by the commercial banks in a manner, that it would, ensure the stability of foreign exchange rate of a country’s currency. The idea behind the policy was to eliminate or contain violent fluctuations in the foreign exchange rate.
But, preoccupation of monetary policy with exchange rate stability often led to fluctuations in the level of economic activity within the domestic economy of a country. Consequently, the emphasis of monetary policy shifted from exchange rate stability to the maintenance of domestic economic stability and price stability. The view that domestic economic stability and price stability should be preferred to the foreign exchange stability gained support on the grounds that stabilization of domestic price was far more conducive to nation’s economic welfare than the stability in exchange rates.
In the underdeveloped countries, the central bank has been entrusted with the role of promoting rapid economic development with price stability. Underdeveloped countries suffers from a serious deficiency of economic resource for bringing about rapid development. Acute shortage of capital, limits the investment capacity in these countries. What is needed urgently is an efficient banking and financial system which can encourage and collect saving of the people and allocate funds among different investment activities according to plan and priorities of development. The central bank by its policy of branch expansion in hitherto unbanked areas and through a suitably designed monetary policy, can help a great deal in initiating and sustaining the process of economic development.
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