UNIT 10 MONETARY POLICY*

Structure
10.0 Objectives
10.1 Introduction
10.2 Quantity Theory of Money
10.2.1 Neutrality of Money
10.2.2 Effect of Change in Interest Rate
10.2.3 Monetary Transmission Mechanism
10.3 Rules versus Discretion
10.3.1 Policy Lags
10.3.2 Reputation and Credibility
10.3.3 Taylor Rule

10.4 Loss Function

10.4.1 Taylor Rule
10.5 Quantitative Easing
10.6 Limits to Monetary Policy
10.7 Let Us Sum Up
10.8 Answers/Hints to Check Your Progress Exercises

10.0 OBJECTIVES
After going through this unit, you will be able to
 discuss the underlying ideas behind the quantity theory of money;
 identify the various tools (or instruments) of conducting monetary policy;
 elucidate the objectives of monetary policy;
 explain why policy rules are better than discretionary policies;
 explain the Taylor rule on determination of interest rate;
 describe the usefulness of quantitative easing;
 identify the limitations of monetary policy.

10.1 INTRODUCTION
In Unit 6 of BECC 103: Introductory Macroeconomics we had a brief
introduction to the objectives and instruments of monetary policy. In this context,
we discussed about inflation targeting and quantitative easing. In the present
Unit, we will recapitulate some of those issues and extend it further towards the
policy formulation aspect. Monetary policy refers to the use of a set of

*
Dr. Kaustuva Barik, IGNOU and Dr. Krishnakumar, Sri Venkateshwara College, University of
Delhi
Fiscal and Monetary instruments by the central bank to influence the level of money supply in an
Policy economy. There are two types of tools or instruments of monetary policy, viz., (i)
quantitative, and (ii) qualitative. Quantitative instruments are also known as
general instruments. They relate to the quantity or volume of money supply in the
economy. Thus these policy instruments do not discriminate across sectors of the
economy or social groups. The important tools in this category are a) interest
rate, b) open market operations, c) cash reserve ratio, and d) statutory liquidity
ratio. Qualitative instruments are also called selective tools. They are used for
discriminating between different uses of credit. The important selective credit
control instruments are a) selective credit controls, b) margin requirements, c)
credit rationing, d) moral suasion, and e) direct actions. We have elaborated on
all these instruments in Unit 6 of BECC 103.
Monetary policy as practiced by countries has evolved over time. These days, the
main instrument at the disposal of central banks is the interest rate. You may
have seen people in the business as well as bankers waiting for the announcement
of monetary policy by the Reserve Bank of India (RBI). In an open economy, the
challenges before the central bank are too many. In fact, in the modern era,
financial stability has become an important consideration of the central banks.
Till the 1970s, it was believed that the central bank would be able to control the
supply of money in the economy. Even then, there were economists who
expressed doubts on the ability of the central bank to do so. However, during the
period 1986-2006, there was stability in ‘economic growth and inflation’ in most
developed countries. This period is often termed as the ‘great moderation’ as it
was somehow believed that we have mastered the art of controlling the economy.
Extreme economic volatility was thought to be a thing of the past, till the world
encountered the global financial crisis during 2007-2009. Subsequent to the
financial crisis, since 2010, many countries have resorted to ‘protectionism’,
which has influenced globalisation adversely.
The importance of monetary policy worldwide has resulted in heads of the
central banks (for example, Governor of RBI in the case of India) receiving
importance. Most of the central banks are governed by their legal mandates, not
just to control the level of inflation, but also maintain a lower level of
unemployment. In fact, in earlier days (up to 1980) most central banks were
pursuing multiple objectives including price stability, employment and economic
growth. Since the 1980s, however, the focus has been more on inflation targeting.
This focus on inflation targeting to the exclusion of other priorities is usually
ascribed to the Federal Reserve System of the United States (US) for its role
played in the 1980s. In the aftermath of the oil crisis during the 1970s, United
States was witness to an unprecedented inflation of sorts. Paul Volcker, the then
President of the Federal Reserve System, administered a large hike in the interest
rate. Even though the level of output contracted as a result of the increase in
interest rate, the rate of inflation declined. It is in this context that inflation
targeting gained acceptability in the policy circles of central banks. Volcker’s
disinflation strategy of hiking interest rate towards reducing price levels gained
wide recognition. Since the 1980s, the focus among central bankers has been
more on inflation targeting to the exclusion of the objective of employment
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generation. You should note that the increase in interest rate in the United States Monetary Policy
resulted in a number of Latin American countries (such as Brazil, Argentina and
Mexico) defaulting on their international debt obligations. Many Latin American
countries had borrowed huge amounts during the 1960s and 1970s for
industrialization of their countries. When the rate of interest increased during the
1980s these countries had to pay huge sums to service their debts. Students of
economics and history would know that the international debt crisis in the 1980s
had a harmful effect on the economic growth in Latin America. This had much to
do with the disinflation strategy pursued by the United States and European
Countries. In the recent years too, you would have noticed that developing
economies witnessed capital flights (outflow of foreign capital) from financial
markets in response to increases in interest rate by the developed economies.

10.2 QUANTITY THEORY OF MONEY

The lineage of the quantity theory of money (at times called classical quantity
theory of money as it is based on classical assumptions) can be traced to the
writings of the Scottish philosopher David Hume. He mentioned about the same
in his classic work, Treatise of Human Nature. In his model of ‘Price-Specie
Flow Mechanism’ in 1749, he developed an explanation of the functioning of the
Gold Standard. Gold Standard, as you know, was a monetary system in which a
country’s currency had a fixed value in terms of gold. According to Hume, if a
country had a positive balance of trade (means exports is greater than imports),
gold would flow into the country. Thus, money supply would increase which
would lead to inflation. Similarly, if the country had deficit in balance of trade,
gold equivalent to the value of deficit would flow out of the country. If there is
no counter measures by the government, money supply will decrease, which in
turn will lead to decrease in price level.
Quantity theory of money was put forth in its current version by Irving Fisher in
the early twentieth century as an equation of exchange. It is given as MV = PY,
where M is the money supply, V is velocity of circulation of money, P is price
level and Y is the level of output produced in the economy. The classical
economists assumed that because of flexibility in prices and wage rate, there is
full employment in the economy. Thus, Y is fixed at the full employment level,
and V (the number of times a unit of money, say, a currency note, changes hand)
is usually constant. Thus, any increase in money supply will increase the price
level.
10.2.1 Neutrality of Money
According to the proponents of the classical economics, money is neutral in the
sense that it affects monetary variables such as prices, wage rate and exchange
rate. It does not affect real variables such as output and employment. Output is
not affected by money supply as, by assumption, there is always full employment
in the economy. Prices and wage rates are assumed to be flexible.
If supply of labour is more than demand for labour, wage rate will decline. On
the other hand, if demand for labour is more than its supply, wage rate will
increase. Similarly, prices are determined by the market forces such as supply
and demand. Certain studies, based on empirical data, have established that
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Fiscal and Monetary money is neutral in the long run. Thus, it could be a long run phenomenon. In the
Policy short run, however, neutrality of money does not get much support from
empirical studies. Thus, in the short run, money may not be neutral.
An increase in money supply leads in the long run to a proportionate increase in
the level of prices with no change in the level of allocation of resources or in the
value of the output produced. As long as the rise in prices is fully anticipated, an
increase in the total amount of money leads to a proportionate increase in all
money prices. This would have no effect on any real variable in the long run. For
a long period of time, the monetarist policies (inspired by the restatement of the
quantity theory of money) continued to be of powerful influence in central
banking circles. Milton Friedman once observed that inflation is always and
everywhere a monetary phenomenon. In fact, till before the global financial
crisis, the focus of the central banks has been to restrict the rate of growth of
money supply. As per Friedman’s postulate in this regard, money supply should
grow only at the same rate of growth of nominal GDP.
In addition to neutrality of money, there is another concept called ‘super
neutrality of money’. Being a stronger proposition than the neutrality of money,
it says that changes in the growth rate of money supply have no effect on real
variables. Suppose money supply in a country is increasing at the rate of 3 per
cent per annum. Suddenly, the central bank decides to increase it by 5 per cent
per annum. Will it have any effect on output growth? Empirical results on this,
however, are ambiguous.
10.2.2 Effect of Change in Interest Rate
By taking into account the expectations (see Units 4 and 5 of this course) about
inflation rate and growth rate in the economy, the central bank sets the interest
rate.
𝑀

𝑖
𝑀

𝑀 𝑀

Fig. 10.1: Effect of Rise in Interest Rate

You may recall from the quantity theory of money that ‘nominal interest rate =
real interest rate + the expected rate of inflation’. Monetary authorities worldwide
set the interest rates and let the money stock adjust to the demand. A policy

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induced rise in the interest rate, say, from 𝑖 to 𝑖 , results in the money stock Monetary Policy
contracting from 𝑀 to 𝑀 (see Fig.10.1).
How does this work? The increase in interest rate results in a reduction in
investment spending as well as consumption spending. This results in a decrease
in the level of income, and hence, there would be reduction of money demand
(𝑀 ). The stock of money supply (𝑀 ) would adjust to the new money demand.
10.2.3 Monetary Transmission Mechanism
Let us assume that the central bank increases money supply. This will increase
liquidity in the economy and interest rate will decrease. A decrease in interest
rate can affect several macroeconomic variables in the economy. These effects
are often called ‘transmission channels’ or ‘transmission mechanisms’. Monetary
transmission mechanism tells us how the effect of a monetary variable transmits
or passes on to other variables. The important channels are as follows:
(i) Credit Channel: A decrease in interest rate will lead to an increase in the
demand for credits. Those projects which were considered unviable
earlier could now become viable because of the lower cost of capital.
Households which did not take a loan from the bank because of higher
interest rate may now think of taking a loan. Such actions would put
purchasing power in the hands of firms and households. Firms and
households would spend this additional money on various goods and
services. As a result of the increase in demand, equilibrium output will
increase (if the economy is operating below the equilibrium output level).
Thus, the classical position that increases in money supply would lead to
increases in price level only, may not be true.
(ii) Exchange Rate Channel: Apart from the credit channel, another channel
of monetary transmission mechanism is through the ‘exchange rate
channel’. As interest rate is reduced, there will be outflow of capital –
foreign investors will pull out their money to invest in other countries
offering higher rate of interest. This will lead to shortage of foreign
exchange and the domestic currency will depreciate. Due to the
depreciation of the exchange rate, however, there will be an increase in
the competitiveness of the exports. Simultaneously, imports will become
costlier. The increase in net exports will lead to increase in aggregate
demand, which in turn will lead to increase in equilibrium level of output.
For this to happen, domestic price levels should not increase with
depreciation. However, note that elasticity of demand for exports and
imports should be greater than unity. Thus, the exchange rate channel
works only if these conditions are fulfilled.
(iii) Cost of Capital: Yet another channel is through the cost of capital. As the
interest rates are reduced, the ease of financing the purchase of shares
increases. This leads to an increase in the price of shares (i.e., stock
prices) of firms. In other words, the market value of the firm increases in
comparison to the replacement cost. This encourages firms to expand

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Fiscal and Monetary further by carrying out new investments. This results in an increase in the
Policy level of output. The same also has a spinoff effect in consumption
expenditure.
As the value of shares increase, households stand to benefit in the form of
increase in the value of the shares they possess. This results in a wealth
effect enhancing the level of consumption expenditure.
These are some of the routes of monetary transmission mechanism. These
channels, however, do not always work due to several reasons. In particular,
when there is a large demand for liquidity in the economy, and the economy is in
liquidity trap, monetary policy ceases to be effective. A monetary variable
(money supply) affects a real variable (output) but this need not happen always.
Even after the interest rate has been reduced, there need not necessarily be an
increase in demand for credit from households and firms. For instance, firms may
not increase the demand for money if the expectations about future earnings are
uncertain. Similarly, households may not require additional money if incomes in
the near future are not certain. Further, even when the central bank reduces
interest rate, it is not necessary that the same will be passed on to the borrowers
by the commercial banks. Commercial banks would be reluctant to do so,
particularly when the banks have a large volume of non-performing assets (bad
debts).
Check Your Progress 1
1. Outline the concept of neutrality of money.
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2. State the various channels of monetary transmission mechanism.

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10.3 RULES VERSUS DISCRETION

As you are aware, Keynesian economics prescribed an activist role for the
government. When the economy is passing through a recession phase, the
government should increase public investment. Increase in investment would
lead to increase in aggregate demand, which in turn will increase aggregate
output. On the other hand, if the economy is over-heated (economy is operating
at the full employment level and aggregate demand is still on the increase), the

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government should reduce public investment so that aggregate demand is Monetary Policy

stabilised. Thus, Keynesian economics visualizes that the government can

moderate the effect of business cycles. Keynesian economics advises that the
government should have a discretionary power so far as government spending is
concerned.
Keynesian economics, proposed an activist role of the government. The new-
classical economists, however, advocated that government policy should be on
the basis of certain rules, and not by the discretion of the policy makers (We will
learn about various schools of macroeconomic thought in Units 11 and 12 of this
course).
10.3.1 Reputation and Credibility
The government policy should be credible in the sense that the government is
committed to its policy measures. The credibility of an announced policy
depends on two factors: (i) past experience regarding a government’s ability to
adhere to commitments, and (ii) expectations of people that the government will
adhere to the policy. Investment decisions by firms and saving decisions by
households are taken on the basis of credibility. In this context, you can observe
that certain governments have built their reputations over the years regarding
good governance.

A government optimizes on its objectives. Suppose, the government announces

that it will give tax holidays (i.e., no taxes) for five years to certain sector, say,
tourism. This will act as an incentive for firms to invest in the tourism sector.
After two years, if the government thinks that investments have been made, and
now the government can increase tax revenue by imposing taxes on the tourism
sector. This leads to loss of credibility.
10.3.2 Monetary Policy Rule
In order to maintain stability in the economy, economists suggest certain ‘policy
rules’. In simple words, it means that government actions should be according to
certain rules. Let us take an example from real life. You might have seen that
there are illegal constructions on the fringes of cities.
These houses are constructed in clandestine manner. These house owners
subsequently plead before the government to legalise these constructions. Before
elections, political parties compete with one another to promise that if they come
to power, they will regularize these illegal constructions. Similarly, political
parties often promise to waive agricultural loans after coming to power. Such
promises work as incentives for people to go for houses in illegal colonies.
Similarly, people take agricultural loans and do not repay with a hope that the
government will waive it. Suppose there is a law of the land that under no

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Fiscal and Monetary circumstances, illegal construction will be regularized or loan will be waived.
Policy
Such rules will work as disincentives for people against such behaviour.
Let us take an example from economics. Under an agreement between the central
government and RBI, the RBI will have to maintain inflation rate in India at 4 per
cent per annum, with an allowable range of 2 per cent to 6 per cent. Thus, RBI
will take such measures that inflation rate does not go beyond the 2 per cent to 6
per cent range.
Thus ‘monetary policy rule’ can be seen as a reaction function of the
government. It is a mathematical function that describes how the central bank
decides interest rate in response to certain macroeconomic variables. As you
know, higher interest rate discourages investment; thus slows down economic
growth. If inflation rate is high, interest rate should be high. If actual growth rate
is higher than potential growth rate, interest rate should high. We will discuss the
Taylor rule, which is a specific case of monetary policy rule, later in this Unit.
Check Your Progress 2
1. Elaborate on the need for policy rules.
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2. What is the importance of credibility and reputation for an economy?

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10.4 LOSS FUNCTION

The main objective of monetary policy is inflation targeting but control of
inflation should not be at the cost of economic growth and employment. You are
aware of the concept of ‘natural rate of unemployment’. It says that a small
fraction of the labour force is usually unemployed as they are in the process of
changing job. The potential output of a country takes into consideration such
natural rate of unemployment.

Let us assume that 𝑦 and πT are output at natural rate of unemployment and
targeted rate of inflation respectively. We assume that the economic welfare of
the country is the maximum when the economy is operating at 𝑦 and πT. It
implies that the economy is at a ‘point of bliss’ when it achieves (𝑦 , πT) and any
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 Monetary Policy
deviation from the same would reduce welfare. Suppose actual output and
inflation are 𝑦 and π respectively. Thus, if targeted inflation is 4 per cent and
actual inflation is 2 per cent the deviation is (𝜋 − 𝜋 ) = (2 − 4) = −2 per cent.
There is a loss of welfare if inflation is higher than 4 per cent or lower than 4 per
cent. Thus, the central bank would like to minimize the function (𝜋 − 𝜋 ) .
Similarly, the central bank would like to avoid deviation in actual output (𝑦) from
potential output (𝑦 ). Thus it will minimize the function (𝑦 − 𝑦 ) .

If we combine both the terms, we obtain a loss function of the central bank, given
by

𝐿 = (𝑦 − 𝑦 ) + (𝜋 − 𝜋 ) …(10.1)

The central bank would minimize the loss in welfare by minimizing equation
(10.1) arising out of deviations in actual output and actual inflation from
respective targets. In equation (10.1) we give equal emphasis on output gap
(𝑦 − 𝑦 ) and deviation in inflation (𝜋 − 𝜋 ). Many a times, a central bank gives
unequal weightage to output (which represents employment) and inflation. For
that purpose we re-formulate (10.1) as

𝐿 = (𝑦 − 𝑦 ) + 𝛽(𝜋 − 𝜋 ) …(10.2)

In (10.2), if 𝛽 = 1, we have a situation same as (10.1). If 𝛽 > 1, the central bank

puts more emphasis on maintaining inflation target (i.e. it perceives a greater loss
if inflation deviates from its target). Such an approach is considered as ‘inflation-
averse’. On the other hand, if 𝛽 < 1, the central bank perceives that there is
greater loss of welfare if people remain unemployed. This type of a position by
the central bank is termed as ‘unemployment-averse’.

𝜋 declining utility

ye y

Fig. 10.2: Balanced Approach (β = 1)

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Fiscal and Monetary We depict the loss function diagrammatically through the ‘loss circles’. These
Policy
circles are quite similar to the indifference curve you have studied in
microeconomics.

Let us take output on the x-axis and inflation on the y-axis (see Fig. 10.2). The
bliss point is given by the inter-section of the lines representing the point (𝑦 , πT).

Let us consider the first quadrant of Fig. 10.2 (top right segment of the diagram)
where we consider position deviations in output and employment (𝑦 > 𝑦 ;
𝜋 > 𝜋 ). If the economy deviates from the bliss point, there is a loss of welfare.
If the approach of the central bank is balanced (i.e., 𝛽 = 1) there is equal
emphasis on unemployment and inflation. An implication of the above is that an
1 per cent deviation in actual output from potential output means the same
amount of welfare loss as 1 per cent deviation in actual inflation from target
inflation. Both the evils can be represented by an indifference curve (concave to
the origin), indicating various combinations of inflation deviation and output gap.
In the second quadrant, we consider the situation where actual output is less than
potential output (𝑦 < 𝑦 ) and actual inflation is more than target inflation
(𝜋 > 𝜋 ). Since this also involves a loss of economic welfare for the country, we
represent it by an indifference curve. You can develop a similar logic and find
that the indifference curve in this case is actually a circle! We call it the ‘loss
circle’. Following the manner in which we have drawn a loss circle for 1 per cent
deviation in both output and inflation, we can draw another loss circle for 2 per
cent deviation. Thus, we can draw a series of concentric loss circles, with (𝑦 , πT)
at the centre. It looks like a bull’s-eye; the objective of the central bank is to hit
the bull’s-eye; and deviation away from the bull’s-eye implies declining utility
for the economy.

Ye Y
Fig. 10.3: Inflation-Averse (β >1)

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 Monetary Policy
The shape of the loss circles would depend on the approach of the central bank
towards inflation and unemployment. In Fig. 10.2 we have depicted perfect
circles because the central bank is equally concerned about deviation from output
and inflation (β = 1).
In case the central bank is inflation-averse (i.e., perceives inflation to be a greater
concern than unemployment), then it would require smaller deviation in inflation
than in unemployment for certain loss of welfare. In this case, the loss circles
would be like ellipsoid (as shown in Fig. 10.3). Here the central bank would trade
off a small rise in inflation with large fall in unemployment.
𝜋

Ye Y
Fig. 10.4: Unemployment-Averse (β <1)
In case the central bank is unemployment-averse (i.e., perceives unemployment
to be a greater concern than inflation), then it would trade off a small decline in
unemployment for a large rise in inflation. In this case, the loss circles would be
like ellipsoid as in Fig. 10.4.
10.4.1 Taylor Rule
Taylor rule of interest rate setting sets the inflation rate at a higher level
compared to the benchmark interest rate. This is in case inflation is expected to
be higher than the targeted inflation rate and output is expected to be higher than
the output at the natural rate of employment.
On the other hand, in case, inflation is lower than the targeted level of inflation or
output is lower than at the natural rate of employment, the level of interest rate is
set at a lower level compared to the benchmark interest rate.
The guiding principle of interest rate determination among central bankers
worldwide has been the Taylor rule. In simple terms, it recommends changes in
interest rates from its benchmark rate on the basis of the deviation from the
natural rate of employment and targeted rate of inflation. As inflation exceeds
targeted rate of inflation, the interest rate is increased. Likewise, if output is
above the full employment level, the level of interest rate is increased. The
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Fiscal and Monetary interest rate is decreased if inflation is lower than the targeted level of inflation,
Policy
or output is lower than the targeted level of output. Therefore, there are no limits
to using interest rates for controlling inflation and output, in general, but it is
different during periods of deflation and unemployment. In fact, in the aftermath
of the global financial crisis, as per the Taylor equation, the rates of interest had
to be reduced to negative nominal rates, which was unsustainable.
We can write the Taylor rule of interest rate setting it as
𝑖 = 𝑖 ′ + 𝛾 (𝜋 − 𝜋 ) + 𝛾 (𝑦 − 𝑦 ) …(10.3)
where
𝑖 is operating target interest rate (the rate decided) for short-term;
𝑖 ′ is existing interest rate (benchmark interest rate);
(𝜋 − 𝜋 ) is the gap of inflation from the inflation target;
(𝑦 − 𝑦 ) is the output gap ; and
𝛾 and 𝛾 are parameters of the model representing the weights assigned to
unemployment and inflation.
If there is a positive output gap (actual output is more than full capacity output)
in the economy, the central bank should raise interest rate according to equation
(10.3). On the other hand, if output gap is negative (actual output is less than full
capacity output), there is spare capacity in the economy and interest rate should
be reduced. If actual inflation rate (𝜋) is higher than target inflation rate (𝜋 ∗ ), the
central bank should raise interest rate. On the other hand, if actual inflation rate is
lower than target inflation rate, the central bank would decrease interest rate.
Suppose, for an economy the following information is given:
𝛾 = 0.5, 𝛾 = 0.5, 𝜋 = 0.04, and 𝑖 ′ = 0.02
The Taylor rule will become
𝑟 = 0.02 + 0.5(𝜋 − 0.04) + 0.5(𝑦 − 𝑦 ) …(10.4)
By applying equation (10.4), the central bank can determine interest rate.

10.5 QUANTITATIVE EASING

When the rates of interest are very close to zero, the economy enters the liquidity
trap region where monetary policy is completely ineffective. People are willing
to hold whatever amount of money is supplied to them. In such a scenario, a
different strategy has to be adopted by the central bank to boost economic
activity. Money is directly pumped into the financial system through a process
known as ‘quantitative easing’, which is also known as asset purchase scheme.
The central bank starts purchasing asset-backed securities.

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Quantitative easing is incorrectly referred to as money printing since no hard Monetary Policy
cash is actually printed. Instead of printing money, the central bank creates
electronic or digital money which is used for purchase of bonds. The central bank
issues credit to the central bank’s reserves to buy bonds. As a result, commercial
banks get more than what they require as reserves. Commercial banks make a
profit by lending out the excess reserves.
With quantitative easing, there is an increase in demand for bonds or safe assets.
The market price of these bonds increases. Banks and financial institutions have
more funds resulting in increased lending, higher business investment, and a
boost to economic activity. When the economy recovers, the central bank sells
these assets and sterilizes the cash it receives from the sales. So there is no
additional money remaining in the system.
Hence, the goal of quantitative easing is to inject liquidity into the banking
system, so that banks are able to lend money to boost economic activity. It is a
deliberate expansion of the central bank’s balance sheet and the economy’s
monetary base. However, there is a danger of increased inflation through this
process.
You may be aware of the global financial crisis of 2007-08. During that time, a
cut in interest rates was implemented by many central banks such as Federal
Reserve, European Central Bank, Bank of Japan and Bank of England. Such
measures were coupled with practices of unconventional monetary policies, i.e.,
purchases of bonds. In the aftermath of the global financial crisis, there has been
large scale purchase of assets on the part of central banks worldwide.

10.6 LIMITS TO MONETARY POLICY

As per the Taylor rule of setting interest rates, in case the economy is on an
inflationary mode or if the level of output exceeds the potential output, the
interest rate should be increased from the benchmark interest rate. But, when it
comes to level of inflation lower than the target rate of inflation, or levels of
output lower than the potential output, the central bank has to reduce the interest
rate in comparison to the benchmark rate. Interest rate setting is not that simple at
times.

This is because interest rate in developed economies is much lower than that in
developing economies. As per the Taylor rule of interest rate setting, the central
bank may not be in a position to decrease the benchmark rate further if it is close
to zero or in the negative zone. In Japan, for example, interest rate has been in the
negative zone since 2016 (current rate on interest, as of May 2021, in Japan is (–)
0.10 per cent per annum). After the global financial crisis of 2007-2009, many
countries went through such situations of zero interest rate. This suggests that
there are limits to monetary policy but expansionary stimulus (through fiscal
spending and unconventional purchases of bonds), i.e., quantitative easing can
help in such situations.
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Fiscal and Monetary Check Your Progress 2
Policy
1. Explain the concept of loss function.
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2. Describe the loss function for an inflation-averse economy through

diagrams.
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3. State the Taylor rule for determination of the interest rate in an economy.
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10.7 LET US SUM UP

In this unit we discussed the quantity theory of money. In this context we dealt
with the concept of neutrality of money in the short run and the long run. The
unit has briefly discussed the Taylor rule which describes how, for each one-
percent increase in inflation, the central bank tends to raise the nominal interest
rate to stabilize the economy. In a liquidity trap like situation, monetary policy
instruments may not work. The central bank can adopt quantitative easing which
injects liquidity into the banking system lowering the lending rates of banks.

10.10 ANSWER/ HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) The quantity theory of money states that there is a direct relationship
between the quantity of money in an economy and the level of prices. Thus
money should be neutral. However, money is not neutral in the short run.
See Section 10.2 for details.
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2) It is the link between monetary policy and aggregate demand. There are Monetary Policy
various channels of transmission mechanism. See Section 10.2 for details.
Check Your Progress 2
1) See Section 10.3 for details.
2) Refer to Section 10.3.1 and answer.
Check Your Progress 3
1) Refer to equation (10.1) and explain.
2) Refer to Fig. 10.3 and explain.
3) Refer to equation (10.3) and explain.

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