In more developed nations, monetary and financial policy plays a major direct and indirect role in governmental efforts designed to expand economic activity in times of unemployment and surplus capacity and to contract that activity in times of excess demand and inflation. Basically, monetary policy works on two principal economic variables: the aggregate supply of money in circulation and the level of interest rates. Expressed in traditional terms, the money supply (currency plus commercial bank demand deposits) is thought to be directly related to the level of economic activity in the sense that a greater money supply induces expanded economic activity by enabling people to purchase more goods and services. This in essence is the monetarist theory of economic activity. Its advocates argue that by controlling the growth of the money supply, governments of developed countries can regulate their nations’ economic activity and control inflation.
On the other side of the monetary issue, again expressed in traditional terms, are the Keynesian economists, who argue that an expanded supply of money in circulation increases the availability of loan able funds, A supply of loan able funds in excess of demand leads to lower interest rates. Because private investment is assumed to be inversely related to prevailing interest rates, businesspeople will expand their investments as interest rates fall and credit becomes more available. More investment in turn raises aggregate demand, leading to a higher level of economic activity (more employment and a higher GDP). Similarly, in times of excess aggregate demand and inflation, governments pursue restrictive monetary policies designed to curtail the expansion of aggregate demand by reducing the growth of the national money supply, lowering the supply of loan able funds, raising interest rates, and thereby inducing a lower level of investment and. it is hoped, less inflation.
Although this description of monetary policy in developed countries grossly simplifies a complex process. It does point out two important aspects that developing countries lack. First, the ability of developed-country governments to expand and contract their money supply and to raise and lower the costs of borrowing in the private sector (through direct and indirect manipulation of interest rates) is made possible by the existence of highly organized, economically interdependent, and efficiently functioning money and credit markets. Financial resources are continuously flowing in and out of savings banks, commercial banks, and other nationally regulated public and private financial intermediaries with a minimum of interference. Moreover, interest rates are regulated both by administrative credit controls and by market forces of supply and demand, so there tends to be consistency and a relative uniformity of rates in different sectors of the economy and in all regions of the country. Financial intermediaries are thus able to mobilize private savings and efficiently allocate them to their most productive uses. This is a critical ingredient in the promotion of long-term economic growth.
By contrast, markets and financial institutions in many developing countries are highly unorganized, often externally dependent, and spatially fragmented. Many LDC commercial banks are merely overseas branches of major private banking institutions in developed countries. Their orientation, therefore, like that of multinational corporations, may be more toward external and less toward internal monetary situations. The ability of LDC governments to regulate the national supply of money is further constrained by the openness of their economies, in some cases the pegging of their currencies to the dollar or to a basket of MDC currencies, and the fact that the accumulation of foreign-currency earnings is a significant but highly variable source of their domestic financial resources. Even the money supply itself may be difficult to measure and more difficult to control when there are, as in many LDCs, problems of currency substitution, whereby foreign currencies serve as an alternative to the domestic currency (e.g., U.S. dollars in northern Mexico). Most important, because of limited information and incomplete credit markets, the commercial banking system of many LDCs lacks transparency (full disclosure of the quality of loan portfolios) and often restricts its activities almost exclusively to rationing scarce loanable funds to medium and large scale enterprises in the modern manufacturing sector that are deemed more creditworthy. This lack of transparency, and the fact that many borrowers were no creditworthy, was a major factor in the 1997 Asian currency and banking crisis, especially in Thailand and Indonesia. As a result, small farmers and indigenous small-scale entrepreneurs and traders in both the formal and informal manufacturing and service sectors must traditionally seek financing elsewhere – sometimes from family members and relatives, but more typically from local moneylenders and loan sharks, who charge exorbitant rates of interest.