The Instruments of Monetary Policy in Countries Without Highly Developed Capital Markets

In the developing countries, the instruments of control available to the central bank or other monetary authority include five that appear to warrant detailed consideration:


In the developing countries, the instruments of control available to the central bank or other monetary authority include five that appear to warrant detailed consideration:

In the developing countries, the instruments of control available to the central bank or other monetary authority include five that appear to warrant detailed consideration:

  • 1. Control of central bank credit to the deposit-money banks;1

  • 2. Manipulation of government accounts;

  • 3. Variation of deposit-money bank reserve requirements;

  • 4. Open market operations;

  • 5. Direct regulation of deposit-money bank lending.

Direct Regulation of Deposit-Money Bank Lending

A good argument can be made for dismissing consideration of the use of the last of these instruments (over-all direct regulation of deposit-money bank lending) in developing countries.

One of the attributes of traditional monetary policy, and of its implementation through central bank policy, is its generality. To maintain that monetary policy has general effects is not to deny that it may have directional effects.2 However, one of the aspects of the nondiscriminatory pressures that central banks normally attempt to exert is that such pressures impinge equally on all economic units in similar liquidity positions. Given the over-all restraints on economic activities deriving from monetary policy, each economic unit3 is free to adjust its own asset and liability position so as to satisfy its own desires. In particular, each unit is free to compete with every other unit in a similar position. Generalized monetary policy does not impede interunit competition and adjustments. However, any direct regulation of deposit-money bank lending is likely to depart from this generality. It is almost inevitable that such regulations will involve specific controls over the actions of individual institutions. Such a system of controls is more likely to freeze the status quo than to encourage competitive adjustment. It follows that this method of implementing monetary policy is likely to encourage rigidity rather than flexibility. This rigidity may be undesirable at any time and particularly serious at a time when general economic policy is directed to the encouragement of structural adaptations in the economy.

This argument relating to total ceilings on, or detailed regulation of, bank lending should not be carried too far. In many cases, where government policy is based on well-considered development plans designed to foster growth in specific directions, prohibitions or limits on lending for purposes which the authorities do not wish to encourage, or encouragement to lending for purposes which are considered to be in the national interest, may be appropriate. However, while these instruments have their place and may well be used, too much reliance should not be placed on them. For any borrower, his total access to credit may be regarded as a pool; any easing of his access to this pool for ostensibly desirable purposes may ease his problems of financing other “less desirable” expenditures.

Open Market Operations

In many discussions of central banks, it is suggested that monetary policy may be implemented primarily by open market operations. This direction of attention to open market operations as a major tool of monetary policy reflects the fact that most writers on the subject are more conversant with conditions in developed than in developing countries.4 In all countries except those with highly developed capital markets, open market operations are likely to be a most ineffective tool for implementing monetary policy. In fact, one of the most complete surveys of central bank policies observes that open market operations have been an effective instrument of monetary policy only in Canada, the United Kingdom, and the United States.5

Open market operations are, as their name implies, transactions conducted on an organized market. They are one of the means by which a central bank can alter the total of its assets and, hence, of its liabilities. However, because they are market operations, they can be conducted only if there is a satisfactory market for the assets normally bought and sold by a central bank—usually government securities. A market will not be satisfactory if significant transactions by the central bank lead to a considerable alteration in the prices of the relevant securities. Therefore, if the central bank is to engage successfully in open market operations, there must be a well-developed capital market in which the activities of the central bank play only a relatively minor role.

Before such adequate capital markets can develop, certain conditions must be met.6 In the first place, the flow of funds for investment must be relatively constant and of considerable volume. Only from such a source can the demand side of the market be supplied, giving the market a realistic existence. Second, the volume of business in existing securities must be large. If the chief business consists of the accumulation of private funds by intermediaries and the purchase of new securities by private investors and such intermediaries, any significant transactions in existing securities will lead to large price movements. Third, to ensure stability there must be a considerable volume of short-term lending and borrowing. The existence of borrowers and lenders engaged in such transactions ensures the existence of operators who are in possession of liquid assets and who will be prepared to move into the medium-term or long-term markets if the prices of such securities fall appreciably. Conversely, if their prices rise appreciably there are opportunities for investors to invest their money for short periods until the market returns to more “normal” levels. Fourth, a satisfactory capital market must be based on domestic sources of funds. If it is dependent on foreign investors, it will be subject to severe crises whenever the inflow of foreign funds diminishes, because any slight “recessions” will frighten the foreign investors and convert such “recessions” into “crises.” On the other hand, if the market is based on domestic sources of funds, and if the lenders in this market are also willing to invest abroad, such capital exports will give stability to the market. Any tendency for domestic security prices to rise will encourage capital exports, and any declines will encourage investors to lend in the domestic market, thus maintaining prices. All four conditions are essential to the price stability required for successful central bank operation in the market.

In most countries, these conditions are not satisfied. Only in the very wealthy countries do economic units have sufficiently large total assets to enable them to hold the amounts of financial assets that are a precondition for the development of adequate markets. Hence, it is only in these countries that central banks may be expected to implement monetary policy by traditional open market operations.

Variation of Deposit-Money Bank Reserve Requirements

To circumvent the limitations arising from the absence of broad and active financial markets, many countries have resorted to techniques of monetary control which do not involve changes in central bank assets. The most effective of these has been variable reserve requirements for deposit-money banks. Provided that the ratio of required reserves to deposit liabilities is greater than the ratio which the deposit-money banks would maintain voluntarily for working needs, a minimum cash reserve requirement will be an effective restraint on, and hence may be an effective instrument for the control of, these banks. Further, changes in the required ratio may be used as an instrument of monetary policy. Increases in the required reserves will act as a restraint on bank lending; decreases will serve to encourage an expansion of bank credit. Thus, changes in required minimum cash reserve ratios can be used for monetary control in countries where open market operations are likely to be an inefficient instrument of monetary policy.

However, this method of implementing monetary policy has certain weaknesses which suggest that its use might well be reserved for crisis situations. It is desirable that the results of central bank action be reasonably predictable. If the deposit-money banks maintain stable ratios between cash reserves and their deposit liabilities, the central bank's action in altering the reserve assets of the deposit-money banks will have predictable effects on money. However, in a community where reserve requirements are frequently altered, the deposit-money banks may well attempt to forecast changes in them, so that they may minimize the adjustment problems which they will face when the changes in reserve requirements actually take place. In order to meet day-to-day needs, the banks will attempt at all times to maintain reserve balances in excess of those required by the regulations. When they expect that the required minimum ratio is likely to be raised, they will probably attempt to widen this spread between the required minimum reserves and their actual holdings. When it is expected that the minimum requirement is to be lowered, the banks will probably narrow this spread. That is, under a system of variable reserve requirements, the actual ratios maintained by the banks are likely to be flexible, so that the effect of the central bank's action may not be exactly predictable. Nevertheless, in a less developed economy where alternative instruments cannot be used successfully, the variable reserve requirement is likely to be a useful instrument of monetary control.

In particular, it may prove to be a most useful instrument in dealing with crisis or near-crisis situations. When a monetary system has been allowed to get out of control, firm measures may be required to restore financial stability. An effective monetary stabilization program may result in large inflows of foreign exchange, leading to an undesired increase in central bank assets, and producing an unfortunate expansionary impact on the economy. The reduction of a government's deficit, which is usually called for because untenable deficits are frequently the source of monetary chaos, may take time, and, in the interim, even the declining deficit will continue to provide expansionary pressures. A marked reduction in central bank credit to the deposit-money banks (discussed later) may impose severe strains on individual institutions whose accounts are already under pressure as a result of the stabilization program.7 Under these circumstances, a general raising of reserve requirements may be the most effective means of putting a general contractionary pressure on the monetary system. Alternatively, high marginal reserve requirements, i.e., high minimum reserve ratios applied against increases in deposits, as distinct from total deposits, may be an appropriate method of applying effective pressure objectively on those parts of the monetary system most able to respond to such pressure without imposing a structural strain on the system.

Manipulation of Government Accounts

Payments by the government serve to increase the stock of money held by the rest of the community, while payments to the government serve to reduce the rest of the community's stock of money. If the government makes payments to the private nonfinancial sectors of the economy that are greater than its receipts from them, including direct borrowing (i.e., by sales of securities, etc.), it will have to borrow from the banking system (usually the central bank). Borrowings by the government from the deposit-money banks will have the same expansionary effect as any other acquisitions of assets by these banks. Borrowing by the government from the central bank (i.e., the acquisition of claims on the government by the central bank) will have the same effect on the monetary system as the acquisition of other assets by the central bank. Conversely, the accumulation of net balances with the banking system by the government will have reverse effects.

In particular, the manipulation of government accounts can have a direct effect on the cash reserves of the deposit-money banks. A payment by the government in the form of either a transfer to a nonbanking economic unit, resulting in an increase in deposit-money, or a transfer to a government account with a deposit-money bank, will lead to an increase in the cash reserves of the deposit-money banks, with a consequent expansionary influence on the monetary system. On the other hand, a build-up of government deposits with the central bank (other than one matched by borrowing from the central bank) will result in a drain on the cash reserves of the deposit-money banks, with a consequent contractionary influence on the monetary system. Thus, manipulation of the size and location of government deposits can serve as an instrument of monetary policy in countries where open market operations are likely to be inefficient, while it is not likely to lead to the undesirable repercussions inherent in variable reserve requirements.

It must be recognized, however, that insofar as government deposits with deposit-money banks are deposits with individual institutions, alterations in their level may have a specific impact on individual institutions; that is, in some respects, this instrument suffers from disadvantages similar to those inherent in the direct regulation of deposit-money bank lending.

Finally, it must be acknowledged that use of this instrument has been possible in only a very few countries. In most countries, governments have been incurring deficits, so that they have been accumulating debts to the monetary system rather than deposits with central banks. This fact of recent history has operated to limit the widespread use of this instrument, even though such use might be applied effectively under other historical circumstances.

Control of Central Bank Credit to the Deposit-Money Banks

A central bank can always increase the cash reserves of the deposit-money banks by lending to them. Such a loan to a deposit-money bank involves an increase in the central bank's assets in the form of loans to banks, and in its liabilities in the form of deposits of banks. Hence, its impact on the economy is similar to that arising from an open market purchase. A decrease in a central bank's loans to deposit-money banks has the same effect as an open market sale. In fact, such loans, particularly when their take the form of rediscounts of notes or securities, or when they must be associated with the surrender of collateral securities, are almost indistinguishable from open market operations.8

Provided that the interest rates charged by the central bank are lower than those which the deposit-money banks can obtain from its customers, it may be assumed that the central bank can lend to the deposit-money banks in virtually unlimited amounts. Traditionally, the central bank has been viewed as exercising control over the volume of its credit by controlling the price at which it lends (bank rate). In fact, in most developing countries, where financial markets are in an early stage of evolution, the desires of the community to borrow are likely to be almost insatiable at any reasonable level of interest rates. Given such a strong eventual demand for credit, and with the deposit-money banks likely to expand their loans to the maximum dictated by business prudence, it is probable that the central bank can influence the deposit-money banks by quantitative controls over credit to them.

Hence, this instrument of monetary control is likely to be most powerful in the developing countries. It is likely to be effective in that the deposit-money banks will probably respond to any easing of central bank policy, while the central bank retains the initiative to restrict its operations if such a policy is appropriate at any time. It is an instrument that is consistent with the institutional situation in most developing countries. It need not lead to countervailing speculative reactions by the community. Finally, it is, by itself, independent of the fiscal and other requirements of a developing country. Hence, it is not surprising that, in almost half of the 81 countries for which data are given in International Financial Statistics, credit from the central bank to the deposit-money banks was equal to at least 10 per cent of money at the end of 1963 and is thus a significant element in the monetary structure.9 (In one country, Yugoslavia, the volume of such credit was greater than the total of money in December 1963.)

Les instruments de la politique monétaire dans les pays sans marchés de capitaux très développés


Dans les pays en voie de devéloppement, cinq types d'instruments, parmi ceux qui s'offrent à la banque centrale ou aux autres autorités monétaires, semblent mériter une étude détaillée:

  • 1. Contrôle du crédit de la banque centrale aux banques commerciales;

  • 2. Manœuvre des comptes de l'Etat;

  • 3. Variation des pourcentages de couverture obligatoires des banques commerciales;

  • 4. Opérations d'open market;

  • 5. Réglementation directe des prêts accordés par les banques commerciales.

Le dernier de ces instruments risque d'être propice à la rigidité du système monétaire, ce qui aura pour effet de décourager le développement.

Pour être mises en œuvre avec succès, les opérations d'open market exigent un niveau de développement financier qu'on a peu de chances de trouver dans un pays en voie de développement. Cet instrument de politique monétaire sera done probablement peu efficace dans ces pays.

La variation des pourcentages de couverture obligatoires, et en particulier la variation des réserves marginales obligatoires, peut constituer une arme puissante pour la stabilisation des économies. Mais son adoption comme instrument permanent de la politique montéire peut réduire l'efficacité des autres instruments.

Dans de nombreux pays, les déficits budgétaires chroniques ont rendu difficile la manœuvre des dépôts de l'Etat. Cependant, si un gouvernement réussit à accumuler des soldes de trésorerie, le transfert de ces soldes entre la banque centrale et les autres banques peut constituer une méthode de contrôle monétaire convenant particuliérement aux économies en voie de développement.

Etant donné la situation financière de la plupart des pays en voie de développement, le contrôle quantitatif du volume global du crédit de la banque centrale aux banques commerciales est sans doute l'instrument le plus efficace de la politique monétaire dans ces pays.

Los instrumentos de política monetaria en países carentes de mercados de capital muy desarrollados


Entre los instrumentos a los cuales pueden recurrir el banco central u otra autoridad monetaria en los países en desarrollo, hay cinco que parecen merecer detenida atención, a saber:

  • 1. Control del crédito del banco central a los bancos de depósitos monetarios;

  • 2. Manejo de las cuentas gubernamentales;

  • 3. Modificación de los requisitos sobre las reservas de los bancos de depósitos monetarios;

  • 4. Operaciones de mercado abierto;

  • 5. Regulación directa de los préstamos que otorgan los bancos de depósitos monetarios.

La última de estas medidas es probable que provoque rigidez del sistema monetario, lo cual, a su vez, restaría estímulo para el desarrollo.

Para que las operaciones de mercado abierto puedan efectuarse con éxito se requiere cierto grado de progreso financiero que no es probable encontrar en un país en desarrollo. De ahí que este instrumento de política monetaria probablemente sería de poca eficacía en esos países.

La variación del encaje, especialmente la variación de las reservas marginales, puede resultar un instrumento poderoso para dar estabilidad a las economías. Sin embargo, su adopcón como instrumento permanente de política monetaria puede llevar a un debilitamiento de otras medidas.

En muchos países los repetidos déficit presupuestarios han dificultado el manejo de los depósitos del gobierno. No obstante, si un gobierno logra acumular saldos en efectivo, el traslado de esos saldos entre el banco central y otros bancos puede ofrecer un modo de control monetario que es particularmente conveniente para las economías en desarrollo.

Dada la situación financiera que prevalece en la generalidad de los países en desarrollo, el control cuantitativo del volumen total de los créditos del banco central a los bancos de depósitos monetarios probablemente resultará el más poderoso instrumento de política monetaria en esos países.


Mr. Dorrance, Chief of the Financial Studies Division, has been a lecturer at the London School of Economics and a member of the staff of the Bank of Canada.


For a definition of “deposh-money banks,” see International Monetary Fund, International Financial Statistics (Washington), January 1960, p. v.


For a discussion of the directional effects of monetary policy, see Committee on the Working of the Monetary System, Report (Cmnd. 827, London, 1959, hereafter referred to as the Radcliffe Report), p. 130.


The term “economic unit” is used to describe any complete decision-making entity whose activities may be identified conceptually (e.g., a bachelor living alone, a family living together, a partnership, a company, a charity, a government).


See, for example, the comments, written in 1951, by Graeme S. Dorrance, “The Bank of Canada,” in Banking in the British Commonwealth, R.S. Sayers, ed. (Oxford, 1952), p. 31.


Peter G. Fousek, Foreign Central Banking: The Instruments of Monetary Policy (Federal Reserve Bank of New York, 1957), p. 31.


For a further discussion of these conditions, see A. F. W. Plumptre, Central Banking in the British Dominions (Toronto, 1947), pp. 4–13.


These pressures may be considered to be desirable, in the sense that they are an essential aspect of a stabilization program.


The Bank of France even refers to some of its short-term direct rediscount transactions with banks (purchases en pension) as “open market operations.”


Of the remaining countries, three have no effective central monetary authority which is not actively engaged in deposit-money banking (Ethiopia, Lebanon, and Panama); in six (East Africa, Ireland, Jamaica, Jordan, Malaysia, and Mauritania), “currency board” arrangements with complete foreign asset coverage of the currency circulation are still essentially effective, even if in vestigial form; in eight (Germany, Iraq, Libya, the Netherlands, Saudi Arabia, Switzerland, Thailand, and Venezuela), the monetary authorities have been trying to offset large increases in their foreign assets in order to maintain monetary stability, and hence have reduced all their assets (including credit to deposit-money banks) to minimal levels; in seven (Afghanistan, Bolivia, Chile, Haiti, India, Israel, and Viet-Nam), the monetary authorities have been attempting, with varying degrees of success, to meet the heavy fiscal requirements of their governments and to restrain inflationary pressures; in eight (Ceylon, Denmark, Ecuador, Honduras, New Zealand, Portugal, Somalia, and South Africa), the central bank holds noticeable claims on the deposit-money banks, even if they are surprisingly small in some cases; in only nine other countries (Australia, Belgium, Burma, Canada, Ghana, Norway, Sweden, the United Kingdom, and the United States) are central bank claims on the deposit-money banks nonexistent or miniscule; and four of these countries (Australia, Canada, the United Kingdom, and the United States) can be considered to be financially highly developed.