Analytic Basis of the Working of Monetary Policy in Less Developed Countries

EVER SINCE the problems of less developed countries came to the forefront in the postwar period, considerable attention has been focused on the importance of money and monetary policy in relation to economic development. The debate has passed through various phases. At an early stage it was widely believed that many of the constraints on the use of a kind of monetary policy that one has been accustomed to associating with the developed countries were imposed by the lack of institutional features, such as well-knit money and capital markets; banking habits, as reflected in a high currency/money ratio; and diversified financial institutions.1 This view has been overtaken by the argument that monetary policy has anything but a passive role in the context of development. While the relevance of monetary policy for the less developed countries is accepted, a considerable divergence of opinion has existed as to the direction and shape of monetary policy that may be designed to speed up the development process. On the one hand, it is argued that, since the basic obstacle in the way of less developed countries is posed by the paucity of savings, the monetary authorities in these countries should set the money rates of interest high enough to elicit a larger amount of savings. This also implies that money is no substitute for real savings, and hence that there should be restraint on credit creation as a means of financing new investment activity.2 On the other hand, ranged against this view are those who perceive investment as the main limiting factor in economic development, indicating thereby that the interest rate policy should be, if anything, a low-geared policy and that monetary expansion is desirable as a concomitant of development.3


EVER SINCE the problems of less developed countries came to the forefront in the postwar period, considerable attention has been focused on the importance of money and monetary policy in relation to economic development. The debate has passed through various phases. At an early stage it was widely believed that many of the constraints on the use of a kind of monetary policy that one has been accustomed to associating with the developed countries were imposed by the lack of institutional features, such as well-knit money and capital markets; banking habits, as reflected in a high currency/money ratio; and diversified financial institutions.1 This view has been overtaken by the argument that monetary policy has anything but a passive role in the context of development. While the relevance of monetary policy for the less developed countries is accepted, a considerable divergence of opinion has existed as to the direction and shape of monetary policy that may be designed to speed up the development process. On the one hand, it is argued that, since the basic obstacle in the way of less developed countries is posed by the paucity of savings, the monetary authorities in these countries should set the money rates of interest high enough to elicit a larger amount of savings. This also implies that money is no substitute for real savings, and hence that there should be restraint on credit creation as a means of financing new investment activity.2 On the other hand, ranged against this view are those who perceive investment as the main limiting factor in economic development, indicating thereby that the interest rate policy should be, if anything, a low-geared policy and that monetary expansion is desirable as a concomitant of development.3

EVER SINCE the problems of less developed countries came to the forefront in the postwar period, considerable attention has been focused on the importance of money and monetary policy in relation to economic development. The debate has passed through various phases. At an early stage it was widely believed that many of the constraints on the use of a kind of monetary policy that one has been accustomed to associating with the developed countries were imposed by the lack of institutional features, such as well-knit money and capital markets; banking habits, as reflected in a high currency/money ratio; and diversified financial institutions.1 This view has been overtaken by the argument that monetary policy has anything but a passive role in the context of development. While the relevance of monetary policy for the less developed countries is accepted, a considerable divergence of opinion has existed as to the direction and shape of monetary policy that may be designed to speed up the development process. On the one hand, it is argued that, since the basic obstacle in the way of less developed countries is posed by the paucity of savings, the monetary authorities in these countries should set the money rates of interest high enough to elicit a larger amount of savings. This also implies that money is no substitute for real savings, and hence that there should be restraint on credit creation as a means of financing new investment activity.2 On the other hand, ranged against this view are those who perceive investment as the main limiting factor in economic development, indicating thereby that the interest rate policy should be, if anything, a low-geared policy and that monetary expansion is desirable as a concomitant of development.3

The contrariness in these policy prescriptions may be found in the difference between the respective theories underlying them. While the high interest rate-cum-small money creation policy derives its strength from a theoretical framework—essentially classical or neoclassical economics—where prior savings are considered to be the most indispensable condition necessary for investment, the low interest rate-cum-large money creation policy is rooted in the Keynesian and neo-Keynesian schema of thought. It will be argued in this paper that the contradiction in these two policies arises principally because of the partial view of what is really involved in the process of economic development; in fact, pursuit of both high and low interest rate policies can be consistent, provided that it is recognized that the market for money and credit is not a single, homogeneous entity as in the developed economies but one that is fragmented into organized and unorganized parts. These two views on the working of monetary policy in less developed countries would perhaps not appear to be contradictory if monetary policy were approached more from a flow-of-funds angle than from either prior-savings or investment-first angles. The discussion in this paper will proceed on the basis of a closed economy, which is assumed mostly for analytical convenience.

I. Prior-Savings and Investment-First Approaches to Monetary Policy—A Critique

Initial skepticism about the efficacy of monetary policy in developing countries was due to a narrow view of monetary policy. If monetary policy is construed as no more than merely “a technique of monetary management,” 4 then it follows that in the absence of institutional conditions in which the monetary policy is managed there is little scope for it to operate. For instance, use of bank rate is not possible, because there are no market instruments or traditions among banks to react to bank rate changes in a definite and predictable fashion; open market operations are not feasible, because there is no “ammunition” in the form of suitable government paper that the central bank can buy and sell, and so on.5 If, on the other hand, monetary policy is considered in its broader aspects, not only in relation to its institutional mechanics but also in terms of interaction between it and the real economy, it would have to have some “content of theory.” There have to be certain broad principles to go by, and it is these principles, derived from generalized experience, that constitute a relevant theory. Techniques then become no more than an appendage to relevant economic theory. It is, therefore, appropriate to analyze the theoretical basis of monetary policy in less developed countries in a wider context.

The principal problem in the developing countries is one of raising per capita income over time.6 Assuming that population is determined exogenously, this implies a certain rate of growth of aggregate gross national product. Given the inflow of foreign resources, and also that output per unit of investment remains unchanged, national output would grow at the same rate as domestic savings, and the policy should be directed toward sharply raising the rate of saving. The expansion of output as a result of technological change also involves a larger amount of savings, as it is now generally accepted that the technological change itself depends on accretion to investment.7 The real difficulty lies in sustaining the additional investment without too much disturbance to the economy. It is because of the divergence of attitudes toward the methods of stepping up the investment rate for rapid economic growth that the two seemingly contradictory positions are taken regarding the nature and significance of monetary policy in less developed countries.

The prevalence of a low level of per capita income in less developed countries, on the face of it, does not appear to permit the community to set aside an adequate amount of savings to finance additional investment. But the low level of per capita income by itself proves very little. Here a distinction between average and marginal propensity to consume, which Keynes has drawn in another context, acquires special relevance.8 In less developed countries the average propensity to consume is high, but that alone should not imply that maintaining a marginal propensity to consume that is lower than the average propensity is beyond the realm of practical policy. Once this is conceded, it is easy to see why different approaches to raising the investment rate are adopted in the context of the less developed countries.

Prior-savings approach

Those who take the position that prior savings constitute a precondition for new investment in fact argue that paring down the average propensity to consume at the beginning of the investment process is the only possible way to break the vicious circle of low income, low investment. This argument is conducted on various planes, but it proceeds from one fundamental premise, which is that the available factors of production are utilized so fully that no new investment would materialize unless some factors of production, currently fully employed, are released. What is in fact suggested by full employment of resources is that capital equipment—a factor in short supply—is utilized fully. Labor remains surplus to the requirements, but its availability is of little consequence from the point of view of production, as there are no cooperant factors of production; employing additional labor, as such, far from adding to output, merely helps to raise the level of consumption.9

If this premise is granted, it follows that an increase in savings has to be brought about via a decline in the existing level of consumption at the beginning of the investment process. Investment that is allowed to run ahead of currently available savings and that is financed by credit creation will only generate a money income multiplier without an associated rise in real output, thereby unleashing serious inflationary pressures; the real income multiplier does not function, because the supply curve of output in less developed countries tends to become vertical almost immediately after new investment demand is created.10

It stems logically from this analysis that the remendy should lie in offering high reward to those who can trade off their present consumption for future consumption, and this means both pursuit of a high interest rate policy and only such expansion of money supply as is commensurate with the rise in real output. The interest rate thus emerges as a price of saving, unlike in the Keynesian system; it is not even a price of loanable funds, which is a wider concept than savings, per se.

While this prior-savings approach has a merit of spotlighting the basic fact that lack of real resources tends to hamper the development process, the way in which it is formulated leaves out many vital links in the chain of reasoning that underlies the approach. First of all, the decisions to save and to invest are not interdependent but independent.11 That accumulation of savings should precede additional investment is characteristic only of an extremely primitive economy in which savers and users of savings are invariably the same. This, however, is not so in most of the developing countries. In such a situation, a mere increase in savings without any assurance of concomitant investment would lead to declining demand and income, or if savings are invested at all, it might be a wrong type of investment with little beneficial impact on growth. It might be argued that the adverse effects of savings are unlikely in an economy in which latent investment demand always remains very high, and therefore more savings should lead to more investment, which, in turn, means more income, and so on. There are instances in which investment cannot take place because of a lack of savings, but as a general proposition, the argument suffers from many shortcomings. Admittedly, investment demand is high in a poor country, but that does not, by itself, mean a high marginal productivity of capital in the economy. The latter has to allow for the high risk of loss and other impediments arising from the very backwardness of the economy.12 In other words, the difference between potential and actual demand for investment is analogous to that between the desire for goods and the effective demand for them.13 Thus, the crucial element in the process seems to be investment rather than savings, from the point of view of economic development.

The prior-savings approach also ignores the implementation of investment decisions in the real world. When an entrepreneur starts a particular industry he does not wait for real savings to come forth; he raises finance from the market in order to meet his initial expenses, and he does this even without being aware of savings accumulating elsewhere in the economy. This means that if he suspends his decision to invest until he acquires savings to finance his investment expenditure no investment would ever get started at all.14

Somewhat exaggerated emphasis on savings as a prior condition for investment is due to the assumption that output is relatively inelastic because of the limited amount of capital equipment in the less developed countries. However, it is possible to raise output, given the capital supply, through changes in factor proportions. It has been shown empirically that even in less developed countries the range within which factor combinations can be shuffled is wide, so that the producer can reduce the use of capital input that is scarce relative to labor input and raise the level of output.15 Apart from this, a level of output can also be raised, given both the capital supply and the factor combination, through changes in output mix, as demonstrated by Kennedy.16

Coming to the policy implications of the treatment of savings as a predetermining factor in investment decisions, it is not even clear that the high interest rate strategy can necessarily lead to a high personal savings ratio. On a purely analytical plane it can be argued that the final effects of the level of the interest rate on savings may be in either direction. If the effects of interest rates, arising from substitution of future for present consumption, and wealth effects, stemming from changes in the real value of assets, remain strong, personal savings may possibly increase with a rise in interest rates, but these effects have to be even stronger than the income effects of the interest rate policy. With higher interest rates, asset holders will be able to obtain larger income flows, which may tend to reduce the incentive to save from current income. Considering that the wealth effects are limited in an economy where financial assets are not abundant, whether the first two effects would be mutually reinforcing or offsetting is a moot question that has to be settled empirically.

The evidence for developed and developing countries alike is not quite conclusive in regard to the interest elasticity of savings. For the United States, income and wealth are found to have a more predominant influence on personal savings than interest rates.17 For less developed countries, even allowing for the dubious nature of statistics, the evidence points toward the same kinds of doubt about the interest elasticity of savings.18 Perhaps the most important consequence of the high interest rate policy is discerned on the financial saving component of personal savings. However, as will be analyzed in the next section, its implications are quite different from those suggested in the prior-savings approach.

Investment-oriented approach

Those who pin their faith on the investment-first approach argue that it is possible to reduce the marginal propensity to consume once investment is allowed to generate incomes. Investment thus emerges as a key element in the development process. If the saving rate is viewed dynamically (as is implied in the investment-oriented approach)—this is what the development process is all about—it can conceivably be raised through pre-empting increment of incomes accruing at some future date.19 Now income-generating investment can be raised under two conditions—when output can be increased simultaneously through changes in either factor proportions or output mix, and when output remains unchanged in the short run. It is the second of these conditions that figures prominently in the arguments of the advocates of the investment-oriented approach.

What happens when a credit-financed investment is made in an economy where the limit of capacity production has been reached? The answer to this lies in two directions—one, focusing the attention on the favorable impact of changes in income distribution, as pointed out by Kaldor and Lewis, and two, envisaging new investment and the multiplier process in the dynamic context.20 Taking up the first argument, in conditions of full employment of resources, any addition to the existing volume of investment would raise prices rather than output. Given the level of money wages, profits would increase in relation to the gross national income, and, since the propensity of profit earners to consume is considered to be less than that of wage earners, the increase in the aggregate savings ratio would catch up with the initial increase in the rate of investment. This interpretation of the Kaldor-Lewis thesis is essentially in the Keynesian mold of comparative statics. The inflationary pressures arising from the initial investment outlay in this sense are transient, and in each successive round of additional investment they recur only to be swamped by the following spurt in savings.

However, the Kaldor-Lewis model of the investment process runs into difficulties—first, on account of high destabilizing price expectations and, second, because of the prevalence of a large subsistence sector and short income-propagation periods. If a rise in prices is expected to generate the expectation of a further price rise, the redistribution of money income initiated by an increase in investment, far from bringing forth subsequent accretion to savings, would in fact accentuate inflationary pressures.21 Regarding the income-propagation period, it is generally believed to be difficult to hold in abeyance an increase in consumption in the agricultural sector (the largest sector in a developing country) because of difficulties entailed in applying restrictive measures.

It is in view of this deficiency of the model that the emphasis in the investment-first approach is shifted in another direction, that is, to the dynamic-multiplier analysis as opposed to the static multiplier of Keynesian vintage. The inapplicability of the Keynesian multiplier to the less developed countries is justified, as observed earlier, on the ground of the presence of inelasticities of supply in those economies.22 This conclusion, however, is more relevant to the static multiplier, which is valid only for a short-period analysis. Once it is recognized that economic development implies a long-term dynamic change, it is imperative to discard the assumptions underlying the static multiplier. Investment is not only an income generator but also a capacity creator,23 so that over a certain time period, the growth of money income and the expansion of capacity may be synchronized. However, the difficulty is to tide over the time interval between the initial rise in investment outlay and income and the outflow of output from the newly created capacity. This can be ensured if the pattern of investment is so devised that there is a certain balance between projects catering to the urgent consumption requirements of the community and the medium-term and long-term projects, producing intermediate and capital goods for use in subsequent rounds of investment outlay. With such a visualization of the dynamic-multiplier process, it can be demonstrated that even in a less developed economy multiplier and acceleration effects are, if anything, beneficial for rapid economic development.24

Although the role of investment in economic development is interpreted by proponents of the investment-first approach with reference to the modified Keynesian analytic frame, the interest rate is given a somewhat different connotation. It comes in more as a price of money for financing investment rather than either a price for sacrificing liquidity, as in the early version of the Keynesian system, or a price of saving, as in classical or neoclassical economics. If investment is all that needs to be increased, then the demand for money for financing investment, or what Keynes later called “the finance motive,” should get precedence over the transactions, precautionary, and speculative demands. As the finance demand for money is not always met in a less developed economy because of the absence of an elastic credit structure, the essence of monetary management is taken to be the availability of money at low cost.25 Thus, monetary policy has come to acquire greater importance in relation to economic development, couched mainly in Keynesian terms, which may seem paradoxical if it is remembered that money and monetary policy have been assigned rather a low rating in the Keynesian system.26

The treatment of investment as a more important variable than savings in development policy reflects, as does the prior-savings approach, a partial view of the reality of the development process. The fact that investment is the catalyst should not lead to the denigration of the role of savings. It is true that decisions to invest are independent of decisions to save, but the former benefits, although circuitously, from the savings accruing in the economy. First of all, a certain proportion of the income of the community in the backward economy is held almost always in the form of gold or currency hoards; these are, however, savings available for investment, but they remain sterile for want of necessary coordination through credit policy.

The second kind of savings in the developing economy—in a way, a variant of hoarding—is the holding of a relatively large proportion of incomes, as they expand, in the form of money. Such a rise in money balances is due to the increase in the number of transactions in the wake of income growth, necessitating larger amounts of money to mediate them. And even when incomes are not rising, the given level of transactions involves a greater use of money when the monetization process is under way.

The third form of savings is denoted by what Nurkse and Lewis call a “saving potential.” 27 With surplus population remaining in the agricultural sector, the opportunity cost of labor tends to be zero. In other words, such workers consume without adding to the community’s output. Now, if they can be employed through additional investment, a net increase in output can be achieved either with the same level of consumption as before or with a level reflecting the difference between such workers’ old rates of consumption and that made possible by the wage rate in the new employment. In any case, a certain amount of potential savings is available for sustaining new investment.

It is clear from the preceding discussion that it is these savings that are mobilized when new investment outlay is incurred. Additional investment means creation of credit and, therefore, money. But this increment in monetary circulation is partly an offset to the hoarding of money in the economy, and the additional demand of the community for money as an asset, but is largely an important conduit for the conversion of potential savings into actual investment. So it seems that the investment-oriented approach implies, at least in some measure, that investment is no more than a counterweight to saving, which otherwise would be frustrated.

The policy implications of the investment-biased framework of the development process are not unambiguous either. If the lack of finance for investment is the bottleneck, it is a relatively simple step for the monetary authorities to reduce the rate of interest with the associated increase in the quantity of money. While such a course of action is appropriate up to the point at which dormant savings are absorbed into new investment, as mentioned above, it would generate an inflationary price rise that might in fact tend to have a perverse effect on the money rates of interest. An increase in money supply and a low interest rate can be ensured by the monetary authorities in developing countries where generally the organized credit market (consisting of a few financial institutions, the government, and a few industrial firms, and the use of some credit instruments) is a very narrow one. But from the point of view of the effectiveness of a policy influencing the whole economy, it is essential to consider the repercussions of such a policy on the money rates of interest in the vast unorganized credit market (which comprises small traders and businessmen, and where lending and borrowing take direct forms). The pure money rate of interest can be interpreted in the sense of the opportunity cost of money lent. Now, if the cheap money policy results in monetary expansion to the extent that there is an upsurge in prices, the opportunity cost of money in the unorganized sector would rise instead of fall. For, with the upward pressure on prices when output inelasticities are marked, lenders in the rural areas would tend to demand higher interest rates for their lending to counterbalance the decline in the purchasing power of money. This would thus raise the money rates of interest, high as they are in rural areas, even further, with an adverse impact on investment demand.28

After a lag, the perverse effects of a low interest rate policy would spread to the organized credit market. The inflationary psychosis would result in a switch from monetary assets to real goods, but at the same time, the transactions demand for money, in the wake of an expectation of inflationary pressures, would so increase as to more than offset the interest-depressing effects of the reduction in demand for money for precautionary balances. In which case, interest rates in the organized sectors too would rise with the increase in money supply, rather than the other way round.29

II. Flow-of-Funds Approach to Monetary Policy

The discussion in Section I shows that the analytical framework of both the prior-savings and investment-first strategies and the monetary policy connotation associated with each of them is subject to a number of criticisms. Essentially, both depict only a part of the reality and hence are inadequate as a theoretical basis for monetary policy in the less developed economies. If this is so, it seems essential to change the perspective on the development mechanism so that it can be perceived as one integrated process wherein savings and investment are both crucial elements.

The main reason for the extreme views on the development process and monetary policies has been that, since the economy is viewed in the aggregate, savings and investment constitute one and the same thing, hardly distinguishable from each other. This identity between savings and investment, however, tends to disappear when a disaggregated view of the economy is taken. Some economic units might be only saving or saving more than they would be willing to invest on their own. It is equally possible that certain other economic units are predominantly investing units or desire to invest more than the savings that they could garner on their own. In other words, what is at the center of things is not a mere act of saving or investment but the existence of a channel through which the surplus funds of some economic units can flow to those that need them.

Thus, if the economy is visualized as dividing itself into surplus-spending units,30 that is, units whose total expenditure—consumption plus investment—is less than their own receipts, and deficit-spending units, whose total expenditure similarly defined exceeds their income, it suggests the need to bring about a flow of savings from the surplus sectors to the deficit sectors if the aggregate investment is to be maximized. Otherwise, the investment would fail to reach a level that is feasible in the circumstances, while a part of the savings would either remain sterile or be misallocated. Once this is conceded, two main problems must be faced from the point of view of a development policy. First, the deficit and surplus units must be identified, and, second, the disposition of the surplus units to spare their excess savings and the form in which they make it available for the users of savings must be determined. Broadly, there are three primary sectors in an economy. The first is the household sector, which comprises individuals, private trusts, and small business enterprises. The second is the modern corporate business sector, and the third is represented by the government sector, which embraces all layers of government and public enterprises. It has been generally found that in the less developed countries the household sector is predominantly a surplus sector, that is, its savings exceed its own investment. The corporate and the government sectors are the deficit sectors, drawing for funds on the household sector and the foreign sector.31 The flow-of-funds data relating to three developing countries—India, Malaysia (excluding Sabah and Sarawak), and China—are given for illustrative purposes in Table 1.

Table 1.

Selected Developing Countries: Flow of Funds Among Primary Economic Sectors

article image

Source: V. V. Bhatt, “Saving and Flow of Funds Analysis: A Tool for Financial Planning in India,” The Review of Income and Wealth, Series 17 (March 1971), pp. 61-80. Figures are all in millions of rupees.

Excluding Sabah and Sarawak. Source: Economic Commission for Asia and the Far East, “Saving of the Federation of Malaya, 1954-1958: A Preliminary Estimate,” Economic Bulletin for Asia and the Far East, Vol. XIII (June 1962), pp. 17-34. Figures are all in millions of Malaysian dollars.

Source: Republic of China, Taiwan Financial Statistics Monthly. Figures are all in millions of new Taiwan dollars.

The exact equivalence between saving and investment in the corporate sector may be fortuitous, being brought about by the average of figures for two years, 1965-66. The figures for the individual years may in fact show a deficit.

The problem then amounts to finding the best way to induce the flow of excess savings of the surplus sectors to the deficit sectors in order to ensure higher investment and growth. The fact that excess savings of the surplus sectors are transferred to the investing sectors should not, however, be taken to mean that the movement of funds is unidirectional, that is, only from the surplus sectors to the deficit sectors. There can be, and often are, economic units in the deficit sector that acquire financial assets by lending to those in the surplus sector. Likewise, some economic units in the surplus sector borrow funds. Further, within a deficit sector there can be some surplus units, and within a surplus sector there can be some deficit units. In other words, the amount of gross financial claims created would be much larger than the net movement of excess savings from the surplus to the deficit sector would indicate.

From the monetary/fiscal point of view, what is pertinent is the mechanism by which such an intersectoral flow of funds comes about. It is at this point that the institutionalization of savings/investment, pioneered by Gurley and Shaw, has considerable relevance for the rapid growth of investment and savings and, therefore, the rate of growth of the economy. When the economy is in the rudimentary stages of growth, intersectoral lending takes a direct form. That is to say, funds from savers in one sector are given directly on the basis of close contacts with investors in the other sectors. No paper as such is used in these transactions for lending and borrowing, except oral or written assurances between the lender and borrower. The market for credit created by this direct form of lending is, therefore, described as an unorganized credit market where arrangements are more informal and personal. This market has two distinguishing features. First, it is not one large market but consists of a number of isolated markets. Second, investment takes place only in those pockets where savings accumulate, while in pockets where savings are insufficient, investment demand, even when high, tends to languish.

However, as the economy expands, personal contacts tend to lose their closeness, and direct forms of lending and borrowing are replaced more and more by indirect forms. The saving units or sector accumulates financial claims on the investing units or on the financial intermediaries that pass the funds so obtained to the final users. Gradually, as the economy progresses, this indirect mode of lending results in a higher ratio of financial assets to income and wealth, leading eventually to higher saving and investment.32 This indirect form of credit transaction brings about a total transformation of the credit market. The savers and investors are joined together by various kinds of credit instruments and financial institutions that disseminate full information necessary for providers and users of funds, thereby breaking the barriers separating them. In other words, with the adoption of an indirect mode of lending/borrowing, the market for credit tends to become organized, unified, and wide, fully exposed to the price mechanism.

The issues of policy involved are now fairly clear. If the development of the economy is to be accelerated, it is necessary, first, to provide financial assets for surplus sectors to hold their transferable savings and, second, to increase the amount of such savings. Regarding the first aspect, the policy should offer those financial assets that are in demand by the surplus sectors. Flow of funds between various economic units creates assets and liabilities in the process, but the structure of these assets or liabilities is not the same in every phase of economic development. Empirical evidence points to the fact that in the early stages money is the financial asset that is most sought after. Income elasticity of demand for money, however defined, is found to be inversely related to the state of development of the money and capital markets. This means that in economies poorly equipped with a financial system, money tends to become a more important repository of wealth.33 As the money and capital markets become better organized, the range of assets for holding savings tends to become diversified to include bonds, equity, and term deposits. A desire for a variegated pattern of financial assets is motivated by such factors as security requirements or income provisions rather than by transactions or liquidity needs alone. Further, asset differentiation also is sharpened because of the desire on the part of savers to minimize the risk and uncertainty involved.34 Hence, financial assets other than money need to be created if savings are to be mobilized for financing investment.

So far the attention has been focused only on the skimming off of available excess savings from the surplus sectors for use by investing units through the medium of financial assets. No less important is the need to enlarge the amount of transferable savings, and this can be achieved through altering the structure of savings of the surplus units, which are, by and large, in the household sector in less developed countries. A large part of savings of the units in the household sector is generally invested either in physical assets, such as goods, or in gold, etc. (the latter is more common in many of the Asian countries, although not in Africa and Latin America). Even the amount of savings invested in business enterprises by the savers themselves is not utilized efficiently, as those who have excess savings invest on their own for want of people with a requisite managerial skill and enterprise. If such entrepreneurs were available, the owners of funds would prefer to lend to them rather than to invest in enterprises where they have no expertise. The policy, therefore, needs to be so designed as to make it attractive for the units in the household sector to hold their savings more in financial assets than in physical goods. In other words, if the development process is to acquire momentum, the ratio of financial assets to total savings of the household sector must be allowed to grow as fast as possible.35

Now it is possible to see the contours of monetary policy emerging. In the early stages of development, when the preference of the surplus-spending units is to hold their savings predominantly in money, it is not only appropriate but also inevitable that the monetary authorities inject additional money into the system; money creation in such a situation contributes to the acceleration of investment.36 At a later stage, when the preference pattern of the surplus-spending units changes in favor of financial assets other than money, the role of money creation tends to decline relatively and a new dimension is added to the monetary policy. To the extent that varied types of financial asset are in demand, the authorities are called upon to initiate the setting up of new financial institutions. Such institutions help not only to satisfy this demand but, in the process of doing so, actually to stimulate it even further. Once the financial institutions come into being, they begin to multiply their assets and liabilities at a rapid rate.

At the same time, the return on the financial assets has to be raised in order that the size of excess saving itself be enlarged in the expectation of higher income. This is, in fact, the rationale of a higher interest rate policy implemented in such countries as Korea and China. However, while the role of interest rates comes out more prominently in this flow-of-funds approach to the monetary policy, its nature and significance are not the same as in the arguments of those who observe its impact on the rate of savings. The interest rate remains effective, but not for the reason that it functions as an inducement to save; it reflects the opportunity cost of holding different kinds of financial asset, which is determined by what the asset holder would receive on an alternative use of his savings, and equilibrium is attained when the rates of return on various assets actually converge. The rate of interest, therefore, has significance not so much for personal savings as for its financial component.

It is, of course, implicit in the foregoing analysis that the rate of interest representing the opportunity cost of holding financial assets should be in real terms. In a period of rapid inflation, there is necessarily a divergence between pure money interest rates and money interest rates adjusted for price increases. If the intention is to induce a shift in savings from goods or gold and other precious metals to financial assets, the money return on the latter should be comparable to the own rate of interest on holdings of goods or other physical assets, which is determined by the rate of change in their prices.

Stating that the interest rate has a primary impact on the financialization of savings does not imply that the interest rate has no impact whatever on the savings rate of the household sector. Its direct influence on the propensity to save may be limited, but its indirect impact seems to be beneficial in two ways. First, to the extent that the rate of return on such financial assets as deposits and debentures was raised, the demand on the surplus-spending units for nonfinancial assets would decline, resulting in lower prices of their total assets. The actual amount of wealth held would then be lower than the desired amount, and the surplus-spending units would strive to restore the previous level of their wealth through reducing the level of consumption. Second, as interest rate changes succeeded in bringing a larger proportion of the household sector’s savings into desired financial assets, the allocation of resources, the efficiency of investment, and the incentive system ensured by financial intermediation would all improve, leading eventually to a higher level of savings by the household sector.37

From the point of view of investment, too, a high interest rate policy yields some beneficial results, although there might appear to be a certain contradiction in high interest rates being conducive simultaneously to accumulation of financial assets and to investment. It is essential to interpret the term “high” or “low” in a relative sense, and as long as the interest rate was not higher than the return on real investment goods on which the saver expends his savings, investment would not be discouraged. More importantly, there is also a consideration that with a growing institutionalization of savings and investment processes the weighted average cost of loanable funds may, in fact, decline. This is so because, with a rapid accumulation of financial savings, a greater part of investment would be financed by institutional sources where the interest rates charged, although higher than before, would still be lower than in the unorganized credit market where the cost of interest is much higher. Investment thus, on balance, stands to gain even with a high interest rate policy applied to the organized credit market. It may perhaps be argued that if funds from the unorganized market were diverted to the organized market with the adoption of a high interest rate policy there, the shrinkage of funds in the unorganized market would accentuate the interest rates even further. This, however, is unlikely to happen, because a transfer of savings to the organized money and capital markets would, in time, also transfer the demand for them. Thus, the entire size of the unorganized credit market would tend to shrivel.

Apart from this, the whole investment process would add to its efficiency, as the savings would be used by real entrepreneurs rather than by those whose sole claim to enterprise stems from the ownership of savings. To the extent that efficiency increases, it is conceivable that the rate of profit could be higher even with the higher interest rate.38

To conclude, various conflicting views on monetary policy, such as high versus low interest rates, or monetary expansion versus contraction, in the context of economic development can be reconciled if the economic growth is seen in terms of intersectoral flow of funds and the diversification of channels of that flow. It makes perfect sense to take recourse to a high interest rate policy in order to encourage the financialization of personal savings, while at the same time advocating a low interest rate policy for investment. As the financialization of personal savings proceeds, the size of the unorganized credit market tends to shrink and, in consequence, the weighted average interest cost of investment declines. This, together with the improvement in the efficiency of the investment process, forces the pace of economic development.

III. Choice of Monetary Policy Instruments

It is against the background of the foregoing description of the analytic basis of monetary policy that the choice of monetary policy instruments open to the less developed countries may be made. In the early stages of development, as stated in Section II, money is the form in which the surplus-spending units prefer to hold part of their savings, and as the economy progresses, a more variegated pattern of financial assets is favored. It is this asset pattern of the saving/investing units that provides a key to the choice of monetary policy instruments in the less developed countries.

When money as an asset is desired for channeling savings, whether between economic units within the same sector or between different sectors, the monetary authorities are justified in meeting that demand through creation of additional money stock. However, the money demand of the asset-holding units does not rise steadily; it fluctuates, and at times markedly, thereby causing disturbance to the investment process, which the initial money creation is designed to sustain. To take care of such oscillation in money demand, direct regulation of the availability of credit and money as an instrument of policy seems to be ineluctable.

At the next stage, the asset preference of the saving/investing units becomes diversified; financial assets other than money are desired to fulfill a variety of motives to which reference was made in Section II. However, the development of financial assets should not be left only to the voluntary decisions of the economic units; it must be fostered by pursuing appropriate policies. The demand for such financial assets can be induced through offering attractive rates of return, so that aversions of the economic units to hold financial assets in preference to real assets, such as goods, gold, or even currency hoards, can be overcome. It is precisely this that a high-interest strategy is supposed to do.

It is necessary to clarify briefly the nature of the interest rate policy that is implied here. It may connote any policy that is directed toward influencing the level and pattern of money rates of interest. It may take the form of either market intervention through discount rate changes or open market operations or, alternatively, direct regulation of interest rates on certain types of financial asset, such as savings and time deposits, as China and Korea have done. At times, it may mean a release of the financial institutions from the ceiling requirements on interest rates. As the credit market organization is not sufficiently advanced to use the market mechanism in the early stages of economic development, by and large the direct control of interest rates or removal of such controls has to be relied on to achieve the financialization of personal savings.

Once the demand for varied types of financial asset is generated, there may be an automatic response from the supply of new financial assets. Only when the response to the stimulus of a high interest rate is weak or inadequate are the monetary authorities required to intervene through the creation of different types of financial intermediary.39 It is often contended that the monetary policy instruments that are common in the developed countries can be introduced in the developing countries only after the capital and money markets are built up.40 This view, however, assumes independence rather than interdependence between the instruments of monetary policy, on the one hand, and institutional development, on the other hand. In fact, interaction between the two is mutually reinforcing. Monetary policy instruments, such as the interest rate, if vigorously and purposively adapted to the conditions in the developing countries, can themselves become the agent to promote the money and capital markets, which, in turn, create further favorable conditions for the effective exercise of a broader range of instruments of monetary policy.

Another instrument of monetary policy that acquires some importance in the early stages is the reserve requirement. This is so because it has, in some ways, the characteristics of a direct regulation of credit. It can work, and quite effectively, even when the financial mechanism is rudimentary. It is true that when saving in the form of deposit assets is limited in less developed countries so is multiple credit creation. But this limitation does not restrict the effectiveness of changes in reserve requirements in developing countries as much as it tends to make its impact uncertain. This is so because reserve requirements, if they are to affect banks’ lending policies, must have a wider range of variation than in the developed economies. However, the behavioral response of banks to such sharp variations in the ratio may be unpredictable, and consequently the error term in the desired result may increase. In view of the imperfections in the money and capital markets, as in the general economy of the developing countries, banks may not react to a change in the reserve requirements in the same way that one would expect them to do in more modern credit markets.

In the final stage, when financial institutions and financial assets are generated, open market operations—a more sophisticated monetary policy weapon, which is basically market oriented—find a fuller scope to operate. As the financial assets accumulate, a market for them develops, and gradually, as the community grows accustomed to the associated financial mechanism, the ownership of financial assets becomes diversified and diffused. It is then possible for the monetary authorities to conduct open market purchases and sales without violent changes in the prices of the assets transacted. Otherwise, any open market policy would culminate merely in fluctuations of prices without any impact on the availability of credit.

IV. Concluding Observations

The principal theme emerging from this paper is that the differences in regard to the working of monetary policy in less developed countries must be ascribed to the tacit assumption in the discussion that decisions to save and to invest in these countries take place in a single credit market. In a situation where one unified credit market prevails, a high interest rate strategy, while proving a boon to savers, might stifle investment decisions. But where “credit dualism” is a dominant phenomenon, as in many developing countries, this may not be the inevitable consequence. A high interest rate policy encourages the financialization of personal savings. This means that direct lending by excess-saving units to deficit-spending units is replaced on an ever-growing scale by indirect forms of lending; in other words, the unorganized credit market is supplanted by the organized credit market. Investment decisions are then governed more and more by the credit conditions in the organized credit market, and since interest rates in the organized markets are lower on average than in the unorganized markets, investment stands to benefit from a high interest rate policy as much as does the financialization of savings.

Although direct impact of the interest rate on total personal savings may be uncertain, its indirect effects may be advantageous: (1) The wealth effects arising from a high interest rate policy may bring about a reduction in consumption; (2) as the decisions to save and to invest will be exposed to the price mechanism via financial intermediation, the overall efficiency of investment may increase.

Fondements analytiques du fonctionnement d’une politique monétaire dans les pays en voie de développement


L’idée centrale qui se dégage de cette étude est que les différences d’opinion concernant le fonctionnement de la politique monétaire dans les pays en voie de développement sont attribuables à l’hypothèse tacitement admise par ceux qui participent à la discussion, selon laquelle les décisions d’épargner et d’investir sont prises, dans ces pays, sur un marché unique du crédit. Dans les cas où existe un marché unifié du crédit, une politique de taux d’intérêt élevés, quoique avantageuse pour les épargnants, risque de faire obstacle aux décisions d’investir. Par contre, là où existe un double marché du crédit, comme dans bon nombre de pays en voie de développement, cette conséquence n’est peut-être pas inévitable. Une politique de taux d’intérêt élevés encourage la transformation du produit de l’épargne des particuliers en avoirs financiers. Il s’ensuit que les prêts accordés directement par des agents économiques épargnant leur excédent à des agents économiques dépensant jusqu’à être en déficit sont remplacés de plus en plus par des formes indirectes de prêt; en d’autres termes, le marché non organisé du crédit est supplanté par le marché organisé. Les décisions d’investir sont alors régies de plus en plus par les conditions du crédit sur le marché organisé et comme les taux d’intérêt sur celui-ci sont, en moyenne, inférieurs à ceux du marché non organisé, il y a bien des chances qu’une politique de taux d’intérêt élevés s’avère aussi bénéfique pour les investissements que pour la transformation de l’épargne en avoirs financiers.

Bien que l’on ne puisse pas savoir avec certitude quelle influence les taux d’intérêt exercent sur l’épargne individuelle globale, leurs effets indirects peuvent être avantageux: 1) l’effet exercé sur la fortune par une politique de taux d’intérêt élevés peut entraîner une diminution de la consommation; et 2) comme les décisions d’épargner et d’investir subiront l’influence du mécanisme des prix par l’entremise des intermédiaires financiers, l’efficacité globale des investissements a des chances d’augmenter.

Base analítica del funcionamiento de la política monetaria en los países menos desarrollados


El principal tema que se perfila en este trabajo consiste en que las diferencias de funcionamiento de la política monetaria en los países menos desarrollados deben atribuirse al supuesto tácito en el estudio de que las decisiones de ahorrar o de invertir en dichos países tienen lugar en un solo mercado de crédito. Con un solo mercado de crédito unificado, la estrategia de tipos de interés altos, si bien favorece a los ahorristas, puede dificultar las decisiones de invertir. Ahora bien, cuando el “dualismo de crédito” es un fenómeno predominante, como es el caso en muchos países en desarrollo, esto puede no ser la consecuencia inevitable. La política de tipos de interés altos estimula la financialización del ahorro personal. Esto significa que los préstamos directos de las unidades con excedente de ahorro a las de gasto dificitario se reemplazan en escala cada vez mayor por formas indirectas de préstamo; es decir, el mercado de crédito no organizado queda sustituido por el mercado de crédito organizado. Las decisiones de inversión se rigen cada vez más por las condiciones del mercado organizado de crédito, y como los tipos de interés de los mercados organizados suelen ser más bajos en promedio que los de los mercados no organizados, las inversiones pueden beneficiarse con la política de tipos de interés altos como también la financialización del ahorro.

Aunque puede ser incierto el impacto directo de los tipos de interés en el ahorro personal total, sus efectos indirectos pueden ser ventajosos: 1) los efectos relacionados con la riqueza que se derivan de una política de tipos de interés altos pueden tener como resultado una reducción del consumo, y 2) como las decisiones de ahorrar y de invertir estarán sometidas a la influencia del mecanismo de los precios por la intermediación financiera, es posible que aumente la eficiencia general de la inversión.


Mr. Khatkhate, Advisor in the Central Banking Service, is a graduate of the Universities of Bombay and Manchester. He was formerly Director of Research in the Reserve Bank of India. He has contributed numerous articles on planning, trade, and monetary policy to academic journals.


Recurrence of this theme, characteristic of the institutionalists, if one may so describe those who hold this viewpoint, is found in many works, such as Richard Sidney Sayers, Central Banking After Bagehot (Oxford, 1957), pp. 108-33; Satyendra Nath Sen, Central Banking in Undeveloped Money Markets (Calcutta, 1952); Arthur I. Bloomfield, “Monetary Policy in Underdeveloped Countries,” in Public Policy, Vol. VII, ed. by Carl J. Friedrich and Seymour E. Harris (Cambridge, Massachusetts, 1956), pp. 232-74; David Horowitz, “Monetary Policy in Underdeveloped Countries,” in The Challenge of Development: A Symposium Held in Jerusalem, June 26-27, 1957 (Jerusalem, 1958), pp. 99-105; and J. D. Sethi, Problems of Monetary Policy in an Underdeveloped Country, with Special Reference to India (Bombay, 1961).


This thesis derives major support from the experience of China and Korea early in the 1950s and late in the 1960s. See, for descriptive accounts, Reed J. Irvine and Robert F. Emery, “Interest Rates as an Anti-Inflationary Instrument in Taiwan,” The National Banking Review, Vol. 4 (1966), pp. 29-39; S. Kanesa-Thasan, “Stabilizing an Economy—A Study of the Republic of Korea,” Staff Papers, Vol. XVI (1969), pp. 1-26; and Anand G. Chandavarkar, “Some Aspects of Interest Rate Policies in Less Developed Economies: The Experience of Selected Asian Countries,” Staff Papers, Vol. XVIII (1971), pp. 48-112. For an analytical exposition of the thesis, see Charles Raymond Whittlesey, Lectures on Monetary Management (Bombay, 1960); Lester Vernon Chandler, Central Banking and Economic Development (Bombay, 1962); and the discussion by Paul W. McCracken and Howard S. Ellis of the article, “Relation of Money to Economic Growth,” American Economic Association, Papers and Proceedings of the Sixty-eighth Annual Meeting (The American Economic Review, Vol. XLVI, May 1956), pp. 203-208.


Reasons of a more fundamental nature for this view may be found in the classic work of Professor Joseph A. Schumpeter, The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (Harvard University Press, 1934), particularly Chapters 2 and 3. A leading exponent of this thesis in the context of less developed countries is Professor K. N. Raj, The Monetary Policy of the Reserve Bank of India: A Study of Central Banking in an Undeveloped Economy (Bombay, 1948).


Raj, ibid., p. 4.


The role of monetary policy has been discussed predominantly in terms of the appropriateness, or otherwise, of certain techniques in the works of Sayers, op. cit., pp. 108-33, and Sen, op. cit., p. 8.


This is on the assumption that per capita gross national product (GNP) is a desirable measure of progress. Other standards of measurement have been used in the context of less developed countries that reflect a structural change more realistically than does per capita GNP. Whichever measure is accepted, it is imperative to raise the rate of saving. See Irma Adelman and Cynthia Taft Morris, “Performance Criteria for Evaluating Economic Development Potential: An Operational Approach,” The Quarterly Journal of Economics, Vol. LXXXII (1968), pp. 260-80; and V. V. Divatia and V. V. Bhatt, “On Measuring the Pace of Development,” Banca Nazionale del Lavoro, Quarterly Review (June 1969), pp. 190-206.


Nicholas Kaldor and James A. Mirrlees, “A New Model of Economic Growth,” The Review of Economic Studies, Vol. XXIX (June 1962), pp. 174-92; and “Introduction,” Growth Economics: Selected Readings, ed. by Amartya Sen, Penguin Modern Economics Readings (Harmondsworth, England, 1970), pp. 9-40.


John Maynard Keynes, The General Theory of Employment, Interest and Money (New York, 1936), p. 126.


Chandler, op. cit., pp. 23-24. See also McCracken and Ellis, op. cit.


Compare V. K. R. V. Rao, “Investment, Income and the Multiplier in an Under-Developed Economy,” The Indian Economic Review, Vol. I (February 1952), pp. 55-67.


Donald C. Mead, “Saving, Investment, and the Analysis of Growth,” Economic Development and Cultural Change, Vol. XII (October 1963), pp. 84-86; and John Richard Hicks, Capital and Growth (Oxford, 1965), p. 290.


H. W. Arndt, “A Suggestion for Simplifying the Theory of International Capital Movements,” Economia Internazionale, Vol. VII (1954), pp. 469-81.


This kind of confusion between potential and actual investment demand led one observer of Korea’s economic development to explain away the high positive correlation between income and interest rates on the ground that high interest rates had resulted in a high rate of savings, which, in turn, led to a high rate of investment. He, however, overlooked the fact that it is the decision to invest savings that raised the incomes, and not the decision to save. Therefore, Brown’s explanation for the high correlation between income and interest rates does not seem to be valid. One can think of other possible reasons for it. An increase in real incomes can lead to a rise in the demand for money, which, in the circumstances of an unchanged or declining level of the quantity of money, can raise the rate of interest. Alternatively, there might be a collinearity problem involved in Brown’s equation of interest rate and income, as y = rw, where y, r, and w represent income, interest rate, and wealth. See Gilbert T. Brown, “The Impact of Korea’s 1965 Interest Rate Reform,” submitted to the CENTO (Central Treaty Organization) Symposium on Central Banking, Monetary Policy, and Economic Development, held in Izmir, Turkey (mimeographed, 1971).


This has been well brought out by Joan Robinson in the essay, “The Generalization of the General Theory,” included in her book, The Rate of Interest and Other Essays (London, 1952), p. 81.


Gerardo P. Sicat, “Production Functions in Philippine Manufacturing: Cross-Section Estimates, 1956-1959,” The Philippine Economic Journal, Vol. II (1963), pp. 107-31.


Charles Kennedy, “Saving and the Development Process,” Oxford Economic Papers, New Series, Vol. 23 (1971), p. 30.


Irwin Friend, “Determinants of the Volume and Composition of Saving with Special Reference to the Influence of Monetary Policy,” in Impacts of Monetary Policy, Commission on Money and Credit (Englewood Cliffs, New Jersey, 1963), pp. 671-73. In this connection, the observation of Professor Lawrence Robert Klein may also be recalled: “No econometrician has ever found a significant correlation between consumption (saving) and interest rate when the correlation between consumption (saving) and income is taken into account,” The Keynesian Revolution (New York, Second Edition, 1966), pp. 59-60. This remark is to be taken as suggesting that it is income that primarily determines the rate of saving.


Jeffrey G. Williamson, for example, in his paper, “Personal Saving in Developing Nations: An Intertemporal Cross-Section from Asia,” The Economic Record, Vol. 44 (1968), p. 204, comes to a conclusion that “… the net impact of real interest rate movements is either negative or insignificant.” On the other hand, K. L. Gupta, in his investigations of Indian data, “Personal Saving in Developing Nations: Further Evidence,” The Economic Record, Vol. 46 (1970), pp. 243-49, comes to the opposite conclusion that in India the rate of interest has a positive impact on personal savings. He notes “… the real rate of return on long-term government bonds is significant both when used with the simple Keynesian function and with the Friend-Taubman model. Similarly, the rate of return on short-term Treasury bills also has coefficients greater than their standard errors,” p. 247. However, neither of these conclusions can be considered to be reliable. Williamson’s conclusion is very much influenced by his choice of a proxy for the interest rate, which is the index of return on all available financial assets. However, Gupta’s solution of choosing individual interest rates is equally unwarranted, at any rate for India. The rates of interest on short-term treasury bills as well as long-term government bond rates in India do not respond to market conditions and hence are notional and virtually managed; therefore they do not show variations in response to market conditions. Treasury bills are sold almost wholly to financial institutions through moral suasion, while individual holdings of government bonds are very small. In fact, as far as personal savings in India are concerned, both the treasury bill rates and the long-term bond rates are simply irrelevant. See particularly V. G. Pendharkar, “Demand for Money in India: A Comment,” The Journal of Development Studies, Vol. 7 (January 1971), p. 201. All this means that it is necessary to exercise extreme caution in using and interpreting the econometric evidence in developing countries where both the availability and quality of data are poor, in addition to the inherent problems of identification and multicollinearity involved in econometric model building.


Ashok Mathur, “On Throwing the Baby Away with the Bath-Water’: An Essay in the Defense of Keynesism in Relation to the Underdeveloped Countries,” The Indian Economic Journal, Vol. XII (April-June 1965), p. 414.


Nicholas Kaldor, “Alternative Theories of Distribution,” The Review of Economic Studies, Vol. XXIII, No. 2 (1955-56), pp. 94-100. See also W. Arthur Lewis, “Economic Development with Unlimited Supplies of Labour,” The Manchester School of Economic and Social Studies, Vol. XXII (1954), pp. 139-91.


Parvez Hasan, “The Investment Multiplier in an Underdeveloped Economy,” in Economic Policy for Development, ed. by I. Livingstone, Penguin Modern Economics Readings (Harmondsworth, England, 1971), pp. 333-44.


See Rao, op. cit.


It may be rewarding to recall what Evsey D. Domar said in his now famous article, “Capital Expansion, Rate of Growth, and Employment,” Econometrica, Vol. 14 (1946), pp. 137-47. He states (p. 139) that “because investment in the Keynesian system is merely an instrument for generating income, the system does not take into account the extremely essential, elementary, and well-known fact that investment also increases productive capacity. This dual character of the investment process makes the approach to the equilibrium rate of growth from the investment (capital) point of view more promising; if investment both increases productive capacity and generates income, it provides us with both sides of the equation the solution of which may yield the required rate of growth.”


This author has attempted elsewhere the dynamization of the multiplier; see D. R. Khatkhate, “The Multiplier Process in Developing Economies,” The Indian Economic Journal, Vol. II (1954), pp. 155-60. See also K. N. Raj, “Dr. Rao on Investment, Income and the Multiplier in an Under-Developed Economy—A Comment,” The Indian Economic Review, Vol. I (August 1952), pp. 114-17; and Mathur, op. cit.


Raj, The Monetary Policy of the Reserve Bank of India (cited in footnote 3), pp. 44-45.


The role of money in the economics of Keynes is not identical with that in the works of the Keynesians. It is now recognized that Keynes himself had never underestimated the importance of money. See Milton Friedman, “A Theoretical Framework for Monetary Analysis,” Journal of Political Economy, Vol. 78 (March/April 1970), pp. 193-238; and Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford University Press, 1968).


Lewis, op. cit., and Ragnar Nurkse, Problems of Capital Formation in Underdeveloped Countries (Oxford, 1953).


Anthony Bottomley, “The Determination of Pure Rates of Interest in Underdeveloped Rural Areas,” The Review of Economics and Statistics, Vol. XLVI (1964), pp. 302-303; see also his book, Factor Pricing and Economic Growth in Underdeveloped Rural Areas (London, 1971), pp. 81-87.


Anthony Bottomley, “Keynesian Monetary Theory and the Developing Countries,” The Indian Economic Journal, Vol. XII (April-June 1965), pp. 336-37.


This is essentially the same schema as pioneered by John Grey Gurley and Edward S. Shaw in their works. See particularly “Financial Aspects of Economic Development,” The American Economic Review, Vol. XLV (September 1955), pp. 515-38; “Financial Intermediaries and the Saving-Investment Process,” The Journal of Finance, Vol. XI (1956), pp. 257-76; and Money in a Theory of Finance (The Brookings Institution, Washington, 1960).


In usual flow-of-funds analysis, five sectors are envisaged—the household, government, corporate, foreign, and financial sectors. However, from the point of view of use of savings, only the first four sectors are of primary importance in our analysis. While the foreign sector is not considered in this paper, in view of the assumption of a closed economy, the financial sector is left out as it is merely a temporary abode for funds. The excess savings are transferred to that sector only to be retransferred to the ultimate users of funds.


Gurley and Shaw, “Financial Aspects of Economic Development” (cited in footnote 30); Raymond William Goldsmith, Financial Structure and Development (Yale University Press, 1969), and The Determinants of Financial Structure, Organization for Economic Cooperation and Development (Paris, 1966). See also Delano P. Villanueva, “Financial Growth and Economic Development: The Philippines,” The Philippine Review of Business and Economics, Vol. IV (April 1967), pp. 1-17.


It has been found by George G. Kaufman and Cynthia M. Latta that for the period 1951-63 income elasticity of the demand for money (demand deposits and currency) for the United States and the United Kingdom was about 0.4, for Sweden, Canada, the Netherlands, and Belgium between 0.8 and 1.0, and for France, Japan, and Italy from 1.1 to 1.3. This demonstrates that in countries with relatively poor money markets, money is more important as a vehicle of saving than in countries with well-developed financial organization, “The Demand for Money: Preliminary Evidence from Industrial Countries,” Journal of Financial and Quantitative Analysis, Vol. I (1966), pp. 75-89. This is also the observation of Gurley and Shaw: “If consumers desire to hold a constant proportion of their financial assets in money balances during output growth, the ratio of money to national income rises during the early stages of growth and then eventually levels off,” Money in a Theory of Finance (cited in footnote 30), p. 130. A variant of this is found in Hannan Ezekiel and Joseph O. Adekunle, “The Secular Behavior of Income Velocity: An International Cross-Section Study,” Staff Papers, Vol. XVI (1969), pp. 224-37.

Recognition of the role of money in this way renders the controversy regarding money rather superficial. Whether money is a casual, permissive, or passive factor is not relevant at all, because monetary, financial, and economic development are intermingled and occur simultaneously. See Charles R. Whittlesey, “Relation of Money to Economic Growth,” American Economic Association, Papers and Proceedings of the Sixty-eighth Annual Meeting (The American Economic Review, Vol. XLVI, May 1956), pp. 188-201.


Hyman P. Minsky, “Financial Intermediation in the Money and Capital Markets,” in Issues in Banking and Monetary Analysis, ed. by Giulio Pontecorvo, Robert P. Shay, and Albert G. Hart (New York, 1967), p. 41.


The importance of changing the structure of household-sector saving in the context of growth has been well brought out by V. V. Bhatt for India in “Saving and Flow of Funds Analysis: A Tool for Financial Planning in India,” The Review of Income and Wealth, Series 17 (March 1971), pp. 61-80.


For an attempt to link up the flow-of-funds analysis to the objectives of monetary/fiscal policies, see Rattan J. Bhatia and Peter Engstrom, “Nigeria’s Second National Development Plan: A Financial Analysis,” Staff Papers, Vol. XIX (1972), pp. 145-73.


Hugh T. Patrick, “Financial Development and Economic Growth in Underdeveloped Countries,” Economic Development and Cultural Change, Vol. XIV (January 1966), pp. 174-89.


Effects of financialization of savings on the efficiency of investment are brought out sharply by Hicks, op. cit., p. 290, and by Rondo Cameron (in collaboration with Olga Crisp, Hugh T. Patrick, and Richard Tilly), Banking in the Early Stages of Industrialization: A Study in Comparative Economic History (Oxford University Press, 1967).


Hugh Patrick’s distinction between “demand following” and “supply leading” phenomena in regard to the growth of financial institutions can be applied here, too. If the supply of financial assets increases in response to demand for them, it can be construed as a “demand following” phenomenon, and no active participation of the monetary authorities is required; alternatively, when the supply fails to respond, the authorities have the responsibility of creating financial assets. Once such assets are created, they may generate the demand for them. This may be categorized as a “supply leading” phenomenon. See Patrick, op. cit., pp. 175-77.


Sayers, op. cit., pp. 108-33; A.F.W. Plumptre, Central Banking in the British Dominions (University of Toronto Press, 1947), pp. 4-17; and Chandler, op. cit., pp. 13-18.