Characterization the Less Developed Countries - Essay Example

• The less developed countries are typically characterized by –
 A low level of output, that is, a low level of gross domestic product
 Low level of employment
 Stagnation combined with inflation, more popularly known as stagflation.
 A lower level of human development is indicated through various development indicators like education and health.

• Increasing the bank rate will lead to an increase in the long-term market rate of interest and that would discourage investment reduce the inflationary gap.

• An increase in reserve ratio will lead to a reduction in the capacity of excess reserve of the commercial banks and thereby will lower their credit creation capacities

• Selling government bonds through open market operations will suck out the excess money supply in the hands of the public and thereby reduce their purchasing power.

• The main difficulty with the monetary policy to control inflation is that it affects the aggregate demand only indirectly and the effect is only realized after a time lag.
(Caprio, Atiyas and Hanson, 1994, 161)

• Secondly, the effectiveness of monetary policy in controlling inflation will depend upon the sensitivity of different economic variables to changes in the supply of money and the rate of interest.

• In a more elaborative way, the less developed countries are suffering from a low level of national output.

• Now, to tame the inflation, if a reduction in money supply is followed then facing the situation the public, in order to meet their transaction demand for money will readily sell out their previously held government bonds in the market.

• Supply of bonds will rise and that will eventually bring a reduction in the price of the bond.

• Due to the inverse relationship between bond price and market rate of interest, the market rate of interest will rise.

• This will discourage investment and lower the aggregate demand and thereby the gross domestic product.

• As the less developed counties are already at a lower level of output, therefore reduction of money supply in order to tame the onrush of inflation will lower their output even further and thereby trapping it within a vicious circle.

• Furthermore, as the investment in the real sector often has a trickle-down effect on the social sector, therefore the educational and health frontier will also receive a setback.

• Most importantly, this reduction in money supply will aggravate the stagnation even more.

• Stagnation, combined with inflation, refers to stagflation, which is a peculiar characteristic of these less developed countries.

• Here on one hand the economy suffers from a low level of output for a prolonged period and n the other hand is subject to a high rate of inflation and both of them combined, lead to a policy maker’s nightmare, that is, stagflation.

• As explained, if in this particular situation, a country’s central bank opts for a reduction in money supply in order to get rid of the inflation present in the economy, it will lower the gross domestic product even more and only strengthen the stagnation present in the economy even more.
(Fry, 1995,115 ).

• Another problem courting these less developed economies is a high rate of unemployment. Now a reduction in money supply, as explained above will discourage investment and thereby lower the level of output.

• As usual a lower level of output is also associated with a low level of employment. So this policy in course of time will make a substantial addition to the pull of unemployed laborers of the less developed economy.

• This concept has its origin in the concept of Philip’s curve which depicts an inverse relationship between the rate of the price increase and the rate of unemployment. (Tool and Bush, 2003, 48)

• The less developed economies have to bear with a certain level of inflation in order to experience growth and thereby ensure employment. Therefore, if a reduction in money supply is taken by the central bank as a policy to tame inflation in such economies it will only lead to long-run aggravation of other economic maladies. (Lipsey and Harbury, 1992, 252)

• Furthermore, the less developed economies are typically characterized by black marketers who manage to bluff the government and thereby run a parallel economy. In such an economy, often inflation is caused by unethical storage of goods with a view to inflate the price artificially and hence reap the profit.

• In such cases inflation is not always an economic phenomenon created through the natural demand-supply gap and therefore an economic policy of reduction in money supply by the central bank cannot reach the root of the problem and usually fails to qualify as an effective policy

• In terms of sensitivity, owing to the primitive nature of the economy, the economic variables are not well integrated into a less developed economy, and thereby monetary policy of such kind cannot produce effective and efficient results in taming the inflation.