Monetary Policy and Stagflation

Monetary policies are traditionally viewed as demand management policies in all kinds of macroeconomic models. For example, when inflation is high in any economy, a natural reaction for the central bank is to reduce money supply through any of the several instruments that are available in its repertory. Such a reduction in money supply will ultimately reduce prices by reducing the demand for either consumer goods or capital goods or both. The effectiveness of these monetary policies, of course, depends on the extent to which prices fluctuate and, hence, wages respond to the fall in money supply. Apart from this demand-induced change in supply, however, there is no direct role of monetary policies on aggregate supply (AS) of the economy.

This article argues that this view of neutrality of the supply side to monetary policies may change if we pay more attention to the role of money supply on the working capital requirements of firms. A contraction in money supply and the resultant rise in interest rates makes bank-financed working capital more costly to firms. This adversely affects their capability to finance day-to-day transactions, including the payment of wages and interests. The effect of such changes on supply is negative.