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1KINGSTON UNIVERSITY, LONDON SCHOOL OF ECONOMICSMonetary Economics in Developing Countries (FE3178), 2009-2010Monetary policy transmission2Monetary policy transmissionIntroductionWe discussed features of monetary policy institutions in developing countries and how these features affect economic performance.Today we try to answer the following question:How do a central bank’s actions work their way through an economy?3The transmission mechanism of monetary policyUnderst
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KINGSTON UNIVERSITY, LONDONSCHOOL OF ECONOMICS
Monetary Economics in Developing Countries (FE3178), 2009-2010
Monetary policy transmission
1
Monetary policy transmission
Introduction
We discussed features of monetary policy institutions in
developing countries and how these features affect
economic performance.
Today we try to answer the following question:
How do a central bank’s actions work their way through
an economy?
2
The transmission mechanism of monetary policy
Understanding how monetary policy actions are actually
transmitted to the rest of the economy is an ongoing
subject of study for economists.
The Symposia on the Monetary Transmission
Mechanism in the Journal of Economic Perspectives,
1995, Volume 9, Number 4, pages 3-96, contains an
interesting set of papers on this topic.
Even though institutional features will likely determine
the exact transmission mechanism for an individual
economy, several hypotheses have been put forward with
the aim of explaining this process.
3
All these frameworks assume that the monetary policy
transmission process begins with a change in the
monetary policy stance of the authorities.
An example would be a decrease in the money supply
originating from a policy aiming at altering bank reserves
or changing a short-term interest rate -e.g. the interbank
interest rate, which is the rate commercial banks charge
for lending funds to each other.
One method of transmission would be the workhorse
mechanism which states that a contractionary
monetary policy will affect output through an increase
in the interest rate, with this increase leading in turn to a
reduction in investment and output.
4
Another possible transmission mechanism operates
through the exchange rate’s impact on net exports.
A reduction in the money supply will generate an
increase in the interest rate, which will subsequently
cause the exchange rate to appreciate, reducing the
amount of net exports and therefore aggregate demand.
This outcome, however, is contingent upon the fulfilment
of the ‘Marshall-Lerner condition’ which states that a
depreciation’s ultimate impact on the trade balance
depends on imports’ and exports’ exchange-rate-
elasticity.
A third possible transmission mechanism is embodied in
the bank lending or credit view.
5
Banks here play a direct role in the transmission
mechanism of monetary policy: a lower money supply
decreases bank deposits, which in turn lowers bank
loans, and that works by reducing investment and output.
The transmission mechanism of monetary policy in developing countries
Analysing monetary policy’s transmission mechanism in
developing countries traditionally focuses on measuring
financial liberalisation’s impact on credit availability.
Recall that the McKinnon (1973) and Shaw (1973) and
the Structuralist views (e.g. Taylor, 1983; van
Wijnbergen, 1982, 1983) hold opposing views on
precisely this question, as explained in detail in Chapter
4 (see also Auerbach and Siddiqui’s, 2004, survey).
6
McKinnon and Shaw argue that higher interest rates
resulting from financial liberalisation raise output and
lower inflation in the short-run: financial liberalisation
leads to increasing savings and financial
intermediation, which boosts bank loans and private
investment in the medium term.
A key assumption underlying this approach is that
liberalising interest rates works by mobilising idle
resources to productive use.
Note that the degree of substitutability between bank
deposits and resources in the informal credit market is
crucial.
7
In contrast, the structuralists argue that financial
liberalisation polices may increase the marginal cost of
funds in the ‘unorganised money market’ by taking
resources away from it (van Wijnbergen, 1982; Taylor,
1983), with those unable to access the formal loans
market suffering from the contraction of funds.
Thus the structuralists predict that a monetary policy
tightening, i.e. reduced credit availability, and
corresponding higher interest rates and costs of financing
working capital, which leads to contracting output and to
an increasing rather than to a decreasing inflation rate.
This effect is equivalent to an adverse supply shock
leading to stagflation.
8
A further prediction from this approach is that, if
effective in reducing real aggregate demand, a
contractionary monetary policy works by reducing
investment and not consumption, with negative
consequences for an economy’s growth prospects.
For the sake of clarity, we summarise the McKinnon and
Shaw and the structuralist transmission mechanisms as
follows
McKinnon-Shaw
FL⇒ i↑⇒ s↑⇒BL↑⇒ I ↑⇒Y ↑
Structuralists
FL⇒ i↑⇒ ILM ↓⇒ MCF↑⇒ I↓⇒Y ↓.
9
In the above mechanisms indicates an increase, and a
decrease in a given variable.
The variables are defined as follows:
i is the real interest rate, I investment, Y real output, E the
nominal exchange rate (an increase is a depreciation), BL
bank loans, FL financial liberalisation, s are private
savings, ILM informal loans market (or unorganised
money market), and MCF stands for the marginal cost of
funds.
10
A benchmark model
Montiel (1991) develops an analytical model considering
salient features of a developing economy’s monetary
dynamics.
In particular, he attempts to explain how a central bank’s
actions are transmitted to the rest of the economy.
He argues (Montiel, 1991, p. 83) that “Curiously,…in
spite of the prominence given to monetary policy in the
developing economy setting, the transmission
mechanism for monetary policy in a typical developing
country has not been studied extensively and
consequently is not well understood”.
11
Even though more empirical evidence on the subject now
exists, Montiel’s analytical framework is still relevant.
The model in question brings into play several features
like domestic currency, bank deposits, foreign currency,
land, and physical capital.
The model also incorporates a curb market –an important
feature in an undeveloped financial system.
Thus, for instance, economic agents can acquire assets
such as land and physical capital either by obtaining
liquidity through the curb market or from the financial
system.
Interest and exchange rate determination also feature in
this model. In developing economies, interest rates are
12
often capped by formal regulations, therefore limiting the
role of financial intermediaries in linking savers and
borrowers; exchange rates are freely determined in a
parallel or black market, whereas the official price is
fixed.
This multiple exchange rate market setting arises chiefly
due to the monetary authorities’ desire to isolate critical
domestic prices, like oil, from external fluctuations (See
Calvo and Reinhart, 2002).
In the setting described so far, traditional monetary
policy instruments, such as interest rates, that are crucial
in developed economies (e.g. Bernanke and Blinder,
1992) are not as important in central bank policymaking
in developing countries. Instead, instruments such as
central bank domestic credit, legal reserve requirements
13
for the banking system, and exchange rate market
interventions play a prominent role in developing
countries.
Accordingly, Montiel explicitly models households, the
government, the monetary authorities, and the banking
system in a Mundell-Fleming framework.
Important assumptions are as follows: full-employment
holds continuously and changes in aggregate demand
only lead to changes in prices; agents form expectations
rationally, this assumption implying that expectations
about future developments in exchange rates and in
prices induced by current policies are allowed to affect
current macroeconomic conditions.
Montiel’s framework leads to several conclusions.
14
Changes in monetary policy impact the effective degree
of financial repression by affecting the fashion in which
that policy taxes households, and by altering the structure
of households’ portfolios as a response to financial
repression.
The model also produces general equilibrium effects that
work via the impact of policy changes on the parallel
foreign exchange market premium, the economy’s stock
of foreign assets, and expected inflation.
However, the effects from changes in the stock of foreign
assets (that are a by-product of policy changes) are only
observed with a lag.
15
Additionally, variations in central bank credit to the
banking system and reserve requirements work their way
through the economy via their impact on wealth, the loan
interest rate, and fiscal effects. Raising administered
interest rates is contractionary.
Finally, the impact of a foreign exchange sale (akin to a
contraction in the money supply) is contractionary. So a
purchase of foreign exchange (an increase in the money
supply) is expansionary.
Carpenter (1999) further studies monetary policy’s
transmission mechanism in developing countries.
He develops an IS-LM model incorporating a regulated
banking system and an informal credit market.
16
Importantly, Carpenter assumes that there are no bond or
equity markets.
The model’s main prediction is that increases in
monetary policy’s control instrument (the money supply)
are expansionary via the credit view, by which more
credit leads to more output.
This result is line with Montiel’s (1991) predictions, but
not with those of van Wijnbergen (1982).
Notably, the latter predicts stagflationary developments
following a monetary expansion.
The next section discusses the empirical evidence on the
topic.
17
Empirical results concerning the transmission mechanism of monetary policy in developing countries
Measuring monetary policy’s impact on real and nominal
economic variables has been approached from various
perspectives
With the vector autoregression (VAR) method (to be
discussed below) popularised by Sims (1980) arguably
the tool macroeconomists employ most frequently when
dealing with such a task.
Sims argues that estimating large-scale
macroeconometric models reveals little useful
information, and demands ‘incredible assumptions’.
18
During the 1960s and 1970s evaluating the likely impact
of alternative policies was largely undertaken by
constructing and estimating large-scale structural
macroeconometric models.
However, a pillar in this approach, i.e. assuming that a
model’s estimated parameters are invariant to the
relevant policy rule’s specification, was criticised in
Lucas’s (1976) influential paper.
But subsequently Lucas’s main critique regarding the
rationality of economic agents has been incorporated
into large scale structural econometric models (e.g. Fair,
1984), and macroeconometric models are still popular in
institutions such as central banks and other policymaking
institutions (see, for instance, Mankiw’s, 2006, remarks
on the topic).
19
VARs have become a popular tool for the evaluation of
theoretical macroeconomic models in developed and
developing countries.
But various authors criticise the VAR approach and its
usefulness in examining monetary policy’s effect on the
economy.
We turn to reviewing several contributions to the
understanding of the monetary policy transmission
mechanism in developing countries, predominantly those
using the VAR approach.
As revealed in the analysis so far, tensions exist between
the somewhat conflicting predictions from various
analytical approaches.
20
Using Korean data, van Wijnbergen (1982) finds
support for the structuralists’ approach. Particularly, he
shows that restrictive monetary policy leads to
stagflationary developments.
But that evidence is to some extent challenged
elsewhere.
For instance, Carpenter (1999) also analyses Korean
data, and discusses the relevance of credit provision by
the authorities and the existence of an informal credit
market.
His empirical modelling employs the VAR approach,
chiefly in estimating impulse response functions
depicting the trajectories of key macroeconomic
variables resulting from shocks to monetary policy
21
instruments, in this case either M2 or the Bank of
Korea’s credit.
The VAR modelling considers Cholesky’s
decomposition as well as Bernanke’s (1996) more
structural identification strategy. Both methods yield
analogous outcomes.
Carpenter’s results are interesting.
He finds that, supporting Montiel’s (1991) and van
Wijnbergen’s (1982) models, there is a positive and
significant reaction in the price level following a shock
to the interest rate.
He argues that the reason for this response is that
increasing credit costs lead to higher input costs.
22
Moreover, as predicted in Montiel’s model, he finds that
increases in money are expansionary.
However, Carpenter does not find evidence of
stagflationary developments found in van Wijnbergen’s
modelling.
He does find that contractions in money lead to a fall in
output, but also in prices.
Carpenter makes an attempt at rationalising his VAR-
based findings vis-à-vis van Wijnbergen’s predictions on
the path of the informal interest rate following a shock to
money or credit.
He actually finds that a positive policy shock leads to an
increase in the informal market’s interest rate; the
23
rationale for this finding is that general equilibrium
effects work by increasing output.
That, in turn, leads to a higher demand for resources in
the informal sector, and so to a correspondingly higher
interest rate.
Other contributions to our understanding of monetary
policy’s transmission mechanism in developing countries
put more emphasis on interpreting shocks than to
reconciling them with relevant theories, as is the case
with VAR-based studies like Leiderman (1984) and
Kamas and Joyce (1993).
For instance, Leiderman estimates a significant and
positive association between money growth and inflation
in Colombia.
24
Reinhart and Reinhart (1991) produce an interesting
analysis comparing the relevance of the neoclassical
synthesis and of business cycle theories in a developing
economy context.
This is a welcome effort, since some economists may be
inclined to rule-out ex-ante the neoclassical synthesis and
business cycle theories’ applicability in a developing
economy context.
Basically, the neoclassical synthesis postulates that
monetary policy can be effective in the short-run; due to
price stickiness, an unexpected monetary expansion will
increase output.
25
But that effect will only survive until prices adjust.
(Goodfriend and King, 1997, explain developments in
this line of thinking.)
On the other hand, business cycle proponents do not take
into account the impact of monetary disturbances on the
economy (e.g. Nelson and Plosser, 1982).
Thus the findings which emerge from applying that
framework may only be able to account for a limited
amount of the many potential sources of output
fluctuations -chiefly technological ones. And that is
despite the vast theoretical and empirical literature
evaluating money’s impact on the real economy.
In contributing to this debate, Reinhart and Reinhart
(1991) key finding is that for Colombia a neoclassical-
26
Keynesian story is more sensible than a business cycle
perspective in which money plays no role. That is,
money does affect output.
Importantly, they find that output falls following a
monetary contraction, so disinflationary policies are
costly.
27
Figure 8.1Standard monetary policy transmission mechanism
Change in monetary policy stance affecting bank reserves and/or short-term interest rate
Investment
Output and prices
Exchange rate and net exports
Bank credit
28
Table 8.1Selected empirical studies on the transmission mechanism of monetary policy
in developing countries (in chronological order)
Investigation CountryEconometric
technique Key finding
van Wijnbergen (1982) South KoreaTwo stage least squares (TSLS)
Short-run stagflationary effect of restrictive monetary policy
Leiderman (1984)Colombia and Mexico
VARsFor Colombia money growth affects inflation. For Mexico two-way causality between money and inflation
Reinhart and Reinhart (1991)
Colombia VARsFinds support for the neoclassical synthesis. That is, monetary shocks affect output
Kamas and Joyce (1993) India and Mexico
VARsDomestic monetary policy does not affect output, but in both economies output responds to changes in foreign money
Kamas (1995) Colombia VARs
Variations in domestic credit affect the balance of payments but not the exchange rate. So it seems that Colombia’s crawling peg effectively works as a fixed rather than a flexible exchange rate regime.
Carpenter (1999) South Korea VARs
Central bank credit significantly affects output, prices and interest rates in the informal sector. Findings support Montiel’s (1991) model, but not the stagflationary response to monetary contractions in van Wijnbergen (1982)
Chong et al (2006) Singapore Time seriesTransmission mechanism from financial institutions’ administered rates is asymmetric across sectors in the economy. A monetary tightening impacts the economy with a longer lag than an expansion
Note. – VAR: vector autoregression.
29