Monetary Policy Transmission: Development Bank’s Perspective

1. Monetary Policy Transmission. Development Bank’s Perspective By Dr. Stephen Robert Isabalija Board Director

2. Presentation Outline • Introduction • The main channels of monetary transmission • Effectiveness of the Monetary Policy Transmission Channels • Constraints to the efficacy of the Monetary Policy Transmission Channels • Policy options to improve Monetary Policy Transmission Mechanism • Conclusion

3. 1- Introduction • An important issue for any country is the effectiveness of their monetary policy and the various channels through which it is transmitted into sustainable growth and low inflation. • Central banks implement policy changes by resetting their policy instruments that affect the economy through various transmission mechanisms of monetary policy. • Unless the transmission mechanisms of monetary policy there is fully understood, there will always be uncertainty about the timing and effectiveness of monetary policy actions.

4. 2-Monetary Policy Transmission Channels • The transmission mechanism of monetary policy involves channels through which monetary policy decisions affect the economy in general and the price level. • Analysis of these channels is important because it helps to determine the most effective set of policy instruments, their relative efficiency and speed of propagating policy effects.

5. 2-Monetary Policy Transmission Channels Main Monetary Policy Transmission channels include: • The interest rate channel: Regarded as the main channel of monetary policy transmission. It operates through the impact of monetary shocks on liquidity conditions and real interest rates, which in turn affect interest rate sensitive components of aggregate demand such as consumption and investment. An expansionary monetary policy leads to a fall in the real interest rate, thus decreasing the cost of capital and stimulating investment, which then results in an increase in aggregate demand and output.

6. 2- Monetary Policy Transmission Channels • Bank lending: Works through the response of credit aggregates to changes in interest rates and other policy instruments. The credit channel has two sub-channels—the bank lending and the balance sheet channels. • The bank lending sub-channel works by influencing banks’ ability to make loans following changes in the monetary base. • Balance sheet channel transmit s monetary policy both directly and indirectly through the borrowers’ balance-sheet.

7. 2-Monetary Policy Transmission Channels • Exchange rate channel: Operates through the impact of monetary developments on exchange rates and aggregate demand and supply. For example, an increase in interest rates would normally lead to an appreciation of the exchange rate, which lowers the price of imported goods and services and thereby pushes down domestic inflation. The effectiveness of the exchange rate channel depends on the exchange rate regime, the extent of exchange rate pass-through and the degree of openness to capital flows

8. 2-Monetary Policy Transmission Channels • Asset channel: Transmits the impact of monetary shocks on yields, equity shares, real estate, and other domestic assets, operating through changes in the market value of corporate and household wealth. • Expectation channels: Works through the impact of monetary shocks on the perception of households and firms about intertemporal versions of static interest rates, asset prices and exchange rates.

9. 3.Effectiveness of Monetary Policy Transmission Channels • Interest rate channel is usually the most important transmission mechanism in advanced economies with developed financial markets • Bank lending and exchange rate channels are generally the dominant channels of monetary transmission in emerging market economies • Interest rate channel is generally weak, and the credit and exchange rate channels are more important although not always very strong in Low-Income-Countries.

10. 4-Constraints to the efficacy of Monetary Policy Transmission • Financial Depth: affects both the nature and the size of financial sector responses to shifts in monetary policy, with particular relevance for the bank lending, interest rate and exchange rate channels. • Consistent with these findings, the bank lending channel’s effectiveness depends on the domestic institutional context, the structure of the banking system, and the intrinsic stability of the domestic macroeconomic environment which is usually problematic in LICs (Mishra et al 2010) • The low degree of financial markets depth weakens the traditional interest rate channel .

11. 4-Constraints to the efficacy of Monetary Policy Transmission • Independence of Monetary authorities: When the degree of central bank autonomy is limited it leaves little room for the exercise of an independent monetary policy. Central banks in LICs usually face interference from the government which leads to multiple and conflicting objectives. • High dollarization: The greater the dollarization of an economy, the less the influence a monetary policy authority has in modifying the key interest rates that affect consumption and investment decisions

12. 5- Options to improve monetary policy transmission. • Financial sector should be fully operational. Four financial markets should be capable of efficiently redistributing liquidity and transmitting policy signals to the real economy • A substantial degree of international financial integration is required to strengthen the transmission mechanisms of monetary policy. • Independence and credibility of the central banks can considerably improve the effectiveness of monetary policies since they increase the confidence of the public’s expectations regarding future central banks' actions and insulate them from political pressures

13. 6- Conclusion In view of the foregoing, it can be asserted that transmission mechanism functions best when signals are clear with a simple regime simple that is coherent. Thank you