Working Paper: CEPR ID: DP7951
Authors: Prachi Mishra; Peter J. Montiel; Antonio Spilimbergo
Abstract: This paper reviews the monetary transmission mechanism in low income countries (LICs). We use monetary transmission in advanced and emerging markets as a benchmark to identify aspects of the transmission mechanism that may operate differently in LICs. In particular, we focus on the effects of financial market structure on monetary transmission. The weak institutional framework prevalent in LICs drastically reduces the role of securities markets and increases the cost of bank lending to private firms. Coupled with imperfect competition in the banking sector, this means that banks with chronically high excess reserves invest in domestic public bonds or (when possible) in foreign bonds. With the financial system not intermediating funds properly, the traditional monetary transmission channels (interest rate, bank lending, and asset price) are impaired. The exchange rate channel, on the other hand, tends to be undermined by central bank intervention in the foreign exchange market. These conclusions are supported by review of the institutional frameworks, statistical analysis, and previous literature.
Keywords: banks; credit; exchange rate; institutions; interest rate; monetary policy
JEL Codes: E5; O11; O16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| weak institutional framework (O17) | impaired traditional monetary transmission channels (E44) |
| impaired traditional monetary transmission channels (E44) | high costs of bank lending (G21) |
| high costs of bank lending (G21) | weak effectiveness of bank lending channel (G21) |
| bank lending channel (G21) | aggregate demand (E00) |
| central bank policy actions (E52) | bank lending rates (G21) |
| bank lending rates (G21) | aggregate demand (E00) |
| weak effectiveness of bank lending channel (G21) | weak link between policy instruments and market outcomes (J48) |