Q&A: Seven Questions on the Monetary Transmission Mechanism in Low-Income Countries

• Author: Andrew Berg - Luisa Charry - Rafael A. Portillo - Jan Vlcek
• Pages: 9-12

IMF Research Bulletin

6

Many central banks in low-income countr ies (LICs) are

attempting to modernize th eir monetary policy frame works,

having largely overcome earlier cha llenges of fiscal domi-

nance, multiple exchange rate s, and high inflation. But the

way forward for monetary policy is clou ded by uncertainty

about the monetary transmis sion mechanism (MTM). Do the

attributes of many LICs imply that forward-l ooking monetary

policy frameworks are unfea sible or unwise in these coun-

tries? A narrative approach to ide ntifying monetary p olicy

shocks in four countries re veals a clear MTM and sug gests

that much of the observed variation in th e MTM may be due

to differences in the polic y framework.

Question 1. Why worry about the monetary transmission

mechanism (MTM) in low-income countries (LICs), in

particular?

e environment for monetary policy i n many LICs has

undergone a fundamental t ransformation in recent decades,

with much lower ination, fewer signs of sca l dominance,

and an end black market excha nge rate premia. And now, as

we describe in Berg and ot hers (forthcoming), many centra l

banks in low-income countries i n Sub-Saharan Africa a re

modernizing thei r monetary policy frameworks.

At the same time, t heir economies are profoundly dier-

ent from those of emerging market a nd advanced countries,

with among other feature s much smaller nancial sectors, a

high incidence of supply shocks, and a la rge share of food in

consumption. Monetary polic y frameworks have also been

very dierent, with g reater reliance on monetary aggregates

to conduct policy.

Some variant of inat ion targeting is the obvious bench-

mark for those countries w ith an independent currency. But

how can a central ban k emphasize an ination objective as

its nominal anchor if it does not k now how monetary policy

inuences the macroeconomy?

Question 2. What is the evidence that transmission

in LICs is radically different?

Mishra and others (2012) argue that tra nsmission in

LICs is “weak and unrel iable.” ey note that the cor-

relation between short and long rates is genera lly much

weaker in LICs tha n in emerging markets or advanced

countries, and th at vector-auto-regression (VAR) based

evidence in developing countrie s tends to nd insignicant

eects of “monetary polic y shocks” on ination and output.

In ongoing work, we are investigating t he question posed in

Mishra and others (2012) as to whether this ev idence reects

the techniques or the “ facts on the ground.” Early results

suggest that there are i ndeed reasons to worry about the

application of some standard empirica l techniques in condi-

tions typical of L ICs. In particular, data scarcit y and regime

changes imply that periods of consis tent policy regime with

adequate data are very short, r arely longer than say 10 years.

Simulations suggest that 10 years is genera lly too short to get

signicant coecients i n a standard small VAR quarterly

data, even if data are mea sured correctly and monetary polic y

is correctly identied . And indeed the regimes in the region

have not been stable (Berg and others, forthcom ing).

It is worth remembering that even in t he United States,

where data series are long and str uctural change less impor-

tant, it took many years and dozen s of papers before anoma-

lies such as the “l iquidity puzzle” (that a monetary policy

tightening seemed to lower interest rates) and the “price

puzzle” (that a monetary tig htening seemed to increase sub-

sequent ination) were solved in VARs.

Question 3. What else can be done to identify the MTM?

As Summers (1991) and Romer and Romer (1989) argue,

views on the real eec ts of monetary policy in the United States

have been more inuenced by the narrative a rguments of Fried-

man and Schwart z (1963) and by reference to the real eects of

the “Volcker disination,” than by formal stat istical analysis.

us, much of our research has focused on cou ntry-specic

analyses rooted in de tailed consideration of particul ar episodes.

In Berg and others (2013), we examine a signicant tig hten-

ing of monetary policy t hat took place in October 2011 in

Seven Questions on the Monetary Transmission Mechanism

in Low-Income Countries

Andrew Berg, Luisa Charry, Rafael A. Portillo, and Jan Vlcek

Q&A