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

Author:Bin Grace Li - Christopher Adam - Andrew Berg

The use of conventional vector auto-regression (VAR)-based methods to identify the monetary transmission mechanism (MTM) in low income countries suggests the MTM may be weaker and less reliable than in advanced and emerging market economies. But are structural VARs identified via short-run restrictions fit for this purpose? Are they capable of detecting a transmission mechanism when one exists,... (see full summary)

Mar ch 2 016
The use of conventional vector auto -regression (VAR)-based
methods to identify the mone tary transmission mechani sm
(MTM) in low income countries sugge sts the MTM may be
weaker and less reliabl e than in advanced and emerging
market economies. But are str uctural VARs identified via
short-run restric tions fit for this purpose? Are they ca pable
of detecting a transmission me chanism when one exists ,
under the structural and re search conditions typical of
these countries? Thi s Q&A article provides brief an swers to
seven questions on est imating the monetary transmission
mechanism in low-income count ries.
Question 1. Why does understanding the monetary
transmission mechanism matter in low-income
The monetary tra nsmission mechanism (MTM) describes
the link bet ween monetary policy i nstruments under the
direct control of the centra l bank—usually a short-term
policy interest rate—and t he ultimate economic outcomes
it is seeking to inf luence, typically agg regate demand
andinf lation.
Transmission occurs along mult iple channels: direct ly
through the ef fect of interest rates on private consumption
and investment, and indi rectly through exchange rates on
import prices and exter nal competitiveness; through the
quantity and price of cred it from the bank ing and non-bank
financia l sectors; through asset prices and wealt h effects;
and through private sec tor inflation expectations. T he
transmission of monetar y policy signals via these di fferent
channels depends on a range of fac tors including the depth
and development of financial ma rkets, the structure and
credibility of the moneta ry policy regime, and the volatil ity
of the domestic and externa l economic environment.
A fundamental ch allenge in the conduct of monetary policy
is for central bank s to develop robust estimates of the speed,
direction, and relative st rength of transmission of its policy
actions through eac h channel. This is a particu larly difficult
task in low-income countries where fin ancial markets are
thin, the economy is undergoing r apid structural change
and policy regimes a re seeking to adjust to this change, and
where limitations in the qu antity, timeliness, and qualit y
of macroeconomic data are widespread. St ructural factors
that play a role in ensuring the t ransmission mechanism in
LICs may be relatively weak compared to those i n advanced
and emerging market economies . Shallow interbank and
money markets may impair t he transmission from short-run
policy interest rates to the st ructure of rates in the broader
financia l markets, while low levels of financial i nclusion and
widespread market power in the f inancial systems may impede
transmission from t he financial sector to the real e conomy.
Question 2. How do VAR methods
seek to uncover theMTM?
Vector auto-regression (VAR) models are perhaps the
most widely used methodolog y to analyze the MTM
empirically. VARs used for monetary policy a nalysis entail
the imposition of identify ing restrictions on macro time-
series data in order to trace t he impact of innovations to
interest rates or other monetary i nstruments (e.g., reserve
money) on the evolution of a vector of macroeconomic
aggregates, usua lly inflation, the output gap, exchange
rates, and interest rates them selves but possibly also
money and credit aggregates. Using VARs for monetary
policy analysi s, dating back to the semina l work of Sims
(1980), confronts the researcher with formidable model
specification a nd identification challenges— see for
example Christia no and others (1999) for a discussion.
Totackle these and respond to perceived weak nesses
with the sta ndard recursive VAR estimation, other
methods have been applied to the adva nced and emerging
countries, including: genera lized non-recursive SVARs
(Sims and Zha, 1995; Kim and Roubini, 2 000); sign
restrictions (Uh lig, 2005); and factor-augmented VARs
(Bernanke, Boiv in, and Eliasz, 20 05).
Most studies of the monetar y transmission mechanism
in LICs, such as those rev iewed by Mishra, Montiel,
and Spilimbergo (2012) and Mishra and Montiel (2013),
still tend to rely on conventional SVAR models, with
the majority identif ying the monetary pol icy shock
using recursive or block-recursive ordering or simil ar
Seven Questions on Estimating the Monetary Transmission
Mechanism in Low-Income Countries
Bin Grace Li, Christopher Adam, and Andrew Berg

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