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

• Author: Bin Grace Li - Christopher Adam - Andrew Berg
• Pages: 10-14

Mar ch 2 016

9

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

countries(LICs)?

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

exclusionrestrictions.

Seven Questions on Estimating the Monetary Transmission

Mechanism in Low-Income Countries

Bin Grace Li, Christopher Adam, and Andrew Berg

Q&A