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

• Author: Peter Montiel - Prachi Mishra
• Position: Professor of economics at Williams College
• Pages: 8-10

IMF Research Bulletin

8

There are strong a priori reasons for believing that the mon-

etary transmission mechanism in low-income countries (LICs)

is fundamentally different from that in economies with more

sophisticated financial systems. A review of the existing litera-

ture also suggests little confidence in the strength of monetary

transmission in low-income countries. It is important to dis-

tinguish between the “facts on the ground” and “methodologi-

cal deficiencies” explanations for the absence of evidence for

strong monetary transmission. There is evidence that “facts

on the ground” are an important part of the story. If this

conjecture is correct, the stabilization challenge in developing

countries is acute indeed, and identifying the means of enhanc-

ing the effectiveness of monetary policy in such countries is an

important challenge. This piece addresses the main questions

in the literature on the monetary transmission mechanisms in

low-income countries.

Question 1: What are the assumptions underlying the

discussion of monetary transmission in advanced

countries?

As argued in Mi shra, Montiel, and Spilimbergo (2012), the

conventional d escription of moneta ry transmi ssion relies on

eective arbitrage a long several margins: between di erent

domestic shor t-term securities , between domestic shor t-

term and long-term securities , between long-term securities

and equities, bet ween domestic and foreign securities, and

between domestic nanci al and real assets. A discu ssion on

monetary tra nsmission is therefore clearly intended to apply

to an economy with a high ly developed and competitive

nancial system . As such, it implicitly assumes the following

institutional se tup, which is typically ta ken for granted in

discussions of monetar y transmission in advanced countries:

(i) A strong institutiona l environment, so that loan

contracts are protected a nd financia l intermediation

is conducted through forma l financial markets.

(ii) An independent central ban k.

(iii) A well-functioning and hig hly liquid interbank

market for reserves.

(iv) A well-functioni ng and highly liquid secondary

market for government securities w ith a broad

range of maturities.

*Peter Montiel is a professor of economics at Wi lliams College .

(v) Well-functioning a nd highly liquid markets for

equities and real est ate.

(vi) A high degree of international c apital mobility.

(vii) A floating exchange rate.

Question 2: Do we expect monetary transmission in a

low-income country context to be different from what we

are familiar with in industrial countries?

Yes. ere are strong a priori reasons for believing t hat the

monetary tra nsmission mechanism in low-income countries

(LICs) is fundamentally d ierent from that in economies

with more sophisticated n ancial systems. First, the com-

plete absence or poor development of domestic securities

markets suggests t hat both the short-run and long-run inter-

est rate channels should be wea k. Second, small and illiqu id

markets for assets such as equ ities and real estate would tend

to weaken the asset cha nnel. ird, in countries that are

imperfectly integ rated with international nancia l markets

and tend to maintain relati vely xed exchange rates, the

exchange rate channel would tend to be completely absent,

or relatively weak.

Question 3: Which channel of monetary transmission, if

any, is likely to be at play in low-income countries?

In general, the nanc ial structure of low-income coun-

tries should lead us to expec t the interest rate, asset, and

exchange rate channels to be wea k or nonexistent in such

countries. By a process of eli mination, the bank lending

channel remains t he most viable general mode for monetary

transmission in LICs.

Question 4: What conditions would determine the

strength of the bank-lending channels? Are these

conditions likely to hold in LICs?

e relevant properties of the ban k lending channel

concern two link s in the causal chain from monetar y policy

actions to aggregate demand : that between monetary policy

actions and the avai lability and cost of bank credit, a nd that

between the avail ability and cost of bank credit and agg re-

gate demand. When the formal  nancial sector is small, as is

true in the vast m ajority of low-income countries, the second

of these link s is likely to be weak. But the link bet ween

Seven Questions on Monetary Transmission in

Low-Income Countries

Prachi Mishra and Peter Montiel*

Q&A