Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 6 - Monetary Transmission Mechanism

The Transmission Mechanism: Evolving Challenges

Apart from the ongoing structural changes, monetary policy transmission in the future would have to contend with the evolving pattern of demographics. Over the next few decades, as the proportion of elderly population to the total increases, the pattern of global savings will change and this may reduce the natural rate of interest. Typically, the elderly population is richer in financial and real capital while the young are richer in human capital. With the growing share of elderly population, the role of the wealth channel in monetary transmission might assume greater importance. A central bank, therefore, needs to constantly monitor the transmission lags for monetary policy effectiveness.

Monetary authorities will have to take into account the implications of the ongoing financial innovations such as e-banking and e-money¹ on the transmission mechanism. In one view, e-banking is expected to reduce transactions costs for depositors. Lower transaction costs, following the Baumol-Tobin framework, suggest a reduction in demand for money². At the same time, e-banking increases depositors' access to a wide range of financial assets in addition to bank deposits. This increases the opportunity cost of money and hence demand for money may turn out to be more interest elastic. In terms of the IS-LM framework, this will flatten the LM curve. Thus, increased recourse to e-banking might have two implications: reduction in money demand and a flattening of the LM curve. Reduction in money demand will reduce interest rates and increase growth as formerly idle transaction balances are reallocated to savings and investment. On the other hand, a flattening of the LM curve (with an unchanged IS curve) could weaken monetary policy effectiveness. Thus, desired changes in output and prices will require a comparatively large monetary policy stimulus.

Moreover, e-finance development could enlarge the pool of potential lenders. Thus, in the event of a monetary tightening, previously credit-constrained firms may more easily find alternative avenues of credit which would weaken the effectiveness of monetary policy. Furthermore, if hedging against exchange and interest rate fluctuations becomes easier and cheaper, this could also reduce the responsiveness of output and prices to changes in interest rates. On the other hand, increased use of internet technology in the real economy is likely to accelerate the impact of monetary policy. Use of information technology for inventory management will mean that changes in sales will reflect more quickly in changes in output and prices.

As regards e-money, its implications will critically depend upon the extent to which private e-money replaces central bank currency. According to Freedman (2000), the special role of central banks in providing for final settlement is unlikely to be ever replaced owing to the unimpeachable solvency of these institutions. To establish its credibility, a private e-money provider will have to promise to redeem its e-money liabilities in government money and will thus be required to maintain deposit accounts with the central banks. Overall, monetary policy is likely to remain a key instrument of macroeconomic stabilisation albeit its effectiveness could be weakened to some extent.

A key aspect of the transmission mechanism is the speed with which the changes in policy rates feed on to banks' deposit and lending rates (Box VII.2). Available empirical evidence on the interest-rate pass-through from policy rates/money market rates indicates that interest rates of banks - deposit as well as lending rates - are sluggish in responding to monetary policy actions with lags ranging from several weeks to several months. . A number of interesting features emerge from the cross-country survey of recent studies on pass-through estimates studies. First, the pass-through estimates lie in a wide range and vary a lot from country to country.

Third, there is no uniform pattern in the pass-through between deposits and loans. In some countries, deposit rates are stickier than lending rates and vice versa. For instance, in the Euro area, overnight deposit rates and 'deposits redeemable at notice of three months' are the stickiest, with even long-run pass-through of, at most, 40 per cent. The low pass-through in this case can be attributed partly to administered nature of these deposits in some Euro area countries and partly the fact that demand for such deposits is relatively inelastic. In contrast to the euro area evidence, Mizen and Hofmann (2002) find that, for the UK, pass-through in case of deposit rates is larger than that for lending rates. Fourth, the size and the speed of the pass-through are found to decline as the maturity of the bank instruments increases. Thus, the higher the maturity, the lower the pass-through. Fifth, between various type of loans, pass-through in case of consumer lending is found to be the weakest, reflecting a variety of factors -weak competition, inelastic demand, asymmetric information and credit rationing. In the US, credit card rates even today remain the stickiest with pass-through of only 0.3 during the 1990s, albeit higher than that of almost negligible level during the 1970s. Sixth, evidence is inconclusive as to whether the response is symmetric to monetary policy signals. A few studies find an asymmetric response: the pass-through is quicker when monetary policy is tightened and sluggish when monetary policy is easing. This has an important implication for the transmission mechanism with monetary tightening being more effective than monetary easing of the same magnitude. Other studies, however, do not find any evidence in favour of this proposition. Finally, the pass-through estimates for emerging economies are generally comparable to that of advanced economies.

Amongst the other key findings of the literature, competition increases pass-through, but mainly in deposit markets. Market concentration (say, mergers) per se does not reduce the pass-through as long as the markets are contestable. A well-developed market for negotiable short-term instruments (such as certificates of deposit) increases the pass-through; on the other hand, a well-developed market for commercial papers does not appear to increase the pass-through. Excessive volatility in money markets reduces the information content of monetary policy signals and hence weakens the pass-through.

As regards the effects of a monetary union, evidence is inconclusive with some studies finding an improvement in the pass-through but others find no such evidence. For the US economy, there is evidence of an increase in pass-through during the recent years. For instance, the pass-through from the Fed Funds rate to the prime rate has increased significantly during the 1990s, being almost immediate. In the case of housing mortgage, the pass-through increased from around 0.2 in the early 1970s to almost unity by 1999-2000. For other loans (car loans, credit cards and personal loans), the size increased by 3-4 times during the 1990s but was still lower than unity. Evidence from Chile indicates significant differences in banks' responses: the smaller the bank, the lower the portion of past-due loans and the larger the share of the household consumers, the faster is the pass-through of lending rates to money market rates

In brief, the above survey shows that pass-through is rather sluggish in the short-run. The pass-through increases over time, but not necessarily complete even in the long-run. There is no uniform pattern on pass-through between deposit and loans. Within loans, consumer loans typically display the weakest pass-through.

¹E-banking may be defined as the use of electronic methods to deliver traditional banking services using any kind of payment media. On the other hand, e-money is any electronic payment media - any material, device or system that conducts payment via the transfer of electro-magnetically stored information (Fullenkamp and Nsouli, 2004).

² Money held for transaction purposes has an opportunity cost in terms of interest foregone on other assets. Economic agents would, therefore, like to economise on their use of transaction balances by making frequent transactions to sell interest-bearing non-money assets. However, as this process involves transaction costs, economic agents hold more transaction balances than if there were no transaction costs. If these transaction costs were to decline, demand for transactions balances will also fall.