Module: 3
The Transmission Mechanism of Monetary Policy in Emerging Market Economies
[An Overview of the Discussion Papers Submitted by the Basel Policy Group - Overview by Steven Kamin,
Philip Turner and Jozef Van 't dack - The Orgnal Article may be referred at - URL http://www.bis.org/publ/plcy03.htm]

The objectives of monetary policy

In recent years, many have argued that central banks should emphasise price stability as a single objective of monetary policy and eschew consideration of other goals such as growth or employment. The desire to limit the objectives of monetary policy in this way is based on the near-unanimity among economists and policy-makers that monetary policy cannot affect the long-term growth of the economy. In this view, efforts to stimulate growth above its potential rate merely lead to higher inflation: accordingly, monetary policy can at most only moderate shortrun fluctuations in output. Many analysts even doubt that discretionary monetary policy can effectively dampen economic fluctuations. Lags in recognising turns in the business cycle, and subsequent lags in the response of the economy to changes in monetary policy, make it difficult to time policy actions accurately enough to moderate business cycles. Moreover, while many central banks may in practice continue to attempt to stabilise output, they find it useful for their public mandate to be restricted to price stability alone, since this reduces their vulnerability to political pressure for expansionary policy.

How should a number be placed on the price stability objective? Figures of 2 to 3% have often surfaced in discussions in industrial countries with a small but positive rate of inflation (rather than zero) taking account of (i) difficulties of statistical measurement and (ii) relative price adjustments reflecting differential productivity trends in various sectors. In rapidly developing countries, some argue, inflation targets need to be somewhat higher. One reason is that relative price adjustments will be more significant in economies where productivity gains in the tradable sectors are large. In addition, price liberalisation will also increase measured inflation in situations where there is downward rigidity of nominal prices: this has been a particularly important consideration in the transition economies.

In developing countries, there are additional arguments both for and against restricting the objectives of monetary policy solely to price stability. On the one hand, the case for an activist monetary policy rests on the difficulties faced by developing economies. The concentration of output in a smaller range of products, combined with more limited development of financial markets that could diversify risk, may make developing countries more vulnerable to destabilising shocks, both internal and external, creating a greater need for countercyclical monetary policy. The limited and uncertain access to international capital markets faced by many developing countries may lead central banks to give a larger weight to balance-of-payments equilibrium in their monetary policy objectives. Finally, where financial systems remain particularly rudimentary, the authorities may seek to use monetary policy to direct credit to sectors regarded as central to the nation's development strategy.

On the other hand, monetary policy in developing countries may be less able than in industrialised countries to achieve goals other than price stability. In industrialised countries, monetary expansion is generally believed to affect output in the short run, even if such actions merely lead to changes in the price level over longer periods of time. In many developing countries, however, monetary expansion may lead immediately to higher prices with little even transitional impact on the level of activity. This situation arises when inflationary psychology, usually reflecting a prior history of high inflation, combines with a lack of central bank credibility, so that monetary policy actions generate immediate changes in inflation expectations and, in turn, actual prices. The presence of shallow and volatile financial markets may further undermine the ability of monetary policy to influence output in a predictable manner. Under such circumstances monetary policy may be required to concentrate exclusively on the goal of price stability.

Yet if the ultimate objective of monetary policy is price stability alone, it may not be possible to ignore the implications of monetary policy for output and employment. In particular, the output costs of reducing high levels of inflation may need to be taken into account in determining the extent and pace of disinflation. Various features of high-inflation developing economies, including a lack of credibility, the indexation of contracts and wages and structural rigidities in labour and goods markets, may impart a high degree of inflation inertia and thereby exacerbate the output costs of disinflation. While the use of the exchange rate as a nominal anchor can sharply reduce output costs at the outset of stabilisation programmes, this strategy may lead to overvaluation, a large external deficit and, possibly, an eventual collapse in the exchange rate. This might result in a rebound of inflation. For such reasons, central banks may opt for a more gradual disinflation policy (relying on purely domestic channels of disinflation) because the inflation reduction thus achieved will be more sustainable.

The debate on the objectives of monetary policy is still very much alive in many emerging market economies and views continue to differ, sometimes widely. In the Indonesian paper reference is made to the multiple objectives of monetary policy to be achieved "primarily through control of monetary aggregates at levels adequate to support the targeted rate of economic growth without giving rise to internal and external macroeconomic equilibrium". In a similar vein, the objective in Thailand is described as "to achieve sustainable economic growth, with a reasonable level of internal and external stability", while it consists in India of ensuring an adequate provision of credit for the productive sectors of the economy without jeopardising price stability. The Central Bank of Peru's paper describes how the previous central bank charter, which assigned to the central bank three objectives which could be mutually inconsistent, was replaced by one that defines the central bank's objective much more narrowly, emphasising that "price stability is the sole objective of the central bank".

Four channels of transmission of monetary policy have been identified in modern financial systems. The first is through the direct interest rate effects - which affect not only the cost of credit but also the cash flows of debtors and creditors. Changes in interest rates alter the marginal cost of borrowing, leading to changes in investment and saving and thus in aggregate demand. Changes in average interest rates will also have cashflow effects on borrowers and lenders.

The second channel is through the impact of monetary policy on domestic asset prices - including bond, stock market and real estate prices. The third channel is through the exchange rate. Credit availability is the fourth major channel. In countries with either poorly developed or tightly controlled financial systems, interest rates may not move to clear the market. Aggregate demand is often influenced by the quantity of credit rather than its price. Even in liberalised, highly developed markets, credit changes operating in addition to interest rate changes have been identified as important factors influencing economic activity. An increasing body of research has found that the financial condition of households, firms and financial institutions can play a key role in the propagation of monetary policy actions.

How these channels function in a given economy depends on its financial structure and the macroeconomic environment. A major purpose of this meeting was to explore the important links between financial structure and the transmission mechanism of monetary policy. Several central bank papers in this volume analyse how the financial structure of their economies has evolved under the twin influences of liberalisation and internationalisation. The Brazilian paper focuses on the macroeconomic environment explaining how chronic inflation produced many adaptations in economic life that tended to reduce the power of all the main channels of monetary policy transmission. To a large extent, then, stabilisation has to do with restoring the effectiveness of monetary policy.

In the most conventional model of monetary transmission, a shift in policy leads to a change in the money supply that, for a given money demand, leads to a change in money-market interest rates. Changes in policy and interbank rates lead, in turn, to changes in bank loan rates for borrowers, which may affect investment decisions, and in deposit rates, which may affect the choice between consuming now and later.

A key issue in this channel of transmission is the extent to which a policy-induced change in the interest rate most directly under the central bank's control (usually an overnight interbank rate) affects all short-term money market interest rates, and in turn spreads to the entire spectrum of interest rates, in particular the long-term interest rates most relevant to investment (including housing) or to purchases of durable goods. The propagation of monetary policy actions along the term structure of interest rates depends upon various factors, including the organisation of financial markets and the state of expectations.

In this model, the present value of durable goods is inversely related to the real interest rate. A lower rate of interest increases the present value of such goods and thus increases demand. In this framework, interest-rate-sensitive spending is affected by changes in the marginal cost of borrowing. Changes in interest rates also lead to changes in average rates on outstanding contracts, and these changes increase over time as old contracts come up for renegotiation. Similarly, marginal adjustments in deposit rates will over time change the average deposit rate. These changes in average interest rates will affect the income and cash flow of borrowers and lenders. Policy-induced movements in average interest rates could thus lead to cash-flow-induced changes in spending (akin to income effects) that could be as important as - or more so than - the substitution effects associated with changes in marginal interest rates. In particular, balance-sheet positions would determine the relative importance of marginal versus average interest rate effects

In differentiating between the effects of marginal and average interest rates, the distinction between real and nominal rates is important. The real interest rate affects the marginal cost of borrowing that determines spending and saving decisions. While a rise in nominal interest rates that reflects higher inflation expectations - so that the real rate remains constant - will not change the perceived marginal cost of borrowing, it will alter the cash-flow and balance-sheet positions of borrowers as it changes the average rate of interest. It does this because the portion of interest payments associated with the inflation premium represents a prepayment of the real part of the debt, so that changes in inflation alter the effective maturity of loans. These cash-flow effects could have a large impact on aggregate demand.

Policy-induced interest rate changes also affect the level of asset prices - principally those of bonds, equities and real estate - in the economy. In Israel, for instance, interest rates have been a significant factor behind cycles in equity and housing markets in the 1990s, with the stock market peaking in late 1993 and housing prices surging in 1993-94 when interest rates reached a trough. In Colombia, too, a positive (though temporary) response of asset prices to monetary policy easing has been observed in recent years.

Where long-term fixed interest bond markets are important, higher short-term interest rates may lead to a decline in bond prices. As such markets develop, this channel of transmission may be strengthened.