Appendix I. Channels of Transmission of Monetary Policy1
- Bernard Laurens
- Published Date:
- December 2005
One key to conducting monetary policy effectively is an efficient transmission mechanism through which monetary policy actions affect aggregate demand in an economy and ultimately inflation (see Figure A1.1). The nature, speed, and intensity of the transmission from the variables directly under the control of the central bank—for example, short-term interest rates or base money—to those variables that most directly affect conditions in the nonfinancial sector—loan rates, deposit rates, asset prices—determine not only the extent of the overall effectiveness of monetary policy, but also the type of instruments that can be used effectively.
Figure A1.1.Stylized Representation of the Channels of Transmission
The functioning of the transmission mechanism, and hence the effectiveness of monetary policy, in a given economy depends on the structure of the economy and its financial system. In particular, a number of factors are at play here: (1) the degree of competition in the banking sector, (2) the extent of access to alternative domestic funding sources, (3) the depth of money and capital markets, (4) the extent of government involvement in financial markets, (5) the liquidity of the financial system, (6) the degree of financial intermediation, (7) the prevailing exchange rate system, (8) the extent of liberalization of current and capital accounts, and (9) the degree of development of the foreign exchange market. These all influence the speed and intensity of the transmission mechanism and therefore the extent to which monetary instruments can be relied upon to transmit monetary policy signals through the normal channels.
Interest Rate Channel
Monetary transmission through the interest rate channel, regarded by many as the main channel of monetary policy transmission, occurs when changes in the monetary policy stance induce changes in the overall level of interest rates in the economy, and those in turn affect the overall level of absorption, through their effects on the demand for credit and the available income of borrowers and lenders. Changes in interest rates alter the marginal cost of borrowing, leading to changes in investment and savings and thus to variations in aggregate demand; they have also a cash flow effect on borrowers and savers.
Predictability of the response of lending and deposit rates to changes in money market rates will depend on the degree of competition in the banking sector, the extent of access to alternative domestic funding sources, and the depths of money and capital markets. In competitive markets for credit, changes in the overall level of interest rates are likely to affect lending and deposit rates rapidly. Conversely, in a highly concentrated banking sector with a small number of banking institutions, oligopolistic pricing will likely make the response of lending and deposit rates to changes of money market rates sluggish and asymmetrical. In addition, the presence of state-owned or state-subsidized banks that are under little pressure to maximize profits and are under pressure to achieve political goals can diminish the responsiveness of lending and deposit rates to monetary policy.
The behavior of lending and deposit rates may also depend on the extent to which households and firms have access to alternative domestic funding or investment sources, most notably through security markets. Alternative sources of financing or investment for households and firms tend to limit the monopolistic power of banks. Moreover, if the banking sector and the securities markets are well integrated and if bank loans, bonds, and stocks are close substitutes, then banks may be forced to enhance the responsiveness of the interest rates under their control.
The depth of money and capital markets can also have an important bearing on how policy controlled rates affect lending and deposit rates, and on the ultimate objective (s) of the central bank.2 A shallow or noncompetitive financial market can amplify volatility of money market interest rates. If money market rates are highly volatile, banks may not adjust lending and deposit rates quickly to those rates, for administrative or customer-relations reasons.
Asset Price Channel
Monetary transmission through the asset price channel occurs when changes in the monetary policy stance affect asset prices in the economy (in particular, equity or the value of collateral), which in turn induces changes in consumption and investment through the wealth effect and the implications on the financing cost of investments.
The main factor influencing the effectiveness of the asset price channel is the level of development and importance of bond, equity, and real estate markets in the economy. Where long-term bond markets are important, for example, an increase in short-term interest rates normally leads to a decline in bond prices, and, consequently, a decline in aggregate demand due to reduced wealth. The more developed such markets are, the stronger will be the effectiveness of this channel in transmitting monetary policy signals.3
The composition of financial portfolios also affects the effectiveness of the asset price channel. When most savings are intermediated through the domestic banking system, and relatively small portions of households or corporate portfolios are invested in securities whose value varies with market conditions, the more restricted will be the impact and intensity of the asset channel. On the other hand, the more diversified household and corporate portfolios are, the more sensitive such portfolios will be to monetary policy actions affecting asset values.
Exchange Rate Channel
Monetary transmission through the exchange rate channel occurs when changes in the monetary policy stance lead to changes in the exchange rate. This affects the competitiveness of domestically produced goods and services vis-à-vis goods and services produced abroad and hence affects the relative demand for both domestic and foreign goods and services.
The exchange rate channel of monetary policy does not exist under a fixed exchange rate regime; among exchange rate regimes that allow flexibility, the exchange rate channel will work more strongly with higher degrees of exchange rate variability allowed within the regime. In addition, the role of the exchange rate channel will increase with an absence of capital controls and in a foreign exchange market characterized by substitutability between domestic and foreign assets. For economies with underdeveloped financial systems, the exchange rate channel becomes irrelevant, usually because of controls on foreign exchange operations. The greater the substitutability between domestic and foreign assets, the greater the response of the exchange rate will be to policy-induced changes in interest rates, and hence the larger the impact of monetary policy will be through that channel.
Availability of Credit Channel
Monetary transmission through the availability of credit channel occurs when changes in the monetary policy stance affect the quantity of credit that is available, regardless of (or in addition to) what happens to interest rates. The credit channel emphasizes how asymmetric information and the cost of enforcing contracts may create agency problems in markets. Two channels of monetary transmission arise: (1) the bank lending channel, which looks at the impact of monetary policy on the capacity of banks to lend to firms, and (2) the balance sheet channel, which looks at the impact of monetary policy on the capacity of firms to borrow from markets in response to changes in their net worth arising from monetary policy decisions.
The financial condition of a country’s banking system is one of the most important factors influencing the transmission of monetary policy signals through the credit channel. The financial condition of the banking system is an important determinant not only of the cost but also of the availability of bank loans. If the financial position of the banking system is weak, reflected by low capital/asset ratios and/or high non-performing loans, banks will tend not to respond to monetary policy impulses. The weaker the financial system, the more likely the asset price channel is to be irrelevant. Weaknesses in the banking system can also be reflected in terms of asymmetries of information and limited enforceability of contracts. Where such asymmetries exist or when there is weak governance and judicial structures limiting the enforcement of contracts, banks may also not respond to monetary policy impulses.
In addition to the foregoing channel-specific factors, there are a number of other factors of a macroeconomic nature that have a significant influence on the efficiency of the channels of transmission. The extent of government intervention in financial markets may influence the monetary transmission channel in three ways: (1) through explicit or implicit interest rate controls or other limits on financial market prices, (2) through explicit or implicit limits on bank lending, and (3) through selective credit policies. Any of these situations is likely to impede the smooth functioning of markets and the transmission of monetary policy signals through them, and hence the conduct of monetary policy with market-based instruments.
Structural excess liquidity in the financial system also impairs the effectiveness of the transmission channel of monetary policy. Although they do not do so directly, the policy measures taken by central banks to sterilize excess liquidity may weaken the transmission channel. The high cost of mopping up excess liquidity has at times prevented central banks from raising their policy interest rates. This is especially the case when the financial position of the central bank is weak such that high sterilization costs may result in large losses for the central bank which are not reflected directly and in a timely way in the government’s budget—a situation which in itself would result in an injection of liquidity into the system. In this context, the constraint imposed on interest rates may distort the optimal interest rate policy and hence limit the effectiveness of monetary policy through the normal channels. The use of liquid asset ratios (LARs) to sterilize excess liquidity may also lead to distortions in interest rates by creating a captive market for the assets that are eligible to fulfill the requirement. High and nonremunerated reserve requirements to sterilize excess liquidity may also lead to distortions as the implied tax affects only the deposit-taking financial institutions and their customers, and not other parts of the financial system.