The views expressed in this chapter are those of the authors and do not necessarily represent those of the IMF or its Board of Directors. This chapter represents an application of Mishra, Montiel, and Spilimbergo (2012) to the Central America, Panama, and the Dominican Republic (CAPDR) countries.

Economists have devoted a lot of attention to monetary transmission in economies with sophisticated and well-functioning financial markets. Much less is known about monetary transmission in economies with more rudimentary financial systems—not just quantitatively, but qualitatively too. This is particularly true in Central America,1 a region characterized by financial environments that tend to confound conventional wisdom about the mechanisms of monetary transmission.

Since the economies of emerging markets and low-income countries have the same reasons to value rules-based monetary policy credibility as high-income economies, and since the optimal design of rules depends critically on the strength and reliability of monetary transmission, understanding the characteristics of monetary transmission in Central America is important.

Countries in the region have introduced changes to their monetary policy frameworks, including commitments to inflation targets from Costa Rica, the Dominican Republic, and Guatemala. These seem to have contributed to progress with disinflation and to have countered weaknesses in the financial structure of most Central America, Panama, and the Dominican Republic (CAPDR) countries—high bank concentration, underdeveloped financial and credit markets, and the prevalence of dollarization—that hamper traditional monetary transmission through market interest rates and market-determined asset prices.

Indeed, the empirical country-specific analysis in this chapter suggests there is evidence of moderate monetary policy transmission of policy rates to market rates in CAPDR. This in turn tentatively indicates that most of the region’s central banks can influence aggregate demand, with different lags and some partially of effect. Consolidation of improvements in the region’s monetary policy frameworks should contribute to more effective monetary transmission, which has important implications for the conduct of monetary policy.

This chapter compares the monetary transmission mechanism in CAPDR with advanced, emerging market, and low-income countries. Not surprisingly, strong reasons exist for believing that the monetary transmission mechanism in CAPDR countries differs fundamentally from that in economies with more sophisticated financial systems. More important, there are strong reasons for believing that monetary transmission may be weak and unreliable in CAPDR countries. This chapter provides some empirical evidence consistent with this view. However, this state of affairs should not stop central banks in Central America from further modernizing their conduct of discretionary monetary policy, giving more weight to forward-looking considerations in their monetary policy design.

The chapter finds evidence suggesting that the relationship between central bank policy rates and bank lending rates in CAPDR is both weaker and less systematic than in the high-income country groups (although information to assess recent progress in monetary policy frameworks in CAPDR countries is scant). Moreover, there are important differences between countries in the region, with two still relying on exchange rate pegs.

The chapter starts with an overview of recent progress in upgrading monetary frameworks in CAPDR, and it goes on to compare typical monetary transmission channels across economies at different stages of development and document differences in financial structure that point to bank lending as the dominant channel for monetary transmission in CAPDR.

Progress in Modernizing CAPDR Monetary Policy Frameworks

In recent years, inflation in CAPDR countries has been below other Latin American countries, reversing a trend from the early 2000s when it was more volatile than the rest of the region (Figure 11.1).2 This reflects the impact on domestic prices of declining oil prices, relatively low levels of currency depreciation, and the softening of economic activity in some CAPDR economies. However, it also stemmed from policy efforts to strengthen monetary policy frameworks and tackle structural problems, with Costa Rica, the Dominican Republic, and Guatemala implementing full-fledged inflation targeting and Nicaragua and Honduras introducing market-friendly features in their monetary operations framework. The region should take advantage of this opportunity to cement upgrades to monetary policy and operations framework to consolidate disinflation gains and better prepare for an end to favorable global trends. Convergence toward lower inflation may also favor further financial integration, which will impact regional growth (Eyraud, Singh, and Sutton 2017).

Figure 11.1.
Figure 11.1.

CAPDR Inflation, Exchange Rate, International Reserves, and Interest Rates

Sources: IMF, World Economic Outlook database; Haver Analytics; national authorities; Garriga, Ana, 2016, “Central Bank Independence in the World: A New Data Set”; and IMF staff calculations.Note: CAPDR = Central America, Panama and the Dominican Republic; CRI = Costa Rica; DOM = Dominican Republic; GTM = Guatemala; HND = Honduras; NIC = Nicaragua; PAN = Panama; SLV = El Salvador.

Most central banks in the Central American region increasingly rely on their policy rates as an instrument to implement monetary policy, but they all still give high weight to exchange rate considerations. Over the years, CAPDR countries started to move away from monetary targeting in the face of instability in the relationships between monetary aggregates, economic activity, and prices. Some countries opted for officially targeting inflation and others for targeting the exchange rate (Box 11.1). Even in inflation-targeting countries, policy decisions account for the level and volatility of the exchange rate, to protect against private sector balance sheet mismatches and maintain external competitiveness. Still, in recent years all countries have managed to converge toward their inflation target range, with trends showing a relatively stable real effective exchange rate, while Guatemala shows appreciation pressures in the past few years.

Central banks in the region have experienced increasing degrees of autonomy, which has translated into higher credibility (Figure 11.1, panel 6). They have been helped by stronger financial positions generally supportive of inflation commitments. At the end of 2012, all central banks in the region held assets lower in value than their liabilities, but all could keep inflation at below 5 percent while generating profit (Swiston and others 2014). In recent years, the situation in the region has improved further because of lower inflation, the accumulation of international reserves (especially Guatemala), the absence of banking crises, the dismantling of most quasi-fiscal activities, and the prevalence of unremunerated reserve requirements. However, in some cases recapitalization plans are still needed to deal with legacy problems of capital erosion.

Global, Cyclical, and Policy Factors Affecting Monetary Stances

CAPDR countries benefited from the end of the commodity cycle and were largely able to avert initial volatility after the 2008 global financial crises. This allowed countries of the region to focus on domestic activity, to make more use of policy interest rates (Box 11.1), and to strengthen their institutional arrangements for monetary policy.3

Cyclical factors may have also played a role. Figure 11.1, panels 1 and 2, show that the region has had several years of disinflation accompanied by higher growth in recent times. If these trends were reversed, the challenge would be to maintain the consistency of monetary policy amid increasing inflation pressures and declining output growth. These regional trends are relevant at the national level, given empirical evidence of commonalities across countries in the region in the magnitude, frequency, and synchronization of cycles, in part driven by trade with the United States (Johnson 2013). This means an opportunity exists to benefit from a regional approach to monitor cyclical developments, which would enrich policy analysis for each country.

CAPDR Monetary Policy and Operations Frameworks

Monetary policy and operations frameworks have been upgraded in CAPDR, although at different speeds. The improvements have helped the region’s central banks maintain consistency in monetary policies and boosted their credibility. Price stability is generally accepted as the main objective of monetary policy in the region, and central banks’ independence over the use of policy instruments has become increasingly ingrained. Consistent with the adoption of inflation targeting in Costa Rica, Guatemala, and the Dominican Republic, and with the intention to move to a forward-looking framework for monetary policy in Honduras and Nicaragua, central banks have also been working toward improving communications with the market.

Status of Monetary Policy and Operations Frameworks in CAPDR

The main developments in monetary policy and operations frameworks in CAPDR countries can be succinctly listed as:

  • Legal reforms: No major central bank legislation changes have been introduced, however the region compares well with the rest of Latin America. That said, only Guatemala and the Dominican Republic have an explicit mandate to pursue price stability, while other countries’ legislation refers to “currency stability.” Central banks are not allowed to lend to the government.

  • Foreign exchange markets: The central bank of Costa Rica has taken measures to deepen its foreign exchange market, including moving toward managed floating since 2015 and introducing a single-price foreign exchange auction among authorized intermediaries in June 2017. This is expected to improve liquidity and price discovery, and to lower uncertainty and volatility. Honduras reduced surrender requirements for foreign exchange earnings to 90 percent, allowing 10 percent to be traded in the interbank market, consistent with gradual liberalization of the foreign exchange market. By contrast, foreign exchange transactions in the Dominican Republic are still conducted over the phone because traders do not trust the electronic platform for foreign exchange trading (Mercado Electronico de Negociación de Divisas), reflecting long-standing problems with market transparency. This has prevented the central bank from gathering information in real time about developments in the interbank foreign exchange market. Guatemala has managed to limit its participation in the foreign exchange market in its bid to accumulate international reserve buffers. The central bank of Nicaragua fully supports a crawling peg regime through purchases and sales of foreign exchange.

  • Money markets: Further steps have been taken to streamline money market transactions in CAPDR countries, again at different speeds. The central banks of Guatemala and the Dominican Republic manage liquidity by way of auctions and a deposit standing facility, and they have functional interbank repurchasing (repo) markets. The central bank of Honduras introduced different maturities for its securities to help build a short-term yield curve (of up to two weeks for its bills and up to two years for its bonds) and has issued regulations to improve the functioning of the interbank money market. However, the use of marketable securities to sterilize structural liquidity is still limited, and the introduction of repo and reverse repo transactions that would support the development of interbank markets has been delayed. In Costa Rica, central bank securities dominate the short-term market, but auctions still rely on “reference prices,” preventing the establishment of benchmarks to help price discovery along the yield curve. Secondary markets remain underdeveloped because issuance has not been standardized. Nicaragua is introducing measures to strengthen liquidity management by introducing shorter-term liquidity management tools.

  • Communications and transparency: Central banks push on with efforts to improve communications with the public. Costa Rica publishes an inflation report twice a year, while Guatemala publishes a quarterly monetary policy report. All countries have periodic reports on economic developments. However, minutes from central bank board meetings are not published. Guatemala, Honduras, and the Dominican Republic conduct publicly available monthly surveys. Costa Rica, Guatemala, and Honduras announce the dates for monetary policy decisions at the beginning of the year.

  • Macroprudential frameworks: Central banks are introducing different arrangements to monitor financial systemic risk, although they all could benefit from better coordination and collaboration with banking supervision authorities. In Costa Rica, the Financial Stability Department reports directly to central bank management. In the Dominican Republic and Guatemala, the central bank has a department devoted to financial stability analysis. Generally, central banks are compiling information to set up a battery of indicators to monitor systemic risk. These could inform the use of macroprudential policies in the future. Currently, microprudential regulations in Costa Rica and Guatemala aim at containing currency risk by unhedged bank borrowers. Improvements of the macroprudential framework would eventually help central banks to focus on monetary conditions when making monetary policy decisions, as macroprudential tools tackle systemic vulnerabilities.

Box Table 11.1.

Key Features of Central Bank Legislation in Latin America as of 2016

Source: Central bank legislation.Note: When they difer, the tenures are for president and board members, respectively.

Monetary Transmission: An Overview

Monetary policy is usually taken to be formulated by an independent or quasi-independent central bank pursuing broad macroeconomic objectives unconnected with a government’s financing needs. The central bank conducts monetary policy by buying and selling short-term government securities in a well-functioning secondary market. Its objective is to meet an intermediate target through controlling the value of a financial market variable such as the interbank interest rate, the stock of unborrowed reserves, the monetary base, or the money stock. The value of this intermediate target is assumed to influence aggregate demand through the transmission mechanism, and therefore to affect the central bank’s ultimate macroeconomic objectives—typically, price stability and/or full employment.

The Transmission Mechanism

The transmission mechanism from a central bank’s transactions in the open market to influencing aggregate demand can be described through the example of a central bank purchase of government securities:

From central bank intervention in the market for short-term government securities to interest rates in the interbank market for reserves. Sellers of short-term government securities to the central bank hold the proceeds in commercial banks (these sellers are often the commercial banks themselves), thereby increasing commercial banks’ free reserves. The increased stock of reserves causes the interbank rate to fall.

From interest rates in the interbank market to interest rates on short-term government securities. Arbitrage in commercial bank portfolios between the interbank market and bank holdings of very short-term government securities creates an equilibrium relationship between the return on those securities and the interbank rate. When the interbank rate is lower than the prevailing rate on short-term government securities, banks reallocate their asset portfolios away from reserves, which can be used for lending in the interbank market, and into purchasing short-term Treasury bills, which lowers the rate of return on those bills (and vice versa when the interbank rate is high).

From the interbank rate to bank lending rates. In principle, an increase in the size of banks’ deposit base should increase the resources for banks to intermediate (but see below), therefore increasing their supply of loanable funds. Competition among banks would cause this increased supply of funds to reduce their lending rates and to increase loan volumes, which induces a second-round effect on aggregate demand through an increase in spending by bank-dependent agents. This second channel of monetary transmission is referred to as the bank lending channel, one component of a broader credit channel. Its effectiveness depends on the extent to which an expansion of reserves increases the supply of bank loans—and to which an increase in the supply of bank loans reduces the cost and/or availability of finance for the nonbank sector.4

From short-term government securities to the exchange rate. Under floating exchange rates and perfect capital mobility, arbitrage between domestic and foreign short-term government securities causes incipient capital flows that change the equilibrium value of the exchange rate required to sustain uncovered interest parity. This triggers a third channel of transmission, the exchange rate channel. With sticky prices, change in the nominal exchange rate is reflected in a real exchange rate depreciation that induces expenditure switching between domestic and foreign goods. The effectiveness of this channel depends on the central bank’s willingness to allow the exchange rate to move (which may be constrained by “fear of floating”), on the degree of actual capital mobility (for a given change in domestic short-term interest rates, exchange rates will move in line with the degree of capital mobility freedom or restriction), on the strength of expenditure-switching effects (this depends on the commodity composition of production and consumption), on the importance of currency mismatches (because adverse balance sheet effects could create negative expenditure-reducing effects that may offset or even dominate expenditure-switching effects on aggregate demand), and on the degree of exchange rate pass-through (because expenditure switching is induced by a change in the real exchange rate, which is less likely to follow from a change in the nominal exchange rate when pass-through is large).

From interest rates on short-term government securities to interest rates on long-term government securities. An expectation mechanism operating on the term structure ties interest rates on short-term securities to the rates on longer-term securities. The effectiveness of this mechanism depends, among other things, on the perceived permanence of the change in short-term rates. Changes in long-term interest rates in turn give rise to two additional channels. The long-term interest rate channel operates through the effects of changes in long-term interest rates, which have a particular effect on firms’ capital investments and on spending on consumer durables.5,6

From long-term interest rates to asset values. Changes in long-term interest rates affect the discount factors applied to future income streams, including from long-maturity bonds, equity investments, and real assets. The asset channel operates through the implications of changes in long-term interest rates for the prices of such assets, which exert wealth effects on private consumption. The effectiveness of this channel depends on the sensitivity of asset values to changes in long-term rates, on the ratio of these components of wealth to household incomes, and possibly on the distribution of these assets among households if the marginal propensity to consume when wealth increases varies across households.

From asset values to external finance premiums. Changes in asset values affect the collateralizable net worth of firms and households. Because the availability of collateral reduces the severity of the moral hazard problem associated with their external financing, it reduces the premium lenders charge over the risk-free interest rate (the external finance premium). Fluctuations in asset values are therefore negatively correlated with fluctuations in the external finance premium. This reinforces the effects of changes in interest rates on the cost of external financing: higher interest rates reduce asset values and therefore increase the external finance premium. This financial accelerator is a manifestation of a distinct component of the channel for monetary transmission, the balance sheet channel.

Institutional Frameworks

Ideally, the following institutional setup would contribute to an optimal environment for better monetary policy transmission, which is typically taken for granted in discussions of monetary transmission in OECD countries:

  • A strong institutional environment, so that loan contracts are protected and financial intermediation is conducted through formal financial markets.

  • An independent central bank.

  • A well-functioning and highly liquid interbank market for reserves.

  • A well-functioning and highly liquid secondary market for government securities with a broad range of maturities.

  • Well-functioning and highly liquid markets for equities and real estate.

  • A high degree of international capital mobility.

  • A floating exchange rate.

The Monetary Policy Environment in CAPDR

To the extent that financial structures and institutional frameworks in CAPDR depart from the assumptions listed above, the transmission mechanism in the region’s economies should be expected to differ from the standard description.

However, many CAPDR countries are moving to a forward-looking framework for monetary policy because of the poor performance of monetary aggregates and exchange rate anchors in guiding monetary policy decisions. The challenges CAPDR economies must overcome in modernizing their monetary policy frameworks are not substantially different from those faced by emerging market economies in the last two decades, but they may be different than advanced economies, and standard methodologies may fail to capture the details, especially as policy consistency improves over time. Actually, monetary policy has been largely inconsistent for many years in these countries, and this may explain the weak empirical evidence found by traditional methods of assessing the effectiveness of monetary policy transmission. On the other hand, time series are not sufficiently long to assess the benefits from this “regime switch” in low-income countries, including in CAPDR. However, authorities in several low-income countries are finding that a forward-looking approach to monetary policy is already helping them gain more certainty about how monetary transmission works.

With this important caveat, this section examines the extent to which the conditions listed above are satisfied in CAPDR, and considers the implications for the channels of monetary transmission that are likely to be dominant in CAPDR and their likely effectiveness of those channels.

Monetary Policy Frameworks and Exchange Rate Regimes

The main monetary policy objective in Costa Rica, Dominican Republic, and Guatemala is price stability (Table 11.1). The three countries have adopted inflation targeting frameworks in recent years. In Honduras and Nicaragua, the objective is to preserve the stability of the currency. El Salvador and Panama do not have monetary policy as they are fully dollarized.

Table 11.1.

Monetary and Exchange Rate Frameworks in CAPDR

Sources: IMF staff and AREAER database.

As of September 2018.

It is expected that the exchange rate may play an important role in the transmission mechanism as it is one of the main channels through which central bank actions affect aggregate demand and inflation in the region. As a result, the central bank accounts for developments in the foreign exchange rate, since they influence inflation directly through their effects on traded goods prices, and indirectly through their effects on aggregate demand and expectations.

The channels through which monetary policy is transmitted to interest rates would depend on the flexibility of the exchange rate. CAPDR countries tend to restrict exchange rate flexibility to a much greater extent than do either advanced or emerging economies. This reduced exchange rate flexibility leaves relatively limited scope for an exchange rate channel.

Financial Dollarization

High levels of financial dollarization may reduce the monetary transmission of interest rates. In this situation, the central bank may have only limited control over interest rates denominated in both foreign and domestic currency, since interest rates in foreign currency are mainly determined by external factors mostly outside the control of the central bank (Acosta-Ormaechea and Coble 2011). As shown in Figure 11.2, CAPDR countries have higher dollarization rates than the Latin American average, measured by the share of foreign currency loans in total loans. However, the dollariza-tion for a typical country in the region is about 40 percent, which is not that different from many emerging market economies, several of which are inflation targeters (Peru, Poland, Turkey). Still, high credit dollarization in CAPDR may discourage central banks from allowing for further exchange rate flexibility.

Figure 11.2.
Figure 11.2.

Dollarization Ratio: Total Credit (Percent)

Sources: IMF Integrated Monetary Database and IMF staff calculations.Note: CRI = Costa Rica; DOM = Dominican Republic; GTM = Guatemala; HND = Honduras; NIC = Nicaragua; LAC = Latin America and the Caribbean.

Size of the Formal Financial Sector

Panel A of Table 11.2 shows that the size of the financial sector in CAPDR countries is larger than for low-income countries. However, relative to advanced and emerging market economies, CAPDR exhibits substantially smaller ratios of deposit money bank assets to GDP. However, the difference is smaller than for other Latin American countries. How should this be expected to affect monetary transmission? The transmission mechanism can be decomposed into two steps: from central bank actions to financial variables such as those described earlier in the chapter, and from financial variables to aggregate demand. When the formal financial sector is small, much of the economy does not interact with the formal financial sector. Consequently, any effects of monetary policy on formal financial sector variables (for example, on bank loan rates) tend to have weaker effects on aggregate demand than where formal financial intermediation is extensive. Still, changes in financial variables, especially the exchange rate, would affect inflation expectations and real asset prices, which, although less than in emerging market economies, may still be significant.

Table 11.2.

Financial Environment: Comparison of CAPDR with Other Countries

Central Bank Independence

Arnone, Laurens, and Segalotto (2006) constructed a measure of central bank independence for a group of 145 advanced, emerging, and low-income countries. Panel B of Table 11.2 provides a comparison of this measure for groups of countries classified into each of these categories. The key observation is that central banks in both emerging and low-income countries appear to be significantly less independent than those in advanced economies, with CAPDR central banks less than half as independent by this measure as those in emerging market economies, and closer to low-income countries. This affects not only the scope for the exercise of monetary policy, but also the effects of that policy, because it influences the perceived implications of any current monetary policy action for future monetary policy. However, significant progress in recent years may suggest the actual degree of central bank independence in CAPDR may be understated. The index is influenced by multiple objectives in the legislation, which in practice may not be as relevant as they once were.

Quality of the Institutional and Regulatory Environment

As indicated in panel C of Table 11.2, CAPDR economies score substantially lower than both advanced and emerging market economies, and are comparable to low-income countries on most of the governance indicators of Kaufmann, Kraay, and Mastruzzi (2009). The poor institutional environment affects not just the overall size of the formal financial sector, but also the environment in which it operates. Political instability, poor accounting and disclosure standards, weak property rights, limited government accountability, a weak regulatory environment, a poorly functioning legal system, and the prevalence of corruption all tend to contribute to the high cost of financial intermediation.

Money and Interbank Market Development

Substantial case study evidence suggests that money and interbank markets are not well developed in many CAPDR economies, as is true in most low-income countries. The poor institutional environment is a plausible reason. Regulatory and supervisory structures still show weaknesses that, paired with the occasional inability to enforce contracts and mutual distrust, cause banks to avoid lending to each other, raising the cost of lending to the nonbank sector.

Secondary Market for Government Securities

The secondary markets for government securities are poorly developed in CAPDR countries, mostly because of partial standardization of securities and lack of incentives for the development of secondary markets. Table 11.2, panel D shows that the index of securities market development reaches only one-third of its average advanced economy value in CAPDR and is worse than the average for lower-income countries.7 The implication of poor securities market development is that central banks cannot conduct monetary policy through open market transactions in liquid secondary markets. Instead, monetary policy instruments tend to consist of purchases of Treasury bills in primary auctions (which effectively give the central bank control over the share of new Treasury issues that must be held by the public) and of the amounts and terms of credit extended by the central bank to the commercial banking system (rediscounts).8

Banking Sector Competition

Banking sectors in CAPDR tend to be only imperfectly competitive, partly because the industry is characterized by a small number of banks and by an important role for government-owned banks, but also because nonbank financial intermediaries are too small to compete with them. As shown in Table 11.2, panel E banking sectors in CAPDR on average have larger net interest margins than in advanced and emerging market economies, and low-income countries. Bank concentration is high in CAPDR compared with emerging markets, but not as high as in low-income countries. As shown in panel A, the nonbank financial sector is much smaller than in advanced and emerging market economies—not only in absolute terms, but also relative to the size of the banking sector.


The evidence presented above has important implications for the channels of monetary transmission in a “typical” CAPDR country. First, the complete absence or poor development of domestic securities markets suggests that both the short-term and long-term interest rate channels should be weak. Second, small and illiquid markets for assets such as equities and real estate would tend to weaken the asset channel. By contrast, the exchange rate channel should be important in small open economies such as countries in CAPDR, despite weak integration with international financial markets, and in fact episodes of rapid depreciation reportedly have a significant impact on inflation expectations. The bank lending channel remains the most viable general mode for monetary transmission in CAPDR.9

Since the bank lending channel is likely dominant for monetary transmission in CAPDR, cross-country evidence on the effectiveness of various bank lending steps in countries at different income levels is explored in the following empirical analysis. Specifically, broad cross-country differences in the links between central bank policy actions and bank lending rates are examined through simple correlations, rather than causal relationships, among relevant financial variables in advanced, emerging, low-income, and CAPDR economies.10

The implications of this detailed analysis are that in a setting in which domestic monetary policy becomes stronger and more reliable, the central bank should be more proactive, both in ensuring policy consistency and strengthening the financial and institutional environment for monetary policy. In addition, this setting strengthens the arguments favoring more flexible exchange rate arrangements as upgrades to the CAPDR monetary policy frameworks make progress.

The Bank Lending Channel in CAPDR: Some Evidence

This section presents cross-country empirical evidence of the effectiveness of the bank lending channel in CAPDR and comparing it to other advanced, emerging, and low-income economies. In particular, by computing correlations among the different interest rate indicators, we present the association between central bank policy rates and money market rates, and that between money market and bank lending rates. This approach seeks to unearth suggestive empirical regularities, rather than to identify causal relationships.

Policy and Money Market Rates

The first step of the transmission mechanism relates changes in policy rates to changes in money market rates. The correlation between policy rates and money market rates across alternative country groups is therefore under the spotlight.

Since direct central bank lending to commercial banks is more often used as a policy instrument in CAPDR than in countries with more sophisticated financial systems, we would expect changes in discount rates to be more closely associated with changes in money market rates in CAPDRs (where such markets exist) than in advanced and emerging market economies. Table 11.3 shows the relationship between discount rates and money market rates in advanced, emerging, low-income, and CAPDR countries, where rates are available.11 The sample is limited for CAPDR countries, nevertheless the comparison can be illustrative.

Table 11.3.

Correlation between Changes in Discount Rate and Changes in Money Market Rate

Note: the discount rate corresponds to IFS line 60 and the money market rate to IFS line 60b. The data are monthly from January 1960 to December 2017, where available. The second through the fifth columns report the average of each variable for the number of countries reported in the last column. Discount rates for CAPDR countries include Dominican Republic, Costa Rica, and Honduras (policy rate). For Nicaragua central bank bonds were used. For Panama the one-year LIBOR plus the EMBI spread were used.

The second column of the table reports the average contemporaneous correlations between changes in discount rates and changes in money market rates in all types of economies. This correlation actually turns out to be not much lower on average in CAPDR countries than in advanced and emerging economies and low-income countries.

Columns (3) and (4) report the average short- and long-term correlations between the policy rate and money market rates. These correlations are calculated by estimating the equation yit = αi yit – 1 + βi yit – 2 + γi xit + δi xit – 1 + ηi xit – 2 + Ɛit (where y is change in the money market rate and x the change in the discount rate) for each country. The short-term effect reported in column (3) is the average estimated y; the long-term effect reported in column (4) is calculated as the average γi+βi+ηi1αiβi. If interpreted causally, these results would suggest that an increase in the policy rate by 1 percentage point would be associated with a 0.82 percentage point increase in the money market rate in advanced economies within one month. Although the impact is only a 0.38 percentage point increase in CAPDR it is not a negligible result given the relatively short experience with flexible interest rates. In the long term, the increase in the discount rate would be fully transmitted to an increase in the money market rate in advanced economies, partially transmitted (0.51) in CAPDRs, which includes two countries that operate explicitly with an exchange rate anchor. With this in mind, the strengths of the correlates between discount and money market rates are not excessively below that for emerging markets.

Money Market and Bank Lending Rates

The second step in the bank lending channel is the link between the money market rate and bank lending rates. A condition for the channel to be operative is that the lending rate charged by banks must be responsive to the money market rate, where that rate exists. Table 11.4, which follows the same structure as Table 11.3, shows a strong contemporaneous correlation between money market rates and bank lending rates in advanced and emerging market economies, but a relatively weaker correlation in CAPDR countries. The results show surprisingly high significance, with long-term elasticities similar to those in advanced economies, although below those of emerging markets. Overall, this suggests inconclusive results that are explored by allowing a richer lag structure in the relation between policy and lending rates using a VAR approach.

Table 11.4.

Correlation between Changes in Money Market rate and Changes in Lending Rate

Note: the discount rate corresponds to IFS line 60 and the money market rate to IFS line 60b. The data are monthly from January 1960 to December 2017, where available. The second through the fifth columns report the average of each variable for the number of countries reported in the last column. Discount rates for CAPDR countries include Dominican Republic, Costa Rica, and Honduras (policy rate). For Nicaragua central bank bonds were used. For Panama the one-year LIBOR plus the EMBI Spread were used.

VAR Analysis

How are changes in monetary policy rates transmitted to lending rates in CAPDR countries? This is explored by estimating a set of country-specific vector autore-gression (VAR) models using monthly data since the mid-2000s, when most countries started using policy rates as their main instrument of monetary policy.12 This would allow us to quantify the reaction of lending rates to changes in the policy rate. However, these pass-throughs should be interpreted as correlations, and should provide a sense of the strength of the comovement of these rates without implying causality. The VAR allows formal evaluation of the relationship between the policy and lending rates. The analysis is conducted with a standard VAR model:


where Yt denotes the vector of endogenous variables, which includes the levels of the policy and lending rates, Xt is an exogenous variable to account for terms of trade proxied by oil prices, and εt is the white noise component. The two endogenous variables are a combination of non-stationary I(1) series and are found to be cointegrated. The cointegration means that the VAR in levels is a well-specified model of the nonstationary variables. Therefore, we estimate a VAR model in levels without imposing cointegration restrictions. This VAR model with integrated variables yields least squares and maximum likelihood estimators that are consistent and asymptotically normal under general conditions, and the estimators may be used as in the stationary case (Kilian and Lutkepohl 2016).

Estimating a VAR in levels facilitates the construction of impulse responses at the different periods we are interested in. The identification strategy is satisfied by a Cholesky decomposition in which the policy rate is ordered first, since we are interested in the reaction of the lending rates as a function of a tightening of monetary policy. Therefore, our pass-through estimates will be impulse responses of lending rates after six and nine months to a shock to the policy rate that leaves it 100 basis points higher.

Figure 11.3 presents estimates of the interest rate pass-through in CAPDR countries and compares them to the five biggest economies in Latin America (LA).13 It shows the three- as well as the six-month response of the lending rate after a shock that raises the monetary policy rate by 100 basis points. The results suggest that the interest rate pass-through is on average weaker in CAPDR than in LA. The average three- and six-month response of the set of CAPDR countries is 51 and 57 basis points, while the average response for LA is 87 and 101 basis points. These averages are quite heterogeneous, and the magnitude of their responses varies greatly. For instance, a 100 basis point hike in the policy rate may be associated with a large cumulative six-month increase in lending rates in the Dominican Republic, Costa Rica, and Honduras (84, 62, and 58 basis points, respectively), while the same shock in Guatemala lifts lending rates by about 2 basis points in the same period. These estimates suggest that the central banks are indeed able to affect lending rates in most of these countries. However, the pass-through from the policy to the bank lending rates is still weak in Guatemala.

Figure 11.3.
Figure 11.3.

Interest Rates Pass-through from Policy to Lending Rates Estimates

Sources: IMF Monetary and Financial Statistics (MFS), and authors’ calculations.Note: Six and nine month responses in basis points following a 100 basis point increase in the policy rate. CAPDR = Costa Rica, Dominican Republic, Guatemala, and Honduras; LA5 = Brazil, Chile, Colombia, Mexico, and Peru; CRI = Costa Rica; DOM = Dominican Republic; GTM = Guatemala; HND = Honduras.

Cross-Country Transmission: Empirical Evidence

To explore the role of institutional limitations on monetary transmission in CAPDR, panel regressions are first run, with monthly changes in bank lending rates regressed on changes in discount rates, a measure of bank concentration, and interaction terms between changes in discount rates and the index of bank concentration for the full sample of countries. The first column of Table 11.5 shows that a 1 percentage point increase in the policy rate is associated on average with a contemporaneous 0.45 increase in the lending rate. The second column shows that the partial correlation between policy and lending rates indeed appears to be affected by bank concentration (this index is equal to 1 if the index of bank concentration is higher than the median and 0 otherwise). The third column shows that bank concentration weakens transmission in CAPDR, even more than it does on average.

Table 11.5.

Transmission Mechanisms and Bank Concentration

Note: * significant at 10%; ** significant at 5%, *** significant at 1%. Robust standard errors clustered by country are in brackets. The index of bank concentration is 1 if banks are highly concentrated. The index of transparency is from Transparency International. CAPDR countries include Dominican Republic, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and Panama.

As shown in column (4), improved transparency increases the correlation of changes in policy rates with lending rates, suggesting that institutional deficiencies that discourage bank lending may explain the limited pass-through from policy rates to lending rates in CAPDR more than bank concentration does. However, the specification in column (5) shows that a dummy variable for CAPDR countries interacted with changes in the policy rate is highly significant in explaining the weak correlation between the policy rate and the lending rate, even after controlling for measures of bank concentration and institutional quality. Therefore, although bank concentration and transparency appear part of the story, unidentified factors may play a key role in the difference between CAPDR and other countries. That is probably because of the heterogenous nature of this group, which includes fully dollarized economies, countries committed to exchange rate pegs, and inflation targeters.14

The last three columns in Table 11.5 assess the robustness of these results. Column (6) reports regression results using the same specification as in column (5) but restricting the sample to observations in the period after 2000. This is done to allow for the possibility that the persistence of financial repression in earlier years may have affected our results. The results confirm that, even without pervasive financial repression, the “CAPDR dummy” continues to play a relevant role in explaining the link between the policy and lending rates. The same results hold when high-inflation countries and emerging market economies are dropped from the post-2000 sample. The motivation for doing so is that correlations between lending rates and policy rates may be contaminated by the large swings in nominal interest rates associated with inflation stabilization, or with stabilizing exchange rates in the face of speculative attacks (arising either endogenously or as contagion from crises in other emerging market economies). Note particularly that transparency is statistically significant in column (8), but it does not eliminate the significance of the CAPDR dummy.

As another robustness check, Table 11.6 restricts the sample to countries with flexible exchange rate regimes, to allow for the possibility that the weak relationship between policy rates and bank lending rates in CAPDRs may in part reflect the greater prevalence of fixed exchange rates among those countries. As can be verified by a comparison of Tables 11.4 and 11.5, this does not seem to be the case. The results in this table are qualitatively very similar to those of Table 11.6. However, the sample is much lower and statistical precision is lost, which prevents us from making strong conclusions.

Table 11.6.

Transmission Mechanisms and Bank Concentration: Flexible Exchange Rate Regimes

Note: * significant at 10%; ** significant at 5%, *** significant at 1%. Robust standard errors clustered by country are in brackets. The index of bank concentration is 1 if banks are highly concentrated. The index of transparency is from Transparency International. CAPDR countries include Dominican Republic, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and Panama.

Policy Implications

The findings presented in this chapter suggest evidence of a moderate monetary policy transmission of policy to market rates in CAPDR, although lower than its LA5 peers. This may suggest that further improvements in the region’s monetary policy frameworks should contribute to more effective monetary transmission, which may in turn allow central banks to affect more effectively aggregate demand. However, in recent years many CAPDR countries have introduced important modifications to their monetary policy frameworks, which may further enhance the strength of monetary transmission. The implications of these changes are now reviewed. They concern the discretionary use of monetary policy for stabilization purposes, the desirability and design of inflation targeting regimes, and the choice between fixed or floating exchange rates.

Stabilization Policy

Consider a simple policy model, based on Blinder’s 1998 adaptation of Brainard (1967). The structure of the economy is given by:


where y denotes aggregate demand, m is a monetary policy instrument, α is a parameter that captures the effect of monetary policy on aggregate demand, and ε is a shock to aggregate demand. It is assumed that α is a random variable with E(α) = μα and Var(α) = σ2α. When monetary policy is “weak and uncertain,” as suggested by previous finding, μα is small and E(y – E(y))2 = σ2αm2 + σ2 is large. Similarly, ε is a random variable with E(ε) = 0 and Var(ε) = σ2. It is assumed that α and ε are uncorrelated, so E(α – μα) ε = 0. The expected value of y is given by E(y) = y0 + μα m and its variance by E(y – E(y))2 = σ2αm2 + σ2.,.

The central bank has to set monetary policy before it observes the realized values of α and ε. Its objective is to stabilize aggregate demand around a desired value y*—that is, to minimize E(y – y*)2. Using (1), the central banks loss function can be written as:


Minimizing (4) with respect to m, the optimal value of m with stochastic α can be derived, which is denoted as m*S :


Notice that if α is nonstochastic (that is, if it has a degenerate distribution around E(α) = μα, so that σα2 = 0), meaning that the effects of monetary policy on aggregate demand are not uncertain, we would have


where m*N is the optimal value of m in the nonstochastic case. That is, monetary policy would be used to stabilize the economy by adjusting the monetary policy instrument so as to set E(y) = y*. In this case, weaker monetary policy (smaller μα) implies more policy activism (larger mN*). When the effects of monetary policy are uncertain, however, optimal monetary policy is less activist, closing only part of the gap between E(y) and the target y*. This can be verified by noting that:


The reason for this result is that when α is stochastic, higher values of m—more aggressive monetary policy—increase the future variability of aggregate demand. This cost of activist policy has to be traded off against its benefit in the form of closing the gap between actual and desired aggregate demand. This tradeoff suggests less activist use of monetary policy the weaker monetary policy is (the smaller μα) and the more uncertain it is (the larger σα2). To see the intu-ition, consider first the effect of smaller μα. Note that we can express the monetary authority’s loss function as:


This expression shows that the central bank’s loss function can be expressed as the sum of the variance of y and the square of the gap between the expected and target values of y. Notice that changes in m play two roles in equation (7): they affect the variance of y (the first term on the right-hand side of (7)) as well as the gap between the expected and target values of y (the third term on the right-hand side). The marginal benefit of increasing m after a reduction in μα is given by 2(y0 + μαm – y*α, which captures the effect of higher m in reducing the larger nega-tive gap between expected y and target y, that would be created by a reduction in μα. This marginal benefit depends on the size of the gap, which is decreasing in m. The marginal cost, on the other hand, is given by 2αm, which captures the effect of higher m in increasing the variance of y, and is increasing in m. It is precisely because increases in m are subject to increasing marginal costs through their effects on the variance of y that it would not be optimal for the central bank to pursue such increases to the point where their marginal benefit is zero—that is, where they would fully eliminate the gap between the expected and targeted values of aggregate demand. The upshot is that weaker monetary policy encourages less activist policy when the effects of policy are uncertain. Similarly, for a given value of μα, an increase in σα2 increases the uncertainty penalty associated with each unit increase in the value of the monetary policy instrument, which is the first term on the right-hand side of (7), and so discourages monetary activism. In short, weak and uncertain monetary policy transmission calls for less activism in monetary policy. However, this also means that improvements in the financial environment will increase significantly the impact of monetary policy consistency on the effectiveness of monetary transmission.

Inflation Targeting and the Exchange Rate Regime

The adoption of formal inflation targeting involves the central bank putting its reputation on the line by making a public announcement of its objectives and being held accountable for achieving them. The desired result is for the private sector to form inflation expectations that are consistent with the central bank’s inflation target. Weak and uncertain monetary transmission may undermine this objective in two ways.

First, unreliable transmission can undermine the effectiveness of public announcement and central bank accountability as a commitment device, because the probability that the central bank would miss its mark would create uncertainty if it is trying to manipulate monetary policy or is genuinely missing the mark— that is, unreliable transmission gives plausible cover to the central bank for deviating from its announced intentions without being caught, which undermines the credibility of future monetary policy measures. Again, this highlights the importance of policy consistency, such that the credibility of the commitment devices also increases.

Second, if the commitment device associated with the public announcement and central bank accountability is effective, questions may arise about its ability to attain that objective where monetary transmission is uncertain. This may loosen the link between the central bank’s announcement and the inflation outcome that the private sector would be led to expect, thereby reducing the benefits expected from adopting inflation targeting. However, since CAPDR countries in recent times have managed to keep inflation below historical averages and below the average for Latin American countries, this suggests that expectations are not as dependent on the strength of monetary policy transmission channels.

Therefore, the adoption of inflation targeting is best accompanied by improvements in the institutional and financial environment to overcome the weakness of monetary transmission. In turn, the central bank would become more and more confident in hitting its target, avoiding the additional social loss associated with a loss of reputation.

Improvements in policy consistency and the financial and institutional environment would also allow CAPDR countries to abandon reliance on the exchange rate as an anchor, when capital mobility is high, increasing monetary autonomy, which would make exchange rate anchoring less necessary. When a country is subject to asymmetric shocks, when domestic wages and prices are sticky, when fiscal policy is inflexible, and when it does not enjoy a migration safety valve, this sacrifice of monetary autonomy can be costly, because it deprives the economy of its only available stabilization policy tool. If monetary policy becomes more reliable, the case for floating exchange rates would become stronger over time.

The value of monetary autonomy can be interpreted as the reduction in the central bank’s loss function that can be achieved by setting monetary policy optimally, compared to eschewing the use of monetary policy altogether. The latter can be derived by setting m = 0 in equation (7), while the former is determined by setting m = m*S. The gain from monetary autonomy, therefore, given by L(0) – L(m*S), is:


After some algebra this can be written as:


Notice that without uncertainty about monetary transmission(σα = 0), the gain from monetary autonomy would be given by (y0 – y*)2, since monetary autonomy would allow the entire gap between the actual and target levels of aggregate demand to be eliminated.


It has long been recognized that, while the general outlines of monetary transmission share many common features across economies, specific channels of transmission are highly country-specific, and depend among other things on each economy’s financial structure. There are significant differences across economies in financial structure, even among those at very advanced stages of financial development. These differences are even more pronounced between economies at advanced stages of financial development and those—such as many CAPDR countries—that have long suffered from financial repression and have only recently liberalized their financial systems, and have a high degree of dollarization.

This chapter shows that recent progress in upgrading monetary policy frameworks in the region are an important step to support strengthening of monetary transmission in CAPDR countries. It has been argued that at lower levels of financial development, the transmission mechanism is likely to be dominated by the bank lending channel. There is some evidence of this in several CAPDR countries, despite institutional deficiencies that restrict bank lending, such as large bank concentration, high dollarization, and weak secondary markets. Therefore, the agenda should include efforts to overcome these limitations at the same time that monetary policy takes further steps to move to a more forward-looking setting.


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Annex 11.1. Data and Sources

A monthly panel dataset covers 105 countries that include 26 advanced, 27 emerging and 52 low-income countries for 1960–2017. The panel data set is unbalanced, with the number of observations varying across countries. Various sources were used to construct the monthly series on lending, discount, and money market rates. The IMF’s International Financial Statistics contains data on interest rates for most member countries. In addition, some series with interest rate data come from Haver Analytics, and the national statistics are from central banks.

Transparency International’s Corruption Perception Index was also used. This aggregates data from different sources that provide the perceptions of business-people and country experts concerning the level of corruption in the public sector. The index is available for 190 countries and it is measured on a scale of 0–100 where a 0 signifies the highest level of perceived corruption and 100 the lowest. Data for banking concentration come from the World Bank’s Global Financial Development Indicators data set, constructed from Bankscope data. It is defined as the assets of the three largest commercial banks as a share of total commercial banking assets.


Central America, unless otherwise stated, refers to the IMF region of Central America, Panama, and the Dominican Republic (CAPDR).


The discussion excludes Panama and El Salvador, both of which ofcially use the US dollar as their legal tender. Te CAPDR central banks with some degree of monetary policy independence are in Costa Rica, the Dominican Republic, Guatemala, Honduras (which recently reestablished a crawling band), and Nicaragua (which has a crawling peg regime).


Policy rates are linked to daily central bank operations in Costa Rica, Guatemala, Honduras, and the Dominican Republic.


The bank lending channel may operate whether or not banks ration credit to bank-dependent customers. To the extent that they do, the channel would operate through the availability of credit to rationed borrowers. But even if banks do not ration credit, the channel would operate through the cost of credit to bank-dependent borrowers.


Why does central bank independence matter from the perspective of monetary transmission as opposed to that of policy formulation? Te answer is that the transmission from short-term interest rates to longer-term rates depends on agents’ interpretation of what an unanticipated change in monetary policy indicates about future monetary policy. This in turn depends on their understanding of the central bank’s “true” policy reaction function—that is, it depends on the central bank’s credibility. Because the degree of central bank independence affects its policy reaction function, it may be expected to also affect agents’ interpretation of the implications of a central bank’s current monetary policy actions for its future actions.


Given the signifcant role of expectations about future monetary policy in this channel, it is sometimes referred to as the expectations channel.


The index is drawn from the IMF structural reform database. It relates to securities markets and covers policies to develop domestic bond and equity markets.


In contrast to advanced economies, discount credit is used very commonly as a monetary policy instrument in low-income countries. As a rough indicator, approximately three-quarters of our LIC sample of 109 countries report at least fve years of monthly data on discount rates, and there is signifcant variation in discount rates over time. A simple variance decomposition exercise suggests that 95 percent of the variation in discount rates in our sample is within countries (as opposed to across countries). Buzeneca and Maino (2007) report that, while no advanced economies in the IMF’s Information Systems for Instruments of Monetary Policy (ISIMP) database used discount credit as a monetary policy instrument, 69 percent of low-income countries did so.


The strength of this channel may be infuenced by balance sheet effects on the cost and availability of bank credit—that is, by the operation of the balance sheet channel.


Annex 11.1 provides details of the data sources used in this section.


Only countries with at least 60 observations are included in the sample. For simplicity we use the same specifcation for all countries. Similar results are obtained if diferent specifcations, including diferent lag structures, are used.


The sample of countries includes Costa Rica, Dominican Republic, Guatemala, and Honduras.


LA includes Brazil, Chile, Colombia, Mexico, and Peru.


As suggested below, such factors may include limited central bank credibility and informal dollarization.

Contributor Notes

The views expressed in this chapter are those of the authors and do not necessarily represent those of the IMF or its Board of Directors. This chapter represents an application of Mishra, Montiel, and Spilimbergo (2012) to the Central America, Panama, and the Dominican Republic (CAPDR) countries.