## Abstract

In many developing countries the financial system is characterized by the absence of organized markets for securities and equities, by capital controls, and by legal ceilings on bank borrowing and lending rates—a situation that gives rise to parallel markets for foreign exchange and informal loan markets. This paper analyzes how changes in monetary policy instruments are transmitted to domestic aggregate demand in a financially repressed economy. Such an analysis is necessary to understand how the move to a more market-oriented system would affect the economy in the short run.

Monetary and fiscal policies are both commonly accorded prominent roles in the pursuit of macroeconomic stabilization in developing countries. It is presumed that the authorities in such countries have access to monetary policy instruments and can manipulate them to achieve desirable macroeconomic objectives. Curiously, however, in spite of the prominence given to monetary policy in the developing country setting, the transmission mechanism for monetary policy in a typical developing country has not been studied extensively, and consequently is not well understood.

By contrast, in industrial countries with highly developed financial markets, a broad consensus on the nature of the transmission mechanism has existed for some time.^{1} In brief, an open market purchase by the central bank leaves the private sector with too much money in its portfolio relative to other assets. In re-establishing portfolio equilibrium, agents bid up the price of durable assets, thereby lowering their respective rates of return. Since the market prices of durable goods such as physical capital thus exceed their replacement costs, private agents attempt to increase their stocks of such assets by increasing their demand for newly produced units of the latter. In this way, an open market purchase results in an increase in aggregate demand.

In developing countries, the structure of financial markets makes the operation of such a mechanism much more problematic. In the first place, the menu of assets available to private agents is limited. Organized securities markets in which the central bank can conduct open market operations simply do not exist in many developing countries. By and large, individuals can hold currency as well as demand and time deposits issued by the banking system, and they can borrow from commercial banks. Durable goods such as land and physical capital can be held directly, but organized equity markets are small or nonexistent. Capital controls and prohibitions on the holding of foreign exchange limit the extent to which foreign assets may be held by domestic residents, although parallel markets for foreign currency often emerge in response to such regulations, thereby allowing private agents to circumvent official controls, at least in part. Finally, even in the case of those assets and liabilities available to individuals such as demand or time deposits and bank credit, official restrictions typically determine the interest rates paid and charged by financial institutions. As in the case of foreign exchange, however, informal markets often emerge to evade interest rate ceilings, resulting in financial disintermediation through “curb” markets for loans.

A typical developing country financial structure, therefore, might be one in which individuals can hold domestic currency, deposits with the banking system, foreign currency, loans extended through a curb market, land, and physical capital. These assets may be financed by the individuals’ personal net worth or by borrowing, both from the banking system and through the curb market. Interest rates on the assets and liabilities of the banking system are fixed by applicable legal norms, while the price of foreign currency on the parallel market, as well as the interest rate on curb market loans, is determined by prevailing market conditions.

The connection between the actions of the monetary authorities and the state of aggregate demand in such an environment is not obvious. In the absence of organized securities markets, open market operations are out of the question. Nonetheless, the monetary authorities retain four instruments of policy—the level of administered bank interest rates, the required reserve ratio, the amount of credit extended by the central bank to the commercial banking system, and intervention in the parallel exchange market. The purpose of this paper is to explore, within the specific developing country context described above, the channels through which these instruments affect domestic aggregate demand, as well as to identify the parameters that govern their effectiveness.

It should be stressed that an understanding of the nature of the financially repressed economy, and the way monetary policy works in this setting, is essential for predicting the effects of financial liberalization policies with which many developing countries are experimenting. There is at present no clear consensus on the effects that allowing interest rates to be market determined (or raising them to positive real levels), or reducing reserve requirements, or eliminating the spread between the exchange rates in the official and parallel markets—policies that are central in financial reform packages—would have on the economy.^{2} When it comes to discussing the consequences of such policies, often the framework adopted is one more akin to the industrial country model discussed earlier.

In the past, explicit analysis of the transmission mechanism for monetary policy under financial repression in developing countries has tended to fall into two camps—the McKinnon-Shaw tradition^{3} and a “neostructuralist” approach.^{4} Adherents of the McKinnon-Shaw view maintain that raising controlled bank interest rates need not be contractionary, because in a rationed regime the induced increase in saving will result in an increased supply of credit that facilitates the financing of private investment or working capital or both.^{5} By contrast, analysts of a neostructuralist persuasion cite the importance of informal loan markets when bank interest rates are subject to legal ceilings. They emphasize the possibility that increases in bank interest rates will draw funds away from such markets, thereby increasing the marginal cost of funds and exerting contractionary effects on the economy from both the demand and supply sides (in the latter case, due to the need to finance working capital).^{6} Notice that for the first group the primary channel of transmission is through the direct effect of the controlled bank deposit interest rate on private saving, whereas the second group focuses on effects that are transmitted through the loan interest rate to interest-sensitive components of demand (and supply).

By contrast, the analysis presented here identifies a number of additional channels that also play important roles in the developing country context. These include the wealth effects induced by changes in the degree of financial repression, as well as effects that operate through the premium in the free exchange market, through changes in expectations of future inflation, and through changes in the economy’s net foreign assets. Since some of these mechanisms are closely affected by expectations of future events, the analysis highlights the important role of such expectations in this context.

This paper is organized as follows. The model employed to analyze these issues is presented in the next section. Section II examines the transmission mechanism under partial equilibrium conditions. The third section examines the macroeconomic general equilibrium effects of changes in monetary policy instruments. The final section summarizes the results and suggests some possible extensions that might usefully be undertaken.

## I. A Model of Developing Country Financial Markets

The model developed below involves a portfolio balance framework expanded to include a commodity market. The economy in question is small and open with four types of agents: households, the government, the central bank, and the rest of the banking system. The authorities maintain an official exchange rate for current international transactions, but prohibit private capital movements. To avoid complicating the analysis, the commodity structure is deliberately kept simple—that is, a standard Mundell-Fleming structure is assumed, with a single domestic and a foreign good. Furthermore, since the focus is on exploring the shifts in the economy’s aggregate demand curve induced by changes in monetary policy instruments, the model abstracts from supply-side complications by assuming that domestic prices are instantaneously flexible, so that full employment holds continuously. In this setting, shifts in aggregate demand will be reflected only in the domestic price level. As indicated above, expectations play an important role in the model, and it will be assumed that agents possess perfect foresight, an assumption that enriches the transmission mechanism by allowing changes in future exchange rates and prices that are induced by current policies to affect current macroeconomic outcomes.

### Model Specification

In principle, private households have access to five assets: domestic currency, bank deposits, curb market loans, foreign exchange, and bank credit (which is, of course, a liability for households). There is no market for either private or government securities, and the stock of physical capital is assumed to be constant.^{7} To simplify the analysis, currency is ignored, and bank credit and curb market loans are taken to be perfect substitutes in household portfolios. The latter permits all rationing-induced “spillover” effects (see Barro and Grossman (1976)) of changes in the stock of bank credit to be concentrated in a single market—that is, the curb loan market—by permitting bank credit and curb loans to be treated as a single asset.

#### Households

With these assumptions, households’ financial portfolios are taken to consist of bank deposits (*D*), curb market loans, bank credit (*C*), and foreign exchange (*f _{p}*).

^{8}The value of households’ financial portfolio (

*A*) is given by

*A = D + sf*, where

_{p}– C*s*is the domestic currency price of foreign exchange traded in the free (parallel) market. Portfolio balance requires

where *i _{L}* and

*i*are, respectively, the interest rate on curb market loans and the (controlled) interest rate on bank deposits;

_{M}*P*is the domestic price level. The signs of the first three partial derivatives of each function reflect the assumption that all assets are gross substitutes. Money (in the form of bank deposits) is assumed to be held strictly for transactions purposes, so the level of real financial wealth enters as a scale variable to satisfy adding-up constraints in the demand functions for curb market loans and foreign exchange, but not for deposits.

^{9}The partial derivatives in equations (1)–(3) must satisfy the standard constraints:

In addition to choosing the composition of their portfolios, households must also determine their level of consumption (*c*). The latter is taken to depend on the real loan interest rate and on the level of household resources:

Household resources consist of real financial wealth (*W/P*) and real factor income. As indicated above, however, real output is constant under present assumptions, so the (unchanging) level of real factor income is omitted from the function *c*( ).^{10}

In the context of financial repression, the calculation of real household financial wealth must take into account the implicit taxes and subsidies that interest rate ceilings impose on households as creditors and debtors with the banking system. Letting *i _{c}* denote the controlled interest rate on bank credit, individuals with access to such credit receive a subsidy of (

*i*—that is, the interest rate differential between the curb loan and bank credit markets times the amount of bank credit extended to individuals with such privileged access. The present value of this subsidy is given by (

_{L}– i_{c})C*i*, and this represents a net addition to household financial wealth.

_{L}– i_{c})C/i_{L}^{11}It is convenient to define an index of financial repression, denoted

*r*, by

That is, *r* is the present value of the subsidy, per unit of bank credit, which is implied by the prevailing interest rate ceilings. Notice that since binding interest rate ceilings imply *i _{c} ≤ i_{L}, r* is bounded between zero and unity. When interest rate ceilings are not binding,

*i*and

_{c}= i_{L}*r*= 0. As the curb loan interest rate rises relative to the administered interest rate

*i*, the constraint becomes more and more binding, and

_{c}*r*approaches unity.

While households are subsidized as debtors under financial repression, they are taxed as banking system creditors. The present value of this tax is given by [(*ĩ _{m} – i_{m})/ĩ_{m}*]

*M*, where

*ĩ*is the deposit interest rate that corresponds to a loan interest rate of

_{m}*i*under the banks’ zero-profit condition (equation (9) below). This condition can be used to show that (

_{L}*ĩ*=

_{m}– i_{m})/ĩ_{m}*r*, so the degree of financial repression can be written equivalently as a function of banks’ lending or borrowing rates, and the present value of the tax on depositors can be expressed compactly as

*rM*.

Taking these taxes and subsidies into account, households’ real financial wealth can be expressed as

Thus, the wealth effects of financial repression depend on whether households are net creditors (*D – C*>0) or debtors (*D – C* < 0) of the banking system. When *D – C*>0, for example, an increase in the degree of financial repression (*r*) reduces household wealth, since the implicit tax imposed on households by interest rate ceilings on deposits exceeds the subsidy received by favored borrowers.

#### The Banking System

Bank assets consist of reserves held at the central bank (*R*) and credit extended to households (*C*). Their liabilities are the deposits held by the public (*D*), and credit received from the central bank (*B*). The balance sheet of the banking system is therefore given by

Banks hold no excess reserves. Given a required reserve ratio of a, reserve holdings are thus given by

Reserves at the central bank pay no interest, but credit extended to the banking system by the central bank carries an interest charge, which, for convenience, is set equal to the interest rate that banks charge their customers, *i _{c}*. Under these conditions, the zero-profit condition for the banking system is given by

#### The Central Bank

The central bank pegs the official exchange rate at a value *f _{c}*, and the trade balance (measured in units of the domestic good and taken to be an increasing function of the real exchange rate, (

*) as*$\overline{s}$ /P)

*x(*$\overline{s}$ /P), the stock of foreign exchange reserves evolves according to

^{12}

The central bank’s assets include both foreign exchange reserves and credit to the banking system, while its liabilities consist of reserves held by the banking system. Thus the central bank’s balance sheet is

#### The Government

Since the central bank’s loans to the banking system earn interest, this income must be allocated in some way. It is assumed to be transferred to the government, which then uses it to purchase domestic goods. Since the analysis is concerned with monetary rather than fiscal policy, the government has no other role in the model than to dispose of these funds. Letting *g* denote real government spending on domestic goods, the government budget constraint implies

#### Commodity Market Equilibrium

The model is closed by the condition that the market for domestic goods must clear. Letting *y* denote domestic real output, and Ω, the excess demand for domestic goods, this condition is

### The Model in Compact Form

Before solving the model presented above, it is useful to introduce some additional notation that can be used to rewrite the simultaneous portion of the model in a more convenient form. Specifically, let *e (= $\overline{s}$/P*) denote the official real exchange rate;

*f = f*the economy’s total net foreign assets; and

_{c}+ f_{p}*d = s/*$\overline{s}$ the ratio of the free market exchange rate to the official rate, which will be referred to as the premium. The rate of change in

*d*is denoted by

In addition to using *e* and *d*, several substitutions have been performed in deriving (14). Using equation (7) in the definition of *A* and then substituting from (11) enables the term *A/P* in equation (2) to be replaced by *e(f _{c} + df_{p}*) in (14). Equations (7) and (9) together imply that

*C =*—that is, the amount of lending that the banking system can undertake consists of deposits net of reserves plus loans from the central bank. Substituting from equation (1) and using the resulting expression to replace

*B*+ (1 – σ)D*C*in equation (2) yields (14), where

*b = B/*$\overline{s}$ . A similar procedure permits equation (3) to be written as

Next, by using equations (7) and (11) in (6), real household financial wealth can be written as

Thus, the wealth effects of financial repression depend on the excess of central bank lending to the banking system (*B*) over reserves held by the banking system. Intuitively, this is because credit to households can exceed deposits only if the resources made available to banks by the central bank exceed the resources extracted by the central bank. Using equations (8) and (1) and letting *w = W/ $\overline{s}$* and

*b = B/*$\overline{s}$ , the preceding equation can be rewritten as

Substituting this in the commodity market equilibrium equation (13) and using the notation introduced above yields

where use is also made of the government budget constraint (12).

Equations (14)–(17), together with the balance of payments equation (10) and the definition of the financial repression index *r*, given in (5), constitute the simultaneous portion of the model. The monetary policy variables are the administered interest rate on deposits *i _{M}*, the required reserve ratio σ, central bank lending to the banking system

*b*, and central bank intervention in the free market. The latter is captured by the stock of foreign exchange available to the private sector

*f*, which can be altered by the central bank subject to the condition

_{p}*df*, since the economy’s net international indebtedness

_{c}= –df_{P}*f*is the state variable in the system, with equation of motion given by (10) (since

*ḟ*= 0). When the central bank sells foreign exchange in the parallel market, it may do so either at the parallel rate or the official rate. In the latter case, households will reap a windfall.

_{P}^{13}The endogenous variables in the system are the curb loan interest rate

*i*, the degree of financial repression

_{L}*r*, the balance of payments

*ḟ*, as well as both the levels of the real exchange rate

_{c}*e*and premium

*d*and their expected and actual rates of change

*e*, since

*e =*$\overline{s}$ /P, and changes in

*P*reflect shifts in aggregate demand, given the economy’s vertical aggregate supply curve.

## II. The Transmission Mechanism in Partial Equilibrium

To solve the model, one can begin by solving the portfolio equilibrium conditions (14) and (15) for the curb interest rate *i _{L}* and the rate of change of the premium

with

or

and

with

or

where

and the alternative versions of *i*_{7} and *d*_{7} depend on whether central bank sales of foreign exchange in the free market are at the official rate (given as the first alternative) or the free rate (second alternative).

These partial derivatives can readily be given intuitive interpretations. Consider, first, the effects of the three dynamic variables *d, e*, and *f*. An increase in the premium reduces the curb interest rate, but increases the rate of depreciation of the free exchange rate. The reason is that, at the initial values of *i _{L}* and

Turning to the real exchange rate *e*, a real depreciation (increase in *e*) corresponds to a reduction in the domestic price level. On impact, this creates an excess asset demand for curb loans, both because the real value of the portfolio of lending households increases and because the real value of the resources provided to the banking system by the central bank is higher. The interest rate on loans therefore falls. The impact effect on the free exchange market is ambiguous, however, as both the real supply of foreign currency and the real demand for this asset increase.

Finally, with regard to net international indebtedness *f*, since an increase in the economy’s net international creditor position must be associated with an increased real value of household financial portfolios, households seek to hold both more foreign exchange and more curb loans as assets. Thus, both the curb interest rate *i _{L}* and the rate of depreciation of the free exchange rate

*f*increases.

Turning to the monetary policy variables, an increase in bank credit increases the asset demand for loans. The loan interest rate *i _{L}* falls, and to prevent the emergence of an excess demand for foreign exchange as households switch out of the loan market,

*i*ambiguous. If the currency is sold at the parallel rate, the latter effect is absent (the last term inside the parentheses in the first version of both

_{L}*i*

_{7}and

*d*

_{7}disappears), and the loan interest rate rises.

Matters are also somewhat complicated with regard to changes in the administered interest rate *i _{M}*. On impact, an increase in

*i*will result in an excess supply of foreign exchange, as funds are attracted into the domestic financial system and away from the holding of foreign assets. However, the net asset demand for loans may rise or fall. Though bank lending will rise as deposits increase, household lending will fall as households shift funds away from the loan market and into deposits. Since banks hold reserves whereas private lending agents do not, each unit moved by households from the loan market into the domestic financial system reduces the net supply of loans.

_{M}^{14}However, to the extent that funds attracted to banks come out of foreign currency holdings instead, the supply of loans rises. Thus, the key to the impact effect of changes in

*i*is whether households primarily move funds out of the loan market or out of foreign currency—that is, whether loans, on the one hand, or foreign currency, on the other, are better substitutes for deposits. This determines the sign of (

_{M}*F*

_{2}L

_{3}–

*F*

_{3}

*F*

_{2}) in

*i*

_{5}. In the “currency substitution” case (in which foreign currency and domestic money are close substitutes), the expansion of deposits would primarily be at the expense of foreign currency, rather than loans, and in this case an increase in

*i*is likely to result in an incipient excess asset demand for loans, causing

_{M}*i*to

_{L}*fall*(

*i*

_{5}< 0, because

*F*

_{2}and

*L*

_{3}are large in absolute value). Whether

*i*increases or decreases, however, the effect on

_{L}To explore the determination of real private financial wealth in the model, substitute for *r* in (16) from (5) and use equations (18) and (19). This yields

with

or

The wealth effects of the variables considered above can be decomposed into three parts: (1) a direct wealth effect; (2) an effect that operates through changes in the degree of financial repression; and (3) an effect that operates through changes in the base on which the implicit financial repression tax is levied.

Equation (20) indicates that wealth effects are one mechanism through which monetary policy instruments may affect aggregate demand. All of the monetary policy instruments under examination here exert such effects. Both an increase in credit to the banking system (*b*) and a sale of foreign exchange in the free market (*f _{p}*) lower the portfolio equilibrium loan interest rate. By reducing the degree of financial repression, this increases real private financial wealth. An increase in controlled interest rates also reduces the degree of financial repression. In the currency substitution case (that is,

*i*

_{5}< 0), this is because market interest rates fall while controlled interest rates rise. Even when market interest rates rise (that is,

*i*

_{5}> 0), under certain conditions their rise will be proportionately smaller than that of controlled interest rates, so that

*i*– 1/

_{5}/i_{L}*i*> 0, and the degree of financial repression will be reduced—generating positive wealth effects in this case as well.

_{M}^{15}When the required reserve ratio rises, however, the proportionate increase in the loan interest rate (

*i*

_{6}/

*i*) exceeds that of the interest rate on bank credit (given by 1/(1 – σ)) for small initial values of σ, so the degree of financial repression increases and the wealth effect is negative. This effect is reversed if σ is large, but only the former case is considered below.

_{L}Notice, finally, that in the case of foreign exchange sales at the official rate, the direct wealth effect is positive. In addition, a positive wealth effect arises from lower household deposit holdings, which reduce the base of the financial repression tax. Since the sign of *i*_{7} is ambiguous in this case, the rate of financial repression may increase or decrease, so wealth effects arising from this source are ambiguous. Finally, if foreign exchange is sold at the free rate, there are no direct wealth effects (the first term in *w*_{7} disappears). Since *i _{L}* rises, the degree of financial repression increases and the wealth effect from this source is negative. In this case, the net wealth effect depends on the initial degree of financial repression, and is more likely to be negative the lower the initial value of

*r*.

Turning to the remaining variables in equation (20), changes in the premium, the real exchange rate, and the economy’s net foreign assets all exert direct wealth effects in a straightforward manner, as well as indirect effects similar to those of the monetary policy instruments through their influence on the degree of financial repression. Both the real exchange rate and the stock of net foreign assets also affect the base on which the financial repression tax is levied. In particular, increases in *e* and *f* are associated with increases in *L*, which increase the private sector’s net creditor position vis-à-vis the public sector. While this effect tends to offset the otherwise positive wealth effects of increases in *e* and *f*, inspection of *w*_{2} and *w*_{3} reveals that this offset is only partial, since it is dominated by the direct wealth effect in both cases. Thus, *w*_{2} and *w*_{3} are both positive.

The next step is to examine the properties of the commodity market clearing equation (17). Using equations (18), (20), and (9) in (17), this equation can be written as

with

Equation (21) is of central importance for understanding the transmission mechanism for monetary policy in this model. Notice that equation (21) must hold at every instant of time, and that the effect of changes in the monetary policy instruments on aggregate demand is the inverse of their effect on the real exchange rate *e* (since *e = $\overline{s}$/P* and changes in aggregate demand are reflected one-for-one in changes in

*P*). Consider, for example, an increase in central bank credit to the banking system (

*b*). Thus, from (21)

The term in parentheses in the second line of equation (22) describes the effect of changes in *b* on the demand for domestically produced goods at a given *P*, while the coefficient *P* (and thus in *e*) required to restore equilibrium in the commodity market. Equation (22) tells us that the effect of changes in *b* on aggregate demand can be decomposed into four parts. The term *e*_{4} captures the “autonomous” contribution of *b* to aggregate demand—that is, the effect of, say, an increase in *b* on aggregate demand after allowing for portfolio reallocations but before allowing for any induced adjustments in the premium *d*, in the expected future time path of the real exchange rate (that is, *f*. Changes in *b* will, however, also induce adjustments in these other endogenous variables, which themselves affect demand and thus represent part of the transmission mechanism through which monetary policy operates. In particular, the term *e*_{1} *dd/db* captures the effects of *b* on demand that operate through induced changes in *d*, the term *—d $\hat{e}$/db* captures effects which appear through induced changes in

*e*

_{3}

*df/db*measures effects transmitted through changes in the stock of foreign assets.

Leaving aside these induced effects for the present, let us consider more closely the autonomous component. This component is given by the partial derivatives *e*_{4} through *e*_{7} under equation (20) for each of the four monetary policy instruments, respectively. As these partial derivatives indicate, the autonomous effect operates through three distinct mechanisms—a real interest rate effect, a real wealth effect, and a fiscal effect.

Consider first an expansion of credit to the banking system (an increase in *b*). From equation (18), given *d, e*, and *f*, an increase in *b* requires a reduction in *i _{L}* to restore portfolio equilibrium (

*i*

_{4}< 0). This stimulates private demand through the real interest rate effect (

*c*

_{1}

*i*

_{4}> 0). Since

*i*falls, the degree of financial repression decreases, and this increases real private wealth (equation (20)). Thus, the wealth contribution

_{L}*c*reinforces the interest rate effect. Finally, an increase in

_{2}w_{2}*b*increases revenues for the public sector due to the interest charges on the larger stock of credit extended by the central bank, and since this additional revenue, amounting to

*i*, is spent by the government on home goods, demand increases for this reason as well.

_{c}eAn increase in the administered interest rate on deposits in principle has an ambiguous effect on demand. Consider, however, the currency substitution case mentioned earlier (*i*_{5} < 0; see equation (18)). The interest rate effect (*c*_{1} *i*_{5}), which is the source of the ambiguity in the more general case, is therefore positive under these circumstances. Since the degree of financial repression falls (*i*_{5}/*i _{L}* – 1/

*i*< 0) whether

_{L}*i*

_{5}is positive (under the conditions mentioned previously) or negative, wealth rises, and the contribution of the wealth effect is therefore always positive. The fiscal effect is also positive, since central bank (and thus government) income is increased when administered interest rates are raised (

*eb*/(1 – σ) >0). Thus, either the currency substitution case or a sufficiently weak positive effect of increases in

*i*on the loan interest rate

_{M}*i*is sufficient to make the partial equilibrium effect of an increase in

_{L}*i*on aggregate demand positive.

_{M}^{16}

Increases in the required reserve ratio increase the portfolio equilibrium loan interest rate, exerting a negative effect on demand through this channel (*c*_{1} *i*_{6} < 0). Moreover, the degree of financial repression is increased as well, resulting in a negative wealth effect on demand. Due to the increase in the administered credit interest rate *i _{c}*, however, fiscal revenue increases, thus providing a positive effect that functions as at least a partial offset to the negative demand effects described above. Though

*e*

_{6}could thus have either sign, only the case

*e*

_{6}< 0 will be considered in the remainder of the paper.

^{17}

The monetary authorities can bring about an increase in *f _{p}* by selling some of their foreign exchange reserves in the free exchange market. The autonomous effect on demand is ambiguous in sign. If the foreign exchange is sold at the free rate and the initial degree of financial repression is sufficiently low (so

*w*

_{7}< 0), an increase in

*f*raises the portfolio equilibrium loan interest rate, making the interest rate effect

_{p}*c*

_{1}

*i*

_{7}negative. The consequent increase in the degree of financial repression exerts an additional negative wealth effect, which is not offset in this case by the reduction in the base of the financial repression tax.

In addition to these autonomous effects, monetary policy instruments induce changes in aggregate demand through their effects on the parallel market premium, on expectations of inflation, and on the economy’s net foreign assets. Increases in both the premium and in the economy’s stock of foreign assets decrease the portfolio equilibrium loan interest rate, which exerts positive interest rate as well as wealth effects (by reducing the degree of financial repression) on demand. They also directly increase real household financial wealth, which supplements the indirect wealth effect through the reduction in financial repression. An increase in the expected rate of inflation, given the loan interest rate, lowers the expected real interest rate and thereby stimulates demand for home goods.

Because of these induced effects operating through *d*, *f*, the total effect of monetary policy instruments on domestic aggregate demand differs from the autonomous effect described above. In order to determine the net effect of policy instruments on aggregate demand, it is necessary to take these indirect transmission mechanisms into account—that is, to calculate the total effect of policy instruments, including effects transmitted through changes in *d*, *f*. These general equilibrium effects can be derived from a solution to the model.

## III. The General Equilibrium Transmission Mechanism

The model can be represented as a system of three differential equations in *d, e*, and *f*. The system consists of equations (19), (21), and (10), respectively. There is a single predetermined variable in this system (the stock of net foreign assets/), and two “jump” variables (*d* and *e*).

To solve the model, the system is first linearized around the steady state defined by *ḋ* = *ḟ* = 0, which is denoted *d ^{*}, e^{*}, f^{*}*:

where

and, for symmetry, the function *f* has been defined as *f*(*e*) = *x(e)/e* (so *f*_{2} = *x’/e* > 0). The properties of this equilibrium can be determined from

Since the trace condition implies that the sum of the roots must be positive, on the one hand, the system has at least one positive root. Since the negative determinant means that the product of the roots is negative, on the other hand, the number of negative roots is odd. This establishes that the system contains one negative and two positive roots—that is, the equilibrium (*d ^{*}, e^{*}, f^{*}*) exhibits saddlepoint stability. Let λ denote the negative root. The solution of the model can be written as

Taking time derivatives of these expressions yields

Equation (25a) indicates that when the economy’s net foreign assets are below their steady-state level (*f _{0}–f*

^{*}< 0),

*f*will be rising (recall that λ < 0); that is, a trade surplus will emerge. Similarly, from (25b), this situation will be characterized by a real appreciation (that is, expected and actual inflation in excess of the world rate, which has been taken to be zero). With regard to the premium, according to equation (25c), its behavior under these circumstances depends on the sign of (

*d*

_{3}+

*d*

_{2}λ

*f*

_{2})/(λ –

*d*

_{1}). The denominator of this expression is negative, but since the sign of

*d*

_{2}is ambiguous, so is the sign of the numerator. Some benchmark cases are considered below.

To investigate the general equilibrium effects of monetary policy, begin by deriving the steady-state effects of changes in monetary policy instruments. Setting *ḋ* = *ḟ* = 0 in (23) and solving for *dd, de*, and *df* yields

Notice that, since under the assumptions of the model there is a unique real exchange rate compatible with trade balance equilibrium, monetary policy instruments cannot affect the steady-state real exchange rate (that is, the second row of the coefficient matrix in equation (26) consists of zeroes). The premium and the economy’s stock of foreign assets, however, will be affected in the steady state, and all three variables will deviate from their steady-state values during the transition. The dynamic effects of each of the monetary policy instruments are now investigated in turn.

### Central Bank Credit to the Banking System

The steady-state effects of an increase in *b* are given by

Thus, an increase in central bank credit to the banking system reduces the steady-state stock of foreign assets (a result familiar from the monetary approach to the balance of payments), but has ambiguous steady-state effects on the premium.

Equation (27a) permits the time path of domestic demand in response to the increase in credit to be described. Since the initial stock of foreign assets is predetermined, the initial level of *f* exceeds its steady-state value *f*^{*} (that is, *f*_{0} – *f*^{*} > 0). From equation (24b), this means that *e*_{0} < *e*^{*}. Since *e*^{*} is unchanged, *e* must appreciate on impact—that is, the domestic price level must rise when *b* is increased. The general equilibrium effect of an increase in *b* on domestic demand is thus expansionary on impact—that is, the economy’s aggregate demand curve shifts to the right.

How is this effect transmitted? From equation (22), we know that part of the effect arises from the autonomous component described earlier. Since *f* does not change on impact, none of the initial effect on demand arises from a change in the economy’s net foreign assets (the fourth term in (22)). From equation (27b), we know that initially *d**db* > 0. This depreciation of the real exchange rate over time implies that the domestic rate of inflation falls below its initial value (zero in this case). In itself, this effect is contractionary (since it contributes to raising the real interest rate), so it does not represent a vehicle for the transmission of positive effects on demand. Unfortunately, it is not possible to establish without further restrictions whether the free exchange rate *d* depreciates or appreciates on impact. Thus, some portion of the expansionary impulse may be transmitted through an increase in *d*.

### Changes in Controlled Interest Rates

Using equation (26), the steady-state effects of an increase in the controlled interest rate *i _{M}* are

^{18}

Thus, an increase in the controlled interest rate increases the steady-state stock of foreign assets and reduces the steady-state premium in the free exchange market. These results have an important implication, moreover. From equation (24b), the increase in *f*^{*} implied by (28a) means that, on impact, *e > e*^{*}; that is, the real exchange rate depreciates. Since this can only be brought about by a reduction in the domestic price level, this means that, even in the currency substitution case in which an increase in the controlled interest rate *i _{M}* reduces the loan interest rate

*i*, the effect of this measure on aggregate demand is contractionary on impact when general equilibrium interactions are taken into account.

_{L}To see how this can happen, notice that in the case of changes in *i _{M}*, equation (22) becomes

In the currency substitution case, *e*_{5} is positive (see equation (21)). From equation (25b), the effect of a change in *i _{M}* on

*e*

_{5}. Finally, since/does not change on impact, the last term in (29) is zero. Thus, the negative impact on domestic demand must arise from the term

*e*

_{1}

*dd/di*. An increase in administered interest rates exerts a contractionary effect on demand on impact because it reduces the premium in the free exchange market. It does so by increasing the relative attractiveness of holding assets in the form of deposits with the domestic banking system, thereby reducing demand for foreign currency.

_{M}This example highlights the importance of a comprehensive treatment of the transition mechanism in developing countries. In this case, taking into account effects that operate through the unconventional mechanism of the free exchange market reverses the sign of the effect of a key monetary policy instrument on aggregate demand.

### Changes in Reserve Requirements

From equation (26), the steady-state effects of an increase in the reserve requirement ratio cr are given by

Equation (30a) indicates that an increase in the required reserve ratio will increase the steady-state stock of foreign assets. As in the case of administered interest rates, however, the effect on the steady-state premium is ambiguous in sign. Since (*f _{0} – f*

^{*}) < 0, equation (24b) indicates that the real exchange rate depreciates on impact—that is, the increase in a has contractionary short-run effects on domestic demand. Since the domestic price level begins to rise immediately (equation (25b)) and since the country’s net foreign assets (

*f*) do not change on impact, this demand contraction represents the net effect of the autonomous component of the transmission mechanism and the component operating through changes in the premium. The autonomous component, which in this case is given by the partial derivative

*e*

_{6}under equation (21), has already been shown to be negative in sign. Though signing the separate contribution of the change in the premium would require additional restrictions, it is clear that general equilibrium repercussions through this channel can at most dampen the effects of the autonomous component.

### Intervention in the Free Exchange Market

The steady-state effects of central bank sales of foreign exchange in the free market are given by^{19}

Although the magnitudes of these expressions depend on whether the foreign exchange is sold at the official or the market price, their signs do not. A sale of foreign exchange in the free market (increase in *f _{P}*) increases the steady-state stock of foreign assets (

*df/df*> 0) and reduces the steady-state premium (

_{P}*dd/df*< 0). This measure will thus be contractionary on impact once general equilibrium interactions are taken into account, even though the sign of the partial equilibrium autonomous component could not be determined unambiguously (see the partial derivative

_{P}*e*

_{7}under equation (21)). As in previous cases, the short-run contractionary impulse must operate through some combination of autonomous effects tending to raise the real loan interest rate and of the induced change in the premium.

## IV. Summary and Conclusions

A typical financial environment for a developing country is characterized by (1) the absence of markets for domestic securities; (2) the presence of capital controls; and (3) legally determined interest rates on bank assets and liabilities. Legal restrictions on foreign exchange and loan transactions give rise to parallel markets for foreign exchange as well as to informal markets for loans. The tools of monetary policy in this environment consist of central bank credit to the banking system, the setting of administered interest rates and required reserve ratios, and intervention in the free exchange market. Both the management of monetary policy in such a setting and an assessment of the macroeconomic effects of financial reform measures such as lowering reserve requirements or raising controlled interest rates require an understanding of the transmission mechanism through which such instruments affect aggregate demand.

The analysis above suggests that they do so in a number of ways other than the conventional effects on interest-sensitive components of demand operating through changes in market-determined interest rates that have been emphasized in the neostructuralist literature. In this paper, these have been divided into autonomous (partial equilibrium) effects and effects that emerge through general equilibrium interactions. The former include, in addition to interest rate effects, those that operate through changes in household wealth and through the government budget. Wealth effects arise from the recognition that financial repression entails an implicit system of taxes and subsidies on households as creditors and debtors of the banking system. Changes in monetary policy instruments affect the effective degree of financial repression, and thus the present value of these taxes and subsidies, both by changing the rate at which financial repression taxes household portfolios of a given composition and by altering the composition of portfolios in ways that affect the base to which the financial repression tax applies. Moreover, since monetary policy changes affect the profits of the central bank, the fiscal consequences of these changes represent a separate channel through which the effects of policy on demand are transmitted.

General equilibrium effects emerge through the consequences of policy changes for the parallel market premium, the expected rate of inflation, and the economy’s stock of foreign assets. Since all these variables affect the state of domestic demand, induced changes in their values represent important additional channels through which monetary policy may exert aggregate demand effects.

In the model specified here, the direction of change in domestic aggregate demand on impact in response to changes in monetary policy instruments is determined by a combination of autonomous effects and effects that operate through the premium in the free exchange market. Regarding the other two mechanisms of transmission, the effects of induced changes in the stock of foreign assets are felt only over time (since this stock evolves as a function of cumulative current account surpluses), while expectations of future inflation tend in each case to dampen the demand effects of the policy change. The reason is that expectations of future inflation are expansionary. Since in this model the price level tends to return to its steady-state level, an expansionary shock (one that increases today’s price level) will reduce expected future inflation, which in itself has a contractionary influence. Conversely, a contractionary shock will reduce today’s price level, but only temporarily, and the expected recovery of prices is itself expansionary.

For two of the monetary policy instruments examined here—central bank credit to the banking system and the required reserve ratio—the short-run general equilibrium impact on demand is qualitatively the same as the partial equilibrium impact operating through loan interest rate, wealth, and fiscal effects. Whether the general equilibrium repercussions through the free market premium and expected inflation augment or weaken these effects depends on the particular values given to the parameters of the model. Thus, in empirical assessments of the likely macroeconomic impacts of prospective monetary policy measures, these general equilibrium mechanisms must be taken into account.

In the case of changes in administered interest rates and intervention in the free exchange market, the full general equilibrium effects of the measures differ from what would be predicted on partial equilibrium considerations. Increases in administered interest rates prove to be contractionary (that is, aggregate demand for home goods decreases), even in the currency substitution case in which partial equilibrium demand effects are positive. The reason is that the adverse wealth effects of a lower premium in the free exchange market overwhelm the positive contribution to demand emanating from lower loan interest rates. Similarly, though the partial equilibrium consequences of a sale of foreign exchange in the free market by the central bank are ambiguous, this measure can also be shown to be contractionary when induced general equilibrium mechanisms of transmission are incorporated into the analysis.

For the purpose of identifying the nature of the macroeconomic interactions that govern the impacts of monetary policy instruments on aggregate demand in developing countries, the model presented here can most usefully be extended in two directions. First, some stickiness in price adjustment is likely to be empirically important in many cases, and this would affect not only the price-output consequences of changes in demand, but also the role of expectations of inflation in transmitting the effects of monetary policy. Second, as indicated at the outset, it is desirable to integrate capital accumulation explicitly into the model. It is important to note, however, that while this would increase the complexity of the general equilibrium analysis, the mechanisms of transmission that have been identified here would remain relevant in the extended model.

## REFERENCES

Barro, Robert, and Herschel Grossman,

(Cambridge: Cambridge University Press, 1976).*Money, Employment and Inflation*Bhandari, Jagdeep, and Carlos A. Végh, “Dual Exchange Markets Under Incomplete Separation: An Optimizing Model,”

, International Monetary Fund, Vol. 37 (March 1990), pp. 146–67.*Staff Papers*Blanchard, Olivier,

*“The Monetary Mechanism in the Light of Rational Expectations,” in*, ed. by Stanley Fischer (Chicago: University of Chicago Press, 1980).*Rational Expectations and Economic Policy*Buffie, Edward, “Financial Repression, the New Structuralists, and Stabilization Policy in Semi-Industrialized Economies,”

, Vol. 14 (April 1984), pp. 305–22.*Journal of Development Economics*Fry, Maxwell J., “Models of Financially Repressed Developing Economies,”

, Vol. 10 (September 1982), pp. 731–50.*World Development*Kapur, Basant, “Alternative Stabilization Policies for Less-Developed Economies,”

, Vol. 84 (August 1976), pp. 777–95.*Journal of Political Economy*Laidler, David, “Money and Money Income: An Essay on the Transmission Mechanism,”

, Vol. 4 (April 1978), pp. 151–91.*Journal of Monetary Economics*Mathieson, Donald J., “Financial Reform and Stabilization Policy in a Developing Economy,”

, Vol. 7 (September 1980), pp. 359–95.*Journal of Development Economics*McKinnon, Ronald I.,

(Washington: The Brookings Institution, 1973).*Money and Capital in Economic Development*Shaw, Edward S.,

(New York: Oxford University Press, 1973).*Financial Deepening in Economic Development*Taylor, Lance,

*“IS-LM in the Tropics: Diagrammatics of the New Structuralist Macro Critique,” in*, ed. by William Cline and Sidney Weintraub (Washington: The Brookings Institution, 1981).*Economic Stabilization in Developing Countries*Tobin, James, “Monetary Policy and the Economy: The Transmission Mechanism,”

, Vol. 44 (January 1978), pp. 421–31.*Southern Economic Journal*van Wijnbergen, Sweder, “Interest Rate Management in LDCs,”

, Vol. 12 (September 1983), pp. 433–52.*Journal of Monetary Economics*Villanueva, Delano, and Abbas Mirakhor, “Interest Rate Policies, Stabilization, and Bank Supervision in Developing Countries: Strategies for Financial Reforms,”

*IMF Working Paper 90/8*(Washington: International Monetary Fund, February 1990).

^{}1

Reviews of this issue in an industrial country setting are provided by Tobin (1978), Laidler (1978), and Blanchard (1980).

^{}2

See Villanueva and Mirakhor (1990) for a recent description of financial reform policies.

^{}3

See McKinnon (1973) and Shaw (1973).

^{}4

Associated with Taylor (1981).

^{}5

See, for example, Kapur (1976) and Mathieson (1980). Fry (1982) provides a survey of such models.

^{}6

See van Wijnbergen (1983) and Buffie (1984).

^{}7

Allowing for investment would make the model much more complicated and preclude an analytical solution. This is an important limitation, because the level of investment is itself an important target for policy. However, as long as the speed of adjustment of the capital stock to its desired value via investment/disinvestment is slow relative to the rate at which markets for financial assets adjust, the analysis of the (short-run) behavior of aggregate demand presented below will remain valid.

^{}8

Alternatively, *f _{P}* could be taken to be the stock of land. In essence,

*f*is an asset with a flexible, market-determined domestic currency price, which is traded in organized markets by well-informed agents. It is intended to represent “inflation hedges,” which figure so prominently in developing country policy discussions and might best be considered a composite of highly substitutable assets, such as land and foreign exchange.

_{P}^{}9

Real output, which tends to shift asset composition among money and all other assets in response to transactions motives, is excluded from the asset demand functions because the assumptions of slow capital stock adjustment and full employment render the level of real output constant over the time frame of the analysis.

^{}10

Since the real interest rate already appears with a negative sign in equation (4), including the present value of factor incomes among the arguments of the function *c*( ) would not qualitatively affect the analysis. Notice that this specification rules out direct McKinnon-Shaw effects of the controlled interest rate *i _{M}* on private consumption via intertemporal substitution. The effects of this omission are discussed below.

^{}11

This is actually an approximation to the true present value of the subsidy, which depends on the entire stream of future interest rates and credit. The approximation is adopted for tractability.

^{}13

Sales at the official rate may be inadvertent. For example, the case of “leakages” from the official to the parallel market arising from export underinvoicing or import overinvoicing can be treated as a sale of foreign exchange to the parallel market at the official rate. A dual-market model incorporating such leakages is presented in Bhandari and Végh (1990).

^{}14

This analysis is familiar from the neostructuralist literature. See van Wijnbergen (1983) and Buffie (1984).

^{}15

Essentially, what is required is that the semi-elasticity of the demand for deposits with regard to the own interest rate *i _{m}* does not greatly exceed the cross-semi-elasticity with regard to

*i*.

_{L}^{}16

Notice that, if the direct McKinnon-Shaw effect of *i _{M}* on consumption were present, this would contribute to a negative interest rate effect on demand, making the ambiguous case more likely. However, as the next section will show, the presence of

*i*in the consumption function will not alter the qualitative nature of the general equilibrium effects of changes in

_{M}*i*.

_{M}