There are strong a priori reasons for believing that the monetary transmission mechanism in low-income countries (LICs) is fundamentally different from that in economies with more sophisticated financial systems. A review of the existing literature also suggests little confidence in the strength of monetary transmission in low-income countries. It is important to distinguish between the “facts on the ground” and “methodological deficiencies” explanations for the absence of evidence for strong monetary transmission. There is evidence that “facts on the ground” are an important part of the story. If this conjecture is correct, the stabilization challenge in developing countries is acute indeed, and identifying the means of enhancing the effectiveness of monetary policy in such countries is an important challenge. This piece addresses the main questions in the literature on the monetary transmission mechanisms in low-income countries.

Question 1: What are the assumptions underlying the discussion of monetary transmission in advanced countries?

As argued in Mishra, Montiel, and Spilimbergo (2012), the conventional description of monetary transmission relies on effective arbitrage along several margins: between different domestic short-term securities, between domestic short-term and long-term securities, between long-term securities and equities, between domestic and foreign securities, and between domestic financial and real assets. A discussion on monetary transmission is therefore clearly intended to apply to an economy with a highly developed and competitive financial system. As such, it implicitly assumes the following institutional setup, which is typically taken for granted in discussions of monetary transmission in advanced countries:

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

• (ii) An independent central bank.

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

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

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

• (vi) A high degree of international capital mobility.

• (vii) A floating exchange rate.

Question 2: Do we expect monetary transmission in a low-income country context to be different from what we are familiar with in industrial countries?

Yes. There are strong a priori reasons for believing that the monetary transmission mechanism in low-income countries (LICs) is fundamentally different from that in economies with more sophisticated financial systems. First, the complete absence or poor development of domestic securities markets suggests that both the short-run and long-run 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. Third, in countries that are imperfectly integrated with international financial markets and tend to maintain relatively fixed exchange rates, the exchange rate channel would tend to be completely absent, or relatively weak.

Question 3: Which channel of monetary transmission, if any, is likely to be at play in low-income countries?

In general, the financial structure of low-income countries should lead us to expect the interest rate, asset, and exchange rate channels to be weak or nonexistent in such countries. By a process of elimination, the bank lending channel remains the most viable general mode for monetary transmission in LICs.

Question 4: What conditions would determine the strength of the bank-lending channels? Are these conditions likely to hold in LICs?

The relevant properties of the bank lending channel concern two links in the causal chain from monetary policy actions to aggregate demand: that between monetary policy actions and the availability and cost of bank credit, and that between the availability and cost of bank credit and aggregate demand. When the formal financial sector is small, as is true in the vast majority of low-income countries, the second of these links is likely to be weak. But the link between monetary policy actions and the availability and cost of bank credit may be weak as well. Specifically, the literature suggests that bank-lending channels may be undermined by two factors: (i) if the banking industry is noncompetitive, changes in banks’ costs of funds may be reflected in bank profit margins, rather than in the supply of bank lending. (ii) If a poor institutional environment increases the cost of bank lending, banks may conduct lending activity in a manner that weakens the effects of monetary policy actions on the supply of loans.

Question 5: Is there any cross-country evidence on the strength and reliability of the bank-lending channel in LICs?

Mishra, Montiel, and Spilimbergo (2012) examine broad cross-country differences in the links between central bank policy actions and bank lending rates by computing some simple correlations among the relevant financial variables in advanced, emerging, and low-income economies. They focus on the association between central bank policy rates and money market rates, as well as that between money market rates and bank lending rates. In doing so, they seek to unearth suggestive empirical regularities, rather than to identify specific causal relationships. They find a much weaker link between the policy instrument and market rates in LICs than for advanced and emerging economies, both in the short and in the long run. The short-term partial correlation between money market rates and lending rates is also significantly weaker among LICs than among either advanced or emerging economies, and while differences in long-term effects are not as pronounced, they remain weaker in low-income countries. Most importantly, changes in money market rates explain a much smaller proportion of the variance in lending rates in low-income countries than in either advanced or emerging economies.

Question 6: What does the country-specific evidence on monetary transmission in LICs suggest?

There is indeed a large VAR-based empirical literature examining the effects of monetary policy innovations (as measured through a variety of monetary policy variables including, but not limited to, policy interest rates) on aggregate demand (as indicated by the behavior of output and/or prices) in a large number of individual LICs. This literature does not restrict the specific channels through which monetary policy may affect aggregate demand. Mishra and Montiel (2012) conclude that it is very hard to come away from their review of the evidence with much confidence in the strength of monetary transmission in low-income countries. They fail to uncover any instances in which more than one careful study confirmed results for the effects of monetary shocks on aggregate demand that are similar to the consensus effects in the United States or other advanced countries. The question is how to interpret this state of affairs. As suggested by Egert and Macdonald (2009) (for the case of transition economies in Central and Eastern Europe), it is likely to reflect some combination of the “facts on the ground” and shortcomings in the empirical methods that have been applied to this issue.

We suspect, however, that “facts on the ground” may indeed be an important part of the story. The failure of a wide range of empirical approaches to yield consistent and convincing evidence of effective monetary transmission in low-income countries, and that the strongest evidence for effective monetary transmission has arisen for relatively prosperous and more institutionally-developed countries such as some Central and Eastern European transition economies (at least in the later stages of their transition) and countries such as Morocco and Tunisia, make us doubt whether methodological shortcomings are the whole story.

Question 7: So, what are the policy implications?

We interpret the evidence in Mishra, Montiel, and Spilimbergo (2012), as well as that of the broader VAR-based literature, as creating a strong presumption that in the financial environment that tends to characterize many LICs, monetary policy is likely to have both weak and unreliable effects on aggregate demand. If this is true, the stabilization challenge in developing countries is acute indeed, and identifying the means of enhancing the effectiveness of monetary policy in such countries is an important challenge.

When domestic monetary policy is weak and unreliable activist policy is less desirable, and the adoption of policy regimes that raise the stakes associated with attaining publicly-announced monetary objectives should be postponed or their design should be modified to take the uncertainty about monetary policy effects into account. In addition, weak and unreliable monetary transmission diminishes arguments for floating exchange rates as well as for capital account restrictions under fixed exchange rates.