Transmission Mechanism of Monetary Policy in Developing Countries

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Transmission Mechanism of Monetary Policy in Developing Countries
Introduction
The monetary policy usually targets interest rates with the aim of enhancing economic growth and currency stability. This is done in order to stabilize commodity prices and to keep unemployment rate as low as possible. Monetary policy is commonly guided by a monetary theory that is in turn determined by needs of a country and objectives of the country's financial authority. The first type of monetary theory is the expansionary theory which tends to rapidly increase the overall supply of money in an economy as stated by Tobin (1969). The aim is to counter mass unemployment as witnessed in a recession. This is achieved by lowering interest rates thus encouraging businesses to borrow from banks thus expanding and hopefully enable them to employ more people. On the flipside, the contrary monetary theory is known as the contradictory theory which is intended to curb inflation with the hope of overcoming a deterioration of the value of assets (Carlyn, 2004). This essay is going to analyze in detail the transmission mechanism of monetary policy in developing countries.
Monetary Policy
A monetary policy refers to regulation on the supply of money instituted in a country by the country's monetary authority, usually the central bank. Monetary policy is determined by interest rates and the total supply of money in that economy. There are systems that are put in place in order to control either interest rates or the supply of money or both. The result is that inflation, unemployment and economic growth are thus manipulated. In instances where the currency is under monopoly of issuance or controlled system of currency issuance through banks, the central bank can change the monetary supply thereby affecting the interest rate (Mishkin, 1995).
Monetary Policy Transmission Mechanism
Monetary policy transmission mechanism refers to the process in which monetary policy directives influence the economy of a country and the price level in particular.
Monetary Policy Transmission Mechanism in Developing Countries
Many developing countries experience difficulty in establishing proper and effective monetary policy. The main challenge is that many developing countries do not have deep markets in government debt an issue that is further aggravated by the difficulty in foreseeing the demand for money and the fiscal pressure forcing the central banks to levy inflation tax. It is important for the monetary policy transmission mechanism to be understood so as to facilitate the proper design and effecting monetary policy. This is so because alterations in the structure of the economy change the effect of structural adjustment. This means that policy makers need to consistently review channels of monetary policy transmission mechanisms or channels (Montiel, 1991).
In developing countries there is a need to have higher inflation rate targets according to some economists. This is because relative price adjustments will be significant in those economies where productivity gains are large in tradable sectors. Alongside this, liberalization of prices will increase measured inflation where there is rigidity towards downward nominal prices.
Most financial authorities in the developing nations are unable to achieve other goals except stabilizing prices. Monetary expansion usually leads to immediate rise in prices. This is due to central banks being unable to have credibility and inflation psychology. This is caused by a history of high inflation, making monetary policy changes to result in instant expectations in inflation and thus the price. Volatile and shallow financial markets make this even more difficult for monetary policy to positively affect output in a way that can be accurately be forecasted. Because of this, monetary policy in developing countries merely concentrates only on price stabilization in developing countries. Although his is the predicament of developing countries, monetary policy's implications on employment and output cannot be overlooked. The costs of output aimed at mitigating high levels of inflation to account in checking the pace and degree of disinflation (Mishkin, 1996). High inflation features like lack of credibility, structural rigidities in both labor and goods as well as contracts and wages indexation all put a high inflation inertia hence worsening the costs of output disinflation. The use of exchange rate can immediately reduce costs of output this option can result in a massive external deficit, overvaluation, and eventually the collapse of exchange rate. When this happens, re-inflation can be experienced. Due to this danger central banks rely heavily on the more gradual and sustainable options like domestic channels of disinflation.
The Four Channels of Monetary Policy Transmission
Direct Interest Rate Effect
This channel of monetary policy transition influences both the cost of credit and debtor's and creditor's cash flow. By changing the interest rate the marginal cost of borrowing changes. This change then affects the adjustment in investment and savings. A shift in policy and interbank lending rates result in adjustment in rates charged for loans which then influence investment decisions, rates of deposit and thus affect present and future consumption. An important aspect of this policy is the degree to which policy triggers changes in interest rates affects short term interest rates of money market and thereby spreads to other interest rates especially the long te...