Transmission mechanism of monetary policy in developingcountries

In a perfect world where the action of the central bank is seen as a signal on thecurrent state of the economy, its actions would be seen as a guideline for all economicagents not only commercial banks. Indeed, lowering the policy rate would implyoptimism among banks and eventually they will drop their lending rate. Therefore,consumers and businesses will see in this drop an incentive to spend and invest. Incontrast, in the case of a rise in the policy rate, the banks but also the economic agentswill understand that there is an overheating in the economy and if they do not inhibittheir activity, problems will ensue. Thus, the reaction of economic agents to the

central bank’s action would simply be a natural reaction with respect to their

understanding of the decisions of the monetary authorities.The breakdown between action of the central bank and decisions of economic agentscan be attributed to three main reasons.First, the credibility of the central bank is considered as a key factor in thetra

nsmission mechanism. It is not considered ’credible’ only the commitment to

maintain the inflation rate at an optimum level, but the credibility also means thecommitment of the central bank to follow a clear policy rule. It follows that the actionof the central bank would be anticipated in advance and it will not create a majorfluctuations in economic cycles due to the action of stabilization by the monetarypolicy. Similarly, this anticipation should strengthen the anchoring of inflation at apredefined target level by the central bank. Thus monetary policy will become a

strong signal reflecting the economy’s condition and guide economic agents’

expectations in line with the objectives of the central bank.Second, in return for the credibility of the central bank, economic agents withoutexception will have to demonstrate a minimum of financial competence: theunderstanding the mission of the central bank, its role and its decisions. In a contextwhere the central bank is understood in its missions and prerogatives, citizens ingeneral would be able to correctly interpret the signals from the central bank and

hence this will allow better transmission of decisions of the central bank. Forexample, in the case of a small business when he realized that the policy rate hasdropped, he will understand that the activity should be boosted and must anticipatebusiness growth which will push him for more investment. Ultimately, byaggregating all the decisions from small entrepreneurs, consumers, etc., this willresult in an increase in aggregate demand and end up with what Woodford calledself-fulfilling expectations.Third, with regard to lending rates, it is clear that in a very small banking marketwhere there is no banking competition, even if there is decline in the cost of moneyfor commercial banks there would be no impact on lending rates. This will preventthe transmission of decisions of the central bank.To conclude, it should be recalled that the transmission mechanism of monetarypolicy is not only an imposed constraint by the central bank to commercial banks.Deeply, it is a mechanism for coordination between all parts of the economy: centralbank, commercial banks and economic agents. This coordination must be based on ashared trust and mutual understanding, throughout the monetary policytransmission chain.