Financial Architecture and the Transmission Mechanism

Project Active from to Firms and Entrepreneurship

To cope with the dual challenge of stabilizing real economic activity and maintaining a low inflation rate, the central banks of many industrial and emerging market economies have adopted monetary policy frameworks that explicitly commit them to medium-term price level stability, while allowing them some discretion to stabilize real output in the short run. However, manipulating the instruments under the central bank’s control so as to achieve the dual mandate of short-term real output stability and medium-term price stability is not a trivial task. Among other things, it requires the central bank to have both a qualitative as well as a quantitative understanding of how the policy instruments under its control affect real output and the price level -- the monetary transmission mechanism.

The economics profession has devoted a substantial amount of attention to understanding this mechanism, but it has primarily done so in the context of economies with highly sophisticated and well-functioning financial markets. However, the links between the central bank’s policy instruments and aggregate demand in an economy depend on how changes in the central bank’s policy instruments affect that economy’s financial equilibrium, and these effects in turn depend on the economy’s financial architecture. Because financial architecture is not uniform across countries, the transmission mechanism for monetary policy is therefore likely to be economy-specific. The profession’s focus on advanced financial systems has therefore meant that at the present time much less is known -- not just quantitatively, but even qualitatively -- about monetary transmission in economies with less developed financial systems. The unfortunate implication is that central banks in low-income countries, or LICs, tend to operate in a highly uncertain economic environment in which the strength and reliability of the links between their own policy actions and the economy’s real output and price level outcomes are not well understood. Consequently, such banks potentially run high risks to their credibility by making public announcements of the intended medium-term path for the domestic price level, and they run the risk of having counterproductive effects if they adopt activist monetary policies in pursuit of short-term real output stability.

Improving our understanding of monetary transmission in low-income countries is therefore critical. This project attempts to further that goal for the case of Tanzania. Its objective is to determine the strength and reliability of the effects of the Bank of Tanzania’s monetary policy actions on the Tanzanian economy. It will seek to do so while developing a framework for the empirical study of monetary transmission that can be applied elsewhere in sub-Saharan Africa, where the financial architecture is not only quite different from that characteristic of industrial countries, but where the financial environment has also been changing rapidly in recent years.