SEVEN

Linkages Between Sectors, Monetary Policy and Transmission Mechanism

"All theorizing is simplifying, cutting out the unimportant and

leaving what is thought to be important, in the hope that by
simplifying we may increase understanding"
[ Hicks, 1967; p. 156 ]

The central banks of the developed countries are keen to exercise their
independence by formulating suitable monetary policy with the twin objectives of
stability of price level and the stability of the exchange rate of the domestic currency.
These two objectives are complementary to each other and the central banks study the
channels of transmission of their different policies to have a fair idea about what is
known as leads and lags of monetary policy. In fact the entity what is known as the
`Economy' of a country is hardly compartmentalized and its stylized different sectors are
linked through the dynamic functioning of different economic parameters some of which
are heavily dependent on social conditions. We assume that the social conditions remain
fixed or some sort of social stability becomes the ground reality of their assumption.
When a person buys a house through the HDFC loans at a specific interest rate, he
seldom realizes that the intrinsic value of his property may change by the changes in the
market interest rate, though his property is tied to the contract rate of HDFC. Neither
does he realize that his decision may have some impact in the linkages between the
money market and the asset market.

The linkages between the sectors are important in the sense that the impact of the
monetary policy spreads through the sectors with the help of those linkages. The effects
of monetary policy through the linkages in different sectors, what is known as the
transmission mechanism, are also different in the developing countries compared to the
developed ones. In the latter, monetary expansion is supposed to affect output in the
short run, even if the effects simply lead to the changes in the price level over a long
period of time. But in the developing countries, an expansion in money supply may
inflate the prices immediately and still have little transitional effects on other real
variables. This situation occurs when the credibility of the central bank is low and
inflationary expectations are dominant. The situation may be aggravated if the financial
markets are shallow and volatile, and in this case the effects of the monetary expansion
on the real sector becomes difficult to predict. Price stability should be the objective of
the monetary policy in this case.

In recent literature there has emerged a near-consensus among the economists that
monetary policy cannot influence the long run growth of the economy, though it can
affect the real sector in the short run. Even the effectiveness of influencing the short run
situations has been under doubt as the lags in recognizing turns in the business cycle,
and the subsequent lag effects in the response of the economy to the changes in the policy
make it difficult for the policy maker to choose the correct time for the announcement of
the policy for fine tuning the business cycle.

Price stability has been the principal objective of the monetary policy. Generally
it is agreed that an approximate 3 per cent inflation should be tolerated which can take
care of the difficulties of the measurement and the adjustment of the relative prices that
reflect differential productivity trends in different sectors of the economy.
In the developing countries the tolerable limit of inflation should be higher, say 5
to 6 per cent as the relative price adjustment will be more significant and pronounced in
such economies because productivity gains in the tradable sector is high and the
differences of productivity gains in different sectors are high also.

The developing countries have another dimension which make it imperative that
monetary policy should have objectives other than price stability. It is generally seen that
the concentration of output occurs in a smaller number of products. Also, the financial
markets are not developed with relevant expertise lacking. All these may make the
developing country more vulnerable to the destabilizing shocks. This necessitates the
usefulness of counter cyclical monetary policy. There is another aspect. Since the
financial system is weak, the apex bank can use monetary policy to direct credit to the
sectors considered to be vital for the growth of the economy.
Even when price stability is the sole objective of monetary policy, the effects of
the latter on the output and employment cannot be neglected when inflation-control
becomes the priority of the monetary policy, the pace of deflation will have a contraction
effects on output and employment. It is generally seen that various features of high
inflation developing economies, including lack of credibility, the wage-rigidities in the
markets, etc. may create an inflation inertia and this increases the output cost of anti-
inflation monetary policy. Considering all these many developing countries follow
monetary policy with multiple objectives consistent to their local conditions.

The Transmission Channels of Monetary Policy :

In a modern monetary system four channels of transmission mechanism of

monetary policy have been identified. The first is through the direct interest rate effects,
and this affects both the cost of credit and the cash flow of debtors and creditors. The
second channel is through the impact of monetary policy on domestic asset prices i.e.
prices of bond, stocks and real estates. The third channel is through the exchange rates
and the fourth channel is the credit availability. In an economy the nature of the
functioning of these four channels depends on the structure and macroeconomic
environment. One recent phenomenon is the globalization and the liberalization. This
has changed the structure of the domestic financial system and thus the dynamics of the
functioning of these channels has changed too.

The Interest Rate Channel :

In the traditional Keynesian model of monetary transmission, a policy induced change in
the money supply, for a given money demand, will lead to a change in the interest rate.
Change in the interest rates induces change in the marginal cost of borrowing, which
leads to change in investment and savings and so aggregate demand.
In Keynesian framework an expansionary monetary policy will have effects that can be
characterized as the following schematic form:

M ↑ => i ↓ => I ↑ => Y ↑

where the symbol (↑ ) indicates an increase.
Thus M↑ indicates an expansionary monetary policy that will lead to a fall in the interest
rate, a rise in investment and aggregates output.

Keynes emphasized that the interest rate channel operates mainly through business
decision about investment spending. But recent research reveals that interest rate
channels work equally well through the consumer expenditure on durable consumer
goods and housing.

Short-term and Long-term Interest Rates :

The behaviour of the short term and long term interest rates in the face of the changes
in the monetary policy can be put in a stylized fashion in the simple framework. Suppose
that a monetary policy change takes place that changes the short term interest rate. The
latter should have effects both on the exchange rate and on the long term interest rates.
But short term interest rate is not the sole determinant of the changes in long term rate
and exchange rate, and the effects of the short term interest rate is uncertain. The
changes in the nominal exchange rate and interest rate will change the real exchange rate
and real interest rate. The change in the latter will have effects on exports, imports,
consumption, investment and gross domestic product (GDP). In the long run, real
interest rate and real exchange rate return to their fundamental level and GDP comes to
normal level. So the linkages are from the short term interest rate, to the exchange rates
and long term interest rates and then to the level of inflation and real GDP.
How is the short term interest rate determined? In a model with a stable demand
for money, aggregate money demand depends on short term interest rate and income.
The apex bank can affect the interest rate by controlling the supply of money. As money
supply increases, a decline in the interest rate will clear the market. But this traditional
analysis suffers from two inadequacies. First, the money demand functions are not stable
enough to give reliable estimated value of the parameters essential for policy making.
Second, the behaviour of the apex bank is not accurately described by one-time changes
in the money supply. Today, many central banks take multiple actions in the money
market to guide the short term interest rate in a particular way. Thus a description of the
central bank's reaction function can show how it adjusts the short term interest rate in
response to various factors in the economy like inflation, exchange rate and real GDP.

The Long Term Rate of Interest :

Following the financial market prices view of the monetary transmission

mechanism, long term interest rate is given by the expected weighted average of future
short rates appropriate for the maturity of the long bond. If the central bank initiates
action to increase short term rates and the agents in the market expect the short term rate
to decline gradually back to the starting value in the future, then the rate of increase of the
long rate will be lower than the short rate. Again, if the central bank initiates action to
increase the short term rates, but the agents in the market think that this is just the first
phase of a longer sequence of events, then the increase in the long rate will be higher than
the short rates. Thus market expectations can play an important role in making the
changes in the short and long rates asymmetrical.

The expectation model of the term structure of interest rate generally work well
when the risks of interest rate changes is covered, but when the risks are not covered, it
lacks precision. That way it has similarity with the covered interest parity condition in
the exchange rate movement. While one should keep this in mind, it is true that changes
in the short term rate is empirically significant factors in determining the changes in the
long rate. Given the rigidities in the price structure in the market, lower short term rate
will reduce the real long term rate, may be for a specific period of time. In the long run
real long term rate will return to the path determined by the fundamental economic
factors and the change in money supply will have no impact on the real gross domestic
product.

Interest Rate Change and Asset Prices : Asset Price Channel :

The change in the interest rate being the result of the change in the monetary
policy can also influence the level and structure of the asset prices in the economy. The
prices of bond, equity and real estate depend on interest rate. In the case of long term
fixed interest bond market, higher short term rate may result in a decline in the bond
prices. This link becomes stronger as market develops though complications are there.
The expectations theory of the term structure implies that long term interest rate
represents the average of future expected short rates plus a risk premium, and the prices
of the equity can be interpreted as reflecting the discounted present value of expected
future earnings of the enterprises. Also the principle of uncovered interest parity implies
that exchange rate changes are determined by the changes in interest rate differentials.
Thus, the changes in the short-term interest rates will influence long rates and asset prices
and to what extent this may happen depends upon how monetary policy affects the path
of expected future short-term rates enterprise earnings and rents.

But even in mature economies the response of long rates and asset prices to the
changes in the short term interest rates has been difficult to predict and this is for the
following reasons; First, this depends on how the expected future path of short term
interest rates is affected by the policy decision of the central bank, especially how market
expectations are changed. Second, asset prices are also dependent on the expectations of
future macroeconomic performance and this again affects both future short term interest
rates and future asset prices. Since future macroeconomic variables are difficult to
predict, the response of the long term interest rate and asset prices to a change in the short
term rates becomes uncertain. The problem becomes more complex as the causality
between asset prices and macroeconomic variables runs both ways.
Third, many a time asset prices are seen to deviate significantly from the results
of the expectations model as these reflect changing risk premiums, speculative bubbles
and other random factors not directly related to expected future returns. Also asset
markets are seen to be shallow and less competitive in the developing countries and this
makes the asset market response to the monetary policy changes less certain. Volatility in
the asset market prices is reinforced by the greater availability of credit in the wake of
financial reforms. The participants in the market are less experienced and information
about many near firms are not complete. All these make price determination less
efficient. All these consideration contribute to uncertainties about the appropriate level of
asset prices and the response of the latter to the changes in monetary policy.

Asset Market in an Imperfect Situation :

In an uncertain and volatile world a small change in monetary policy might have
large effects on asset market and aggregate demand. A small dose of expansionary
monetary policy may lead to a sharp increases in all but very short run interest rates, if it
brings concerns about a new surge of an inflation. This induces a sharp fall in equity
prices and exchange rate and the net effects of all these movements will be contractionary
and not expansionary as originally planned. The movement of asset market prices may
be such that it may offset the direct effects of a monetary policy action in mature
economy also, though empirical evidence suggests that the offset experience is much
more pronounced in developing countries.

Q - Theory and James Tobin :

Monetary policy induced change in the asset prices can affect the aggregate
demand and this is Q-Theory of investment of Professor Tobin. When the monetary
policy is easy and expansionary, equity prices will rise on the wave of inflationary
process, and this increases the market price of firms relative to the replacement cost of
their capital. Also newly issued equity in the primary market can command a higher
price relative to the cost of real plant and equipment and this reduces the effective cost of
capital. Thus, even in bank loan rates react little to the policy easing, monetary policy
can influence the cost of capital and investment expenditure.
 The changes in asset prices induced by monetary policy can also affect demand by
altering the net worth of households and enterprises. This type of changes may trigger a
revision in income expectations and induce the households to adjust their consumption
expenditure. Again, the change in the value of assets held by firms will change the
quantum of resources available for investment.

When the asset prices decline, it will have negative effects on spending as the
resultant change in debt-to-asset ratios make it difficult for the firms and households to
meet their debt obligations. A large fall in stock and bond prices may reduce the value of
liquid assets available to the firms and households to repay loans. All these explain the
effects of monetary policy changes on aggregate demand and their transmission
mechanism working through the asset prices may become amplified as the pace of
economic activity begins to respond in a more dynamic fashion. A decrease in the
interest rate increases the asset prices and improve the balance sheets of firms. This leads
to an initial increase in output and income and thus improved economic activity increases
the cash flow of firms and households. All these induces a second round, expansion of
expenditure and prolonged upward swing in economic activity may continue for
sometime even when monetary policy may be reversed.

Exchange Rate Channel :

Consistent with its overall objectives the central bank of a country tries to affect
the exchange rate through the operation of its monetary policy. In many developing
countries the markets for equities, bonds and real estate are not mature and deep and
exchange rate is probably the most important asset price which is affected by the
monetary policy. In a flexible exchange rate regime, a tight money policy increases the
interest rate leading to an increase in the demand for domestic asset. This induces an
appreciation of the nominal and real exchange rate in the beginning. This appreciation is
transmitted to the increase in the expenditure in two ways. First, the appreciation of the
exchange rate makes the foreign goods cheaper, and thus the latter substitute the domestic
goods to some extent. Thus this relative price effects reduces the domestic aggregate
demand.

Second, the result of the change in the exchange rate may have a balance-sheet
effects, as the firms and households in many countries may have huge foreign debt. If the
latter is not offset by the holding of foreign exchange reserve and foreign currency asset,
changes in the exchange rate should have effects on the net worth of the firms and
households.

In many developing countries domestic households and firms are net debtors in
foreign currency through the banking system. When the domestic currency appreciates,
this leads to an improvement in the balance-sheet situation of the firms and thus this
induces an expansion of domestic aggregate demand. Sometimes, this sort of balance-
sheet effects dominates the relative price effects.

The above explains how the exchange rate channels can affect the aggregate
demand when monetary policy changes. But it can affect the aggregate supply also
domestically. An expansionary monetary policy will reduce the interest rate, increase
domestic price level and leads to a depreciation of the exchange rate. The latter increases
the import costs and this induces the firms to increase their domestic producer prices even
when there has been no expansion in the aggregate demand. In many countries with
weak financial structure and not-so-developed market mechanism exchange rate changes
are seen as a signal of future price movements, and thus wages and price may change
even before the adjustment time works it out through the change in the import costs
having effects on the cost structure.

Fixed Exchange Rate Regime and Monetary Policy

When a country is having a fixed exchange rate, the effect of monetary policy on
the latter is constrained. For a long time, fixed exchange rate has provided a helpful
environment for faster economic growth to many developing countries. Even when
flexible exchange rate has become the dominant paradigm, many countries with weak
financial system prefer exchange rate as the nominal anchor and they pay their currency
with one strong currency in the world i.e. US dollar, French franc or German mark.

One major defect of the fixed exchange rate policy is that the central bank cannot
pursue independent monetary policy, as it is forced to accept the international level of
interest rate. This means that the central bank is unable to use the domestic interest rate
to influence aggregate demand. A single objective policy (fixed exchange rate) may lead
to the persistence of disequilibrium in the domestic economy.

When domestic currency becomes over-valued, the balance of payments crises

may come in the form of deficit in current account. The adjustment mechanism while
maintaining the fixed exchange regime is painful for the economy as downward rigidities
in the domestic prices mean that current account deficits should be adjusted by monetary
outflows and demand compression. This causes disruption in the economy in the form of
unemployment and decline in output.

But it has been observed that in the developing countries domestic and foreign
assets are not perfect substitutes. In such situation, with capital flow regulated by the
authority, there is some scope for independent monetary policy even under fixed
exchange rate regime. As the rates of return on domestic and foreign asset diverge, the
effects of monetary policy through the asset market cannot fully offset by the reverse
capital flow as the latter is regulated. So in the short run, the changes in the monetary
policy may have some effects.

Institutional factors also have some influence in the divergence of rates of return
of domestic and foreign assets. When the financial markets are segmented and become
clear through the non-price rationing mechanism, the participants in the market cannot
successfully arbitrage deviations of domestic rates of return from international norms.
Suppose domestic money market is well integrated with international capital markets,
even then the changes in the money market rates may not lead to immediate
corresponding movements in deposit or loan rates. This sort of situation prevailed in
some east-Asian countries as they used to enjoy some independence in monetary policy
through market segmentation.

One fall out of the type of monetary policy followed in the Asian countries is the
existence of financial fragility and the dilemma of the central bank to maintain the
pegged exchange rate. When the country is having a huge foreign currency debt, the
central bank cannot afford the downward revision of the exchange rate as that would
impose huge burden on the domestic front. Again, if the banks are in poor financial
position, the central bank is constrained to raise the interest rate to defend the pegged
exchange rate. The dilemma continues and the economy remains in a highly leveraged
state. This sort of constraint posed by financial fragility on the monetary policy does not
vanish even when the currency is floated as the depreciation of the domestic currency
imposes heavy burden on the firms and households and lead to a crises of confidence in
the economy.

We come back again to the importance of institutional factors as the country with
weak financial system should adopt structural reforms first so that it can grasp the
benefits of independent monetary policy. Before we take up that issue, another
important policy perspective should be discussed briefly. This is the situation of
sterilized intervention in the money market.

Policy Intervention and Foreign Exchange market

When the central bank resorts to sterilized intervention in the money market, what
is its effects in the foreign exchange market? The literature is confused in this aspect as
the question whether sterilized intervention can be used independent of the monetary
policies so that the monetary authorities can pursue twin objectives of exchange rate and
domestic stabilization. Theoretical discussion suggests that there may exist one or more
channels through which the intervention can affects the exchange rate of the domestic
currency.
In a system of independently floating exchange rate regime without capital
control the inflow of foreign money will increase the money supply. If the authority
follows a money supply target policy or a policy of inflation rate targeting, it is to control
the money supply. Faced with an automatic increase in money supply, the central bank
can perform open market operations to suck money out of the system so that the stock of
money available in the market does not change significantly. In short, the effect of the
inflow of foreign money into the economy is sterilized so that it can not destabilize the
domestic equilibrium. This is sterilized intervention (SI ) which is widely practiced by the
central banks all over the world.
In theoretical analysis sterilized interventions can influence the exchange rate of
the domestic currency in four channels:
---- the portfolio balance channel:: SI induces disequilibrium in the private portfolios and
the adjustment takes place within the portfolio through the change in the exchange rate,
----the market efficiency channel:: SI focuses the attention of the public on the neglected
information which are important for exchange rate adjustments,
-------superior information channel:: SI transmits otherwise unavailable information
that induces the economic agents to make necessary adjustments in the foreign exchange
market,
-------future anticipation channel:: the SI creates future anticipation about the potential
changes of other policy related to money supply and exchange rate and the resultant
adjustment of the economic agents in their respective market positions can change the
exchange rate.
If SI operates through the first two channels, the influence of SI is independent of the
other present and potential domestic policies. But if SI operates through the third and
fourth channels, that may signal the changes of other policies in the future.
Whether the SI will have impact on the exchange rate through the changes in the
portfolio depends on the degree of substitutions among the assets. If the investors think
that the identical assets denominated in different currencies are perfect substitutes , then
the SI which increase the supply of securities denominated in pound sterling and reduce
the supply of the securities denominated in French franc will have little effects on the
exchange rate of GBP/ F franc, as the investors will continue to hold the changed stock
of securities without any expectation of exchange rate changes. But if the investors think
the assets denominated in different currencies as imperfect substitutes, the SI will cause
the relocation in the portfolio as the changed incipient demand and supply situation
will come to an equilibrium through a change in the exchange rate of GBP in terms og
French franc.
If the investors know before hand the impending SI, they will use this information
in their forecasts of the future spot exchange rates, and this altered behaviour will
ultimately change the exchange rate. The influence of the prior knowledge of the SI can
induce the investors to neglect the structural variables affecting the exchange rates and
rely only on the information on future SI.
The portfolio balance model of exchange rate determination depends on the
uncovered interest parity condition, and the latter is found to experience deviations in
real life as the interest rate movements may not ensure the constancy of the real
interest rate . The deviations from the uncovered interest parity will induce the changes
in the exchange rates and these are quite consistent with the operations of the first two
channels.

Credit Availability Channel :

The credit availability channel is explained on the assumption that banks play a
special role in the financial system as they are well suited to deal with certain type of
borrowers who are important from the standpoint of the economy. There exists a large
number of small firms in any economy who confront asymmetric information regarding
the financial system and these firms require funds for their operations. They approach the
banks who are to meet their liquidity problem. The big firms can approach the capital
market directly.

In many developing countries private markets for credit are poorly developed
because of structural reasons. Again such private markets may be prevented by
government regulations from operating freely on efficiency consideration alone. In such
situation monetary policy is likely to affect aggregate demand more by changing the
availability of credit than through the direct or indirect effect of the changes in the price
of credit. This is true when the banks are directed to channel a certain quantum
(percentage) of credit to some priority sectors. Again, sometimes there exists binding,
ceilings on the interest rates to be charged by the banks. In such cases banks use non-
price means of rationing loans and this increases the importance of credit availability
effects.

Sometimes government of some countries get involved directly in the market for
loans either through public sector or government controlled development banks or
through fiscal subsidies on the loans of commercial banks. This sort of situation also will
have the credit availability effects as explained above.

Recently, the financial sector in many developing countries has been liberalized.
This liberalization does not eliminate the credit availability effects. Recently economists
have established that imperfect information and contract enforcement problems are
important in the sense that they change the means by which credit market clear. In
response to tight money policy, banks may not rely exclusively on increasing the interest
rate on the loans to ratio credit, as this may encourage riskier investment behaviour on the
part of borrowers. To prevent the risk-lover borrowers coming as customers, banks do
tighten credit worthiness standards apart from increasing the loan interest rates. This
leads to a decline in the supply of credit along with the increase in the price of credit.

We see that credit can play a special role even in the liberalized financial sector.
For this central banks in many countries including India closely monitor credit growth in
the evaluation of their own monetary policy.

Again, monetary policy has its effects on the credit availability through its effects
on the value of assets of both the borrowers and the banks. As monetary policy alters the
monetary conditions, asset prices change which changes the value of the collateral for
bank loans. The latter changes the power of access of the borrowers. The changes in the
credit worthiness of the bank customers and the financial conditions of the banks together
would induce the changes in the credit rationing when the banks perceive the constraints
in the economy.
Transmission Mechanism, Intervention and Recent Changes :

Leaving out the extreme situations like high inflation and recession in the
economy, when normal conditions prevail, the monetary authorities in many countries
have abandoned monetary targeting. Because it has been observed that changes in the
demand for money have caused the relationship between the monetary aggregates,
aggregate demand and prices to shift over time. Some central banks give importance to
the real rate of interest, though the definition of inflation for the determination of the real
interest rate is still debated.

In many developing countries, uncertainties about the channels of transmission of

monetary policy have been made more complex by the structural changes in these
channels themselves. All these have made the interpretation of the indicators of monetary
situation difficult. Sometimes, the volatility of the financial markets and macroeconomic
instability may loosen the linkage between indicators of monetary conditions and future
economic situation of the country even when the channels of monetary transmission
mechanism are stable.