Monetary Policy Transmission : Context Nepal

Monetary transmission refers to the process by which the impact of the monetary policy actions passes on to its ultimate goal or the real sector of the economy. Changes made in money supply and policy rates will bring change in aggregate demand such that improvements would be brought in monetary policy objectives such as employment, price and output as desired. That is why monetary policy is also called demand management policy.

Main Transmission Channels 

1    1. Interest Rate Channel:

Interest rate channel is the traditional and most widely used channel in monetary transmission mechanism. According to this channel, when the monetary policy rates are changed, it causes changes in the short term interest rates which will ultimately bring changes in long term interest rates. Such changes affect the demand for credit and the aggregate demand of the economy. Change in aggregate demand, in turn, will influence real sectors such as employment, output and price level. The working mechanism of this channel can be shown in the chart below: 

The effectiveness of this channel depends on the structure of the economy and the level of the development of the financial markets. If the relationship between interest rate and the demand for credit is weak, this channel is not effective. In such a case if the central bank reduces interest rate by adopting expansionary monetary policy, the demand for credit does not rise as expected as such the impact on aggregate demand is minimum. Alternative transmission channel should be used in such a case.

      2.     Asset Price Channel:

In this channel, the policy actions of the monetary authority brings changes in value of assets (real estate, security) of households and business firms which in turn change the aggregate demand of the economy. For instance if expansionary monetary policy is used resulting in an increase in the prices of equity and real estate, it will raise the consumption demand of the households and investment demand of the firms. An increase in aggregate demand will in turn results in an increase in output, price and employment.

According to this channel, the impact of monetary policy actions is transmitted through two mediums:

A. Tobin's q :

Tobin's q ratio shows the relationship between the market value of the company and its book value. A q-ratio greater than one is indicative of higher market value which gives incentive to investment. If expansionary monetary policy raises the market value of the company by reducing interest rate, the investment demand of the economy will increase thereby pushing the aggregate demand upwards. 
B. Wealth Effect

Wealth effect works through the changes in the financial and physical assets of the households due to monetary policy actions. Such changes affect the consumption and investment behaviors of the households thereby affecting the aggregate demand of the economy. For instance, if expansionary monetary policy leads to an increase in equity and real estate prices, it will increase the consumption and investment demand of the households and raises output, employment and price level by raising the aggregate demand.

The working mechanism of this channel can be shown in the chart below: 

This channel will be effective when there is a clear and strong relationship between interest rate and asset prices.

 3.     Credit Channel

Credit channel is the direct transmission channel of monetary policy. Under this channel, changes in monetary policy actions change the credit availability which brings changes in consumption and investment demand. This channel can be effective in credit deficient economy where availability of credit is more important rather than the cost of credit. Such a situation exists in underdeveloped countries where the allocation of financial resources is generally sub-optimal.

The working mechanism of this channel can be shown in the chart below:

 4.     Exchange Rate Channel

Under this channel, change in monetary policy actions influences the exchange rate of the economy which in turn influences the export and import demand. For instance, if the central bank adopts expansionary policy, interest rate decreases which reduces the capital inflow resulting into a fall in the supply of foreign exchange. Reduction in foreign exchange creates pressure in BOP as such the domestic currency depreciates. It encourages export and discourages imports. As a consequent of this, the aggregate demand of the economy rises.

The working mechanism of this channel can be shown in the chart below: 

For this channel to be effective:

• The country should have adopted the flexible exchange rate regime.
• Capital account must be convertible.
• Exports should be sensitive to devaluation i.e. price elasticity of exports should be high.  

       5.     Expectation Channel

The expectations made by economic agents about economy also influence transmission of monetary policy. Such expectations will affect consumption and investment decision of the agents and thus affect aggregate demand.  This channel can be effective only if the financial and economic sectors are well developed.

The working mechanism of this channel can be shown in the chart below:

 Effectiveness of Monetary Policy Transmission Channels

• The effectiveness of monetary policy transmission mechanism depends on the economic and financial sector development, institutional and policy framework and monetary policy framework, among others.

• The price based transmission mechanisms are less useful in underdeveloped economies due to the weak relationship between interest rate, exchange rate and investment. 

•  According to an IMF study, the credit channel of the monetary policy is more effective in UDCs.

• In Nepal the impact of changes in policy rate on interest rate is not much strong and the impact of changes in interest rate on consumption, investment, output and employment is minimal. Investment decision is rather affected by policy regime, internal rate of return, political stability, labor relation and others.

• Since Nepal has adopted pegged exchange rate regime and capital account is only partially convertible, the exchange rate mechanism has limited role to play.

• The asset price channel seems to work to some extent as the monetary policy actions often brings changes in the real estate prices and share prices. However, such increase has meager effect on the real sector of the economy including output and employment. This is due to the underdeveloped capital and real estate sector.

• In Nepal, different empirical studies have emphasized the use of credit channel as an effective channel. They include Khatiwada (2005), Kharel (2012), Budha (2013). This channel works well when access to financial services is low, the market is less competitive, there is lack of capital and the environment is not much supportive for large scale investment.

• For transmission mechanism to effectively operate, independence of monetary policy is must.  The situation of pegged exchange rate system with India, convergence of Nepal’s inflation to the Indian inflation, the labor mobility and the long-open border with India raise question on independence of Nepalese monetary policy.

           The monetary transmission channels are not substitutes of each other. Rather they may complement each other while working to attain the final target of the policy.  In Nepalese context, among different channels of monetary policy transmission, bank lending channel is more effective. Other channels at the same time complement it to attain the desired targets of the policy.