Relative Importance of Monetary Transmission Channels in Inflation Targeting Emerging Economies

As the globalization is increasing and economies are becoming more and more interdependent, some questions have gained more importance, for example, has globalization changed the inflation determinants? The control of monetary authority over domestic inflation & interest rate has decreased or not? What has happened with the channels of monetary transmission mechanism and has there been any change in their relative importance? Researchers have started to look for these questions. We present results of some papers before we dwell upon our research question. Woodford (2007) highlights variety of factors that might lead to less control of monetary authority on inflation. However, the study concludes that there is little reason to expect that globalization should eliminate or even substantially weaken the influence of domestic monetary policy over domestic inflation. Gudmundsson (2007) focuses on monetary policy transmission mechanism within the economy with respect to financial globalization and concludes that there is some evidence of weakening of interest rate channel and overburdening of exchange rate channel. The study uses Vector Error Correction Model (VECM) and simple correlation matrix. However, the study does not talk about the relative importance of channels of monetary transmission mechanism. There is sizeable literature about the impact of financial globalization on the effectiveness of monetary policy. However, scarce one that focuses on the issue that what has happened to the relative importance of monetary transmission channels within the economy due to financial globalization. Do the channels of monetary policy transmission - interest rate channel, credit channel, asset price channel and exchange rate channel - retain the same order of importance or it has changed due to financial globalization. It is our conjecture that the potency of monetary policy might be at the same level but with the changed relative importance of transmission channels. So the objective of this study is to investigate the relative importance of different channels of monetary transmission mechanism, and the following paragraphs reveal the motivation of the study. As financial globalization increases, the currency value may become more responsive to interest rate differentials, thereby reinforcing the exchange rate channel of monetary transmission mechanism. Despite the vast literature that exchange rate pass-through has fallen in many countries in recent decade still there are opposing forces, on the one hand, trade and financial globalization might have strengthened the exchange rate channel and on the other hand, reduction in pass-through due to competition might have weakened exchange rate channel. Gust et al. (2006) conclude in their theoretical model that simultaneous increase in trade openness and decline in pass-through is due to competition with the foreign firms. In addition to this, there is now literature about the valuation channel that makes exchange rate important one, for instance, Lane and Milesi-Ferretti (2006). So it would be interesting to investigate that what happened to exchange rate channel in the recent years. Similarly, financial globalization might be altering the evolution of liquidity and credit conditions. The lending activities of foreign banks might be less affected by the domestic conditions. They might be receiving from or sending funds to their parent banks offshore. This can lead to waning relationship between operating tool and the transmission variable (bank credit) and subsequently weakening of credit channel. So for as interest rate channel is concerned, if the correlation between domestic saving and investment is weakening, there may be some signs of weakening interest rate channel. Moreover, capital inflows can exert upward pressure on asset prices and thus can make the asset price channel stronger. If asset prices are claim, as is considered, on the future output then financial globalization may have strengthened asset price channel. Although a qualification required, that there is a reasonable participation in the equity market. The increased price of shares can serve as collateral and thus can strengthen asset price channel. In this backdrop, this study investigates the relative importance of channels of monetary transmission mechanism in the recent years of financial globalization in inflation targeting emerging economies. We will use Vector Auto Regressive (VAR) methodology. VAR methodology has been extensively used in monetary transmission literature. In our case we will use VAR “shut down” methodology as used by Ramey (1993); Levy and Halikias (1997) and Ludvigson et al. (2002). In this approach baseline model (when all channel are functional) is compared with constrained model (when one channel is shut down). The deviation of the constrained impulse response function from the base line impulse response function represents the strength of the channel. Our sample countries include Brazil, Chile, Mexico, Korea, Thailand and Czech Republic. Moreover, the same exercise will also be repeated for variance decomposition analysis. This analysis will allow us to rank the monetary transmission channels according to their importance.It is very ticklish to come up with clear-cut expected results because of opposite results in empirical literature. However, we do expect in the countries where financial reforms have taken place, credit channel might have assumed more importance. The exchange rate channel might have become less important due to increased competition because of globalization. Interest rate channel and share price channels are expected to be low in ranking because of breaking relationship between domestic saving & investment, and generally low market capitalization respectively.