Effect of Financial Development on the Transmission of Monetary Policy

Abstract

This paper looks at the effect of financial development on output and bank liquidity by doing a cross-country analysis of 119 countries across 18 years from 1997-2014. We develop three hypotheses by combining multiple strands of literature which have heretofore existed in parallel. The main research question is whether financial development serves to provide greater bank liquidity and whether it does indeed stimulate output growth. This question is of particular relevance when there are changes in monetary policy. This paper goes to the heart of examining whether monetary policy is transmitted more effectively with better financial development and whether the goal to achieve output changes via monetary policy is better effected in an environment of developed financial markets. Our results support the hypotheses that financial development positively impacts output, and negatively affects bank liquidity. We also show that with financial development, the effect of bank liquidity on output is heightened.

The relationship between financial development and effectiveness of monetary policy: new evidence from ASEAN-3 countries

“…There is a different effect of FD on MPE in developing countries relative to advanced ones, in which the inflation rate has increased in response to FD in advanced countries, whereas output declines with FD in developing economies. Seth and Kalyanaraman (2017) found that the effect of monetary policy is strengthening in response to the level of FD in advanced economies. However, the effect of monetary policy is less in poor countries, possibly because of the lower number of financial intermediaries available to assist in the delivery of monetary policy.…”

“…This is because the fast growth of the financial system has a direct impact on the monetary policy set by the Central Bankers in Given this backdrop, this paper contributes to the existing literature in FD and MPE in several ways. First, some studies, for example, Carranza et al (2010), Ma and Lin (2006) and Seth and Kalyanaraman (2017), have examined the relationship between FD and MPE in cross-countries using panel data analysis. However, the previous study cannot formulate the role of financial sector development on MPE for an individual country perspective.…”

Monetary policy effectiveness in Africa: the role of financial development and institutional quality

“…This research interest has been kindled mostly by the notion that "finance leads growth"a hypothesis that seems to be winning the argument with most economists, despite the fact that the debate on the finance-growth nexus still rages on. Over the years, a number of studies that are devoted to financial development has identified its level as a key ingredient in the pursuit of economic agendas, including policy effectiveness (Gigineishvili, 2011;Seth and Kalyanaraman, 2017). According to Aghion et al (2009), financial development is beneficial to economic performance at sufficiently high levels.…”

The impact of exchange rate volatility on inflation targeting monetary policy in emerging and advanced economies

“…Accordingly, a central bank is deemed credible when it delivers its stated inflation objective. As institutional and financial strength improves, so does the transmission of monetary-policy action (Seth & Kalyanaraman, 2017). Institutional strength and policy credibility in EMEs still tend to be weaker than in their advanced counterparts.…”