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Ebook Monetary transmission in low income countries

Economists have devoted a substantial amount of attention to the monetary transmission mechanism, but typically in the context of economies with highly sophisticated and well-functioning financial markets. Much less is known about monetary transmission in economies with more rudimentary financial systems not just quantitatively, but even qualitatively.

Consequently, the links between the central bank's policy instruments and the behavior of aggregate demand in such countries remain something of a black box. This situation may be acceptable from the perspective of policy formulation as long as those links do not change i.e., as long as the reduced-form effect of monetary policy instruments on aggregate demand remain stable but in a world of financial reform and financial innovation this situation is not common.

Financial development is highly correlated with income per capita. Accordingly, most countries with rudimentary financial systems tend to be low-income countries (LICs). Since low-income countries typically peg their exchange rates and are characterized by fiscal rigidities, monetary policy is often the only short-run stabilization instrument at their disposal.

A situation in which the functioning of the primary short run macroeconomic stabilization policy that is available to the majority of the world's countries remains a black box is clearly not acceptable for policy makers.

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