Monetary Policy in Low Financial Development Countries

Abstract

The book gives broad coverage of monetary policy issues in Low Financial Development Countries (LFDCs). These low- and lower-middle-income countries are characterized by a predominance of bank finance, shallow financial markets, low financial inclusion, weak integration with world capital markets, and a high degree of informality in economic activity. Monetary policy acquires special twists, making it different in many aspects from the policies followed in advanced and emerging market economies. The book covers the main facets of monetary policy-making, using an approach that combines discussion of theoretical arguments, of results from empirical studies, and of policy experiences relevant for LFDCs. The book presents the monetary policy instruments used in these countries, and assesses the specificities of their monetary transmission mechanism. It evaluates the advantages, drawbacks, and challenges of the different nominal anchors they may choose from: exchange rate targeting, monetary targeting, and inflation targeting. This discussion is set against the background of the three main goals pursued by central banks: price, output, and financial stability. Particular attention is devoted to the issue of the credibility of central banks and to the trade-offs they face when external shocks, to which these countries are very vulnerable, lead to conflicts among the three goals they pursue. The book also covers more specific topics, such as challenges raised by fiscal dominance and by dollarization, implications of informal labour markets and of microfinance institutions for monetary policy-making, and the role of models for forecasting and policy evaluation.