Literature Review
There is a vast literature studying the effects of monetary policy, which advances as improvements are made in the methods used to identify exogenous monetary policy shocks and is also updated as the implementation of monetary policy changes over time. Reviewing this literature is beyond the scope of this paper and focus on several recent cross-country studies of transmission in developing countries and studies of monetary policy transmission in Sri Lanka.
The monetary transmission literature on developing countries finds mixed evidence for the effectiveness of monetary policy and bank lending in influencing price and the real sector of an economy. \citet*{Das_2015} study stated that there is significant, albeit slow, pass-through of policy changes to bank interest rates in India. The extent of pass-through to the deposit rate is larger than that to the lending rate, and the deposit rate adjusts more quickly to changes in the policy rate. Further, they found there is evidence of asymmetric adjustment to monetary policy: throughout most of the sample period, deposit rates do not adjust upwards in response to monetary tightening, but do adjust downwards to loosening; and the lending rate adjusts more quickly to monetary tightening than to loosening. Finally, he found the extent of pass-through to the lending rate has increased in the later part of the sample period to a cumulative elasticity of 0.46 with respect to the policy rate. For both the deposit rate and lending rate, the speed of adjustment to changes in the policy rate has increased in the later part of the sample.
\citet*{Afrin_2017} finds that the exchange rate channel is not effective in transmitting monetary policy in order to affect the price level. This is to be expected in the context of Bangladesh’s highly intervened foreign exchange market. However, study show that monetary policy has a significant role in influencing the domestic price level, and bank credit plays a non-trivial role in the process. The credit shock, on the other hand, influences output and inflation; however, the responses are short-lived compared to the monetary policy shock. The central bank plays a stabilizing role in its responses to a credit shock by raising interest rates to reduce the impact of a credit shock.