INTRODUCTION
There are several channels of monetary policy transmission, but the functioning and effectiveness of these mechanisms vary across countries due to differences in the extent of financial intermediation, the development of domestic capital markets, and structural economic conditions. There are four basic channel of the monetary policy transmission mechanism. The first is interest rate channel, its operates through the impact of monetary shocks on liquidity conditions and real interest rates, which in turn affect interest rate sensitive components of aggregate demand such as consumption and investment. The second is credit channel, its works through the response of credit aggregates to changes in interest rates and other policy instruments. Therefore, the credit channel is an extension—an enhancement mechanism—to the interest rate channel and amplifies the real effects of monetary policy through changes in the supply of bank credit \citep*{Bernanke_1995}.
The third is exchange rate channel, its works through the impact of monetary developments on exchange rates and aggregate demand and supply. For example, an increase in interest rates would normally lead to an appreciation of the exchange rate, which lowers the price of imported goods and services and thereby pushes down domestic inflation. The forth is asset price channel, its operates through the impact of monetary shocks on yields, equity shares, real estate, and other domestic assets, operating through changes in the market value of corporate and household wealth. Changes in short-term interest rates and/or other policy instruments can alter firms’ capacity for fixed investment spending through balance sheet effects, and household consumption through wealth effects \citep*{Mishkin_1996}.
The interest rate is a key channel of the monetary policy transmission mechanism, through which a central bank attempts to influence the short-term money market interest rates, and thereby the commercial bank lending and deposit rates, in order to curtail inflationary pressures while providing adequate lubrication for economic growth. The transmission of interest rate channel is broadly divided into two stages. The first stage is the interest rate pass-through from central bank tools to inter-bank money market rates. The second stage is inter-bank money market rates to retail interest rates. The retail interest rates are the lending and deposit rates of commercial banks and other non-bank deposit taking institutions.
Objective
the objective of this research are;
- To assess the effectiveness of monetary policy transmission channels in the Sri Lanka by using structural vector autoregressive (SVAR) models.
- To investigate is the interest rate channel the most important transmission channel of monetary policy.
- To examine what is the extent and speed of pass-through from monetary policy to deposit and lending rates of the banks.
Justification
The existing literature on monetary policy transmission channels is very limited for Sri Lanka. Among the available studies, Amarasekara (2005) examines interest rate pass-through and Aazim and Cooray (2012) examine monetary policy and yield curve dynamics. However, these studies do not focus on the effectiveness of monetary policy transmission channels. Whether and to what extent monetary policy will be able to transmit its impact through different channels will depend crucially on the impact of policy rate innovations on market interest rates, and hence it deserves a closer examination \citep*{Jamilov_2014}. However, this study contributes to the ever growing literature on the effectiveness of monetary policy transmission channels by evaluating its empirical importance for an emerging market economy, Sri Lanka.
Research Question
Which is most effective channel of monetary policy transmission mechanism? how is speed of pass-through determine monetary policy rates to deposit and lending rates of the banks and whether interest rate channel is most important in the monitory policy in the Sri Lanka.
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.