1. Monetary Transmission Mechanism: Case of Rwanda
Dr. Thomas Kigabo Thomas

2. I. Monetary Transmission mechanism ( MTM): Definition
MTM describes the way in which monetary policy impacts aggregate demand and prices by influencing the investment and consumption decisions of:
Households;
Firms;
Financial intermediaries.

3. MTM…
Monetary policy influences economic activities in short to medium term through changes in interest rates or money supply due to:
Nominal price rigidities ( Keynesian view), and/ or
Wealth, income, liquidity effects;
MTM does not influence economic activities in long run ( neutrality of money);
Six channels: Interest rate channel; bank lending channel; balance sheet channel; asset price channel; exchange rate channel; and expectation channel.

4. II. MTM: International experience: Summary
Operation of MTM varies across countries due to
Differences in the extent of financial intermediation;
The size, concentration and health of the banking system;
The development of capital markets;
Structural economic conditions ( Checetti, 1999)

5. International experience…
The link between monetary policy instruments under the control of central bank such as short term interest rate, reserve requirement and variables that drive conditions in the nonfinancial sector such as deposit and lending rates, exchange rates and asset prices depend on the depth, breadth and structure of the financial system;
The link between financial conditions and spending/investment decisions among households and firms depend on macroeconomic environment and structure of the economy ( degree of monetization and dollarization; cash based payment systems; size of informal sector; openness of the economy; and inflows of private and official financing resources)

6. III. Interest rate channel
It works through the effect of real interest rate developments on aggregate demand;
Traditional Keynesian view: Monetary policy can influence the real cost of borrowing by setting nominal short term interest rates:
Changes in nominal interest rates lead to corresponding real interest rate changes due to price rigidities;
Changes in real interest rate ( real cost of borrowing) will have impact on investment/ consumption decision

7. Interest rate channel…
The channel is active in developed than in developing counties;
In developing countries it is constrained by different factors such as:
Low levels of monetization and financial intermediation; high level of foreign currency denominated loans to the private sector; low degree of competition between banks; high bank switching costs.
These factors limit:
the sensitivity of aggregate demand to changes in bank lending rates;
The elasticity of demand for deposits and loans.

8. Interest rate channel…
The interest rate channel is dived into two stages:
Interest rate pass-through: describes how market rates react to changes in monetary policy rete and how bank deposit and lending rates are affected by such changes
The impact of nominal interest changes on real economy.

9. Interest rate channel…
Interest rate pass through is :
Generally incomplete;
The speed of adjustment and the size of pass through in the long run vary across bank products, countries, markets in time period ( see the case study of Rwanda)

10. Selected indicators of financial sector development in Rwanda
M3/ GDP
Ass/ GDP
DP/ GDP
CPS/ GDP
Imp/ GDP
2000
20.4
15.5
10.6
14.9
2001
17.6
19.1
15.7
10.3
15.6
2002
18.1
22.0
16.7
10.7
15.1
2003
16.9
15.0
11.9
14.8
2004
23.3
14.1
15.8
2005
15.2
22.8
16.0
11.3
2006
18.7
24.9
17.9
12.1
2007
18.4
26.7
12.5
19.9
2008
15.9
13.1
24.3
2009
17.8
23.5
23.9
2010
18.8
26.2
24.7
2011
20.3
27.4
13.2
29.5
2012
27.5
30.8
2013
21.3
29.7
18.9
30.2

11. Use of the technique of locally weighted polynomial regressions (LOESS) of degree one to assess the nature of loans market (see e.g. Tarron Khemraj, 2008):
Extract the bank liquidity preference curve to measure the elasticity of excess liquidity demand to loan rate;
It is assumed that under a perfectly competitive loan market, excess liquidity and bank loans should become substitutes at a zero loan rate;
A high level of rate of substitution indicates a less competitive sector;
In Rwanda, the liquidity preference curve for the banking sector becomes perfectly elastic at around 16% confirming market power of some banks.

12. Liquidity preference curve in the banking system

13. 3 largest banks share in loans, deposits and assets
3 largest banks share in loan market which was 59.1% in average between 2002 and 2012, 66.6% and 63.3% in total deposits and assets respectively.
However, these shares have been declining showing an improvement in the banking sector competition.

14. Herfindah Index ( HI) for Rwanda

15. MTM using VAR Determine the lag length; Test the stability of the VAR;
Estimate impulse response functions
Compute Variance decomposition

16. 1. Lag determination Transformation of variables into logarithm
Instruction: Quick, generate series: ly=log(y),…
Determination of lag of VAR: use of information criteria;
Instructions: Quick, estimate VAR and enter variables: ly lp tb lm le
View, lag structure, lag length criteria

17. Determination of lags….

18. Determination of lags….
We select the lowest lag ( lag=1)
Criteria
Lag LR 5
FPE
AIC SC 1 HQ

19. II. Structural VAR ( SVAR)

20. III. Stability of VAR
Instruction: View, lag structure, AR roots table/AR roots graphs;
AR roots table

21. AR roots graphs

22. Impulse Response

23. Variance decompositions give the proportion of movements in the dependent variables that are due to their own shocks, versus shocks to the other variables because:
A shock to the variable directly affect that variable, but will also be transmitted progressivelly to all of the other variables in the system through the dynamic structure of the VAR

24. Variance decomposition