Dr. Samuel K. Nyarko¹, Dr. Lila M. Fernandes², Dr. Ahmed R. El-Badry³
¹Department of Economics, University of Nairobi, Kenya.
² School of Business and Economics, Federal University of São Paulo, Brazil
* Corresponding Author: Dr. Samuel K. Nyarko Email: [email protected]
Abstract
This paper presents a comprehensive review of existing literature on the role of monetary policy in developing economies, with an emphasis on its effectiveness in fostering economic growth and the nature of their interrelationship. The review highlights that conventional economic model often underrepresent the functions of central banks in these contexts. However, recent research underscores several determinants that influence the success of monetary policy measures in developing countries. These determinants include the operational autonomy and profitability of central banks, the presence of monetary unions, as well as structural constraints such as policy lags, institutional rigidities, and disequilibrium conditions. The findings across the reviewed studies are varied—some suggest a minimal or negligible effect of monetary policy on growth, while others emphasize its significant role. This review aims to synthesize current insights and pinpoint gaps that warrant further scholarly investigation.
Keywords: Monetary policy, Economic growth, Developing countries, Central banks, Literature review.
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1. Introduction
In recent years, monetary policy in developing economies has become an increasingly prominent topic within economic research. Traditional macroeconomic models have largely centered their focus on the functions and policies of central banks in advanced economies, often neglecting the unique conditions and institutional characteristics present in developing nations. Nonetheless, more recent studies indicate that several elements shape the effectiveness of monetary policy in these contexts, such as the operational profitability of central banks and the structure of monetary unions. Moreover, the degree of central bank independence tends to be more limited in developing countries, resulting in ambiguous or shifting policy goals. Scholars have emphasized the importance of considering factors like policy lags, institutional rigidities, and disequilibrium dynamics when analyzing short-term macroeconomic performance in these economies. This section introduces the state of academic inquiry into monetary policy in the developing world and outlines the principal issues and obstacles faced by monetary authorities in these regions.
Monetary policy encompasses the strategies implemented by central banks to influence a nation’s money supply and interest rate levels. Pioneering economists such as Friedman, Cagan, Mishkin, and Tanzi have pointed out that expanding the money supply generally boosts credit availability, while a decrease in interest rates can encourage monetary demand. Yet, the practical impact of monetary policy depends on numerous variables, including the sensitivity of money demand to changes in income and interest rates, the responsiveness of overall spending to interest rate adjustments, and the extent of capital mobility in open economies. On the supply side, structural conditions—like labor market performance and productive capacity—can also moderate the effects of monetary policy interventions. Furthermore, the aims of monetary policy and the scale of the government’s fiscal deficit are essential considerations in assessing the policy’s potential influence on economic performance. Consequently, a well-rounded evaluation of monetary policy outcomes necessitates accounting for both the enabling factors and constraints that exist on the supply and demand sides of the economy.
The linkage between monetary policy and economic growth continues to be a subject of debate, with empirical studies producing diverse conclusions. Some research asserts that monetary policy has little to no measurable effect on economic growth, while other studies argue it plays a pivotal role in shaping economic performance. For example, works by Cyrus and Elias (2014) and Lashkary and Kashani (2011) suggest that monetary policy exerts minimal influence on real output. In contrast, research by Havi and Enu (2014) and Rasaki et al. (2013) presents evidence of a substantial positive impact of monetary policy on economic growth. These discrepancies often reflect differences in country-specific conditions and the nature of the monetary tools applied. The purpose of this paper is to synthesize current academic perspectives on monetary policy in developing countries. It will examine the distinct features of monetary policy in these contexts, evaluate its effectiveness in promoting economic growth, and review the relevant empirical literature. The overarching aim is to deliver a clear and thorough understanding of current research trends while identifying gaps that merit further investigation.
2.Specific Characteristics of Monetary Policy in Developing Economies
Traditional macroeconomic models that attempt to define a reaction function for monetary authorities often prioritize the experiences and institutional frameworks of central banks in advanced economies. In contrast, the monetary operations of central banks in developing nations have historically received limited scholarly attention. A prevailing assumption has been that these institutions were primarily established to finance public deficits. Nonetheless, recent research has shown growing interest in exploring the complexities of monetary policy within developing economies, identifying a range of variables that influence its effectiveness—including central bank profitability (Buiter, 2008) and the dynamics of monetary unions (Kamar and Naceur, 2007).
Notably, scholars have distinguished between two fundamental approaches to monetary policy: accommodative and stabilizing. Accommodative policy refers to monetary actions that sustain the provision of credit to support economic expansion. Stabilizing policy, in contrast, is designed to counteract undesirable economic fluctuations. Under an accommodative regime, money supply growth aligns with increases in output and inflation. Under a stabilizing regime, the monetary authority adjusts money supply growth in response to various macroeconomic shocks, guided by the central bank’s policy objectives.
One of the persistent challenges for many developing countries is the limited autonomy of their central banks. This lack of independence often leads to ambiguous policy goals and restricted institutional effectiveness. Scholars such as Behrman (1981) and Crockett (1981) emphasize the importance of considering temporal lags, structural rigidities, and disequilibrium frameworks when analyzing short-term macroeconomic behavior in these regions. In parallel, Porter and Ranney (1982) have examined the structural divergences between the financial systems of developed and developing countries, highlighting how these differences shape monetary policy outcomes.
In practice, central banks in developing countries may prioritize economic growth as part of their stabilizing function. This often involves expanding liquidity to spur credit growth and stimulate demand during economic downturns. In more interventionist frameworks, governments may assume an active role in shaping economic and social development, with central banks compelled to finance escalating public expenditures. This, however, presents a potential conflict: when government borrowing rises substantially, it may absorb available credit resources, thereby crowding out private sector investment (Bean and Buiter, 1989).
The extent to which public sector borrowing displaces private investment has been a focus of empirical inquiry. One research stream evaluates how government expenditure influences interest rates (Evans, 1987), while another examines how sensitive investment demand is to changes in borrowing costs (Chirinko, 1993). Moreover, when increased public spending is not effectively directed toward enhancing productive capacity, it can generate inflationary pressures. Financing such expenditure through monetary expansion can also erode foreign exchange reserves in small open economies, often prompting currency devaluation. This, in turn, can trigger a destabilizing cycle of depreciation and inflation.
To navigate these challenges, some central banks rely on nominal anchors to structure their monetary frameworks. In small open economies, a fixed exchange rate often serves as a nominal anchor. However, this significantly reduces the central bank’s ability to adjust interest rates independently, since efforts to defend the exchange rate may contradict domestic monetary needs or strain foreign reserves.
In contexts where inflation poses a more immediate threat than exchange rate instability, some developing countries have shifted toward inflation targeting as their preferred nominal anchor. Under this regime, monetary authorities monitor a range of economic indicators to guide the inflation process, adjusting the money supply accordingly. Although this approach enhances transparency, it still limits discretionary policymaking.
Alternatively, in settings where greater operational independence is granted to central banks, a more discretionary and adaptive approach may be adopted. Here, the monetary authority may quietly prioritize objectives such as exchange rate stability, price control, or output growth, depending on prevailing macroeconomic conditions. These objectives may not always be publicly announced but are reflected in policy actions.
Regardless of the specific monetary policy objectives, fluctuations in the money supply ultimately influence both economic output and inflation. The transmission of monetary policy to the real economy primarily occurs through changes in aggregate demand. The extent to which demand shifts in response to monetary expansion depends on the liquidity effect and the responsiveness of aggregate demand to such changes. However, if inflation expectations rise or if capital flight occurs, the stimulative effect of monetary policy can be muted due to crowding-out pressures.
Furthermore, even when monetary policy effectively boosts aggregate demand, the distribution of that increased demand between real output and price inflation depends on supply-side conditions. Structural constraints—such as limited productive capacity—can intensify inflationary pressures. Still, the presence of wage and price rigidities may dampen nominal effects and enhance the real impact of monetary policy.
3. Effectiveness of Monetary Policy
From a theoretical perspective, expanding the money supply is expected to enhance credit availability within the economy. This fundamental idea has been advanced by prominent economists including Friedman (1968), Cagan (1972), Mishkin (1981), Tanzi (1984), and Mishkin (1988). To reestablish equilibrium in the money market following such an increase, it is necessary to lower interest rates, thereby encouraging a higher demand for money holdings. This dynamic has been thoroughly investigated by scholars such as Colleman, Gilles, and Labadie (1992), Leeper and Gordon (1992), Fama (1990), Mishkin (1992), Wallace and Warner (1993), Evans and Lewis (1995), and Soderlind (1997, 1999), all of whom have explored the liquidity effects stemming from monetary expansion.
In the context of the goods market, reduced interest rates tend to stimulate aggregate spending. As aggregate income rises, this in turn generates an increased demand for money, which partially counterbalances the initial need to lower interest rates further. The overall efficacy of monetary policy in stimulating aggregate demand is shaped by three critical elasticities: (i) the responsiveness of money demand to changes in income, (ii) the sensitivity of money demand to fluctuations in interest rates, and (iii) the elasticity of aggregate spending with respect to interest rate movements.
The effectiveness of monetary intervention diminishes when money demand reacts strongly to income growth. Following a monetary expansion, a pronounced increase in money demand as income rises helps close the gap between supply and demand in the money market, which consequently reduces the extent of the necessary decline in interest rates. Conversely, when the demand for money exhibits limited sensitivity to interest rates, monetary policy is rendered less efficient, as achieving equilibrium requires a larger reduction in borrowing costs. The impact is amplified if aggregate spending shows a high degree of responsiveness to interest rate changes, thereby intensifying shifts in demand when monetary shocks occur.
While this mechanism is typically described within a closed-economy framework, an open economy introduces additional complexities. In such settings, variations in interest rates can significantly affect cross-border capital flows. For example, when domestic interest rates fall, capital outflows tend to accelerate while capital inflows diminish. This process can erode foreign exchange reserves and contract the monetary base, thereby reducing the effectiveness of monetary expansion. Exchange rate adjustments further compound these effects. As reserves dwindle, monetary authorities may choose to curb domestic credit in an effort to lift interest rates and attract foreign capital. Under a floating exchange rate regime, rising net capital outflows generally cause the currency to depreciate, enhancing export competitiveness. The resulting boost to net exports can partially offset the contractionary impact and reinforce the stimulus generated by monetary policy.
Supply-side factors also exert a critical influence on how monetary policy transmits to the real economy. Lane and Perotti (1996) investigated the role of labor market dynamics in determining the constraints on output expansion. When wages and prices are more flexible, monetary policy is more likely to drive up inflation rather than significantly increasing output. Likewise, capacity limitations can dampen the responsiveness of production to monetary stimulus, necessitating quicker adjustments in price levels. Accelerated inflation diminishes real money balances and raises nominal interest rates, thereby countering the expansionary pressure on aggregate demand. The scale of the price surge ultimately dictates the degree to which higher costs crowd out spending in the product market.
Additional complexities also arise from the broader policy environment. The specific objectives pursued by monetary authorities are highly relevant to assessing policy effectiveness. For instance, if money supply growth is coupled with persistent government budget deficits, the central bank may be forced to deplete already limited foreign reserves to finance public expenditures. This dynamic often fuels inflation expectations, prompting a decline in money demand and hastening price increases. Should confidence in the stability of the exchange rate deteriorate, devaluation can become unavoidable, further intensifying inflationary pressures and undermining policy credibility (Caballero and Pyndick, 1996). In such circumstances, uncertainty can dampen foreign direct investment and accelerate capital flight, exacerbating macroeconomic instability.
In light of these intricate channels of interaction within the macroeconomic system, evaluating the effectiveness of monetary policy requires a careful examination of multiple parameters. Analysts must assess both the flexibility of economic structures and the constraints imposed by domestic and external factors on the supply and demand sides. Only by systematically analyzing these relationships can policymakers and researchers form a comprehensive understanding of how monetary interventions translate into real economic outcomes in developing countries.
4. A Survey of the Empirical Literature on the Relationship between Monetary Policy and Economic Growth
A substantial body of empirical research has attempted to clarify how monetary policy influences economic growth, yet scholars have not reached a uniform conclusion. Certain studies contend that monetary policy’s impact on growth is negligible or altogether absent. For example, Cyrus and Elias (2014) employed a recursive VAR methodology on Kenyan time series data spanning 1997 to 2010 to estimate how monetary and fiscal policy shocks affect economic output. Their analysis revealed that monetary policy tools—whether money supply or short-term interest rates—exerted only a minimal influence on real output levels. The authors attribute this limited connection primarily to weak structural conditions, institutional shortcomings, and regulatory deficiencies within the Kenyan economic environment (Cyrus and Elias, 2014).
Similarly, Lashkary and Kashani (2011) applied econometric regression grounded in a monetarist framework to assess Iran’s experience between 1959 and 2008. Their findings indicated no significant statistical relationship between variations in the money supply and real economic indicators such as GDP growth and employment (Lashkary and Kashani, 2011).
In contrast, a number of studies have documented that monetary policy can play a decisive role in driving economic performance. Havi and Enu (2014) explored the comparative influence of fiscal and monetary policies on Ghana’s economic growth over the period from 1980 to 2012. Utilizing ordinary least squares (OLS) estimation, they demonstrated that money supply as a monetary policy instrument had a meaningful positive effect on Ghana’s GDP growth (Havi and Enu, 2014). In Sri Lanka, Vinayagathasan (2013) estimated the macroeconomic impact of monetary policy by constructing a structural VAR model with seven variables, using monthly observations from January 1978 to December 2011. The analysis showed that shocks to interest rates had a statistically significant impact on real output, in alignment with theoretical predictions. However, when a positive currency shock was introduced, the output response was significant but inconsistent, occasionally declining instead of rising (Vinayagathasan, 2013).
Other research further supports the view that monetary instruments contribute meaningfully to growth. Rasaki et al. (2013) used OLS regression and a correlation matrix to investigate the respective impacts of fiscal and monetary measures on Nigeria’s economic development between 1998 and 2008. Their results indicated that monetary aggregates such as narrow and broad money were important determinants that positively influenced Nigeria’s real GDP growth (Rasaki, Afolabi, Raheem, and Bashir, 2013).
Davoodi, Dixit, and Pinter (2013) conducted a study of monetary transmission mechanisms across the East African Community by applying three variants of structural VAR models on monthly datasets covering 2000 to 2010. They discovered that while traditional statistical inference revealed a generally weak transmission of monetary policy to output, alternative non-standard inference techniques detected somewhat stronger effects. For instance, expansionary monetary policy—reflected in positive shocks to money reserves—resulted in significant output increases in Burundi, Rwanda, and Uganda. Conversely, when the policy rate was lowered (a negative shock), output rose in Burundi, Kenya, and Rwanda (Davoodi, Dixit, and Pinter, 2013).
Complementing this work, Berg et al. (2013) employed the narrative approach pioneered by Romer and Romer (1989) to assess monetary transmission mechanisms in Uganda, Kenya, Tanzania, and Rwanda. Their findings provided clear evidence of effective policy transmission: when policymakers raised short-term interest rates considerably, market lending rates climbed, domestic currencies appreciated, and output growth slowed as expected (Berg, Charry, Portillo, and Vlcek, 2013).
Fasanya, Onakoya, and Agboluaje (2013) examined Nigeria’s monetary policy impact by employing an error correction model (ECM) over the period 1975–2010. Their analysis revealed a long-run equilibrium relationship among the variables. Specifically, the inflation rate, exchange rate, and external reserves emerged as critical policy instruments supporting growth, in line with conventional economic theories. However, they concluded that money supply itself did not have a statistically significant impact (Fasanya, Onakoya, and Agboluaje, 2013).
In a similar context, Onyeiwu (2012) investigated the Nigerian economy using OLS estimation over the years 1981–2008. This study found that the money supply positively contributed to GDP growth, underscoring the relevance of monetary policy in the country’s macroeconomic management (Onyeiwu, 2012).
Research outside Africa has also enriched the debate. Coibion (2012) evaluated the effects of monetary shocks on the U.S. economy between 1970 and 1996, contrasting the conventional VAR model with the Romer and Romer (2004) identification strategy. The findings demonstrated that when using the standard VAR approach, monetary policy shocks accounted for only a minor portion of variability in real economic indicators such as industrial production and unemployment. Moreover, the recessions of the early 1980s and early 1990s were not adequately explained by standard VAR estimates. By contrast, estimates from a DSGE model by Smets and Wouters (2007) highlighted larger average effects of monetary shocks on output and other real variables (Coibion, 2012).
Finally, Jawaid, Qadri, and Ali (2011) analyzed how monetary, fiscal, and trade policies shaped economic growth in Pakistan using annual time series data from 1981 to 2009. Applying cointegration techniques and ECM analysis, they established a significant positive relationship between money supply and economic growth in both the long and short term (Jawaid, Qadri, and Ali, 2011).
Amarasekara (2009) employed both recursive VAR and semi-structural VAR methodologies on monthly data covering the period from 1978 to 2005 to evaluate the influence of monetary policy on economic growth and inflation in Sri Lanka, a small, developing, and open economy. The findings from the recursive VAR analysis aligned closely with those obtained from the semi-structural VAR approach, demonstrating a significant negative correlation between interest rate adjustments and economic growth. Specifically, positive shocks to interest rates were associated with reductions in GDP growth. However, when alternative indicators such as money growth and exchange rate fluctuations were incorporated into the analysis, the observed impacts on GDP diverged from conventional theoretical expectations (Amarasekara, 2009).
In another study, Muhammad et al. (2009) applied Johansen’s cointegration technique to investigate the long-run dynamics between money supply (M2), government expenditure, and economic growth in Pakistan. Using annual data spanning 1977 to 2007, their results revealed a positive and significant long-term relationship between broad money supply and economic growth, underscoring the relevance of monetary aggregates in influencing Pakistan’s macroeconomic performance (Muhammad, Wasti, Lal, and Hussain, 2009).
Rafiq and Mallick (2008) analyzed how monetary policy shocks impact output in three major euro-area economies—Germany, France, and Italy—by employing a novel VAR identification procedure. Their results indicated that monetary policy innovations exerted the most pronounced effects in Germany, where policy-induced changes in interest rates translated more consistently into output fluctuations. Conversely, in France and Italy, the relationship between rising interest rates and declining output remained ambiguous, highlighting the lack of uniformity in policy transmission across the European Monetary Union. Overall, the authors concluded that while monetary policy shocks do contribute to variations in economic output, their role in driving broader cyclical fluctuations is relatively modest (Rafiq and Mallick, 2008).
Balogun (2007) focused on the macroeconomic stability and monetary policy stance of countries within the West African currency area, analyzing quarterly data from 1991:Q1 to 2004:Q4. The regression outcomes suggested that monetary policy—proxied by money supply growth and credit extended to government—had adverse effects on real domestic output in these economies. Additionally, interest rate policy was shown to negatively influence GDP, contradicting the traditional expectation of an inverse relationship between interest rates and output. Moreover, exchange rate devaluations appeared to have no significant impact on production levels (Balogun, 2007).
Smets and Wouters (2007) developed and calibrated a dynamic stochastic general equilibrium (DSGE) model incorporating nominal rigidities in prices and wages to analyze the euro area. This model was estimated using Bayesian techniques and included seven core macroeconomic variables—GDP, consumption, investment, price levels, real wages, employment, and nominal interest rates. By introducing ten orthogonal structural shocks, including those related to productivity, labor supply, investment, preferences, cost-push pressures, and monetary policy, the study offered a robust empirical framework to gauge the effects of shocks and their contribution to business cycle volatility. Their findings highlighted that monetary policy shocks played a substantial role in driving output fluctuations within the euro area (Smets and Wouters, 2007).
Khabo and Harmse (2014) assessed the impact of monetary policy in South Africa by employing OLS regression techniques on annual data from 1960 to 1997. Their analysis demonstrated that the broad money supply (M3) and inflation were both significantly associated with economic growth, supporting the conventional theoretical perspective that monetary aggregates can meaningfully influence macroeconomic performance (Khabo and Harmse, 2014).
In a more recent contribution, Daoui and Benyacoub (2021a) applied a Factor-Augmented Vector Autoregression (FAVAR) model to evaluate how monetary policy shocks affect economic growth in Morocco. Drawing on an extensive dataset of Moroccan macroeconomic time series from 1985 to 2018, the FAVAR approach summarized a large body of information into a limited set of latent factors. Their results indicated that unexpected shifts in monetary policy had a negative effect on GDP, as evidenced by an overall decline in output following such shocks.
Expanding upon this line of inquiry, Daoui and Benyacoub (2021b) utilized an advanced Factor-Augmented Error Correction Model (FECM) to further explore the relationship between monetary policy and growth in Morocco. Based on 117 quarterly series over the same 1985–2018 timeframe, the FECM integrated the strengths of dynamic factor models with the properties of error correction modeling, thereby accounting for non-stationarity in the underlying data. Their analysis revealed that the FECM yielded insights consistent with those obtained through the FAVAR model, while also highlighting the value of this methodological extension for capturing long-run equilibria and short-run adjustments in response to monetary shocks.
5. Conclusion
Historically, scholarship on monetary policy in developing economies has concentrated primarily on the role of central banks in financing public sector deficits. In recent years, however, there has been a growing body of research dedicated to exploring the effectiveness of monetary policy in these contexts. Emerging studies have examined diverse factors—such as the profitability of central banks and the function of monetary unions—that may influence how effectively policy instruments operate. The evidence indicates that central banks in many developing countries often lack operational independence, a limitation that contributes to ambiguity in setting clear monetary policy objectives. Furthermore, some analyses have investigated how government spending affects interest rates and the responsiveness of investment demand.
As a result, monetary authorities in these economies frequently rely on nominal anchors, such as exchange rate stabilization or inflation targeting frameworks, to guide the conduct of policy. While such anchors can enhance credibility, they often constrain monetary policy autonomy. Ultimately, the degree to which monetary policy succeeds in fostering economic expansion and maintaining price stability depends critically on the nature of supply-side constraints and the extent to which public expenditure may crowd out private sector activity.
The ability of monetary policy to stimulate aggregate demand is determined by several interrelated factors. Chief among these are the elasticities of money demand with respect to fluctuations in income and interest rates, as well as the sensitivity of aggregate spending to movements in borrowing costs. As monetary policy becomes more effective, the demand for money tends to be less responsive to interest rate variations, necessitating a deeper understanding of these dynamics. In open economies, the analysis is further complicated by the impact of interest rate changes on capital mobility and exchange rate adjustments. Additionally, broader structural considerations—including labor market flexibility, capacity constraints, and the scale of fiscal deficits—can significantly shape the outcomes of monetary interventions.
While extensive empirical research has been undertaken to evaluate the influence of monetary policy on economic growth in developing countries, no consensus has yet emerged. Certain studies conclude that monetary policy exerts limited or negligible effects, whereas others find robust evidence supporting its pivotal role in driving economic performance. Overall, the literature suggests that the relationship between monetary policy and growth is inherently complex, context-specific, and warrants further investigation to deepen understanding of these critical interactions.
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