Monetary Policy Transmission Mechanism
The key transmission channels of monetary policy in the Zambian Quarterly Models (ZQM) are the following:
- Interest rate channel;
- Exchange rate channel; and,
- Expectations channel (included via the lags of macroeconomic variables or adaptive expectations).
Interest rate channel – This operates through changes in the BoZ Policy Rate, which directly affect banks’ lending rates given that the Policy Rate is the reference rate for banks’ pricing of their credit products. Changes in the lending rates are then expected to impact inflation through the price equation in the models. Adjustments in the Policy Rate are also transmitted through changes in monetary aggregates (broad money), and ultimately inflation. The interest rate channel is also reflected in the aggregate demand equation through the real lending rate, with the higher real lending rate induced by upward adjustment in the Policy Rate dampening aggregate demand and moderating inflationary pressures.
Exchange rate channel – Changes in the Policy Rate will also work through the exchange rate channel. An increase/decrease in the Policy Rate should result in an appreciation/depreciation in the exchange rate, leading to a decline/increase in consumer prices. The exchange rate channel is also reflected in the aggregate demand equation, where changes in the real exchange rate following adjustments in the Policy Rate can result in changes in net exports, aggregate demand and ultimately consumer prices.
Expectations channel – This works through the expectations economic agents form about key macroeconomic variables, such as the exchange rate. For instance, expectations of a depreciation in the exchange rate is likely to result in upward revision of consumer prices, thereby exerting inflationary pressure on overall prices. An increase in consumer prices will result in economic agents’ expectation of higher interest rates in the future to contain inflationary pressures, a situation which may lead to increased aggregate demand and heightened inflationary pressures in the short-run.
In the extended version of ZQM, the interest rate channel is also reflected in the equation of the 5-year government bond yield rate, which is assumed to depend on the Policy Rate in the long-run. In the short-run, the fiscal deficits in the model are transmitted to average lending rates through changes in the 5-year bond yield rate with increases in bond yield rates pushing up average lending rates.