Monetary policy, a key tool used by economists to stimulate the economy, is one of the government's most powerful instruments for achieving long-term macroeconomic goals. However, its reliability and effectiveness from country to country have been the subject of ongoing debate among economists.
Economists Colin Bamford and Susan Grant argue in the book The Economics that while interest rate changes are a powerful policy tool, they are blunt and affect households and firms unevenly. They suggest that the rise of diverse financial instruments has weakened the influence of interest rates.
Scholars, including Team CORE, highlight external factors like currency unions that limit central governments' control over economic activities. In response to the paucity of valid research in this field, this study aims to develop a comprehensive tool that evaluates central bank policy effectiveness by integrating key variables that shape economic agents' responses to policy shifts.
Political stability significantly affects consumer and firm confidence. Consistent government policies foster an environment conducive to investment and spending, while political instability or potential drastic policy changes can undermine this confidence. To quantify political instability, I will use the World Bank’s Worldwide Governance Indicators (WGI), which compiles data from 1996 and rates countries on a scale from 0 to 100 based on six dimensions: Voice and Accountability, Political Stability and Absence of Violence/Terrorism, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption. For example, Libya scored a mean of 20.63 in 2003 and 19.7 in 2004 on the World Governance Indicators (WGI) scale, reflecting political instability. This suggests a negative relationship with the effectiveness of monetary policy. During this period, the Libyan Central Bank lowered interest rates from 3% to 2.08% in an attempt to stimulate economic activity. However, this led to a further decline in economic growth, from 13% to 4.46%, indicating a lack of public trust in the central bank's actions.
In many developing nations, the informal economy consists of businesses that operate without government registration or tax payments. This sector can be significant due to the burdens faced by formal firms, such as tax obligations. Since banks usually require registration for corporate loans, informal firms are excluded from mainstream financing and thus less impacted by interest rate fluctuations. Consequently, informal firms continue to invest and pay their employees at consistent rates, leading consumers to maintain their spending habits, as their disposable income remains unaffected by interest rates.
In contrast, formal firms are more sensitive to interest rate changes because they rely on borrowing from banks. Even a small shift in interest rates can significantly affect the cost of production for these firms.
Social and religious values significantly influence consumer and firm behavior, impacting economic outcomes and sometimes limiting the effectiveness of traditional monetary policies. In Islamic countries with strong traditional values, interest-based monetary policies can face challenges, as interest (riba) is often frowned upon. This cultural perspective may lead to lower savings rates in formal banking systems, diminishing banks' ability to lend and nullifying the intended effects of interest rate adjustments and reserve requirements set by central banks. To quantify this, I will use the Average Propensity to Consume (APC), which measures the proportion of disposable income that households spend, calculated by dividing total consumption by total disposable income (or GDP, equivalent to household income in the circular flow of income model).
Following this logic, APC serves as a factor for expansionary monetary policy, indicating how much of their income households are likely to spend. However, when assessing the effects of contractionary monetary policy, the equation should be adjusted slightly. In this case, APC becomes the relevant factor, reflecting the proportion of income that households save rather than spend, which is crucial for understanding the impact of interest rate increases.