The previous subsection demonstrated that there is a theoretical and empirical literature providing evidence that institutional development has a positive impact on economic performance. In addition, there is a literature showing that institutions determine
macroeconomic variables as government spending, inflation and exchange rates. In Mihal (2009) and Duncan (2011) institutions determine monetary policies. In the first,
corruption determines seigniorage and taxes. In the second paper, output movements interact with institutional quality determining central bank discount rates.
This research has a strong association with the literature that poses institutional development as a factor that changes the effectiveness of monetary policies. This is the case of Hardt (2011), who claims that economies with low institutional development tend to be investment constrained, a characteristic that alters the effectiveness of monetary policies. However, the paper does not present any empirical evaluation. Mishra et al. (2010) is another paper included in that literature. However, they investigate only whether the transmission from central bank discount rates to bank lending rates is dependent upon institutions. They do not investigate the effects on output and they do not study positive and negative changes in interest rates separately.
Cecchetti (1999) and Aysun et al. (2013) are the only papers that somehow test whether the effectiveness of monetary policies on output is dependent upon a measure of institutional development. However, there are many reasons to believe that this research will certainly move our understanding of the role played by institutional development in the transmission of monetary policies forward.
monetary policies on output is dependent upon institutional development, considering positive and negative changes in interest rates as two different phenomena. This
discrimination was never used in the literature on monetary policy and institutions and can enhance the quality of our empirical results, given the evidence that monetary policies have asymmetrical effects on output (Cover (1992), Rhee and Rich (1995), Garibaldi (1997), Karras and Stokes (1999), among others), meaning that expansionary policies have smaller and less statistically significant effects on output than contractionary policies. This fundamental differentiation also appears in the motivational theory presented in this research, which provides a unique perception of the role played by institutional development in the transmission of expansionary and contractionary policies.
Hypothesis 2 of this dissertation states that monetary contractions have more adverse effects on output in countries with low institutional development than in countries with high institutional development. Hypothesis 3 of this dissertation states that monetary expansions are more effective in terms of output promotion in countries with high
institutional development than in countries with low institutional development. These hypotheses imply that the degree of asymmetry of monetary policies on output increases with the worsening of the institutional development. Thus, as a very relevant contribution, this dissertation provides a potential explanation for the asymmetric effects of monetary policies on output: the degree of institutional development.
Second, we propose a panel methodology, which is appropriate for comparative analysis across countries and for understanding the effects of common monetary policies, as opposed to monetary shocks. In Cecchetti (1999) and Aysun et al. (2013) the empirical tests are based on impulse response functions, being more appropriate to test the impact of
monetary policy shocks rather than the impact of common monetary policies. In addition, the time series methodology used in these two papers is also not very suitable for
comparative analysis across countries.
Third, we will test whether the effectiveness of monetary policies on output is dependent upon institutional development using a larger sample of countries than the one presented in Cecchetti (1999). Cecchetti’s paper studies only developed countries
(Belgium, France, Germany, Ireland, Italy, Portugal, Spain, Denmark, Sweden, United Kingdom and United States). This contribution is valuable because the question proposed in this research is especially important for developing countries, where the lack of
institutional development may explain some monetary policy failures, for example. Thus, the presence of emerging and developing economies in our sample is an important feature of this research.
Fourth, a larger set of institutional development indicators is used in our empirical analysis than in Aysun et al. (2013) and Cecchetti (1999). Aysun et al. (2013) uses in the empirical analysis the countries’ legal origin and a measure of institutional quality built as an average of law and order, corruption and bureaucratic quality and Cecchetti (1999) focuses on the quality of the legal system. In this research, we will investigate separately the effect on the strength of monetary policies of six aspects that characterize institutional development: quality of the legal system, level of corruption, political stability,
government’s accountability and transparency, regulatory quality and government effectiveness. This is an important contribution because it will indicate the specific features of the institutional development that matter most for the effectiveness of monetary policies.
Fifth, we propose the development of a comprehensive theoretical framework. The literature review showed that the theoretical framework presented in Cecchetti (1999) to support his empirical evaluation is based on the idea that institutions determine the financial structure quality, thus determining the effectiveness of monetary policies. His theoretical framework is limited to explain how institutions affect the supply of financial resources, not including the fact that low institutional development countries may be investment constrained, as proposed by Rodrik and Subramanian (2009). On the contrary, the theoretical framework presented in Hardt (2011) is limited to explain how institutions affect the demand for financial resources. Finally, the theoretical framework presented in Mishra et al. (2010) is the only one also expressed in terms of mathematical equations with banks maximizing a profit function. The model shows that the optimal response in bank lending rates after a change in central bank discount rates is a function of
institutional quality. However, the theoretical framework presented in Mishra et al. (2010) is limited to explain how institutions affect the supply of financial resources. The
theoretical framework presented in Aysun et al. (2013) is focused on the role of financial frictions rather than on the role of institutional development. We can realize that the papers about monetary policy transmission and institutional development focus only on the supply of financial resources or on the demand for financial resources, that is, they focus on the financial constraints (Cecchetti (1999) and Mishra et al. (2010)) or on the demand for investments (Hardt (2011)). These non-competing explanations will be put together for the first time in a more complete theoretical framework proposed by this research, that is, in this research we consider that institutions affect the supply and the demand for financial resources.
And finally, it is also relevant to mention that Cecchetti (1999) and Aysun et al. (2013) are essentially monetary policy papers, without a clear association with the institutional economics literature and its main authors (North, Acemoglu, Rodrik, among others). This research, on the contrary, brings together the two strains of the literature, institutional economics and monetary policy, making a contribution to both of them. In Cecchetti (1999), a measure of monetary policy impact is regressed on a measure of financial structure quality, using three measures of legal quality (shareholder rights, creditor rights and law enforcement) as instruments for financial structure quality. According to Rodrik (2004), a good econometric instrument does not provide a good explanation, meaning that it is not appropriate to build a theory stating that the differences in the dependent variable are explained by the differences in the instrumental variable. This means the empirical analysis in Cecchetti (1999) does not evaluate the relationship between institutions and monetary policies, being limited to evaluate the relationship between the exogenous component of the financial structure and monetary policies. And in Aysun et al. (2013), the theoretical focus is on the financial frictions (the cost of monitoring borrowers or the bankruptcy recovery rate - the percentage of the value of a loan that banks can recover when there is default) rather than on institutional development.
5
Theoretical Framework
In this section we explain how some of the traditional channels of monetary policy transmission can be altered by the level of institutional development. We present some important definitions and detail which aspects of the institutional development matter for monetary policy diffusion. Finally, we develop the three hypotheses that will be tested in the following sections.
5.1
Some Definitions
First, we will follow North (1990) and define institutions as the formal and informal rules that determine the incentives and constraints in a society, shaping human economic behavior.
Second, institutional development is a measure that evaluates the quality of the rules or the quality of incentives and constraints in a society. We will follow Kaufmann, Kraay, and Mastruzzi (2010) and argue that the quality of the institutions in a society depends on the following characteristics: the respect of citizens and the state for the institutions that govern economic and social interactions, the capacity of government to effectively formulate and implement sound policies, and how governments are selected, monitored and replaced.
Thus, the level of institutional development increases with: the quality of contract enforcement, the protection of property rights, the level of protection against the use of public power for private gains, the government’s capability to implement sound policies and regulations that promote private sector development, the citizens’ participation in
government’s stability.
Finally, in this study monetary policies will be represented by central bank discount rates and, as a consequence, monetary policy transmission refers to the process through which changes in central bank discount rates influence the real output.
The choice of an interest rate over some monetary aggregate as the instrument of monetary policy finds support in the literature on monetary economics. According to Friedman and Kuttner (2011), the idea that central banks make monetary policy through the set of some interest rate is clear enough and broadly accepted. First, most central banks abandoned the money growth targets, which were used mostly during the 1980s. Second, differently from what is presented in conventional economics textbooks, Friedman and Kuttner (2011) demonstrates that, currently, the practical set of short-term interest rates by central banks involves little or no variation in the supply of reserves. This means that it is the announcement effect and not the liquidity effect that matters most for the set of central bank interest rates. In addition, Bernanke and Blinder (1992) concludes that the federal funds rate is a better indicator of monetary policy and a better forecaster of real variables than money growth rates for the United States. Finally, Ball (2011) states that most central banks in emerging and advanced economies pay little attention to monetary aggregates.
The central bank discount rate is the rate at which the central banks lend or discount eligible paper for deposit money banks. We select the central bank discount rate as the relevant monetary policy instrument because, in general, the monetary authority has direct control over this rate. The selection of the central bank discount rate as the
appropriate instrument of monetary policy applies both to the theoretical motivation in this section and to the data choice in the empirical sections that follow.