The response of retail interest rates to changes in policy rates is sluggish.
than when the market was not open.
Stiglitz & Weiss (1981) provide another explanation for interest rate rigidity based on information asymmetry. If the risk of bankruptcy of commercial banks is high, these banks will maintain a large spread between lending and deposit rates. And if this cushion is large, lending rates may be insensitive to a small change in the policy rate.
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On the other hand, the level of financial market development also has an impact on the degree of interest rate adjustment. In a highly developed financial market, there are many instruments and intermediary institutions for investors and depositors to choose from. In such a market, there is no intermediary institution that holds centralized power and therefore, as discussed above, interest rate adjustment will be very flexible.
1.2.2 Asymmetric adjustment behavior of retail interest rates
As mentioned above, if the policy interest rate or interbank interest rate has an equilibrium relationship with the retail interest rate, then when the retail interest rate moves away from the equilibrium position, an adjustment process will take place. If the adjustment speed changes due to market conditions or market information, the markup 12 or markdown of the pass-through and the pass-through coefficient may be different. This is an asymmetric case.
in transmission. Conversely, if the markup or markdown rate and the transmission factor are not different, this case is called symmetric transmission mechanism.
Many studies believe that the reason why retail interest rate adjustment is rigid is due to the asymmetric adjustment process of retail interest rates. According to Hannan & Berger (1991); Neumark & Sharpe (1992), there are two causes of asymmetry: the collusive pricing arrangements hypothesis and the consumer behavior or customer reaction hypothesis.
12 Coefficient β1 (additive coefficient) in the retail interest rate pricing model (Rousseas, 1985), see equation (1.2) section 1.1.2. In case coefficient β1 has a negative value, it is called markdown (Wang & Lee, 2009).
The implied rigidity in raising deposit rates and lowering lending rates. This means that when the policy rate increases, banks will compromise with each other to slow down the increase of deposit rates and when the policy rate decreases, commercial banks will also slow down the decrease of lending rates. The consumer behavior hypothesis implies rigidity in lowering deposit rates and raising lending rates. According to this theory, deposit rates will maintain a rigid downward trend when the policy rate decreases while lending rates will maintain a rigid upward trend when the policy rate increases.
The pricing trade-off hypothesis is based on concentrated market conditions. Neumark & Sharpe (1992) in their study of US interest rate adjustment found that banks in highly concentrated markets were slower to adjust deposit rates higher but faster to adjust lending rates higher. They concluded that while banks were slow to adjust interest rates upward when market rates rose and quick to adjust interest rates downward when market rates fell, in concentrated markets banks’ adjustment behavior seemed to allow them to generate more surplus from deposits than banks in less concentrated markets. Hannan & Berger (1991) found that banks in highly concentrated markets were more rigid in adjusting interest rates ceteris paribus. According to Scholnick (1999) in the lending market, only under the condition that firms have control over the market can they be sure that lending rates will slowly move towards lower levels as policy rates fall.
Hannan & Berger (1991) also argue that asymmetric adjustment of retail interest rates also stems from customer bias, which is often referred to in studies as the consumer behavior hypothesis. This hypothesis argues that in competitive market conditions, banks are interested in asymmetric adjustment of interest rates to retain customers. Bank lending rates are slowly moving towards higher levels, while deposit rates are slowly moving towards lower levels. The reason why banks do this is because of the fear that large customers may switch to other banks.
provide other services if the bank does not adjust interest rates disproportionately according to consumer bias.
According to the information asymmetry cost hypothesis, Stiglitz & Weiss (1981) pointed out the problem of adverse selection and moral hazard. If banks increase their lending rates, they will attract riskier investors (adverse selection) or increase their lending rates, which will create incentives for borrowers to accept riskier projects (moral hazard). In other words, banks anticipate that their earnings may decline in the short term when they increase their lending rates even if the cost of funds increases and the probability of default is high enough. For these reasons, banks will instead set their lending rates below the market interest rate. In this case, the bank's lending rates show a slow upward trend.
Bondt (2002) argues that the inelasticity of demand for retail banking products may also be due to the existence of switching costs and asymmetric information costs. Switching costs arise when bank customers consider switching from one bank to another. For example, when a household wants to transfer their savings from bank A to bank B, switching costs such as information gathering, research and administrative costs will become significant in markets where information and transaction costs are significant. However, even in cases where switching costs are small, the theory predicts that only a small proportion of customers will switch to another market, so the elasticity of demand will not increase and prices will become less competitive. Bondt (2002) also argues that switching costs often lead to market segmentation and reduced elasticity of demand. Even with non-cooperative behavior, switching costs result in retail interest rate adjustments of less than 1 to changes in market interest rates.
In empirical studies, Scholnick (1996) failed to reject the price-matching hypothesis in Malaysia and Singapore. The results in Ender and Granger (1998) showed that the asymmetric error correction model can explain the equilibrium relationship between short-term and long-term interest rates in
USA. Frost & Boeden (1999) find an asymmetric relationship between mortgage rates and CD rates in New Zealand. Bolh & Siklos (2002) find an asymmetric cointegration relationship between short-term and long-term interest rates in Germany. Lim (2001) empirical results indicate that there is rigidity in both deposit and lending rate adjustments in Australia.
1.2.3 Impact of monetary policy transparency, dollarization issue
In theory, transparency is understood as a state of information symmetry. Reducing information asymmetry between monetary policy makers and the private sector can increase monetary policy transparency. Geraats (2002) pointed out five different aspects of central bank transparency including political transparency, economic transparency, procedural transparency, policy transparency and operational transparency.
- Political transparency involves making policy objectives and institutional arrangements public so that policymakers' motives are clear. This includes clear views on inflation targeting, central bank independence, and other constraints.
- Economic transparency focuses on the economic information used in monetary policy including economic data, usage patterns and central bank forecasts.
- Procedural transparency describes how monetary policy instrument decisions are implemented.
- Policy transparency means promptly announcing and explaining policy decisions.
- Operational transparency regarding the implementation of monetary policy decisions including discussion of control failures over operating instruments and disturbances in macroeconomic transmission.
Several studies analyzing the effects of central bank announcements regarding reserve targets show that policy secrecy has the effect of increasing interest rate uncertainty. Tabellini (1987) shows that the presence of target uncertainty
average reserves, keeping the short-term reserve targets secret increases the volatility of the Fed's base rate, which may be detrimental to the achievement of monetary targets. Rudin (1988) found that keeping the short-term monetary policy target secret can increase the predictability of the federal funds rate. However, the issue of measuring transparency of the studies Tabellini (1987), Rudin (1988) has not been agreed upon. Specifically, Eijffingery & Geraats (2003) used a scoring survey to assess the level of central bank transparency in a group of 10 countries including Australia, Canada, Euro Zone, Japan, New Zealand, Sweden, Switzerland, UK and US. The transparency index was established with 5 components proposed by Geraats (2002), this index fluctuates in the range of 0-15. The authors' analysis results show that central bank transparency reduces nominal short-term interest rates in the Euro Zone, UK and US at the 5-10% statistical significance level. In the US alone, policy transparency has a negative relationship with short-term interest rates at the 1% significance level. Similar results were also found by Geraats et al. (2006).
Liu et al. (2008) were the first to examine the impact of monetary policy transparency on the transmission mechanism in New Zealand. This is the first OECD country to adopt a formal inflation targeting regime with specific responsibilities and transparent regulations. The authors analyze whether increased monetary policy transparency affects the pass-through and adjustment speed of retail interest rates in New Zealand. Monetary policy in New Zealand has undergone a major change: moving from monetary quantity (payments account) targeting to interest rate targeting in market operations. This is clearly shown in the three-stage process. First, the exchange rate was indirectly used to implement monetary policy. Then, from July 1997 to March 1999, the RBNZ used the monetary conditional index (MCI) as a means of communicating monetary policy requirements. Finally, in March 1999, the RBNZ introduced market control through the Official Cash Rate (OCR). This change made monetary policy more transparent. To examine the impact of this change, the author uses econometric models to analyze the pass-through of retail interest rates before and after
with OCR. The results show that monetary policy has a greater impact on short-term interest rates. Increased transparency in monetary policy reduces volatility in official interest rates and makes the banking sector more competitive. This increases the pass-through of official interest rates to retail interest rates, contributing to the effectiveness of monetary policy.
Recent literature has also focused on the impact of institutional quality, governance efficiency, and accountability (e.g., Masciandaro et al., 2008; Mishra et al., 2010) on retail interest rate adjustment. Mishra et al. (2010) argue that transparency is positively related to retail interest rate pass-through and that it is more important than other factors related to the banking system. The authors argue that bank-specific characteristics and institutional and governance characteristics are only part of the story, while unspecified factors such as central bank credibility may also play an important role in explaining retail interest rate adjustment behavior. Perera & Wickramanayake (2016) also found evidence of a positive relationship between central bank policy transparency and retail interest rates, when studying retail interest rate pass-through through panel data of 122 countries around the world.
Several other studies have also measured the impact of central bank policy transparency on retail interest rates over the years. Papadamou (2013) found that Fed policy transparency increases the pass-through from policy rates to bond yields in the US. Papadamou et al. (2015) also found evidence that retail interest rate pass-through is stronger for emerging markets with higher central bank policy transparency.
In the 21st century, the trend of global integration has become more popular, and issues of policy transparency have also received more attention from countries. Collins-Williams & Wolfe (2010) argue that the principle of transparency of members when
Joining the WTO as a new policy tool. Trade in the WTO includes financial services, so trade policy transparency will include transparency of central banks and governments regarding monetary policy.
Transparency is one of the basic criteria of international trade agreed by WTO members. The WTO defines transparency as the process of policy making and promulgation that must be published and predictable. This issue refers to how a number of related actions are carried out, such as: the law or policy is issued domestically; the policy or law is implemented; the law is adopted; other WTO members are informed of the new regulation or policy; the notification is discussed in Geneva; and the results of the discussion in Geneva are published. The concept of transparency involves both the creation of information related to the policy or law and the unified understanding of these documents.
Collins-Williams & Wolfe (2010) identified five areas of transparency in the WTO as new policy tools:
i. Specific policy objectives: The information provision mechanism is effective when citizens and management agencies can jointly contribute to policy objectives. This mechanism is less effective when there is no participation of information recipients in the policy making process, information recipients do not contribute to or influence policy situations when the policy is adopted.
ii. Clear objectives: Who must provide the information? Who must collect the data?
iii. Identifying disclosures: What information is needed to address policy issues? Transparency is most effective if information providers (regulators) and users can agree on what information to disclose.
iv. Benefits: Information provided must be considered to help the recipient gain benefits for its objectives. The information provided, when analyzed, synthesized or disseminated in some way is useful to the user or is important in the commercial relationship.
v. Definition of information structure and transmission channels: Information must be aggregated and presented in useful forms. Big data can be provided in the form of websites and can have forecasts similar to weather forecasts. Or it can even create aggregate data that allows for quick policy making comparisons between countries. Basu (2008) tested the hypothesis that WTO member countries can improve their policies and institutions. Basu argued that the WTO accession process, under certain circumstances, can lead to positive improvements in domestic economic policies in member countries. The author used dummy variable techniques in the research model. The results showed that countries that became WTO members improved their economic policies and institutions compared to before. Similarly, Aaronson & Abouharb (2013) argue that countries joining the WTO will improve their governance due to spillover effects. Countries joining the WTO will improve their governance performance in terms of data disclosure, administrative procedures, access to information, and fairness and equity to gain an advantage in accession negotiations. Or after joining, new member countries will gradually learn to improve their governance performance as part of their commitments upon joining the WTO.
In short, when there have not been strong improvements in monetary policy transparency such as the implementation of inflation targeting regimes like some countries, WTO accession can be seen as the time when policies need to be more transparent, including monetary policy.