Effectiveness of Monetary Policy under Financial Frictions in Developing Economies

Abstract

This study investigates the effectiveness of monetary policy in developing economies under conditions of financial frictions. Such frictions including credit constraints, inefficiencies in the banking sector, limited financial access, and information asymmetries significantly influence the transmission of policy actions to the real economy by modifying standard transmission mechanisms and reducing their predictability. To examine these dynamics, the study adopts a Dynamic Stochastic General Equilibrium (DSGE) framework augmented with financial frictions and complements it with empirical panel data analysis across emerging and developing economies (EMDEs). This integrated approach provides both theoretical rigor and empirical validation across diverse macroeconomic settings. The findings indicate that monetary policy continues to affect key macroeconomic variables, including output, inflation, and investment; however, the transmission process is substantially reshaped by financial frictions. In particular, these frictions amplify business cycle fluctuations by increasing the responsiveness of firms and households to variations in credit conditions, thereby contributing to greater macroeconomic volatility. Furthermore, financial frictions weaken the conventional interest rate channel, as policy rate adjustments are transmitted less efficiently through formal financial intermediaries. Conversely, alternative channels—most notably the credit channel and the exchange rate channel—become more prominent, with bank lending conditions and external financing constraints playing a critical role in shaping economic outcomes. Overall, the results highlight that monetary policy in developing economies operates through multiple, and at times asymmetric, transmission pathways. The study underscores the importance of integrating financial stability considerations into monetary policy frameworks and advancing structural reforms aimed at improving financial market efficiency and reducing informational asymmetries to enhance policy effectiveness in EMDEs.