A monetary policy shift tends, generally, to transmit a change for the future in the expected behaviour of macroeconomic variables from their initial position, alter in the process the behaviour of economic agents and, finally, create a new equilibrium position, hopefully, in the direction expected by the central bank in the fulfilment of its objectives.
In a developing or emerging economy, monetary policy shift is often designed in response or reaction to undesirable shocks in the monetary system and macro-economy in order to restore equilibrium and achieve a set of objectives.
For instance, in Nigeria in the fourth quarter of 2007, due to the challenges from autonomous private capital inflow resulting in the appreciation of the naira, the Monetary Policy Rate (MPR) was raised from 8 per cent to 9 per cent in October, probably aimed at a contraction of the system in order to choke off the likely excess liquidity and inflationary pressures of the undesired external shock. Such undesirable shocks generate effects which tend to challenge central banks as the shocks work contrary to their objectives and render monetary policy ineffective.
Central banks, as many studies (to be reviewed later in section 3) have shown, face the challenges of actually understanding the process by which their policy actions impact the objectives of monetary policy.
It would be fair to say that central banks do not always know, ex ante, with a high degree of precision (despite their use of macroeconomic forecasting models) what the exact effect of their policy action would be when such policy is put in place.
What is often unclear is whether or not the policy would actually achieve the desired objective, i.e., the probable effectiveness of the monetary policy.
More importantly, when an outcome is achieved, there is the fundamental issue of the transmission channel through which such an outcome is achieved.
Consequently, there is continuing debate about the transmission mechanism of monetary policy, namely, the process by which a change in a monetary policy input affects the desired policy objective.
In recent times, interest rate changes, such as the case mentioned above, have become generally accepted as the monetary policy instrument input and inflation as the monetary policy objective. For instance, the Monetary Policy Committee of the Bank of England has described the Monetary Policy Transmission Mechanism as “the process by which interest rate changes affect inflation”.
While the general acceptability of inflation as a monetary policy object appears not in doubt, given that monetary stability is a fundamental functional objective of the monetary policy of central banks, the channel through which interest rate affects the economy and, hence, inflation is still very much up for debate. Accordingly, the subject of the optimum channel of the monetary policy transmission mechanism continues to generate much research. A good many of the studies on this economic concern are reviewed in the third section of this paper.
