Financial Inclusion and Optimal Monetary Policy

30 Pages Posted: 7 Jan 2015

See all articles by Aaron N. Mehrotra

Aaron N. Mehrotra

Bank for International Settlements (BIS)

James Yetman

Bank for International Settlements (BIS)

Date Written: December 2014

Abstract

Limited access to the formal financial sector is a common feature of the economic environment in many emerging market and developing economies. In this paper, we examine how the level of financial inclusion affects welfare-maximising monetary policy. Our theoretical framework is based on Galí, López-Salido and Vallés (2004). In this model, only financially included households are able to borrow and save to smooth consumption in the face of income volatility. We show that optimal monetary policy implies a positive relationship between the share of financially included households and the ratio of output volatility to inflation volatility. We find strong empirical support for the model's predictions using a broad cross-country dataset on financial inclusion. The empirical results are driven primarily by central banks with a high degree of autonomy in their monetary policy decisions, who might be most likely to set monetary policy optimally.

Keywords: financial inclusion; optimal monetary policy; limited asset market participation

JEL Classification: E52, O23, G21

Suggested Citation

Mehrotra, Aaron N. and Yetman, James, Financial Inclusion and Optimal Monetary Policy (December 2014). BIS Working Paper No. 476, Available at SSRN: https://ssrn.com/abstract=2542220

Aaron N. Mehrotra (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

James Yetman

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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