Financial Inclusion and Optimal Monetary Policy

Examining the implications of different degrees of financial inclusion for optimal monetary policy

This paper examines how level of financial inclusion affects welfare-maximizing monetary policy. It focuses on the consequences of limited financial inclusion on macroeconomic outcomes, defined in terms of output and inflation volatility during periods when monetary policy is used to maximize social welfare. The paper is based on a model in which only financially included households are able to borrow and save to make consumption smooth during volatile times. It shows that optimal monetary policy implies a positive relationship between the share of financially included households and the ratio of output volatility to inflation volatility. It also finds strong empirical support for the model’s prediction using a broad-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. The paper covers the following sections in detail:

  • Discussion on the scope of the study and a review of relevant literature;
  • Evaluation of a model developed by Galí, López-Salido and Vallés in 2004, which acts as a basis for the study;
  • Empirical evidence with a focus on testing the predictions of the model using impulse responses on both panel and cross-sectional data;
  • Discussion on the findings and concluding remarks.

About this Publication

By Mehrotra, A. & Yetman, J.