A common view shared by many studies is that dollarization makes monetary policy more complicated and less effective. The existence of dollarization generally makes the credit, balance sheet, and interest rate channels less effective, while the exchange rate channel is more effective.
One reason for the exchange rate channel to be more effective is that dollarization makes exchange rate more volatile, which forces central banks to frequently intervene in the foreign exchange market in an attempt to stabilize the exchange rate. Also, openness, remittance, and availability of external funds for loans give individuals a wider opportunity to finance their consumption as well as investment. As a result, even if there is a change in domestic monetary policy, the response might be slow which makes the interest rate and bank lending channels less effective.
One key finding in the dollarization literature hypothesizes that, since dollarization reduces the costs associated with switching to use of foreign currency, it causes an increase the volatility of money demand, which impinges on the central bank‘s capacity to conduct monetary policy. One challenge that policymakers contend with relates to the choice of intermediate target for monetary policy. This occurs especially with reserve money targeting framework, where the central bank has to choose whether to take account of or omit foreign currency in the definition of monetary aggregates. A commonly held view is that, a suitable intermediate target depends on the control it has on the final target – usually price level (see Balino et al., 1999).
This has generated an unending debate. Alvarez-Plata and Garcia-Herrero (2008) argue that, if the choice of intermediate target is dependent on its effect on the price level through transaction demand for money, then including foreign currency in circulation in the targeted monetary aggregate is appropriate. Accordingly, if foreign currency deposits are held as store of value but not as means of payment or unit of account, it should be omitted. Opposing this line of argument, Berg and Bonensztein (2000a) provide evidence for Latin American countries and suggest that monetary aggregates that comprise foreign currency deposits are better. According to them, including foreign currency in circulation does not enhance the power of narrow monetary aggregates in predicting prices. This issue becomes more crucial in the case of
developing countries where the determination of foreign currency in circulation remains a tedious job.
Billmeier and Banoto (2004) argue that, the effectiveness of monetary policy is not hampered if dollarization takes the form of asset substitution. This is because domestic currency is still used as a medium of transactions, even if there is asset substitution which involves using foreign currency holdings for store of value functions. This suggests that monetary policy is only hampered when there is currency substitution – where the function of foreign currency is to serve as a medium of exchange in the domestic economy. According to Balino et al. (1999), whether it takes the form of currency substitution or asset substitution, dollarization makes the demand for domestic money more volatile. A side issue of this argument is that the control of broad monetary aggregate becomes challenging due to the existence of the foreign currency component. This usually confounds the role of the central bank in the fight against inflation. Zamaroczy and Sa (2003) provide evidence for Cambodia where the difficulty associated with the control of narrow money has rendered the monetary aggregate channel of monetary policy ineffective.
The widespread acceptance that dollarization weakens the monetary policy transmission mechanism is anchored on the purported limited effect of monetary to control monetary aggregates. The inability of the central bank to control liquidity could fuel consumer price inflation, particularly as monetary policy instruments affect only a portion of domestic currency holdings. Also, the fact that high dollarization reduces the capacity of central banks to stem a liquidity crisis by playing the role of lender of last resort, exposes the financial system to liquidity and solvency risks (Mengesha & Holmes, 2015). Since international reserves are the only cushion to curb bank runs on foreign currency deposits, the incidence of high rates of deposit dollarization also impinges a colossal limitation on monetary policy management.
It has been argued that a higher degree of partial dollarization would create a potentially serious problem for inflation targeting. According to Calvo (1999), this is expected to be more crucial in emerging markets where the balance sheets of households, firms, and financial institutions are substantially dollarized, and the bulk of long-term liabilities are denominated in foreign currencies. Because inflation targeting necessarily requires flexible exchange rates, exchange rate fluctuations are inescapable. However, large and abrupt depreciations may increase the burden of debt denominated in foreign currency, bring about deterioration of balance sheets, and build-up the risks of a financial crisis along the lines discussed in Mishkin (1996). This recommends that the exchange rate cannot be ignored under an inflation targeting regime in emerging economies, although the importance ascribed to this should be subordinated to the inflation objective. This also denotes that strict supervision of, and severe prudential regulations on financial institutions aimed at ensuring that the system is capable of withstanding exchange rate shocks, is imperative for a viable inflation targeting regime (Mishkin, 2000).
A few studies on African economies provide some empirical findings to show that one policy instrument or the other has been ineffective or weak (Christensen, 2011). Although Cheng (2006) and Ngalawa and Viegi (2011) provide some evidence of effective monetary transmission in Malawi, a number of studies report otherwise. In particular, Buigut (2009) finds the interest rate channel ineffective in three East African Countries, namely Kenya, Uganda and Tanzania. The study by Mugume (2011) also demonstrates that the exchange rate, interest rate, and credit channels are less successful in Uganda. Also, Saxegaard (2006) describes the transmission mechanism in three Sub-Saharan African countries, namely Kenya, Nigeria, and Uganda as weak.
Among other factors, the study by Christensen (2011) points out that an underdeveloped financial market has undermined the monetary policy transmission mechanisms in most African
countries, including the financially developing low income African countries of Angola, Ethiopia and Malawi. Conclusively, the ability of monetary policy adjustments to direct the development of prices and economic activity is still limited, since important transmission channels are virtually ineffective. The difficulty with stabilization in developing countries is severe indeed, which possibly presents a key challenge to policymaking.
In the case of Ghana, research on this subject is virtually absent. The only study that addresses monetary policy transmission is Abradu-Otoo, Amoah, and Bawumia (2003) for 1969-2002. Analysis of impulse response functions reveals that monetary policy in Ghana is less effective, whether M2 (broad money) or Treasury bill rate is used as the policy variable. The study reports some findings that are not consistent with theory. For example, inflation increases and exchange rates depreciate in response to a positive movement in the rate of return on Treasury bill.
On methodology, analysis based on vector autoregression (VAR) technique proposed by Sims (1972) in the form of impulse response function and variance decomposition has been applied extensively in the literature. A vast body of economic literature applies VAR estimation to explore monetary policy instruments and their relationship with macroeconomic variables for developed economies (for example, Bernanke & Woodford, 1997; Blanchard, 1989; Christiano, Eichenbaum & Evans, 1996; Friedman & Kuttner, 1992; Sims, 1992). The technique has been applied to studies in emerging and developing countries including the ones reviewed above.
Overall, the review has revealed that both the interest rate and the monetary base have served as a weak tool for monetary policy transmission in sub-Saharan Africa. Again, whether the said variable is modelled within the structural or recursive means does not yield different results (Mishra & Montiel, 2012). The emerging economies face crucial challenges in the
implementation of monetary policy. Actually, monetary policy in these countries has experienced occasions of very high inflation and instability (Mishkin, 2000).