The monetary policy transmission mechanism under financial dollarisation : the case of Peru 1996-2006

This paper surveys the monetary policy transmission mechanism in Peru. The survey covers the most recent empirical papers dealing with the measurement of monetary policy. From the onset we stress that the last ten years have witnessed important changes in monetary policy procedures that led to the adoption of the inflation targeting (IT) framework in 2002. From the policy perspective, it is important to know the empirics of the monetary policy transmission mechanism, yet the nature of this mechanism is complex. And it is more so in a financially dollarised economy. The degree of financial dollarisation in Peru is still high (around 65 per cent of private credit is denominated in dollars). The high degree of financial dollarisation is key to understanding the transmission mechanism. One important element of the mechanism is the non-linear nature of the balance-sheet effect coming from currencyinduced credit risk in the financial system. The measurement and identification of the deep mechanisms at work in the transmission channel is difficult because monetary policy, as well as the environment surrounding it, has been evolving rapidly. So, uncertainty about the dynamics of the transmission mechanism is an important element the Central Bank of Peru has to deal with. Accordingly, this paper also performs exercises aiming to show the likely effects of central bank policy actions on the nature of the transmission and the way financial dollarisation reduces the monetary policy power to affect inflation. To the practice of monetary policy in a partially dollarised economy, the exercises imply that central bank actions have to be even more pre-emptive with regard to future inflation pressures and more watchful of potential balance-sheet vulnerabilities.