In most countries, controlling interest rates is now the key instrument of monetary policy. However, despite the almost single use of this instrument, the interaction with the real economy is varied and complex, and there is no single transmission channel. Several transmission channels are usually identified. An ISLM-type channel passes through the quantity of money and the rate of interest. It concerns the direct effects on final demand of interest rates (i.e. income and substitution effects), as well as the impact of variations in the quantity of money on agents' behaviour. The credit channel has recently generated much literature, its effect being tributary to the way in which banks supply credit. 'I'he exchange rate channel is also important, as a variation in interest rates modifies the parity of the national currency, producing an indirect effect on inflation and real activity.
The relative importance of these different channels conditions the effectiveness of monetary policy, though their effects may be contradictory. It seems likely that these transmission channels may differ from one country to another, or even from one period to another within the same country. The reasons for this are simple: financial systems are different both in terms of their structure and their regulation: financing circuits are more or less disintermediated or integrated; indexation is more or less widely practised; economies are open to different degrees; the intensity of competition in the banking sector varies from one country to another, etc. Given this diversity in financial structures, a certain monetary stance may have different macroeconomic consequences from one country to another. Thus, a particular level of interest rates may have a varying impact on demand, depending on the country.
This issue is especially important within the context of Stage III of EMU. If a common monetary policy is implemented, the likely effects of a change in interest rates need to be fairly similar from one country to another, or else unwanted distortions may follow. That is why numerous studies have recently been carried out on this topic, especially by the European central banks and the BIS.
This paper aims to give a summary view of' the possible sources of' divergence in the transmission of monetary policy. It is organised as follows. Section 2 discusses some results evaluating the intensity with which a change in the money market rate is passed on to the other rates. Indeed in the first instance, the intensity of transmission is linked to the speed and degree to which the money market rate, controlled by the central bank, affects interest rates accorded to non-financial agents. Section 3 reviews some credit indexation practices, which may affect the interest rates carried by agents' liabilities Section 4 adresses the issue of possible differences in the transmission channels across countries and focuses on the substitution effects, the size of which may vary according to the intensity of liquidity constraints. Section 5 investigates possible differences in income and wealth effects.
The manner in which different interest rates react to a shift in monetary policy constitutes the first source of divergence. The greater integration of financial markets, the way partitions between markets have come down, and the creation of new financial products have strengthened the links between interest rates. For example, the financial liberalisation of the eighties in France and Italy certainly contributed to raising the direct transmission of interest rates to non-financial agents: more direct financial products were created, such as deposit certificates, commercial bills, etc., while products with fixed or regulated rates were limited. By contrast, in Britain, the financial system had already been liberalised, and in Germany, bank interest rates have been deregulated for a long time.
As a result of the financial liberalisation, measures taken by central banks with respect to the money market rate affect the conditions applied to non-financial agents far more directly. However, interest rates as a whole never move in parallel. Spreads between interest rates, which are in fact incompressible, persist across different markets, due partly to the imperfect substitutability of assets. An important issue for the credit borrowers stems from how financial intermediaries modify their interest rates, following a change in monetary policy.
The rigidity of bank credit interest rates differs across countries. Empirical evidence can be found in two recent studies, which calculated the response of the bank credit rate to a 1 % point rise in the money market rate for different horizons (2). In the long run, a change in money market rate is completely passed on to bank rates in most countries. Nevertheless, the speed of adjustment differs substantially across countries. The bank credit rate adjusts fastest in the United Kingdom and in the Netherlands. In these two countries, the effect of a change in the central bank rate is fully realised within three months, which makes this the highest level of responsiveness in the OECD, over this period (save Mexico). The short term impact is notably weaker in Germany and in Italy, standing at between 40 and 69% after three months. France, Denmark and Finland are the countries for which the bank rate is the most inert, since after six months, less than half of the change in money market rate is passed on to the bank rate.
The differences in the responsiveness of interest rates are linked to the financial characteristics of the various countries. Numerous factors intervene, including: the level to which the financial system is developed; the size of the money market; the openness of the economy; the intensity of competition in the banking system which modulates the possibilities for banks to reach agreement on the fixing of their rates.
Bank practices relating to the setting of credit rates are also important to assess the actual effect of interest rates. For example, in France, the bank base rate is less and less used as a reference rate for bank credit, and indexation to the money market rate has greatly developed in recent years. More generally, recent inquiries made by European central banks and the BIS have shed light on the indexation practices in each country. Differences in these practices were shown to be rather high across countries.
In the Anglo-Saxon countries, credit provided to households is largely attributed using floating rates, and household credit is especially high, compared to other countries. The most striking differences are to be found in the mortgage market In France, 95% of such credits are at completely fixed rates, compared to 25% in Italy, and only 10% in the United Kingdom, the Netherlands and Germany (3). Differences even exist within the category of adjustable rates. In Italy, mortgage credit at adjustable rates are directly indexed on the short term. In the United Kingdom, the bulk of mortgage loans is not indexed on the short term rate, but is lent at rates that may be revised at the discretion of the lender, without any particular reference. In Germany, 45% of loans are at rates that may be revised, and 45% of loans are at re-negotiable rates, which are changed at regular intervals as stipulated in the terms of contract. Therefore, interest rate transmission may lead to some differences among countries; when interest rates move, already indebted households are not affected in France and in Sweden, while their interest payments may be changed in United Kingdom, Germany and the Netherlands.
Strong differences also emerge across countries for total credit, even if the estimates are almost certainly fragile and have to be interpreted with care. In the United Kingdom and in Italy, three quarters of all credit is allocated at short term or adjustable rates, compared to 43% in France, and 39% in Germany. Furthermore, there seems to be no trend towards convergence in these credit practices, on the basis of comparing two points in time -1983 and 1993. Credits allocated in foreign currency also play a part, no doubt by reducing the impact of domestic monetary policy. This type of credit has developed mainly in Italy and the United Kingdom, where it accounts for about 20% of loans made to companies.
Differences in interest rate indexation practices almost certainly play an important role in the transmission of monetary policy. But the stress which has recently been placed on these factors should not lead to an exaggeration of' their importance. This would lead to under-estimating the effects that are transmitted through the supply of credit. Indeed, while a shock to monetary policy is quickly transmitted through to the credit rate as is the case when the credit rate is indexed to the money market rate - the demand for credit may also adjust very quickly. But if there is a long lag, the resulting contraction of bank margins may also lead to a contraction of the supply of bank credit, and the rationing of credit for certain agents, which would ultimately have the same restrictive effect. This was the sort of mechanism through which Japanese monetary policy functioned explicitly, prior to financial liberalisation. Such a setting of the money market rate was accompanied by rigid rates in bank credit, which were in fact so rigid that the variation of bank margins, that conditioned the supply of credit, allowed activity to be modulated.
Bank margins and the supply of credit may also play an important
role, as suggested by some recent econometric tests
for the G5 countries. These showed up a positive correlation between
bank margins - calculated as the difference between the credit
rate and the money market rate - and future activity in these
countries. Thus a tightening of bank margins, linked to the slow
transmission of a rise in the money market rate could lead to
a contraction in credit. The indexation of interest rates is therefore
not necessarily a sign of the greater efficiency of monetary policy.
Furthermore, some share of total credit is still subsidised and distributed below market rates in many countries, despite the liberalisation. The rates of these preferential loans are generally regulated and their sensitivity to market rates is low, which of course weakens the transmission of monetary policy. Data on these preferential loans are not readily available, so it is difficult to assess their importance. However, the available figures for France and Germany show that they are not negligible. The share of preferential rate loans in France amounted to 57% of total credit in 1986. It was greatly reduced by financial liberalisation but still amounted to 28% of total loans in 1992 (5). These preferential loans are aimed at easing residential financing; hence the impact of market rates on housing in France may have been reduced. In Germany, interest subsidies have much increased in recent years to finance reunification. Approximately half of the loans to eastern Germany were subsidised at rates roughly 2 points below market rates, in 1991-1993(6). This is not negligible, since between a quarter and a third of total credit to private sector has flowed to the new Länder.
The repercussions of monetary policy may vary across countries depending on the different transmission channels. One source of possible divergence may come from substitution effects. These effects are well known: they tend to limit final demand when rates rise, and conversely to boost it when rates decrease, as households are more inclined to borrow. However, the size of the effect depends on households' ability to borrow money when rates decline. For the effect to work fully, households have to be able to arbitrate completely between present and future consumption. In reality, households are subject to liquidity constraints, as their access to credit depends on bank practices, or regulatory constraints that vary across countries. Thus, ceilings on indebtedness and constraints on down-payments in house purchases more or less shut out the possibilities of arbitrating between credits. When the constraint is strong, as in Italy for example, the desire by households to raise their spending when rates fall will be limited by their current earnings.
An interesting indicator from this point of view is the down-payment required of individuals seeking a loan to buy a house. The minimum down-payment required to buy a dwelling was especially high in Italy (44%), Austria and Portugal (40%), when compared to France, Germany (20%), and the United Kingdom (13%), for the period l98l-l987(7). Access to housing credit seems to be easier in Scandinavian countries, since 95% of the house value can be borrowed in Denmark and 85% in Finland. This indicator is correlated with the importance of consumer credit relative to GDP. The greater the indicator for the down-payment, the more households' access to credit is constrained, and the less households are indebted. In Italy, households are relatively little indebted with respect to their disposable income, somewhat more so in France and Germany, whereas they are highly indebted in the United Kingdom. The share of the required down-payment, which may be considered as an indicator of the constraints on credit access, is also an explanatory factor for differences in saving levels.
The more credit is constrained, the more savings are high. This fact can lead to differences in saving rates between countries. It can also explain the evolution of savings within individual countries, since financial liberalisation has lead to the opening up of house-hold's access to credit, and hence to a fall in saving rates. This is especially true in Scandinavia countries and to a lesser extent, in France. It should be added that the more credit is constrained, the less effective monetary policy acting on interest rates will be, as the substitution effect is no longer free to make itself felt.
Thus the credit access constraints of certain agents (households, and small- or medium-sized companies) may lead to important changes in the transmission of monetary policy using interest rates. In fact, if agents are constrained in their demand for credit, a rise in interest rates could bring about a fall in the demand for bank credit, assuming that the rise is carried over to the cost of credit. But, this will not necessarily lead to a fall in distributed credits, when demand is in excess. Numerous studies concerning the credit channel do indeed show that a rise in the rate of interest is not immediately followed, by a fall in bank credit.
Leaving aside the impact on anticipated income, which is difficult to quantity, any variation in interest rates will automatically lead to an immediate modification of agents' income. This will be proportional not only to the different levels of asset stocks, but also to the debts held by agents. The direct effects are felt in the flow of interest payments made or received. But, here again country differences are important, for a number of reasons. Firstly, different categories of institutionnal agents are creditors and debtors to different degrees. Secondly, assets are held in variable proportions as bank deposits, bonds or shares. Debts are taken out over the more or less long term, in the form of bank credit and bonds, whose income effects vary from country to country.
Households, as overall creditors, are likely to experience a loss of potential earnings following a fall in interest rates, given that financial wealth of households always exceeds their debts. On the opposite, companies and the state should benefit from a decrease in interest rates, since they are generally indebted. The size of their gains depend on the extent and the structure of their indebtness. It should be observed that these modifications in incomes between agents could lead to real effects of various sizes. For instance, the more households are in credit and the more a state is in debt, the less effective monetary policy will be, as a rise in interest rates will raise income and increase public deficit, rather than constrain household spending. 'I'his should be the case of Italy in particular, where there is much low-maturity public debt, largely held by households.
Changes in interest rates also yield modifications of household assets which result in wealth effects. Here again, the magnitudes of these effects depend on the structure of assets held by agents. For example, a rise in interest rates leads to a fall in the value of bonds held, and generally to a fall in the value of shares as well. If households hold a large share of their assets in such forms, as is the case of the Anglo-Saxon countries, they will be encouraged to save more to reconstitute their savings. This implies the fall in consumption that runs counter to the previous income effect. Moreover, the experience of the last business cycle shows what an impact wealth effects can have on credit. Much credit was provided on the basis of asset-backed collateral, and variations in asset prices may find themselves at the centre of a dynamic process affecting the economic cycle. Balance-sheet effets can also be observed for firms, whose credit is often backed by financial collateral.
Some sources of divergence in the transmission of monetary policy may disappear with the monetary union. That is the case of the exchange rate channel. Any variation in interest rates also leads to a variation in the exchange rate, which affects prices and real activity. This transmnission channel of monetary policy helps raise the effectiveness of monetary policy. Indeed, a restrictive interest rate shock is generally accompanied by an appreciation of the exchange rate, which contributes to moderation of inflation and fall in activity. But the intensity of the channel is linked to the openness of' the economy, and also to the degree of commitment to exchange rate targets of the monetary authorities. This may typically constitute a source of divergence among European countries, which will immediately disappear with monetary union. However, some of the differences reviewed here may persist at least for several years after monetary union. Access to credit for example could be harmonised, as competition between European retail banks will be boosted by monetary union. However, the harmonisation will take time. The delay necessary to equalise indexation practices will be still longer, these are linked to cultural preferences, which stem from the collective consciousness of a people and depend on the history of inflation in each particular country. This kind of collective perception of risk is very slow to change.
(2) "Financial Structure, Bank Lending Rates and the Transmission Mechanism of Monetary Policy", C. Cotarelli and A. Kourelis, IMF Working Paper, March 1994." The Response of Short Term Bank Lending Rates: a Cross-country Perspective". Borio C. and Fritz, in BIS. "Financial Structure and the Monetary Transmis-sion Mechanism", W. C.B. 394. Basle, pp. 106-153, march 1994.
(3)"The Structure of Credit to the Non-Goverment Sector and the Transmission Mechanism of Monetary Policy: "A cross-country
(4) "Taux d'intérêt, spreads et comportement bancaire: les effets sur l'activité réelle" Barran F. Coudert V. et Mojon B., Revue Economique, vol. 46, n° 3, pp. 625-634, may 1995 or '"Interest Rates, Banking Spreads and Credit Supply: the Real Effects" same authors, Document de travail CEPII n° 95-0l.
(5) According to B. Enfrun and J.Cordier, in "Factors affecting the Process of Transmission of Changes in Interest Rates in France", in BIS "National Differences in Interest Rates Transmission, C.B. 393, Basle, March 1994.
(6) According to B. Enfrun and J. Cordier, in "Factors Affecting the Process of Transmission of Changes in Interest Rates in France", in BIS "National Differences in Interest Rate Transmission, C.B.393, Basle , March 1994.
(7) "Saving, Growth and Liquidity Constraints", T. Jappelli et M. Pagano, Quaterly Journal of Economics, vol. CIX, issue 1, pp 83-110.