The transmission mechanism of monetary policy in Mexico

An important question in macroeconomics has been how the transmission mechanism of monetary policy works. In particular, the question of whether there exists a credit channel for the transmission of monetary policy has been one of the central themes in the discussion of the effectiveness of monetary policy. If this channel exists, then shocks to cr edit markets, particularly to bank loans, can have real effects. This paper presents new evidence on the credit hypothesis for the case of Mexico after 1984. We present a simple valiant of the open economy IS-LM model which includes a credit channel. The model has the following empirical implications which are absent from models which do not include a credit channel. We show that changes in the expectations of devaluation, the desired cash/deposit ratio, and measures of financial deregulation, will have real effects because they change the quantity of credit available in the economy. We explore these implications of the model through standard VAR techniques and find that the evidence strongly supports the credit view. We find that the impact on economic activity of credit and nominal depreciation rate shocks is very significant.