Financial development: Is it an advantage or obstacle for monetary policy?

Abstract

PurposeThe objective of this study is to assess the impact of financial development (FD) on monetary policy efficiency (MPE) in developed G7 countries in the period 1980–2017, based on data availability.Design/methodology/approachThis study followed a two-step process as follows: (1) using the Monte Carlo simulation based on Taylor curve theory to build the MPE measure and (2) evaluating the effect of FD on MPE by feasible generalized least squares (FGLS) estimation.FindingsThe results of this study show that (1) MPE varies over time. Monetary policy appears ineffective during the crisis period and is subject to many impacts of domestic and external shocks. On the contrary, the ability to influence the economy to achieve the central bank's goal tends to increase in the recovery stages, and this is in line with the actual. (2) FD has a negative impact on MPE. Interestingly, when considering the role of component FD indicators, the development of financial markets (FMs) has a negative impact on MPE while the development of financial institutions (FIs) has a positive impact. In particular, the impact of FI on MPE is mainly attributed to the impact of the depth of FI. Meanwhile, the impact of FM on MPE is mainly due to the impact of the efficiency in the FM.Originality/valueTo the author’s knowledge, this is the first study that evaluates the impact of FD on MPE in the context of measuring MPE by using the Taylor curve theory. Results from this study suggest a scientific and practical MPE measure and provide significant policy implications. This paper also offers suggestions for future research.