Monetary policy, transmission mechanism and financial reform in a small open economy: The case of Dominican Republic

The effectiveness of monetary policy innovations depends on the characteristics of the transmission mechanism. When a financial reform takes place in a developing country a new transmission mechanism is put in place and the effectiveness of monetary policy could be strengthened or weakened. This issue is fundamental for any financial reform process, because the level of instability and vulnerability of the new reformed financial system will depend to great extent on how effective the monetary policy will be within the new institutional setting. In the first part of the 1990s the Dominican Republic started a deep financial reform that was completed and stabilized in the second part of the decade. Using the credit view approach to monetary policy as the theoretical framework, and based on detailed data on monthly financial statements of Dominican Republic's commercial banks, this dissertation estimates, for the period in which the financial reform was completed (1991--1999), a VAR systems aimed at describing the interaction between a set of variables considered to play essential roles in the transmission mechanism of monetary policy. The econometric tests generate solid evidences on favor of the persistence of a strong credit channel in the transmission of monetary policy innovations in the Dominican financial system, and on favor of the hypothesis of a weakening of the monetary policy effectiveness for the second part of the 1990s. The last issue is particularly important since it may have played a fundamental role in the huge banking crisis that affected the economy in 2003.