[Blog] Effectiveness of Monetary Policy

This paper investigates the structural bottlenecks that render conventional monetary policy tools ineffective within the Mauritian economy.  Monetary policy is ineffective because it is wrongly based on the assumption of the existence of these foundational macroeconomic assumptions — namely developed financial markets, smooth transmission mechanisms, capital integration, and exchange rate parity theories.  

I claim that local idiosyncratic structural realities undermine the above assumptions. Jankee (2003) highlighted that in the post-financial liberalization period, the abolition of direct banking controls did not lead to competitive efficiency. Instead, it cemented institutional asymmetries, characterized by high market concentration, wide interest spreads, and a structural decoupling of local interest rates from external parity models. Demand-side monetary adjustments are fundamentally mismatched against supply-side vulnerabilities, and I propose a strategic shift toward macroprudential insulation and targeted credit guidance.

The institutional friction between the Bank of Mauritius (BOM) and fiscal planners highlights a structural design flaw rather than a simple communication breakdown. Conventional inflation-targeting frameworks assume an economy driven by domestic demand-side impulses, smooth price discovery, and rapid banking sector alignment. However, when applied to a highly open, small-island developing state (SIDS) characterized by structural trade imbalances, these assumptions result in systemic policy impotence.

Unrealistic Assumptions 

A. Developed Financial System & The Post-Liberalization Reality

Conventional monetary policy relies on deep, liquid, and highly competitive financial markets that can propagate central bank liquidity signals instantly. In Mauritius, this assumption fails due to asymmetric banking concentration and structural anomalies highlighted in Jankee’s research on the finance-growth nexus. 

• Jankee K (2003) work on Financial Liberalisation and Monetary Control Reform in Mauritius proves that moving away from direct instruments (credit ceilings, interest rate controls) toward market-based mechanisms requires a highly competitive financial network. In Mauritius, financial liberalisation did not automatically lead to an increase in real interest rates or to perfectly competitive deposit mobilization. Instead, the sector is dominated by a tight banking oligopoly. Because of this oligopolistic concentration, commercial banks maintain high interest spreads driven by unidirectional market share power. 

When the BOM adjusts liquidity parameters, banks absorb the shock to preserve margins. Instead of expanding productive credit to high-growth, higher-risk domestic enterprises (SMEs, local manufacturing), financial capital pools into low-risk real estate speculation, leaving key sectors credit-constrained. 

B. The Broken Monetary Transmission Mechanism

Standard macroeconomic modeling assumes changes in the Key Repo Rate seamlessly transmit through the banking system to reshape consumer demand, capital investments, and inflation. In our financial system, domestic inflation is historically decoupled from local aggregate demand. It is heavily skewed toward imported inflation, directly tied to global maritime freight costs, oil shocks, and imported consumer essentials. 

Raising interest rates fails to cool global supply chain disruptions; instead, it raises the cost of local capital, penalizing domestic import-substituting industries.

There is evidence that financial deepening in Mauritius is not positively related to the real interest rate (K. Jankee 2003). This means aggressive policy movements fail to trigger consumption and investment elasticity. For instance, changes in Repo rates would fail to anchor expectations as domestic consumer prices remain vulnerable to external friction. Raising interest rates fails to cool global supply chain disruptions; instead, it raises the cost of local capital, penalizing domestic import-substituting industries.

C. Financial Integration and the Dualistic Economy

Perfect capital integration models assume that an economy features seamless capital mobility where domestic interest rates instantly adjust against foreign yields to manage external accounts. There is also evidence  that despite financial liberalization, Mauritius exhibits a lower-than-expected degree of financial linkage with external financial markets regarding core domestic interest rate determination. Domestic factors, localized liquidity hoarding, and institutional behaviors hold greater sway over local yields than pure global arbitrage (see Jankee 2003). 

This decoupling is exacerbated by the Global Business Sector (GBS / Offshore). The massive scale of the offshore segment creates a distinct, dual financial architecture. Capital flows moving through the GBS are driven by global tax treatments and cross-border corporate rebalancing rather than local credit conditions. These massive flows systematically distort domestic liquidity management, causing high volatility in international reserves and rendering broad domestic policy changes impotent.

D. The Collapse of Exchange Rate Parity Theories

Monetary policy relies on Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) to guarantee that the national currency adjusts predictably based on relative inflation and interest rate differentials. There is a structural bottleneck. The Mauritian Rupee (MUR) does not trade under pure parity conditions. It is heavily influenced by systemic trade deficits, central bank interventions and widespread domestic foreign currency hoarding. 

Consistent with Jankee’s findings that open-market adjustments do not smoothly equilibrate capital and goods markets, parity models fail when market participants lose confidence in the asset backing of the currency. The exchange rate experiences persistent downward pressure. Despite high interest rate differentials, market players continue to hoard foreign currency. This self-fulfilling speculative cycle drives structural depreciation, proving that standard parity mechanics break down under institutional and fiscal dominance.

Proposed Strategic Remedies for Monetary Policy Potency

To transition monetary policy from a state of structural impotence to a meaningful engine for economic stability, the institutional framework must undergo a targeted recalibration. The market-based control in our uncompetitive financial system is not effective (Jankee 2003)

1. Reintroduce Qualitative and Selective Credit Controls: Because broad interest rate changes fail to transmit cleanly through a concentrated banking sector, the BOM must shift toward selective macroprudential rules. In the absence of a perfectly competitive financial system, direct or selective techniques are inevitable. The central bank should establish frameworks that penalize speculative real estate and luxury import financing while explicitly lowering reserve costs for commercial lending to high-value domestic sectors like agriculture, green energy, and local manufacturing.

2. Statutory Separation of Monetary and Fiscal Policy : Legally enforce strict rules against the direct or indirect balance-sheet financing of fiscal deficits. Halting non-traditional reserve transfers to the central government is essential to rebuild market confidence and reverse structural currency depreciation.

3. Advanced Liquidity Sterilization: Restructure open market operations to aggressively lock up long-term domestic excess liquidity. Forcing short-term domestic interbank market rates into alignment with the Key Rate will make the credit channel more responsive and reduce the structural capacity of banks to maintain wide interest spreads

Conclusion 

Mauritian monetary policy suffers from structural impotence due to a concentrated banking sector and supply-side inflation, rendering conventional interest rate hikes ineffective. Future stability requires transitioning from market-based tools toward macroprudential insulation, targeted credit guidance, and strict legal separation between central bank and fiscal operations to curb speculative capital flows and structural depreciation

Reference 

Jankee Kheswar (2003)  : Interest rate Policies  and Economic management in emerging economies:  The case of  Mauritius

By Dr Chandan Jankee, economist.