Financial Inclusion and Optimal Monetary Policy
Limited access to the formal financial sector is a common feature of the economic environment in many emerging market and developing economies. In this paper, we examine how the level of financial inclusion affects welfare maximising monetary policy. Our theoretical framework is based on Gali, Lopez Salido and Valles (2004) In this model, only financially included households are able to borrow and save to smooth consumption in the face of income volatility. We show that optimal monetary policy implies a positive relationship between the share of financially included households and the ratio of output volatility to inflation volatility. We find strong empirical support for the model's predictions using a broad cross country dataset on financial inclusion. The empirical results are driven primarily by central banks with a high degree of autonomy in their monetary policy decisions, who might be most likely to set monetary policy optimally.