Relationship between financial inclusion, monetary policy and financial stability: An analysis in high financial development and low financial development countries

Abstract

This article studies the linkage between financial inclusion, monetary policy and financial stability in 58 countries including 31 high financial development countries (HFDCs) and 27 low financial development countries (LFDCs) from 2004 to 2020 using the PVAR method. Results of impulse - response function suggest that in LFDCs, while financial inclusion and financial stability are positively correlated, they are negatively correlated with the inflation rate and the money supply growth rate. In HFDCs, financial inclusion is positively corelated with inflation rate and money supply growth rate, while financial stability is negatively correlated with financial inclusion, inflation rate and money supply growth rate. These findings imply that in LFDCs, financial inclusion increases financial stability and reduces inflation. In HFDCs, on the contrary, financial inclusion increases financial instability, leading to long-term inflation. The results of the variance decomposition confirm the above outcomes, specifically, this relationship is clearer in HFDCs. From the above findings, we propose some policy recommendations on financial inclusion and monetary policy for financial stability for each group of countries.

Keywords: Financial development; Financial inclusion; Financial stability; Monetary policy; PVAR.

Fig. 1

The linkage between financial inclusion, monetary policy and financial stability under the role of financial development.

Fig. 2

Inverse roots of AR characteristic polynomial.

Fig. 3

Impulse-response function results for LFDCs.

1. -

   When there is a monetary policy impact shock represented by an inflation rate increase of one standard deviation, financial stability decreases by 0.08% in year 1 and lasts for many years, financial inclusion decreases by 6.00% and lasts up to year 4. These results show that there is a negative correlation between monetary policy and both financial inclusion and financial stability.

2. -

   When there is a monetary policy impact shock represented by an increase in the money supply growth rate by one standard deviation, financial stability declines by 0.02% in year 3 and lasts for many years, while financial inclusion declines by 0.09%. These results once again confirm the negative relationship between monetary policy and both financial stability and financial inclusion

3. -

   When the financial stability index shock increases by one standard deviation, financial inclusion increases by 0.75% in the first year and ends in this year, the inflation rate and the money supply growth rate decrease by 0.24 and 3.1%, respectively. This implies that financial stability is negatively correlated with financial inclusion, inflation rate and money supply growth rate.

Fig. 4

Impulse-response function results for HFDCs.

1. -

   When the financial stability index shock increases by one standard deviation, financial inclusion declines by 0.19% in the first year and at the end of the year, the inflation rate and the money supply growth rate decrease by 0.04% and 1.01%, respectively. This shows that financial stability is negatively correlated with financial inclusion, inflation rate and money supply growth rate.