be a challenging task for central banks in LICs. The survey of International Monetary Fund (IMF) country desk economists reported in IMF (2015) found that most low- and lower-middle-income countries that listed price stability as a central bank objective, but that had not adopted formal inflation targeting, did not have a numerical inflation target, and those that had such a target simply tended to align it with the bank’s inflation forecast.<sup>5</sup> To the extent that central banks in LICs have objectives in addition to low and stable inflation, such as small output or employment gaps, these will also need to be quantified. This too may pose serious challenges for LICs. Estimation of output and employment gaps, and of appropriate objectives for them, is highly problematic in advanced economies, because of instability in the relationship between unemployment and inflation and uncertainty surrounding estimates of potential output. It is likely to be even more so in LICs, for example, because of the higher incidence of supply shocks and the greater prevalence and variability of underemployment.

# 2.4. Weaknesses in the instruments and transmission mechanism of monetary policy

In advanced economies and many of EMDEs, the key (conventional) monetary policy instrument is a very short-term interest rate, most often an interbank rate such as the federal funds rate in the United States. The central bank can exert close control over the interbank rate through its supply of reserves to the banking system and administration of standing facilities. In LICs, however, interbank markets are typically absent, as are liquid secondary markets in government securities, which the central bank could seek to influence through open-market operations. The government securities market in LICs tends to be a primary market in which the counterparties to the central bank are commercial banks that adopt a buy-and-hold strategy for such securities. Thus, the central bank conducts monetary policy by directly lending to and borrowing from the commercial banking system (for example, through repo transactions) or by doing so indirectly through the primary market for government securities. These transactions operate by altering the cost of official funds for the banking system.

Thus, in LICs monetary policy heavily depends on the bank lending channel, and it is typically not activated through an interbank market. Other channels of transmission that are operative in advanced economies, including through interest rates on traded securities, exchange rates, and asset prices, are much weaker in LICs (Mishra, Montiel, and Spilimbergo 2012). This reflects the absence of highly liquid markets for privately issued traded securities; weak links with international financial markets, coupled with relatively inflexible exchange rates; small and illiquid markets for equities; and poorly organized real estate markets.

The strength and reliability of the bank lending channel are therefore particularly important in LICs. But they tend to be limited by several factors. First, LICs are generally characterized by limited financial inclusion and relatively small formal financial sectors that have only weak links to economic activity in the important informal sectors of the economy. Second, the institutional and legal environment in these economies—including property rights, accounting and disclosure standards, and contract enforcement—tends to be relatively weak (see, for example, Beck, Demirgüç-Kunt, and Levine [2009] on LICs in Sub-Saharan Africa). This makes financial intermediation from private savers to private borrowers costly and risky, inducing banks to limit this activity and prefer holding safer government securities. Third, productive activity in these economies is often dualistic, characterized by a few large, well-established firms and many very small, opaque, and often unstable ones. The marginal cost of bank lending to large firms tends to 8