ABSTRACT
The aim of this dissertation is to study how monetary policy
is conducted in Rwanda. The task has been accomplished by designing and
estimating a Taylor rule, monetary policy reaction function for the National
Bank of Rwanda over the period 1997-2001.
Applying Ordinary Least Squared (OLS) on the time series data,
we test whether the Central Bank in Rwanda reacts to changes in the inflation
gap, the output gap and the exchange rate. The results of the study show that
the Central Bank of Rwanda has had a monetary policy over the years with the
monetary stock aggregate (M1) as the principal instrument. The results also
show that the Central Bank of Rwanda reacted by giving much importance to the
exchange rate than to inflation and neglected the output.
CHAPTER 1: INTRODUCTION
In recent years, Central Banks appear to have conducted
prudent monetary policies in several countries. In such a context, the role of
monetary policy as a stabilisation policy is becoming more powerful and well
determined. As argued in Blinder (1998), Central Banks have never been more
powerful than now. Monetary policy has become the principal means of
macroeconomic stabilisation, and in most countries it is entrusted with the
responsibility of an independent Central Bank.
From the experience of developed economies in the world which
exhibit strong economic management, various countries in developing economies
have undertaken economic reforms consisting essentially of a set of
market-oriented economic policies intended to readjust the economy to the
liberalisation as well as bringing about an institutional reorganisation.
In the sub-Sahara African context, reforms increased
significantly in the 1990s. The broad strategy has been the emphasis placed on
the policy programs supported by the International Monetary Fund (IMF) and the
World Bank, including among others fiscal reforms, liberation of exchange
restriction and the adoption of indirect instrument of monetary policy,
market-based interest policies, and so on. (IMF, December 2000).
Rwanda is no exception to this situation. Rwanda's economy is
very small and open, heavily reliant on the export of few major products,
especially coffee and tea. In addition it is also very reliant on imports for
most of its consumables.
The destruction of the economic base that took place during
the civil war period (1990-1994) forced the authorities to begin a process of
economic liberalisation: to turn away from the situation of control, regulation
and state command and turn towards more market related policies since 1994. In
1997, Rwanda embarked on a program of sustainable economic growth. A revised
Central Bank statute underpinning the National Bank of Rwanda's independence in
conducting the country's monetary policy was adopted. The period of
1998/99-2000/2001 was characterized by an enhanced structural adjustment
facility program supported by IMF and World Bank. Based on this strategy, the
macroeconomic objectives included an annual average real Gross Domestic Product
(GDP) growth of 8 percent a year during the period 1998-2000; and a reduction
in inflation to 5 percent by end 1999. In the period 1999-2002, the
macroeconomic objectives were to achieve an annual real GDP growth of 6%, while
keeping inflation at or below 3%.
In such program, the monetary policy played a central role in
producing macroeconomic stability. It stated that monetary and credit policies
would aim at further reducing the rate of inflation, and the authorities would
continue to monitor development in both reserve money and broad money closely
(IMF and Rwanda 1995/2002).
What it is clear from the Rwandan Central Bank behavior is
that an achievement of the inflation target seems to be a fundamental goal of
the monetary authority. On the basis of all the macroeconomic objectives
mentioned above, Rwandan monetary authorities seem to assess the performance of
monetary policy rules in terms of their effect on inflation and output. Such an
assessment can be based on a situation in which the Central Bank refers to an
equation, which is intended to establish the goal that has actually been
influencing the actions of the Central Bank. One could interpret such behavior
as being approximated by a particular rule referred to as the Taylor rule. In
such a rule, monetary policy is adjusted in response to the deviation of
inflation from its target value and the deviation of output from potential.
More than five years have passed since the monetary policy
was given a central role in maintaining macroeconomic stability and a new
statute has provided rule for monetary policy objectives and Central Bank
independence. Enough observations have become available to perform an
assessment of the Rwanda Central Bank's conduct of monetary policy based on
choosing a rule and then using a model of the economy to examine how the
economy would have behaved under the rule.
The objective of the thesis is thus, to attempt to
approximate the policy behavior of the Rwanda Central Bank by estimating a
variant of the Taylor rule for Rwanda. In this specific model, the dependent
variable is the monetary base that the Central Bank is assumed to control,
while the explanatory variables are those that are assumed to affect Rwanda
Central Bank's behavior. By attempting to measure the policy behavior, the
question that arises is what was the Central Bank really reacting to? Or in
other words, which targets did the Central bank actually follow?
More specifically, the study aims to:
- Review the literature on the theoretical foundation of
monetary policy: examining the process of monetary policy and describing
monetary policy strategies
- Examine the conduct of monetary policy in Rwanda
- Describe the monetary policy strategy in Rwanda by means of
a model. That is, a Taylor Rule monetary policy reaction function applied to
Rwanda and to interpret the estimated results in the context of the Rwandan
economy.
The Taylor Rule has been considered as a representation of
Central Bank behavior in various countries. It provides information about the
responsiveness of the monetary policy instrument to the monetary variables.
Therefore, estimating the policy behavior of the Rwanda Central Bank and
determining the target the Central Bank followed, is essential to the different
policy implications, especially to the implementation of an accurate and
successful monetary policy.
The structure of the study is as follows:
Chapter 1 is an introduction. Chapter 2 presents the
theoretical foundation of monetary policy and describes the process of monetary
policy and monetary policy strategies focusing on the discussion about the main
rules for monetary policy. Chapter 3 presents the monetary policy in Rwanda and
describes the way the National Bank of Rwanda formulates and carries out its
monetary policy. It also shows exchange policy management and its relationship
to the monetary policy. Chapter 4 presents an illustration of the monetary
policy strategy by means of a model and focuses on estimating a Taylor-type
monetary reaction function for Rwanda. This chapter also covers the
methodology, including the estimation results and its analysis. Finally in
chapter 5, a conclusion and suggestion are provided.
CHAPTER 2: THEORETICAL FOUNDATION OF MONETARY
POLICY
2.1 THE OBJECTIVES OF MONETARY POLICY
Broadly speaking, the objective of monetary policy is to
influence the performance of the economy as reflected in factors such as
inflation, economic output and employment. It works by affecting demand across
the economy in terms of people and firms willingness to spend on good and
services (Federal Reserve Bank of San Francisco, 2004).
In such context, the main goal of any monetary policy is to
maintain stability in the broadest sense. Wallich (1982: 45) explained that by
helping to promote price stability and to avoid recession monetary policy
contributes to a framework within which the market can operate with greater
confidence. According to Mishkin (1997) six basic goals are continually
mentioned by Central Banks when they discuss the objective of monetary
policy:
- High employment level
- Economic growth
- Price stability
- Interest- rate stability
- Stability of financial markets
- Stability in foreign exchange rate markets.
In general, a high employment level has a strong link with a
sustainable output and this relationship makes the employment an important
objective. Indeed, it can be considered that when unemployment is high,
resources and workers are not sufficiently used in the economy and this results
in a low output.
The goal of economic growth is related to the one of
employment. Indeed, the economy is characterised by business cycles in which
output and employment are above or below their long term levels. The role of
monetary policy consists of affecting the output and the employment in the
short term. For example, when demand weakens and there is a recession, the
Central Bank can stimulate the economy temporarily and help push it back toward
its long term level of output by lowering interest rates.
The goal of price stability is also most desirable. This can
just be illustrated by the fact that persistent attempts to expand the economy
beyond its long term growth path will result in capacity constraints and will
lead to higher inflation without lowering unemployment or increasing output in
the long term (Federal Reserve Bank of San Francisco, 2004). Dornbusch, Fisher
and Startz (2001) show in the same way how the costs of high inflation are easy
to see: in countries where prices increase all the time, money no longer a
useful medium of exchange, and sometimes output drops dramatically.
According to Mishkin (1997: 476), the goal of interest-rate
stability, stability of financial markets and stability in foreign exchange
markets can be shown in short as the following:
Interest- rate stability is important because fluctuations in
interest rates can lead to uncertainty in the economic environment and disrupt
the plan for the future. Concerning the stability of financial markets, it is
known that financial crises can interfere with the ability of financial markets
to channel funds to people with productive investment opportunities, resulting
in a sharp reduction in economic activity. Having a stable financial system in
which financial crises are avoided is an important goal for a Central Bank.
Finally, the stability in foreign exchange markets has become
a major consideration of the Central Bank given the increase in international
trade and the increase in international integration.
Not all of those goals can be pursued by a given Central Bank.
Each one has to choose which goals they consider most important and vital to
their economic realities. However, when Central Banks have to decide about
which specific objectives to adopt, some conflicts among goals create veritable
difficulties. Mishkin (1997) explains that although many of the goals mentioned
are consistent with each other, this is not always the case. The goal of price
stability often conflicts with the goals of interest-rate stability and high
employment in the short term.
When all these bank's objectives are decided upon, the next
question becomes what instruments or tools does the Central Bank need to put
into operation and how useful are these tools?
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