3.2.2 Exchange Rate Policy
The main objectives of Rwanda's exchange rate policy are to
preserve the external value of the national currency and also to ensure the
effective operation of the foreign exchange market. The instruments that are
often used to conduct exchange rate policy are the rate of exchange and
exchange regulations. The latter comprises all the arrangements resulting from
the legislative texts and lawfully taken by the government in order to
supervise the management of foreign currencies.
The flexible exchange rate regime was established in Rwanda in
1995 and at the same time the organisation and the management of the foreign
exchange market were entrusted to the Central Bank.
The characteristic of the Rwanda flexible exchange rate regime
is the fact that it is a controlled flexible policy. The mentioned policy
pursues three main goals:
- To approach as much as possible the balance level of the
rate of exchange,
- The price stability and the support for the growth,
- To connect the Rwandan foreign exchange market to the
international markets.
The instruments of the controlled flexible exchange regime in
Rwanda are simply the rate of exchange reference and the interventions of the
Central Bank on the foreign exchange market. The intervention of the Central
Bank on the foreign exchange market conforms to the pattern of its mission of
ensuring monetary stability and carrying out its objectives regarding the rate
of exchange. This is done with the aim of correcting imbalances of liquidities
of the market, as well as correcting the erratic movements of the national
currency.
In other respects, there is a close link between the monetary
policy and the exchange rate policy. Indeed, one of the principal counterparts
of the money supply, which is the Net External Assets constitute an important
source of monetary creation. According to this view, any positive balance of
the balance of payments results in an increase in the money supply, while any
deficit results in a reduction of the money supply. As a result, since the two
policies aim either at the preservation of the internal value of the currency,
or at its external value, their action must be harmonized for the stability of
the currency.
With the help of international institutions such as the IMF
and the World Bank, the Central Bank of Rwanda is trying to follow an
objective, which entails developing a careful monetary policy, which will allow
it to maintain harmony between the pace of the money creation and that of
economic growth. The management of its stock change has contributed to reducing
the exerted pression on the Rwanda currency and foreign payments. The harmony
that has characterized the growth of the money supply and that of production
has contributed to stabilize the inflation rate, the currency exchange offer
has increased by 9% while it was 13.7% in 2000 (Republic of Rwanda, 2002:
10).
CHAPTER 4 ILLUSTRATION OF THE MONETARY STRATEGY BY
MEANS OF A MODEL
Through economic research, various models have been developed
to better understand the monetary policy impact on the real economy and
ultimately inflation. `The management of monetary policy consists to define the
level of the instrument that, given the transmission mechanism of monetary
policy, is consistent with the achievement of the target' (Martinez, Sanchez
and Werner, 2000: 184). In the context of the conduct of monetary policy in
several countries, the achievement of inflation target has become the
fundamental goal of the monetary authority.
One way to evaluate the effectiveness of the monetary policy
is by estimating the effect on the interest rate of the variables that should
enter into the authorities reaction function. The Taylor rule mentioned
previously is one of the more popular approaches to the empirical analysis of
the reaction function. Indeed this rule works with the interest rate policy and
the latter implies the open market operations, which are often taken as the
most important monetary policy tool because they influence short-term interest
rates and the volume of money and credit in the economy.
The monetary reaction function based on the Taylor rule has
been used in both developed and underdeveloped countries. Judd and Rudebush
(1998) quoted in Hsing, (2004) investigated and reviewed previous works and
maintained that the Taylor rule is a valuable guide to characterize major
relationships among variables in conducting monetary policy. Similarly, Romer
(2001) quoted again in Hsing, (2004) analysed several issues in applying the
Taylor rule. He noted that the values for the coefficients of the output gap
and the inflation gap would change the effectiveness of monetary policy. Larger
values of the coefficients would cause the actual inflation rate and output to
decline more than expected. Due to a lag in information, it would be more
appropriate to use the lagged values for the output gap and the inflation gap.
The exchange rate and the lagged federal funds rate need to be included to
incorporate the open economy and the partial adjustment process. Martinez,
Sanchez and Werner (2000) analysed the mechanisms empirically by which the
transmission of monetary policy has occurred in the Mexican economy from 1997
to 2000. Using VARS he found that the behavior of the real interest rate was
determined by the traditional variables that guide the discretionary actions of
any Central Bank and that this rate affected aggregate demand and credit in a
statistically significant way. Applying the VAR model, Hsing (2004) estimated
the monetary policy reaction function for the Bank of Canada. The results show
that the overnight rate has a positive and significant response to a shock in
the output gap, the inflation gap, the exchange rate or the lagged overnight
rate. The author pursues the latter concluding that the main outcomes suggest
that in pursuing monetary policy by the Bank of Canada, targeting output is as
important as targeting inflation.
Sanchez-Fung (2000) estimated a simple Taylor-type monetary
reaction function for Dominican Republic during the period 1970-98. He noted
that the implicit reaction of such authorities suggest that they were more
systematic during the period 1985-98 which might be attributed to a
determination to» implicitly» follow feedback rules, rather than
discretion, in monetary policy-making. Setlhare (2003) studying how monetary
policy was conducted in Botswana by specifying and estimating an empirical
monetary policy reaction for the Bank of Botswana over the period 1977-2000,
identified a predominantly countercyclical policy reaction function. This
reaction function suggests that inflation (directly and indirectly via the real
exchange rate) is the ultimate variable of policy interest.
Smal and Jagger (2001) examined the monetary transmission
mechanism in South Africa. The results of the model developed indicated that
there was a fairly long time (one year) before a change in monetary policy
affected the level of real economic activity, and another year before it had an
effect on the domestic price level.
Sanchez-Fung (2000) however, observed that although the
framework related to Taylor type monetary policy reaction has been implemented
in the analysis of advanced economies, little work has been done for less
developed countries.
The purpose of the following section will look at how monetary
policy was conducted in Rwanda by specifying and estimating a monetary reaction
function for National Bank of Rwanda.
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