Monetary Policy Strategy in Rwanda

2.3.2.5 The Taylor Rule

The Taylor rule is also known as a simple interest rate rule. That is, simply speaking, it is the current practice where Central Bankers could formulate policy in terms of interest rates. This rule was originally proposed by the economist John Taylor following to the need of American Central Bank to set the interest rates to achieve stable price while avoiding large fluctuations in output and employment (Mankiw, 2000).

Considering the monetary transmission mechanism as the process through which monetary policy decisions are transmitted into changes in real GDP and inflation, Taylor (1995) argued that most Central Banks today are taking actions in the monetary market to guide the short-term interest rate in a particular way. In other words, rather than changing the money supply by a given amount and then letting the short-term interest rate take a course implied by money demand, the Central Banks adjust the supply of high-powered money in order to give certain desired movements to the fund rate. The aim is knowing how much the Central Bank should adjust the short-term interest rate in response to various factors in the economy including real GDP and inflation. Taylor proposed a simple interest rule in which the funds rate reacts to two variables: the deviation of inflation from a target rate of inflation, and the percentage deviation for real GDP from potential GDP.

Specifically, the Taylor rule can be written as follows:

R_t = r + Ð_t + ë₁ (Ð_t - Ð_t^*) + ë₂ (Y_t - Y_t^*)

Based on the US context in which this rule was conceived, the symbols in the equation are as follows:

R_t is the nominal federal funds rate, r is the average equilibrium real federal funds rate, Ð_t is the current rate of inflation, (Ð_t - Ð_t^*) is the current rate of inflation less the inflation target,

(Y_t - Y_t^*) is the output gap specified as the excess of actual output over potential output. The responsiveness of the nominal federal funds rate to the deviation of inflation from target, and the output gap is determined by the weights ë₁ and ë₂. The way this rule works can be understood in simple terms as follows:

The Taylor principle states that the Central Bank's policy interest rate should be increased more than one for one with increases in the inflation rate. The Taylor principle ensures that an increase in the inflation rate produces a policy reaction that increases the real rate of interest. The rise in the real interest reduces private spending, slows the economy down, and brings inflation back to the Central Bank's inflation target. Conversely, if inflation falls below the Central Bank's target, the Taylor principle calls for a more than one for one cut in the Central Bank's policy interest rate. This reduces the real rate of interest, stimulates private spending, and pushes inflation back to its target level (Walsh, 2001).

Over several years there has been an emerging consensus among economist authors that the Taylor rule appears to be a good description of the interest rate policies of many Central Banks. Thus, Taylor's rule is the most popular approach to the empirical analysis of reaction functions (Sanchez-Fung, 2000).

Mankiw (2000) shows that Taylor's rule for monetary policy is not only simple and reasonable, but it also resembles the American Central Bank behavior in recent years fairly accurately.

In the light of the different policy rules mentioned above, it is worth noting that studies on monetary policy rules show that it is possible to use very simple rules to achieve better economic performance. However, generally speaking, the question of determining the best rule needs first of all a better understanding of the transmission mechanism of monetary policy through the economic system.

CHAPTER 3: MONETARY POLICY IN RWANDA

3.1 Macroeconomic Background

The destruction of the economic basis that took place during the civil war period (1990-1994) and the genocide (1994) in Rwanda left an economy in a shambles and characterized among others factors by:

- A very high rate of inflation (64% in 1994) that eroded real incomes and damaged economic growth,

- A lack of financial control in government ministries leading to large deficits,

- A narrow export base which concentrated on coffee and tea,

- Dilapidated infrastructures due to the war and the looting of saving banks. The institutional structure of the country was in latters.

Overall, the GDP had fallen between 1990 and 1994 by almost a half.

In response to these challenges, the government embarked along an ambition path of economic reform which started at the end of 1994. Rwanda made the transition from responding to emergencies to ensuring sustainable development. The major objectives of the transition program have been focused on laying the foundations of the transformation of the economy based on a process of economic liberalization and turning away from control regulation and state command to market policies. In the first phase, from 1995 to 1997, macroeconomic policy reforms concentrated on reviving economic activity, restoring macroeconomic stability and rebuilding the capacity for macroeconomic and budget management.

The implementation of the economic reform programs benefited from the help of IMF and World Bank. The key areas of reforms were in the trade and exchange regimes, the fiscal area, the financial sector, and the privatisation. The main emphasis of the policy package adopted was placed on liberalizing the trade and payment regime. External tariffs were reduced, exchange regulations were streamlined and further liberalized in 1998, and the convertibility of the Rwanda francs for current account transactions were also made in 1998. In the financial sector, in addition to liberalizing interest rates, and the adoption of a Central Bank law that gave the National Bank of Rwanda independence in monetary policy in 1997, a new commercial banking law that provides for effective prudential regulation of commercial banks was adopted in 1999.

The country began the process of recovery in earnest in 1995. In 1995 growth in real GDP was 35.2%, in 1996, 12.7%; 1997, 13.8%; 1998, 9%; 1999, 7.6%; 2000, 6%; 2001, 6.8%; 2002, 9.9% (Republic of Rwanda, 2000)

However, it is important to emphasis that the international community also played a significant role in that success. Indeed, Rwanda has benefited from IMF and the World Bank sponsored Highly Indebted Poor Countries (HIPC) debt relief initiatives to tune of US $ 850 million which is about US $ 640 million in Net Present Value (NPV) terms. The principal government objective is controlling inflation. This is being done through measures such as:

- Improvement in monitoring and control of budget expenditure,

- Improvement in government saving by enhancing revenue performance,

- Liberalization of interest rates. Monetary management has shifted from direct controls to indirect monetary management through open market operations,

- Reform in tax policy, and the creation in 1997 of the Rwanda Revenue Authority (RRA). The government took measures to improve the fiscal situation mostly through improved tax and customs administration and tax reforms.

These measures were intended to address the traditional sources of monetary instability in Rwanda, such as monetization of the fiscal deficit and excessive borrowing from the commercial banks with a view to strengthening the conduct of monetary policy and the process of financial intermediation.

Many changes have been noticed in Rwanda from 1995. The improvements reflect a commitment by the country to sound macroeconomics policies and more open and better managed economies to address the many social challenges that exist in the country. The success of such policies have often been realised with the help of international community in the context of Medium-Term Policy Programs supported by the IMF and World Bank. Between 1987 and 1999 this help was provided for African countries through the Fund's Enhanced Structural Adjustment Facility (ESAF). But in late 1999, the ESAF was transformed into the Poverty Reduction and Growth Facility (PGRF), signifying a new approach to policy programs and poverty reduction. The issue, therefore, is for Rwanda's Central Bank to design an appropriate framework that can accommodate high economic performance in terms of GDP growth and price stability while contributing to the poverty reduction in the country.