Analysis Of Monetary Policy Frameworks

There are four main types of monetary policy frameworks identified from review: exchange rate targeting, inflation targeting, monetary quantity targeting and dollarization. Developing countries can chose from inflation, exchange rate and money supply as nominal targets. Most countries are moving towards inflation targeting due to its greater achievement of monetary policy objectives compared to other frameworks. For instance, Lin and Ye (2009) established that inflation targeting has large and significant effects on lowering both inflation and inflation variability in developing countries, but its effectiveness depends on specific country characteristics. While the belief about inflation targeting has grown over time, the global financial crisis of 2007-2009 challenged its use shifting the focus of central banks to other nominal variables such as exchange rate, prices of agricultural and mineral products, and asset prices such as equities and real estate. Monetary targeting is applicable where there is a stable relationship between one or more aggregates and the general level of prices, and requires adequate knowledge of the parameters characterizing the demand for money. However, exchange rate targeting is ineffective where there is a high capital mobility and unstable capital movements as fixing exchange rate in a financially integrated environment implies giving up monetary independence to supply shocks.

In Sub Saharan Africa (SSA), monetary policy frameworks in place are monetary targeting and fixed exchange rate regimes (including the CFA monetary unions), though most countries in SSA use quantitative money targets as domestic anchor for monetary policy. Kenya follows a hybrid regime of inflation targeting and monetary targets, maintaining inflation at single digit levels, while setting targets for monetary aggregates annually depending on the prevailing macroeconomic conditions. Studies on evaluation of monetary policy have gone to estimating dynamic stochastic general equilibrium (DSGE) models, referred to as the new Keynesian framework. While DSGE models have not been popular in studies within African countries, their use has lately been advocated for given the inherent structural and monetary policy challenges facing African countries that are not reflected in current models. The DSGE models have become relevant as African countries move to greater exchange rate flexibility with emphasis on inflation as the intermediate target of policy.

Among the various components of a DSGE model is monetary reaction function. While use of DSGE models is important, we focus on monetary reaction function rather than DSGE model. DSGE models can be implemented as an interest-rate rule, with endogenous money stock or as a money-growth rule with endogenous interest rate, making the models applicable for African countries that use reserve-money rather than interest rate as policy instrument or operating target. Use of monetary rather than inflation targeting is advocated for since it allows greater control over monetary aggregates and the targets are easier to meet than inflation targets, though they have lower information content .

To effectively establish price stability, the central bank makes forecasts of the macroeconomic environment. This assists in making decisions on the nature of monetary policy to pursue in the medium term. Questions have been raised about the accuracy of these estimates, especially in African setting where a number of risk factors have to be controlled. However, a study by Rulke (2012) found that central bank projections are rational and unbiased, though inflation projections are more biased than growth projections.