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The impact of monetary policy on consumer price index (CPI): 1985-2010


par Sylvie NIBEZA
Kigali Independent University (ULK) - Master Degree 2014
  

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2.1.4 Strategies of monetary policy

Having identified the instruments available for active monetary policy implementation, it is important to understand the current conduct of monetary policy needs to be operated within a well-defined to independent Central bank. This means simply to provide the authorities of Central banks with the power to determine quantities and interest rates on its own transactions without interference from government institutions (Lybeck, 1998 quoted in Worrel, 2000).

Similarly, Blinder (1998) shows that Central bank independence means two things: Firstly, that the Central bank has the freedom to decide how to pursue its goals, and secondly, that its decisions are very difficult for other branches of government to reverse.

This implies that an independent Central bank needs to be free of the political pressures that influence other government institutions. This is particularly important when a Central bank needs to target inflation, exchange rates or the monetary base for example.

On this basis, an important point to analyze could be the way Central banks process before following a given strategy.

Monetary policy will aim at keeping the annual inflation rate below 5 percent. The monetary authorities will pursue a reserve money target, while closely monitoring developments in bank liquidity and broad money.

The BNR will control monetary aggregates and influence interest rates through indirect instruments: the Treasury bill auctions (commenced in late 1998) and money market operations on its own account.

The Government intends to progressively replace the outstanding stock of consolidated debt held by commercial banks by negotiable treasury bills in the course of 1999-2000, so as to contribute to the development of a secondary market for government paper. Coordination between the Ministry of Finance and the BNR will be strengthened to ensure the consistency of the program's fiscal and monetary objectives.

2.1.5 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 knows 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:

In this equation,

  Is the target short-term  nominal interest rate 

· is the rate of  inflation as measured by the  GDP deflator

·   is the desired rate of inflation,

·   is the assumed equilibrium real interest rate,

·   is the logarithm of real  GDP

·  is the logarithm of  potential output, as determined by a linear trend.

In this equation,

Both  and  should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting

That is, the rule "recommends" a relatively high interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its  full-employment level, in order to reduce inflationary pressure.

It recommends a relatively low interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target while output is below full employment. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output

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.

( http://en.wikipedia.org/wiki/Taylor_rule visited on 2 September, 2014)

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 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.

 The exchange rate will continue to be market determined, with the BNR's intervention in the exchange market confined to meeting the net foreign assets target and smoothing short-term exchange rate fluctuations, while not resisting underlying trends.

To improve the functioning of the exchange market, the BNR will continue to communicate to economic agents the cost advantages of bank settlements instead of cash transactions (currently causing a premium for dollar bills), and develop a forward market, for which the regulatory framework was established in May 1999.

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