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Tue dole of National Bank of Rwanda from 1995 to 2010

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par Paterne RUKUNDO
National university of Rwanda - A0 2011

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This dissertation intended to study how monetary policy was 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 1995-2010.

Applying Ordinary Least Squared (OLS) on data taken from the National Bank of Rwanda, the Ministry of Economic and Finance of Rwanda and Rwanda National Institute of Statistics (RNIS) together, the study shows that the National Bank of Rwanda has had a monetary policy over the years with the monetary stock aggregates as the principal instrument.

According to the Taylor rule, monetary policy responds directly to inflation as any inflation-targeting central bank must. But it also responds to the output gap, which can be viewed as a measure of inflationary pressures.

The Rwanda Central Bank's reaction function can be characterized by:

- A previous monetary stock aggregate weight of (0.9961), which is positively related to the current monetary stock aggregate,

- Current inflation gap weight of 1.492988, which is positively related to the monetary stock aggregate,

- A previous inflation gap weight of 2.824734, which is positively related to the monetary stock aggregate,

- A Current Output gap weight of - 0.549954 that is negatively related to the monetary stock,

- A previous Output gap weight of 0.099609, which is positively related to the monetary stock aggregate,

- A Current variation of Exchange weight of - 0.088485, which is negatively related to the monetary stock,

- A previous variation of Exchange weight of - 0.311933, which is negatively related to the monetary stock.

Judging these results according to the importance of each variable weight, one may be inclined to contend that while the National Bank of Rwanda reacted to the inflation from the previous and the contemporaneous period, there was a much stronger response to the change in the previous exchange.

In general, such strong response of the National Bank of Rwanda to the exchange rate may reflect the economic environment in which the monetary policy was operating, because international aid has flow into Rwanda since 1995 in the context of various economic programs undertaken with the help of the International Monetary Fund (IMF) or World Bank (WB). In addition, the estimated results indicated a neglect of output gap as a goal variable.

Given the fact that the Rwanda Central Bank claimed to be following the objective of preserving the internal and the external value of the currency in order to maintain harmony between the pace of the money creation and that of economic growth it may be suggested that the Central Bank of Rwanda should give more consideration to the way the output changes, that is, the Central Bank should respond to the variation of output gap following the influence of its change in the economic state.

In addition, the results of this study of course, are backward looking, in the sense that they represent the relationships that existed so far in the data. It is worth noting that a forward-looking model may enable the implantation of a more successful monetary policy rule for Rwanda and there may be areas for future research.

The NBR's monetary programming could benefit from attributing a higher weight to the specification of money demand. The analysis in this dissertation shows that, despite political and economic volatility, and extensive controls, money demand, both in the short and long terms, reacts in a way consistent with economic fundamentals.

Taking this into account when planning interventions in the foreign exchange and money markets (both through changes in discount interest rates and open market operations) could help the NBR to avoid monetary overhangs and exchange rate volatility, or bursts in the core inflation rate.

· The National Bank of Rwanda should continue to promote measures that could stabilize

excess reserves. Measures could include closing the commercial bank accounts at the central bank later in the day and promoting the interbank market by reducing credit risk through more transparency (for example, an automated book-entry system).

· Based on the results of the study, it is urgent suggested that Rwandan government could take the financial sector as a pillar of economic growth which can replace non performing industrial sector and agriculture. The emphasis put on it can allow Rwanda to be the net exporter of financial services within East African Community and Commonwealth where Rwanda was admitted recently, as we do not have any comparative advantage in remaining sectors.

· The emphasis should be put on the level of financial intermediation through increase in the credit allocated to private sector. It is however important to note that the allocation of the credit should be changed from private consumption and services to agriculture and other investment projects like construction sector. Additionally, credit allocation should be based on the profitability of the investment rather than personal considerations or values.

· More so, National Bank of Rwanda should continue to accelerate the financial innovations which are currently very low, by making compulsory: distribution of ATM cards by banks upon bank account opening; and the use of credit cards as a means of payment in strong legalized supermarkets and shops, as a first step in the introduction of card-based system of payment.

· BPR S.A has provided evidence that bank branch proximity is a key factor in bank profitability. It is therefore, suggested that other commercial banks in Rwanda should open at least one branch in each district. Due to the absence of positive impact of financial innovations on economic growth explained by inflationary pressures and exchange rate depreciation, the national bank of Rwanda should put more efforts on price and exchange rate stability.

· It is important for policymakers to make credible announcements. If private agents ( consumers and  firms) believe that policymakers are committed to lowering  inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is entirely different matter; compare for instance  rational expectations with  adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no  demand pull inflation because employees are receiving a smaller wage and there is no  cost push inflation because employers are paying out less

in wages. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand ( demand pull inflation) and a firm's costs ( cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect.

· More so, Rwandan government should accelerate financial innovations which are currently very low, by making compulsory: distribution of ATM cards by banks upon bank account opening; and the use of credit cards as a means of payment in strong legalized supermarkets and shops.

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