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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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1.1 Background to the study

Monetary policy can be defined as the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. The Central Bank is the highest authority employed by the government for formulation of monetary policy to guide the economy in a certain country. Monetary policy is defined as the regulation of the money supply and interest rates by a central bank. Monetary policy also refers to how the central bank uses interest rates and the money supply to guide economic growth by controlling inflation and stabilizing currency.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies.

The economic theory states that monetary policy is important policy to affect the level of output which is one of the targets of economic policy (Teigen 1978). The monetarists believe that monetary policy exerts greater impact on economic activity. The Keynesians believe that the monetary policy exerts greater influence on economic activity.

Adam Smith first delved into the subject monetary policy rules in the Wealth of Nations arguing that «a well-regulated paper-money» could have significant advantages in improving economic growth and stability compared to a pure commodity standard. By the start of the 19th century Henry Thornton and then David Ricardo were stressing the importance of rule-guided monetary policy after they saw the monetary-induced financial crises related to the Napoleonic Wars.

The choice between a monetary standard where the money supply jumped around randomly versus a simple policy rule with a smoothly growing money and credit seemed like a no brainer.

The choice was both broader and simpler than «rules versus discretion.» It was «rules versus chaotic monetary policy» whether the chaos was caused by discretion or simply exogenous shocks like gold discoveries or shortages.

A significant change in economists' search for simple monetary policy rules occurred in the 1970s, however, as a new type of macroeconomic model appeared on the scene. The new models were dynamic, stochastic, and empirically estimated. And because they incorporated both rational expectations and sticky prices, they were sophisticated enough to serve as a laboratory to examine how monetary policy rules would work in practice. These were the models that were used to find new policy rules, such as the Taylor Rule, to compare the new rules with earlier constant growth rate rules or with actual policy, and to check the rules for robustness.

Examples include the simple three equation model in Taylor (1979), the multi-equation international models in the comparative studies by Bryant, Hooper, and Mann (1993), and the econometric models in robustness analyses of Levin, Wieland, and Williams (1999).

More or less simultaneously practical experience was confirming the model simulation results as the instability of the Great Inflation of the 1970s gave way to the Great Moderation around the same time that actual monetary policy began to resemble the simple policy rules that were proposed.

From the experience of developed economies in the world which exhibit strong economic management, various countries in developing economies have undertaken economic reforms consisting essentially of a set of market-oriented economic policies intended to readjust the economy to the liberalization as well as bringing about an institutional reorganization.

Monetary policy is only one element of overall macroeconomic policy, and can only affect the production process through its impact on interest rates. Contractionary monetary policy raises longer-term real interest rates. The nominal interest rate equals the real interest rate plus the expected inflation rate. If contractionary monetary policy lowers expected inflation or leaves it unchanged, then evidence that it increases the nominal interest rate implies that it must be increasing the real interest rate also (Thorbecke and Zhang, 2008).

Hardouvelis and Barnhardt (1989), Frankel (2008) and others have shown that if monetary policy actions are expected to increase real interest rates they will lower commodity prices and if they are expected to lower inflation they will also lower commodity prices. The main cause of high interest rates is high inflation, through the expected inflation Premium. Conversely, the best prospect for low interest rates is a stable environment of low inflation.

In this context, the relatively high interest rates that may be necessary to achieve a desired disinflation represent «short-term pain for long term gain.» Central Bank, therefore, has a current focus on anti-inflation policy which will ensure steady growth in the long run (Shamshad, 2007).

In the sub-Sahara African context, reforms increased significantly in the 1990s. The broad strategy has been the emphasis placed on the policy programs supported by the International Monetary Fund (IMF) and the World Bank, including among others fiscal reforms, liberation of exchange restriction and the adoption of indirect instrument of monetary policy, market-based interest policies, and so on. (IMF, December 2000).

In such program, the monetary policy played a central role in producing macroeconomic stability. It stated that monetary and credit policies would aim at further reducing the rate of inflation, and the authorities would continue to monitor development in both reserve money and broad money closely (IMF and Rwanda 1995/2002).

The control of money supply is an important policy tool in conducting monetary policy. The success of monetary policy depends on the degree of predictability, measurability and controllability that the monetary authority has over Money supply.

Rwanda is no exception to this situation. Rwanda's economy is very small and open, heavily reliant on the export of few major products, especially coffee and tea. In addition it is also very reliant on imports for most of its consumables. The government of Rwanda's commitment to create a favorable production is deeply enshrined in its Vision 2020, where it has one of its strong pillars «Development of entrepreneurship and private sector (MINALOC.Rwanda Vision 2020 Umurenge, 2000, p4.), EDPRS in order to achieve sustainable economic development.

Monetary policy in Rwanda has had several reforms over time, from the use of direct instruments to indirect instruments to achieve macroeconomic targets within a liberalized system.

Currently, the National Bank of Rwanda (BNR) conducts monetary policy based on a monetary targeting framework with the monetary base as operating target and interest rate (the Key Repo Rate) as the policy instrument (BNR 2013, 13).

A monetary program is prepared considering the economic outlook of the country and projections based on the desired rate of monetary expansion to achieve a target rate of inflation, consistent with the projected rate of economic growth, balance of payments forecast and expected fiscal operations of the government (BNR 2013, 13).

The outcome of this study will help improve monetary policy implementation and thus strengthen macroeconomic stability in Rwanda.

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