Academic journal article Journal of Economic Development

Evolution of Monetary Policy Transmission Mechanism in Malawi: A Tvp-Var Approach

Academic journal article Journal of Economic Development

Evolution of Monetary Policy Transmission Mechanism in Malawi: A Tvp-Var Approach

Article excerpt

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The main objective of this paper is to investigate whether the monetary transmission mechanism has changed since Malawi adopted the financial reforms in the 1980s. We investigate how and when the changes in the exogenous shocks of the monetary policy instrument of bank rate have influenced changes in the stability of inflation and output growth. Based on the Bayesian Time Varying Parameter Vector Autoregressive (TVP-VAR) techniques by Primiceri (2005) and Nakajima (2011), we empirically examine how the transmission mechanism and the monetary shocks have been varying overtime. Specifically, we evaluate whether the responses of prices and output level to bank rate, exchange rate and credit growth have been changing during and after financial reforms.1

Prominent work by McKinnon (1973), Shaw (1973) and Levine (2005) provide good foundations in understanding how financial reforms impact economic activities. One main goal of financial reform is to establish a vibrant financial sector that is accommodative of improved monetary policy transmission mechanism. Malawi's financial reform packages have brought about new financial innovation with growing banking system, removal of interest rate and credit controls, opening current and capital account, adopting a managed and floating exchange rate regime, mushrooming of both credit facilities and other non-financial institutions such as insurances. These policy changes have posed macroeconomic challenges for the Reserve Bank of Malawi (RBM). In tandem, we have seen an improvement of the evolution of various economic activities following these reforms. For instance, inflation declined to single digits in 2000s and the country managed to achieve a stable economic growth of about 6 percent on average until 2010. In addition, the country experienced interest rates and exchange rate stability with mushrooming of private sector credit. Therefore, it would be interesting to investigate whether the monetary stabilisation policy had any effects on this hard earned economic stability and how the effects have evolved overtime.

Abundant empirical work regarding monetary transmission mechanism focus on how the monetary policy shocks affect output, prices, exchange rates as well as other key economic variables. Most of these studies use Vector Auto-Regression (VAR) frameworks in their analysis following a breakthrough seminal work by Sims (1980). Some of the most prominent ones include an authoritative survey by Christiano et al. (1999) on USA, Peersman and Smets (2001) on the euro area and a recent survey by Mishra and Montiel (2012) on low-income countries. These models are based on the assumption of constant parameters and constant volatility. However, financial reform is a process and the effects may vary overtime. In addition, Franta et al . (2013) revealed that the reforms can affect the monetary transmission mechanism by changing the overall impact of the policy or by altering the transmission mechanism channels. Hence, the use of these models fails to evaluate how changes in the way macroeconomic variables respond to shocks and how the volatility of shocks hitting the economy evolves overtime. Consequently, the outcome of these models have been affected by omitted variable bias, identification problem, and spurious dynamics in random coefficients (Sims, 1992; Eichenbaum, 1992; Giordan, 2004; Bernanke et al., 2005; Cogley and Sargent, 2005; Sims and Zha, 2006; Koop et al., 2009; Korobilis, 2013).

Accordingly in recent times, empirical researchers have developed the TVP-VAR models to address the issue of time varying parameter problems in the estimation of the monetary policy transmission. For instance, work by Canova (1993) followed by Cogley and Sargent (2001) considered the estimation of the TVP-VAR based on the assumption of constant volatility. However, Koop et al. (2009) and Cogley and Sargent (2005) argue that the transmission mechanism may not be constant overtime and the way the exogenous shocks are generated can change overtime. …

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