On the Optimal Adherence to Money Targets in a New-Keynesian Framework: An Application to Low-Income Countries
IMF Working Papers
Many low-income countries continue to describe their monetary policy framework in terms of targets on monetary aggregates. This contrasts with most modern discussions of monetary policy, and with most practice. We extend the new-Keynesian model to provide a role for "M" in the conduct of monetary policy, and examine the conditions under which some adherence to money targets is optimal. In the spirit of Poole (1970) , this role is based on the incompleteness of information available to the
... l bank, a pervasive issues in these countries. Ex-ante announcements/forecasts for money growth are consistent with a Taylor rule for the relevant short-term interest rate. Ex-post, the policy maker must choose his relative adherence to interest rate and money growth targets. Drawing on the method in Svensson and Woodford (2004) , we show that the optimal adherence to ex-ante targets is equivalent to a signal extraction problem where the central bank uses the money market information to update its estimate of the state of the economy. We estimate the model, using Bayesian methods, for Tanzania, Uganda (both de jure money targeters), and Ghana (a de jure inflation targeter), and compare the de facto adherence to targets with the optimal use of money market information in each country. for helpful comments and suggestions, as well as seminar participants at the IMF Workshop on Frameworks for Policy Analysis in Low-Income Countries. All errors remain ours. Ultimately, the importance of money is an empirical question. We therefore estimate the model for Ghana, Tanzania and Uganda. Uganda and Tanzania are de jure money targeters; Ghana followed a de jure inflation targeting regime since 2004, with an interest rate instrument, but authorities continue to pay attention to monetary aggregates. 7 We use Bayesian methods, which help us estimate the model despite the limited time-series available for these two countries. Our estimation strategy has three main features. First, we impose the same priors on each country, which implies that differences in estimated parameters across countries only reflect information contained in the data. Second, we take the weight given to the interest rate target relative to the 5 See Portillo (2010). 6 In the context of an optimal monetary policy problem, Svensson and Woodford (2004) refer to this circularity as the failure of the separation principle between signal extraction and (the choice of optimal) monetary policy. 7 Ghana and Uganda are relatively well-studied cases: Alichi and others (2010) apply a New Keynesian-type model-without money-to Ghana, while Berg and others (2010) calibrate a micro-founded DSGE to Uganda to understand the impact of aid shocks and the monetary policy response during the period 2000-2004.