Monetary policy and macroeconomic stabilization: an application of new Keynesian framework for forecasting and policy analysis in Ghana
Date
2020
Authors
Akosah, Nana Kwame
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Abstract
The role of monetary policy in macroeconomic stabilization remains an important research focus for central banks, particularly in frontier and developing economies where the institutional structure are not quite complete, integration with the world economy is partial and also just at the beginning of a process of growth and transformation. These economies are also confronted with relatively large and recurrent correlated shocks entirely different from their developed counterparts. Notwithstanding, there is paucity of studies on monetary policy making in frontier and developing economies as the bulk of the literature has concentrated on either advanced economies or emerging markets where there is stable institutional structure and relatively predictable economic linkages. One of such leading frontier markets is Ghana. The West African nation became the 28th economy in the world but second Africa country after South Africa to officially opt for inflation targeting framework of monetary policy in May 2007. Regardless of the well-formulated price stability objective and operational independence clearly preserved in the Bank of Ghana (BOG) Acts 2002 (Act 612) after the adoption of inflation targeting regime, inflationary pressures have lingered over the years in Ghana. Without a doubt, Ghana’s consumer price inflation has been among the highest in sub-Saharan African economies, and the inflationary developments are often linked to large internal and external aggregate demand and supply-side shocks. The BOG has over the years adopted different policy stance in an attempt to steer inflation towards its medium term target of 8±2 percent, and hence, to ensure overall macroeconomic stability. The disinflationary process has often been short-lived, triggering controversy in policy and academic discourses regarding the appropriateness of the current monetary policy regime in Ghana. At the same time, some fast pace of GDP growth has recently been recorded, placing Ghana among the fastest growing economies in Africa. In the midst of these uneven macroeconomic outcomes, it is of paramount interest to comprehend the effectiveness and the dominant channel of monetary policy transmission mechanism in Ghana. Also given the fact that BOG currently follows a certain policy rule, it is necessary to ascertain how BOG has reacted to macroeconomic shocks over the years. Furthermore, available empirical literature is inconclusive on the extent of the policy pass-through (i.e. via interest rate) to the real economy in Ghana amid large segment of unbanked population (i.e. nonRicardian consumers) and continuous fragile fiscal profile. Besides, the New Keynesian framework for monetary policy analysis and forecasting adopted in frontier and developing economies still follows the representative agents’ approach - which assumes that all households have complete access to the financial system and hence, able to smooth consumption - even though a large segment of the population face acute financial constraints and are thus “hand-to-mouth” consumers. Given the pace of financial integration and international trade dynamics, evidence of shock transmission and interdependence of macroeconomic variables could provide meaningful suggestions for monetary policy implementation in a small but highly opened economy like Ghana with underdeveloped financial market. This thesis addresses these gaps inherent in extant literature and offers empirical solutions for the Ghanaian case by investigating the monetary and business cycle dynamics, exploring interdependence (spillovers) between policy instruments and targeted macroeconomic variables, estimating monetary policy reaction function, developing a New Keynesian DSGE framework with and without non-Ricardian consumers for monetary policy forecasting and analysis as well as for consumption effects of monetary and fiscal policies.
On a whole, the thesis is methodically organized into six essential and interrelated empirical chapters, each significantly touching on peculiar theme(s) that form the crux of the problems or research questions on monetary policy and macroeconomic stability while employing advanced macroeconometric techniques and models that underpin monetary policy transmission mechanism in a leading frontier market, Ghana. The first four empirical chapters of the thesis judiciously use empirical macroeconometric methods to investigate four aspects of monetary policy making in Ghana. In particular, the first empirical chapter focuses mainly on the institutional and practical architecture of the current monetary policy framework in Ghana. In a sense, it comprehensively explores the level of transparency, accountability and credibility of Bank of Ghana, following much of the literature. The salient finding is that monetary policy framework is consistent with inflation forecast targeting and exhibits moderate levels of policy transparency and credibility. The second empirical chapter investigates the macroeconomic benefits of inflation targeting strategy in Ghana using business cycle analysis and standard econometric methods. This chapter shows significant interconnectedness with business cycle and that the inflation targeting strategy has been broadly beneficial in Ghana compare to the previous policy regimes. The third empirical chapter investigates monetary policy transmission mechanism and its overall effectiveness with particular focus on the macroeconomic interdependence or volatility spillovers among money market interest rate on one hand and among the policy (interest) rate, exchange rate and the real sector (i.e. inflation and output gap) on the other hand, over time and in multiscale domain. Using appropriate models such as three-dimensional continuous Morlet wavelet coherency technique, parametric and nonparametric Granger non-causality tests, as well as the generalized forecast error variance decomposition (GFEVD) methods, the chapter mainly suggests moderate levels of interconnectedness among money market interest rates across time and multiscale domains in Ghana. The third empirical chapter further reveals that the degree of interdependence among the policy interest rate, exchange rate and the real macro-variables are scale-dependent, as strong interlinkages are observed at the longer time-scale. The fourth empirical chapter looks at macroeconomic policy reaction functions with the view to determining monetary policy preference across economic cycles and political regimes in Ghana using generalized least squares and quantile regression methods. The basic finding of the fourth empirical chapter is a clear evidence of an asymmetric monetary policy rule with vivid vacillation in the key policy parameters across business cycles and time, strong interest rate inertia and weak evidence of heterogeneous policy preference in different political regimes, surmising the exercise of monetary policy independence. Together, the findings of the preceding four chapter form the basis for the development of small-open economy general equilibrium model in the subsequent two empirical chapters. Notably, the fifth empirical chapter develops and estimates a small-open economy New Keynesian general equilibrium model with representative agent (i.e. RANK) for monetary policy analysis in Ghana. It empirically tests the RANK model with the view to analyzing and determining the optimal monetary policy rule for Ghana. The salient finding is that forward-looking monetary policy rule is optimal for Ghana. However, the impulse response function demonstrated that model is prone to price puzzle. Given the large proportion of unbanked population in Ghana, we further extend the analysis of the preceding chapter to accommodate heterogeneous household behaviour. Accordingly, the sixth empirical chapter develops a small-open economy New Keynesian general equilibrium model with heterogeneous agent (i.e. HANK) with the view to exploring the implications of the inclusion of non-Ricardian households on monetary and fiscal policy transmissions in Ghana. Thus, the empirical chapter six assesses the relative suitability of the HANK model for monetary policy analysis in Ghana. Though the findings corroborate the earlier support for forward-looking monetary policy rule for Ghana, the HANK model in chapter six rather generates meaningful impulse response functions and hence, more suitable for monetary policy investigations in Ghana.
Collectively, the findings of the thesis provide new and unique perspectives that extend current understanding of the monetary policy framework and its interconnectedness with the real sector within a frontier or developing economy saddled with underdeveloped financial markets as well as heterogeneous economic agents.
Description
A thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy in the field of Economics to the Faculty of Commerce, Law and Management in the Graduate School of Business Administration, Wits Business School, University of the Witwatersrand, Johannesburg, 2020