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Student Publications
Author: Gideon Gono
Title:
Monetary Economics And Central Banking: The International Experience And Case For Zimbawe
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1.0 INTRODUCTION AND BACKGROUND
Monetary economics has made much success in making
inroads in influencing real life developments in the design
of monetary institutions and day-to-day conduct of
monetary policy. Monetary economics has established a
firmer footing for Central Bank`s monetary policy design in
many countries. Central Banks used to operate in a partial
theoretical vacuum before the inter-linkage between
economic theory, research and models from actual practice.
Modern monetary policy is now based on a fairly firm
theoretical and empirical foundation, which presents quite
consistent advice for policy making.
1.1 To see this inter-linkage it is important to first define what
monetary economics is. Monetary economics is the body of
accepted theories that concern the role of money at micro
and macro level. It largely involves the role of money in an
economy. Role of money in affecting the price level,
interest rate, employment, output and exchange rate.
1.2 Various theories that are sometimes in contradiction due to
different assumptions made about the economy have been
formulated trying to show how money may affect these
variables. They range from Classical, Keynesian and
Monetarist thinking. McCulum(1998) defined monetary
4
economics as the effect of monetary institutions
and policy
actions on economic variables such as commodity prices,
wages, interest rates, employment, consumption and
production.
1.3 The subject also covers the origin, functions and value of
money, a large part of macroeconomics with emphasis on
monetary policy, central banking and financial markets.
Monetary policy tries to use mainstream monetary
economics in formulating policies to achieve general
objectives in the economy.
1.4 Specifically monetary policy, which is the main activity of
central bank, is the deliberate effort by the Central Bank to
control the money supply and credit conditions for the
purpose of achieving certain broad economic objectives.
1.5 These objectives are price stability, promote economic
growth, stabilise the exchange rate, and bring soundness
and stability in the financial sector. More commonly the
goal of monetary policy is to accommodate economic
growth in an environment of stable prices.
1.6 From these definitions it can be envisaged that there is a
greater inter-linkage between Central banking activity and
5
monetary economics. There is an element of
reliance on
each other. Developments both from practice and monetary
economics per ser have enabled convergence between these
two.
1.7 First, advances in macroeconomics and monetary
economics have aligned theory more closely with central
banks` ideas of the importance and effectiveness of
monetary policy.
1.8 Second, changes in the framework, communication and
design of monetary policy-making have also impacted
theory � the introduction of inflation targeting is probably
the clearest example.
1.9 Third, the focus of research has increasingly shifted towards
central bank tasks. Finally, model design has been reshaped
in light of new knowledge. Academic economists and
central bank experts now work closely together on
developing new Classical, Keynesian and Monetarists
general equilibrium models.
1.10 Monetary policy is now at center stage in discussions about
how to promote sustainable growth and low inflation in the
economy. Fiscal policy has lost its luster as a tool to
6
stabilize the aggregate economy because of
doubts about
the ability to time fiscal policy actions to obtain desirable
stabilization outcomes, as well as concerns about budget
deficits.
1.11 The result is that both economists and politicians in recent
years advocate that the stabilization of output and inflation
be left to monetary policy. The economics profession has
also become more supportive of price stability as the long-
run primary goal for a central bank.
1.12 In order to be successful in such an enterprise, the monetary
authorities must have an accurate assessment of the timing
and effect of their policies on the economy, thus requiring
an understanding of the mechanisms through which
monetary policy affects the economy.
1.13 In formulating monetary policy Central Banks takes four
main factors into account:-
The latest economic theories at any time
Empirical research results for example the transmission
mechanism of monetary policy and determinants of
inflation
Practical experience from previous monetary policy
making
7
Forecast of models that aim to incorporate all
the above
three.
1.14 Monetary economics is quite a diverse field. In the past
models used in monetary economics were fiercely criticised
by central banks. The gap between academic
macroeconomic models and applied policy models has
decreased in recent years.
1.15 There has been a clear tendency away from the large-scale
disaggregated models of the1970s towards traceable small-
and medium-sized models, well suitable for short and
medium-term policy analysis, which is the basis for
efficient monetary policy-making in an uncertain
environment.
1.16 The older large scale models were criticized on a number of
fronts, e.g. for lacking microeconomic foundation, their
treatment of expectations formation, their forecasting
abilities in comparison to simple vector auto regression
(VAR) models, their underlying econometric methodology
and their modelling of the cost of disinflation in terms of
output losses.
8
1.17 In the words of Pesaran and Smith (1995):
The models did
not represent the data , ... did not represent the theory ... and
were ineffective for practical purposes of forecasting and
policy (Pesaran and Smith, 1995: 65-66). It is therefore of
paramount importance to reflect both international and
Zimbabwe experience on how Central Banking activity and
monetary economics has been related.
1.18 Theories that are of importance to reflect on are those that
deal with :
Role of money on economic activity (transmission
mechanism)
Stabilisation programmes
Central bank independence and governance
1.19 This paper is divided into five sections. Section two deals
with theoretical review, which is divided into three
subsections; role of money on economic activity (the
transmission mechanism), stabilisation programmes and
central bank independence and governance. Given these
theories, section three reviews empirical evidence, section
four analyses Zimbabwe`s experience. Policy implications
are contained in section five . Finally section six concludes
the study.
9
2.0 THEORETICAL REVIEW
Under this section theoretical models will be reviewed in
regard to three important concepts in monetary economics:-
Role of money on economic activity (the transmission
mechanism)
Stabilisation programmes
Central bank independence and governance
2.1 ROLE OF MONEY ON ECONOMIC ACTIVITY
An understanding of the transmission mechanism process is
essential to the appropriate design and implementation of
monetary policy. Monetary policy transmission mechanism
is the process through which monetary policy decisions
affect aggregate demand in the economy, inflation
expectations and the inflation rate. Monetary policy actions
are primarily manifested by changes in short and long-term
interest rates, asset prices, liquidity and the exchange rate of
domestic currency. There are various theories, which try to
explain the role of money in an economy and its
transmission mechanism. These ranges from Classical,
Keynesian and Monetarist thinking.
10
2.1.1 Classical Transmission Mechanism-money
Classical theory is based on the notion that market always
clear and assumes that the economy is always at fully
employment. Prices and wages are flexible and the
economy moves automatically and quickly to its full
employment.
2.1.2 The Classical theory holds that money is just a veil; it does
not affect real variables in the economy that is output,
interest rate and employment. Rather they state that money
directly affects the price level. Real variables for example
output is determined by real supply side factors such as
technological change, population growth, change in labour
and capital formation. They base their arguments on the
assumption of production function.
2.1.3 To them the quantity theory of money provides the basis for
illustrating the effect of money in an economy. The
following equation by Fisher (1921) illustrates the quantity
theory
of
money:
MV Q
P ....................................(1) where M is
money supply in circulation, V is velocity of money
circulation , which is assumed constant as it is determined
by buying habits and institutional transactions which
changes slowly in the economy. , P is the price level, and
11
Q is output and is also assumed fixed
from the classical;
assumption of flexible prices and wages.
2.1.4 What it means is that if money supply changes prices will
change by the same proportion. If money supply is doubled,
price will double, nothing else in the world changes, money
is just a veil. Its sole purpose is to determine the general
price level at which transaction of goods will take place.
2.1.5 As money supply increase this will spill over to excess
demand of goods and services, but as there will be no goods
and services as they are fixed by supply side factors. The
result will be, too much money chasing too few goods.
Prices will continue to rise until excess supply of money is
eliminated.
2.1.6 Implication for monetary policy for them is that money is
neutral; it does not affect the real economic activity.
Monetary policy should not therefore be geared to control
real variables such as output and employment. In another
sense money to them is very important, as it determines the
aggregate price level. Therefore the goal for monetary
policy is price stability as suggested by the classical
quantity theory.
12
2.1.7 Keynesian Transmission Mechanism
�interest rate
channel
Keynesian theory holds an opposite view to Classical
neutrality proposition. Keynes observes that a modern
market economy can get trapped in an under employment
equilibrium.
2.1.8 He emphasised that because of wage and price inflexibility,
there is no economic mechanism that restore production at
full employment capacity. A nation could remain in its low
output, misery condition for long time from the absence of
self-correcting mechanism or invisible hand to guide the
economy back to full employment.
2.1.10Money affects real variables such as output, employment
and interest rate. Keynesian viewed interest rate as a price
for parting with liquidity and thought interest rate as a real
variable determined by money supply and money demand.
2.1.11 Basically the monetary transmission mechanism is that
from the interest rate to aggregate demand. The effect can
either be through the portfolio (investment) effect, credit
availability effects and exchange rate effect.
13
2.1.12 The traditional Keynesian ISLM view of
the monetary
transmission mechanism can be characterized by the
following schematic, showing the effects of a monetary
expansion:
M s i I Y .......................................(2)
where
s
M indicates an expansionary monetary policy
leading to a fall in real interest rates i which in turn
lowers the cost of capital, causing a rise in investment
spending I , thereby leading to an increase in aggregate
demand and a rise in output Y . Although Keynes
originally emphasized this channel as operating through
businesses' decisions about investment spending, later
research recognized that consumers' decisions about
housing and consumer durable expenditure are also
investment decisions.
2.1.13 Thus, the interest rate channel of monetary transmission
outlined in the schematic above applies equally to
consumer spending in which I represent residential
housing and consumer durable expenditure. An important
feature of the interest rate transmission mechanism is its
emphasis on the real rather than the nominal interest rate
as that which affects consumer and business decisions.
2.1.14 In addition, it is often the real long-term interest
rate and
14
not the short-term interest rate that is viewed
as having the
major impact on spending. How is it that changes in the
short-term nominal interest rate induced by a central bank
result in a corresponding change in the real interest rate on
both short and long-term bonds?
2.1.15 The key is sticky prices, so that expansionary monetary
policy, which lowers the short-term nominal interest rate,
also lowers the short-term real interest rate, and this
would still be true even in a world with rational
expectations. The expectations hypothesis of the term
structure, which states that the long-term interest rate is an
average of expected future short-term interest rates,
suggests that the lower real short-term interest rate leads
to a fall in the real long-term interest rate.
2.1.16 These lower real interest rates then lead to rises in
business
fixed investment, residential housing investment,
consumer durable expenditure and inventory investment,
all of which produce the rise in aggregate output.
2.1.17 Exchange rate effect:- changes in money supply can also
15
affect aggregate demand via an effect on
exchange rate.
This happens through the effect of money supply on
interest rates. Reduction in money supply causes interest
rate to rise, which in turn cause exchange rate to
appreciate.
2.1.18 The reason is that higher interest rates make domestic
financial assets more attractive than comparable foreign
assets, all other things being equal. Demand for domestic
currency therefore increases, causing a rise in its price that
is an appreciation. However this depends on prevailing
country situation. a rise in nominal interest rates which
reflects higher inflation expectations generally causes the
domestic exchange rate to depreciate since investors
expect higher future inflation to reduce its value, i.e. cause
a depreciation.
2.1.19 Therefore they immediately sell the domestic currency to
avoid exchange rate losses later. This increased supply of
domestic currency then causes it to depreciate. A rise in
the policy rate may therefore weaken the domestic
exchange rate if it is insufficient to offset higher inflation
expectations, meaning that the central bank`s real policy
rate has in fact fallen, despite the nominal rise.
16
2.1.20 Monetarist Transmission mechanisms
Monetarists believe that changes in the money supply are a
very important determinant of changes in the level of
economic activity in both real and nominal terms.
Friedman (1970) has stated a modern quantity theory of
money, which has its roots in the classical quantity theory
but is broader than its predecessor.
2.1.21 The modern quantity theory of money states that change
in the money will change the price level as long as the
demand for money is stable, such a change also affect the
real value of national income and economic activity but in
the short run only whilst in the long run monetary shocks
changes nominal values.
2.1.22 Monetarists attributes short run non-neutrality of money to
nominal rigidities or mistaken expectations and in the
long run these rigidities wash out the error in expectations
which are corrected making real outcome independent of
the monetary changes. As long as demand for money is
stable it is possible to predict the effects of changes in
money supply on total expenditure and income. Money
supply will lead to a rise in output and employment
because of a rise in expenditure, but only in the short run.
17
2.1.23 An implication to monetary policy is
that monetary policy
should be governed by a simple rule for money growth
and not be left to the discretion of policy makers. They
advocated for a constant money- growth rate rule to
prevent instability in money growth rate with resulting
instability in prices and output. Central Banks can
therefore control the volume of spending by controlling
money supply (given stability in velocity)
2.2 STABILIZATION PROGRAMMES
In developing countries stabilisation programmes are aimed
at bringing inflation from generally high levels down to
levels similar to those observed in developed countries or,
at least, to what is considered acceptable given a country's
inflationary history. Because high inflation is harmful to
growth and development, stabilisation is a major policy
objective in countries facing it and is treated as a major
issue in monetary economics.
2.2.1 This mainly stems from the general consensus that the main
primary goal of Central banks is price stability. Different
nominal anchors have been advocated in disinflation
programmes. According to Agenor and Montiel (1999),
18
efforts to combat high inflation have been
undertaken under
mainly three different approaches:
Populist
Orthodox
Heterodox.
2.2.2 The Populist approach: under this approach the focus is
on
direct intervention in the wage�price process through the
implementation of wage and price controls, not necessarily
accompanied by adjustment in underlying fiscal imbalance.
The logic behind is that the economy suffers from
unutilised productive capacity due to deficient demand, and
monopoly power, and that by stimulating aggregate demand
production will increase leading to a concomitant increase
in total profits even though per-unit profits may be
depressed. Price controls would be aimed at dealing with
monopoly power.
2.2.3 The Orthodox approach: is concerned with getting the
fundamentals right. The emphasis is on demand
management through strong fiscal adjustment. Given that
credit to the public sector is not the only source of monetary
expansion - the others are the balance of payments and
19
credit to the private sector - a stabilisation
plan based solely
on fiscal adjustment does not necessarily imply controlling
monetary aggregates. A plan that has the expansion of
monetary aggregates as monetary targets is referred to as an
orthodox money-based stabilisation (Agenor and Montiel,
1996). Thus, in this specific type of orthodox programme
money is used as a nominal anchor this contrasts with other
stabilisation experiences that use the fixed exchange rate as
a nominal anchor. So basically under this approach we have
two programs: money based program which rely on money
as nominal anchor and the exchange rate based programme
which rely on pegging exchange rate as nominal anchor.
2.2.4 Heterodox programmes: their main premise was that
inflation has strong inertial components. Therefore,
restrictive aggregate demand policies, which are at the
centre of orthodox stabilisation, would only cause a deep
and prolonged recession, with little success in terms of
reducing inflation. Heterodox plans included fiscal
adjustment, the use as the exchange rate as a nominal
anchor, and price controls. Thus, heterodox plans combined
elements of all the approaches mentioned above: populist
(price controls); orthodox (fiscal adjustment); and exchange
rate based (the use of exchange rate as a nominal anchor) or
20
social contract.. These plans were adopted in
the second
half of the 1980s.
2.2.5 Table below table reveal different types of stabilisation
programmes developing countries have adopted in the past,
in response to high inflation. Also briefly the result of each
programme is shown on the results column.
Type
Main Diagnosis
Main Measures
Results
Country Examples
Populist
Unutilised
price controls
Very high inflation
Chile (1970-1973);
productive capacity
expansionary fiscal
and even
Peru (1986-1990).
and monopoly power
policy
hyperinflation
increase in real
wages
Orthodox
Large fiscal
strong fiscal
Gradual decline in
Chile (1973);
money based
imbalances and
adjustment
inflation; high output
Bolivia (1985).
monetary decontrol
specific targets for
lost and labour
monetary aggregates unemploy ment
Exchange rate
Large fiscal
fiscal adjustment
Low in flation
Argentina (1978);
based
imbalances and
fixed nominal
convergence;
Chile (1978);
monetary decontrol
exchange rate (or
exchange rate
Uruguay (1978).
timetable fo r
appreciation; large
nominal exchange
trade and current
rate depreciation)
account deficits;
major currency and
financial crises
Heterodox
Inertia due to
fiscal adjustment
Initial drastic
Argentina (1985);
backward-looking
use of a fixed
reduction in inflation,
Israel, 1985); Brazil
contracts
exchange rate as a
followed by rapid ly
(1986).
nominal anchor
increasing inflation to
price controls
levels higher than at
the outset of the plan
2.3
CENTRAL
BANK
INDEPENDENCE
AND
GOVERNANCE
The issue of central bank independence has generated
considerable debate all over the world in recent years. The
issue has attracted attention from both practitioners and
academic economists. Central bank independence refers
21
to the freedom of monetary policymakers from
direct
political or governmental influence in the conduct of
policy. Most discussions have focused on two key
dimensions of independence.
2.3.1 The first dimension encompasses those institutional
characteristics that insulate the central bank from political
influence in defining its policy objectives. The second
dimension encompasses those aspects that allow the central
bank to freely implement policy in pursuit of monetary
policy goals. Grilli, Masciandaro, and Tabellini (1991)
called these two dimensions political independence and
economic independence.
2.3.2 The more common terminology, however, is due to Debelle
and Fischer (1994) who called these two aspects goal
independence and instrument independence. Goal
independence refers to the central bank`s ability to
determine the goals of policy without the direct influence of
the fiscal authority. Instrument independence refers only to
the central bank`s ability to freely adjust its policy tools in
pursuit of the goals of monetary policy.
22
2.3.3 Lybek1 (2006) points on the different
forms of autonomy
which ranges from goal , target, instrument autonomy. Goal
autonomy gives Central bank the authority to determine its
primary objective from among several objectives included
in the central bank law. Target autonomy allows the central
bank to decide specific target for achieving primary
objectives. Instrument autonomy allows central bank to
retain sufficient authority to implement the monetary policy
target using the instrument it sees fit.
2.3.4 The issue is as old as central banking itself, having been
debated on and off over the past couple of hundred years.
The hallmarks of independence � namely, autonomy from
the government and non-financing of budgets � were
identified clearly by David Ricardo in a paper on the
establishment of a national bank in 1824: `It is said that
Government could not be safely entrusted with the power of
issuing paper money; that it would most certainly abuse it
... There would, I confess, be great danger of this if
Government � that is to say, the Ministers � were
themselves to been trusted with the power of issuing paper
money. But I propose to place this trust in the hands of
Commissioners, not removable from their official situation
but by a vote of one or both Houses of Parliament. I
1 This has been viewed different. The European Monetary institute
measures autonomy as institutional ,
functional, organisational and final independence as discussed by
Amtenbrink (1999), for example.
23
propose also to prevent all intercourse
between these
Commissioners and Ministers, by forbidding any species of
money transactions between them. The Commissioners
should never, on any pretense, lend money to Government,
nor in the slightest degree be under its control or influence
... If Government wanted money, it should be obliged to
raise it in the legitimate way; by taxing the people; by the
issue and sale of exchequer bills; by funded loans; or by
borrowing from any of the numerous banks which might
exist in the country; but in no case should it be allowed to
borrow from those who have the power of creating money.'
2.3.5 Importance of central bank lies in the importance of
achieving price stability (low inflation). Independence
actually installs credibility from the public that the central
bank is committed to its goals. This will entail that the
central bank are far from being influenced by politicians to
push the economy to grow faster and further than its
capacity limits and also shrug off the temptations that
government have to incur budget deficit and fund these
borrowing from the central bank.
2.3.6 Central bank independence has often been represented in
theoretical models by the weight placed on inflation
objectives. When the central bank`s weight on inflation
24
exceeds that of the elected government, the
central bank is
described as a Rogoff-conservative central bank (Rogoff
1985). This type of conservatism accorded with the notion
that independent central banks are more concerned than the
elected government with maintaining low and stable
inflation.
2.3.7 Rogoff`s formulation reflects both a form of goal
independence � the central bank`s goals differ from those of
the government � and instrument independence � the central
bank is assumed free to set policy to achieve its own
objectives. Because the central bank cares more about
achieving its inflation goal, the marginal cost of inflation is
higher for the central bank than it would be for the
government. As a consequence, equilibrium inflation is
lower.
2.3.8 Measurement of Central bank independence: Cukierman,
Webb, and Neyapti (1992) index is based on four legal
characteristics as described in a central bank`s charter. First,
a bank is viewed as more independent if the chief executive
is appointed by the central bank board rather than by the
prime minister or minister of finance, is not subject to
dismissal, and has a long term of office. These aspects help
insulate the central bank from political pressures.
25
2.3.9 Second, the higher the independence the greater the extent
to which policy decisions is made independently of
government involvement. Third, a central bank is more
independent if its charter states that price stability is the sole
or primary goal of monetary policy. Fourth, independence is
greater if there are limitations on the government`s ability to
borrow from the central bank. Cukierman, Webb, and
Neyapti (1992) combine these four aspects into a single
measure of legal independence. There are also informal
indicators of actual independence, based on work by
Cukierman, which measures of actual central bank governor
turnover, or turnover relative to the formally specified term
length, High actual turnover is interpreted as indicating
political interference in the conduct of monetary policy.
2.3.10 Central bank governance
Broadly corporate governance encompasses systems and
process that the Central bank has in place to oversee its
affairs with the aim of meeting its goals and objectives.
Its also provides the structures through which objectives
of a central bank are set and the means of attaining these
objectives including the determination of monitoring
performance.
26
2.3.11The Good governance should be entailed as
a means to
provide macroeconomic stability, orderly economic
growth and a stable regulatory environment. Given the role
commonly assigned to them, central banks are thought to
play a vital role in achieving these goals to the extent that
the legal framework in which they operate reflects good
governance. As Lybek (1999) has pointed out: Good
central bank governance means that the objectives and
tasks delegated to an institution are performed effectively
and efficiently, thus avoiding misuse of resources, which is
crucial for establishing a good track record.`
2.3.12 This contribution identifies a number of principles that
arguably should form the basis for the good governance of
central banks and what their impact is on the institutional
structure of a central bank. Central bank governance is
arguably defined by a number of key-concepts or pillars,
which together should form the basis of the legal
framework governing a central bank and on which central
bank governance should rest, that is independence,
democratic accountability and transparency.
2.3.13 While these concepts are in the first instance introduced
27
separately this is not to say that they should
be considered
in isolation. Arguably, the key to good governance in this
regard lies in the combined application of these principles
in designing the legal framework of a central bank.
3. EMPIRICAL REVIEW
Under this section empirical review is divided into the three
elements listed below. It is also notable to see how
developed and developing countries differ in their
application of various theories reviewed. This section
provides a link between theoretical underpinnings
(monetary economics) and central bank practice
(behaviour).
3.1 EMPIRICAL EVIDENCE ON TRANSMISSION
MECHANISM
Various empirical evidence will be exposed under this
section. Taylor (1995) has an excellent survey of the recent
research on interest rate channels and he takes the position
that there is strong empirical evidence for substantial
interest rate effects on consumer and investment spending,
making the interest-rate monetary transmission mechanism
a strong one.
28
3.1.1 His position is a highly controversial one, because many
researchers, for example Bernanke and Gertler (1995), have
an alternative view that empirical studies have had great
difficulty in identifying significant effects on interest rates
through the cost of capital. Indeed, these researchers see the
empirical failure of interest-rate monetary transmission
mechanisms as having provided the stimulus for the search
for other transmission mechanisms of monetary policy,
especially the credit channel.
3.1.2 However, existing empirical works by Kashyap-Stein,
(1994) based on macroeconomic models consistent with the
credit view have hitherto failed to deliver robust results,
owing to the so-called "causation puzzle": namely, inability
to identify whether the observed positive correlation
between bank loans and output is really due to credit supply
shifts or whether it is instead due to credit demand
shifts
consistent with the traditional monetary transmission
mechanism, or even to a passive role of endogenous
monetary aggregates over the real business cycle (King-
Plosser, 1984).
3.1.3 P�tursson T (2001), found out that The Central Bank of
Iceland bases its monetary policy on setting its interest rate
29
in transactions with other financial
institutions in the money
market, in order to affect the behaviour of individuals and
firms, thereby keeping aggregate demand in line with its
growth potential and maintaining inflation expectations
which are consistent with the Bank`s 2�% inflation target.
3.1.4 The paper discusses the transmission mechanism and the
lags from monetary policy decisions to its effect on the
economy. The findings suggest that Central Bank of Iceland
monetary policy changes are in general first transmitted to
domestic demand after roughly half a year, with a peak
effect after one year. Policy first affects inflation after a
year, with a peak effect about 1� years after the interest rate
rise. In the long run, however, monetary policy has no
effects on the real economy. Broadly speaking this is
consistent with other countries` experience.
3.1.5 Carlo A. Favero, Francesco Giavazzi. Luca Flabbi (1999)
have done empirical work on Europe. Available studies on
asymmetries in the monetary transmission mechanism
within Europe are invariably based on macro-economic
evidence: such evidence is abundant but often
contradictory. Their paper takes a different route by using
micro-economic data. They used the information contained
in the balance sheets of individual banks (available from the
30
Bank Scope database) to implement a case study
on the
response of banks in France, Germany, Italy and Spain to a
monetary tightening.
3.1.6 The episode they studied occurred during 1992, when
monetary conditions were tightened throughout Europe.
Evidence on such tightening is provided by the uniform
squeeze in liquidity, which affected all banks in our sample.
They studied the first link in the transmission chain by
analysing the response of bank loans to the monetary
tightening. They experiment provides evidence on the
importance of the Europe and thus on one possibly
important source of asymmetries in the monetary
transmission mechanism.
3.1.7 They could not find evidence of a significant response of
bank loans to the monetary tightening, which occurred
during 1992, in any of the four European countries they
have considered. However they find significant differences
both across countries and across banks of different
dimensions in the factors that allow them to shield the
supply of loans from the squeeze in liquidity.
3.1.8 Ramlogan C (2004) has done a study on Caribbean
countries. His paper presents an empirical analysis of the
31
monetary transmission mechanism in four
Caribbean
countries: Jamaica, Trinidad and Tobago, Barbados and
Guyana. This research was timely since little was known
about the transmission mechanism of monetary policy in
developing countries in general and in the Caribbean in
particular. In developing countries financial markets tend to
be relatively unsophisticated hence monetary policy is
likely to affect the real sector by altering the quantity and
availability of credit rather than the price of credit.
3.1.9 The results showed that the credit and exchange rate
channels are more important than the money channel in
transmitting impulses from the financial sector to the real
sector. The findings can assist policy makers in other
developing countries in the design and implementation of
monetary policy.
3.1.10Spinelli F and Tirelli P (1991), traces the long historical
evolution that Bancad` Italia has undergone concerning
objectives and strategies of monetary policy in the post war
period. During the 1950s the Bank aimed at providing
sufficient monetary growth to accommodate economic
growth in an environment of low rates of inflation. In the
1960s the Bank become Keynesian: its preference function
gave substantial weight to output stabilisation. In the 1960s
32
the activist Bank followed an interest rate
stabilisation
strategy and for a period of three years a complete pegging.
3.1.11 The regime of fiscal dominance in the 1970s generated a
new
intermediate target, total domestic credit creation. Thus in
practice served to accommodate substantial monetary
financing of government budget deficits. Finally, the
more inflation conscious Bank of the 1980s returned to
target the monetary base.
3.1.12 In conclusion the transmission mechanism has varied
across
countries. In some countries money has been used as a
nominal anchor for price stabilisation. Interest rate
channels have also been used to target macroeconomic
objectives.
3.2 EMPIRICAL EVIDENCE OF STABILIZATION
POLICIES
3.2.1 Populism: empirical evidence
Examples of populist policies are Chile in the early 1970s
and Peru in 1986-89 under the Alan Garcia administration.
33
3.2.2 Chile 1970-73
Initially result of this strategy was quite favourable. GDP
and employment grew. The result was that the Chilean
economy was overheated by the end of 1971 and inflation
was simply kept repressed by price controls. As a response
to these controls, a substantial underground economy
emerged which reduced tax revenue for the government.
The rate of inflation exceeded 200% in 1972 and the
currency become seriously overvalued. Capital flight
contributed to draining the stock of international reserves.
By 1973 the fiscal deficit amounted to 25% of GDP, the
informal economy was pervasive and foreign exchange
reserves neared depletion. Inflation as a result soared and
real economic activity declined.
3.2.3 Peru 1986-1990
As in Chile the initially result were favourable. As
repressed inflation squeezed profit margins, subsidies made
the difference putting pressure on the government budget.
Losses in tax revenue were experienced. High fiscal deficit
and increases in subsidized prices fuelled inflation, which
reached 114% in 1987 and finally exploded in 1988. the
overvaluation of exchange rate , together with the
controlled interest rates, contributed to massive capital
flight and international reserves were rapidly depleted.
34
Devaluation in early 1988 also contributed to
inflation. By
the end of 1988 inflation ran at an annual rate of 6 000%.
The conclusion from the above international experience
shows that populism programs have not succeeded in
bringing inflation rate down. Even the US government did
apply price control from 1971 to 1973. And the US
economy did go through a recession from Dec 1973 to Mar
1975. Here's what price controlling does. It causes shortages
because equilibrium prices are what keeps supply and
demand in check. So the common results from the populist
approach: very high inflation and even hyperinflation.
3.2.4 Orthodox Money based programme: empirical evidence
It has been adopted in different countries such as
Chile(1973), and Bolivia. However this paper will only
review the Chilean experience. The results of fiscal
contradiction were dramatic. Real GDP fell dramatically in
1975, while unemployment rate increased to almost 17% of
the labour force from 4.5%. Inflation controls were not
successful. The annual inflation increased almost to 500%
in 1975 before starting to decrease but the short run
response to inflation was sluggish. The key feature of the
Chilean experience is that even sharp and seemingly
credible fiscal correction did not succeed in bringing the
35
inflation rate down quickly and painlessly to
international
levels. However external correction was achieved.
3.2.5 Mankiw's text (Chap 18) cites Sargent's study of the
European hyperinflation of 1923 as evidence that inflation
is reduced by monetary restraint. In fact the major point of
Sargent's article was that it was fiscal restraint--NOT
monetary restraint that ended the European hyperinflations.
In particular, inflation ends when a currency receives
adequate backing. Unfortunately, quantity theorists are
blind to the importance of the backing of money, and
Mankiw is no exception.
3.2.6 Orthodox exchange rate based programme: empirical
evidence
The case to be considered is Argentina (1978). The
schedules of pre-announced exchange rate succeeded in
dampening inflation, which decreased gradually from 175%
in 1978 to a little over 100% in 1980. This occurred in spite
of the very limited fiscal adjustment that took place in 1978
and 1979. However the speed of convergence of the
inflation rate to the pre-announced rate of devaluation
proved to be very slow and the resulting real exchange rate
36
appreciation and deterioration in the external
accounts
fuelled expectation of devaluation.
3.2.7 Heterodox programme: empirical evidence
Argentina (1985) experience will be considered. It was a
response to the failure of the gradualist orthodox
stabilization programme that the new government had
attempted to implement during 1984. The effect on the
inflation rate was immediate and sharp. Inflation rate
declined. Immediately after the stabilization real interest
rate were extremely high, with lending rate averaging over
90% per year in the last quarter of 1985. Monetary
expansion remained fairly high, and although the Treasury
did not borrow from the central bank, the bank financed
both the servicing of external debt by some public
enterprises and lending by public financial institutions to
provincial government feeding a sustained rapid increase in
money supply. In August 1986 the rate of inflation
increased reaching 8.8%. Response was tight monetary
policy from October 1986 to February 1987. In February a
new wage price freeze was announced together with a pre-
announced crawling peg for exchange rate. Although a
transitory reduction in inflation was achieved vigorous
inflation returned when controls were relaxed in January
1988.
37
3.2.7 Conclusion
Stabilisation programmes has varied across countries. The
main departure point on this stabilisation was the use of
nominal anchors. However important point is that
stabilisation programmes can be successful in taming
inflation rate down, but it depends on the prevailing
economic condition in a certain countries.
3.3 EMPIRICAL EVIDENCE OF CENTRAL BANK
INDEPENDENCE AND GOVERNANCE
Empirical studies for central bank autonomy are generally
supportive but not compelling. Most studies compare an
index of the central bank`s de jure autonomy--sometimes
also accountability--with inflation performance. The design
of the index, the elements considered, their weights, and
normalization procedures, all affect the results (Mangano,
1998).
3.3.1 Another type of study also tries to find such a correlation,
but takes other factors into account as well. A third type of
study identifies proxies for de facto autonomy and
compares them to inflation performance. However, these
proxies are often questionable. For instance, a low turnover
rate of central bank governors may indeed be caused by
strong autonomy, but it may also be caused by governors
38
willing to accommodate government instructions
(de Haan
and Kooi, 2000).
3.3.2 Finally, a few studies estimate whether inflation
performance or changes of interest rates after amendments
of the legislative framework are significant. While a
correlation may be identified, verifying the causality
remains a challenge. The question is whether sound
economic policies lead to price stability and central bank
autonomy, or whether central bank autonomy and
accountability result in price stability and promote sound
economic policies, or both.
3.3.3 Several studies have shown that the industrialized countries
that accorded greater legal autonomy to their central banks
also experienced lower average inflation during the period
following the breakdown of the Bretton Woods system of
fixed par values in the early 1970s (Berger, de Haan, and
Eijfinger, 2000 and Grilli, Masciandaro, and Tabellini,
1991). Evidence from these countries further strengthened
the case for central bank autonomy because the higher
degree of autonomy did not appear to harm average real
growth (Alesina and Summers, 1993), although a discussion
of sacrifice ratios has later emerged (Cukierman, 2002).
39
3.3.4 In recent years, there has been a general
commitment to
combat inflation, and it has thus become increasingly
difficult to identify a correlation between more autonomy
and accountability on the one hand and lower inflation on
the other. Daunfeldt and de Luna (2003), for instance, find
that the decline in inflation often has happened before
reforms of the legislative framework. Spiegel (1998),
however, found that the announcement of the new
legislative framework for the Bank of England in 1997 did
coincide with a decline in the interest rate.
3.3.5 Cukierman, 1994 and 1992 has done studies that indicate
that the correlation between legal autonomy and lower
inflation in developing countries is less significant . This
has been led to the use of other nominal anchors. If a
pegged exchange rate is used as nominal anchor, it may
temporarily alleviate inadequate autonomy (Anyadike-
Danes, 1995). Furthermore, the size of the budget deficit
and its financing tend to dominate the standard measures of
central bank independence (Fry, 1998).
3.3.6 Schuler (1996) finds, based on a survey of 156 countries
analyzing the period 1952�93 that central banks in
developing countries have performed worse than central
banks in developed countries. Guti�rrez (2003) applied an
40
index covering both autonomy and accountability
to the
constitutions of Latin American and Caribbean countries,
taking several factors into account, and does find a
significant relationship between a higher degree of
autonomy and accountability in the constitution and better
inflation performance. J�come and V�zquez (forthcoming),
find, after controlling for the exchange rate regime and
fiscal deficits, a negative correlation between more legal
central bank autonomy and better inflation performance in
Latin American and Caribbean countries.
3.3.7 Lybek (1999, has done some studies in transitional
economies and found the correlation between stronger
central bank autonomy and better inflation performance in
transition economies.
3.3.8 In a study done by Cukierman A, (1994), Bundesbank was
ranked the second in terms of being as independent and last
ranked is Poland. Also from his study the results were
consistent with the view that Central Bank independence
affects the rate of inflation in the expected direction but
there are other factors as well. An important conclusion is
that discrepancies between actual and legal independence
are larger in developing than in developed countries.
41
4. THE CASE FOR ZIMBABWE
In the same manner Zimbabwe has in the past tried to
follow theoretical underpinnings in formulating monetary
policy. Role of money in economic activity has been
viewed differently in different ways. Stabilisation efforts
have also varied from populist, orthodox and heterodox
measures depending on the situation prevailing at different
times. Central Bank independence and governance has also
evolved with passage of time.
4.1 ZIMBABWE CASE: TRANSMISSION MECHANISM
Monetary policy in Zimbabwe is geared at containing
monetary and credit expansion at levels that ensure that
economic activity takes place in a low inflationary
environment. The objective of monetary policy is, thus,
price stability, reflected in low and non-volatile rates of
inflation.
4.1.1 The conduct of monetary policy in Zimbabwe has gone
through two distinct phases since 1980, reflecting major
shifts in broad macroeconomic policies. In the 1980s, the
country
inherited
a
structurally
weak
economy
characterized by extensive controls and regulations in the
42
financial, productive and international trade
sectors. Under
this environment, monetary policy was relatively inactive.
4.1.2 The inception of economic reforms in the 1990s, however,
saw the economy transform to a market- based system
where free market forces had a significant role in promoting
sustainable economic growth and employment generation.
The shift from a highly regulated economy in the 1980s, to
a market-based system in the 1990s, widened the scope for
the conduct of monetary policy.
4.1.3 This saw the Reserve Bank of Zimbabwe adapting its
operating procedures to the changing financial environment
and monetary policy assumed a more active role. The major
challenge to monetary policy in the 1990s and beyond has
been stagflation � presenting monetary authorities with the
staggering task of striking a balance between the need to
arrest runaway inflation while at the same time avoiding
exacerbating recessions.
4.1.4 Monetary policy framework in the 1980s
Economic conditions in the 1980s were characterized by
extensive controls on domestic economic activity. These
ranged from controls on prices, wages, interest rates and
credit to controls on foreign exchange allocation. The
43
conduct of monetary policy under these
conditions, where
effective demand was administratively controlled, was,
therefore, inactive and largely based on direct instruments.
4.1.5 Monetary policy focused on restraining credit creation to
levels consistent with credit demand for productive
activities in order to contain inflationary pressures and to
promote agricultural development � the backbone of
economic activity
4.1.6 Instruments of monetary policy in the 1980s
The main instruments of monetary policy were direct
controls on both lending and deposit rates (interest rate
caps), quantitative controls on credit (credit ceilings), use of
Reserve Bank bills, prescribed liquid asset ratios, moral
suasion and other monetary measures designed to
discourage non-essential and deferrable consumption
expenditures.
4.1.7 The use of interest rates, as an active instrument of
monetary policy was quite limited, and this saw the same
levels of interest rates being maintained throughout the
1980s. With the rate of inflation averaging 13% and interest
rates averaging 9,8%, controls on interest rates led to
negative real interest rates which discouraged savings
mobilization and competition among financial institutions.
44
4.1.8 Challenges to monetary policy in the 1980s
High fiscal deficits, which absorbed disproportionately high
levels of domestic savings, limited the contribution of
monetary policy to economic growth and development.
These arose from Government`s need to redress past social
imbalances through expanded social service investments.
4.1.9 Monetary policy framework in the 1990s
In the 1990s, a more active monetary policy was witnessed
as most controls on domestic economic activity were
removed under the overall economic reform and
liberalization programme. Integral financial sector reforms
saw the removal of controls on financial sector activity, and
the emergency of new financial institutions and instruments.
This facilitated competition, efficiency and depth in the
financial sector, thus encouraging savings mobilization and
broadening the availability of financial services.
4.1.10 The removal of direct controls on interest rates paved the
way
for the emergence of a responsive money market � crucial
for the efficient execution of monetary policy.
45
4.1.11 Consistent with the shift towards a
market-oriented
economy,
monetary policy implementation switched to indirect
instruments of control. Open market operations and a
flexible interest rate policy became the principal
instruments through which the monetary authorities
conducted monetary policy. Where market conditions
require the use of a more longer-term instrument, these
instruments have been supported by appropriate changes
to reserve requirements.
4.1.12 Shift in monetary policy strategy towards monetary
targeting
In the 1990s, the Reserve Bank of Zimbabwe`s monetary
policy strategy shifted significantly to one based on
targeting the intermediate monetary aggregates. The
adoption of this strategy was based on econometric
evidence which revealed that monetary aggregates were
closely linked to the ultimate objective of monetary policy �
price stability. In a correlation test conducted using
quarterly data from 1980-1999, monetary growth (M3) was
shown to be positively and highly correlated to inflation.
4.1.13 Given that price stability is the ultimate objective of
monetary
46
policy, monetary aggregates are thus a suitable
intermediate policy target. Under monetary targeting, the
day-to-day level of liquidity in the money market is
carefully monitored and influenced by the Reserve Bank,
consistent with the monetary growth target. This is largely
to ensure that the amount of liquidity in the money market
does not translate into excessive
credit creation, which will in turn expand money supply
and fuel inflation.
4.1.14 The money supply aggregate (M2), which excluded the
deposits of building societies, finance houses and the
POSB, was the main intermediate policy variable up to
1997. Thereafter, further financial liberalization and
innovation, greater importance was placed on a broader
measure of money supply (M3) which included deposits
of other banking institutions.
4.1.15 The framework of monetary targeting
The departure from the regime of direct monetary and
credit controls prevailing prior to 1991, saw the Reserve
Bank adopt a monetary targeting framework to guide its
policy decisions. The rationale for the Bank`s action in
this regard has always been that, if unchecked, excessive
47
monetary growth would impact on future
inflation and,
hence, on macroeconomic stability.
4.1.16 Intermediate monetary targets, consistently derived from
the
potential real economic growth and desired level of
inflation, guide the formulation of monetary policy
measures. The Bank`s monetary targeting framework is
guided by the quantity theory of money. The theory
provides a transparent framework in which to analyze the
relationship between the growth in money supply (M) and
inflation (P). By identity, the theory shows that the stock
of the money supply (M) multiplied by the speed at which
it moves around the economy, velocity (V), equals output
measured at current prices (PY).
MV Q
P ,
4.1.17 This theory provides a quantitative relationship between
money supply (M) and inflation (P). An increase in money
supply is directly reflected in higher inflation, assuming
velocity (v) is stable, and output (Y) is at full potential. In
the long run, the higher inflation will result in lower
output.
4.1.18 2007 monetary policy
48
Central Bank has recognised that experience
over the past
3 years has amply demonstrated that singular application
of traditional monetary policy tools, such as interest rates,
in the absence of concerted, holistic, well sequenced
policy packages will only serve to throw the productive
sectors deeper into stagflation � low capacity utilization
co-existing with high inflation. The new framework of the
Roadmap to Our Recovery proposed in the Policy
Statement outlined the need to use the month of February
2007, as the soul-searching period, marked by decisive
collective implementation of measures that remove the
devastating distortions which have hitherto stood in the
way of all efforts to turnaround the economy, before we
the bank can announce an interest rate framework that is
consistent with an agreed program of holistic measures.
4.1.19 In a bid to fight the galloping inflation, the Bank target
annual
broad money supply which will be reduced from the
levels above 1 000% to between 415%and 500% and
60% by end of 2008. The Bank also recognized that in
order to achieve the set monetary aggregates, the Reserve
Bank will continue to closely manage money market
liquidity conditions Consistent with this, during the
second half of 2006, the money market has largely been
49
kept in a short position, so as to buttress
efforts to fight
inflation.
4.1.20 So it can be seen that the bank is following the monetarist/
classical case in trying to use money supply to reduce
inflation and achieve broad macroeconomic objectives.
4.2 STABILIZATION POLICIES: ZIMBABWEAN CASE
Kovanen A(2004), in his paper a Zimbabwe: A Quest for
a Nominal Anchor , examines the appropriateness of
alternative intermediate monetary policy targets for
Zimbabwe in light of the stability of the demand for money
and the information content of financial variables for
predicting price level movements. Results of the study
indicate that a well-defined long-run demand relation exists
for currency in circulation, but not for other monetary
aggregates.
4.2.1 Currency in circulation has strong information content for
predicting future price level movements. The information
content of other financial variables, such as the exchange
rate and interest rates, is weaker. Statistical relationships
break down of the outset of high inflation.
50
4.2.2 Zimbabwe has experimented with exchange
rate and
monetary anchors in the past, but as we discussed earlier,
these policies failed to provide guidance for price
expectations. This is for the most part because these policies
have lacked credibility and were not supported by other
macroeconomic policies, in particular fiscal policy. Studies
by Jenkins (1999) and Nyawata (2001) report a well-
identified relationship between monetary variables and the
price level. However, empirical evidence to support an
exchange rate anchor is more elusive.
4.2.3 Their study has analysed the underlying determinants of
prices in Zimbabwe using a wide range of statistical
techniques. The results are robust to alternative
specifications. The key results for the full sample are as
follows.
4.2.4 First, there is a strong linkage between currency in
circulation and the price level. This suggests that currency
in circulation would provide a good leading indicator of
future price movements.
4.2.5 Second, cointegration analysis establishes a well-identified
long-run money-demand relation for currency in circulation,
suggesting that this monetary aggregate could be helpful to
51
the Reserve Bank of Zimbabwe as an intermediate
monetary operating target.
4.2.6 Third, reserve money, which the Reserve Bank of
Zimbabwe has used as an intermediate policy target, is
ineffective in the current high inflation environment,
because the demand for reserve money is not well defined,
while its information content for predicting future price
movements is weak.
4.2.7 Fourth, well-defined money-demand functions for narrow
and broad money cannot be established in the full sample.
Sixth, statistical relations seem to break down during the
high-inflation period of the past few years. This raises
serious challenges for monetary policy implementation,
particularly regarding the appropriate anchor to facilitate
disinflation in the Zimbabwean economy.
4.2.8 It has been argued that the exchange rate could serve as a
nominal anchor in Zimbabwe. As experience has shown,
however, pegging the exchange rate has not succeeded in
constraining other--namely, monetary and fiscal policies--
I therefore believe it has not been a credible policy anchor.
This may in part explain its low information content for
predicting future price movements.
52
4.2.9 The study`s analysis suggests that exchange rate changes
have an impact on domestic prices through the currency-
substitution channel and influence the demand for currency
indirectly through the interest rate channel. The pass-
through effect to domestic prices is only partial, which does
not mean that exchange rate changes are insignificant. The
Reserve Bank of Zimbabwe would be well advised,
therefore, to counter inflationary effects arising from
exchange rate changes with an appropriately tight monetary
policy. In general Central Bank once followed a populist
programmes like nature, but it failed.
4.3 CENTRAL BANK INDEPENDENCE: ZIMBABWE
CASE
The Central Bank is governed by an RBZ Act (Chapter
22.15) which prescribes a clear set of objectives, functions,
accountability structures and arrangements for monitoring
performance and financial reporting and auditing and other
matters incidental or connected thereto. However it should
do so in consultation with the Ministry of Finance.
4.3.1 The RBZ claims that it is independent in setting its target as
it adopts its own internal practice in governance. The RBZ
53
has in place internal governance structures and
process that
allow the Bank to operate in a transparent, efficient and
effective manner, not only in respect to the functions
outlined in the RBZ Act but also in respect to the Banks`
stewardship of the resources entrusted to it.
4.3.2 The RBZ like any other central bank world-wide plays a
vital role in advancing government`s economic policies and
implementing measures that are aimed at strengthening the
domestic economy. It is also among government agencies
that are responsible for implementing international
measures aimed at consolidating global financial
association.
4.3.3 Mujutywa Melania`s ( 2007), study Further, the study
analyses the institutional set-up of the Reserve Bank of
Zimbabwe (RBZ) to determine its independence in
monetary policy implementation. Results show that political
interests have been driving the monetary policy and this has
undermined the credibility of the central bank. The study
concludes that, even if independence is not the complete
answer, it is at least suggestive that a more autonomous
central bank would be effective even though it is neither
necessary nor sufficient by itself for achieving and
maintaining low inflation.
54
5. IMPLICATIONS ON POLICY
5.1 TRANSMISSION
MECHANISM
POLICY
IMPLICATIONS
Important lessons that can be drawn here is that a country
should actually learn from past monetary policy in
implementing new decision. What has been seen in
Zimbabwe is a shift from one transmission mechanism to
the other. The general lesson is for the monetary policy to
be used to reduce inflation. However of importance is to
empirical determine the influence of interest rate, exchange
on macroeconomic behaviour.
5.1.1 Another challenge confronting Zimbabwe`s monetary
authorities is the current trend of changing channels and the
emergence of new ones in the transmission mechanism of
monetary policy. In a rapidly changing environment, it is
indeed very difficult to identify with precision the channels
through which monetary policy affects the economy. The
remarkable development of the financial system in recent
years has provided the business community with a much
wider array of financing alternatives.
5.1.2 Businesses are now able to avail themselves of a great
diversity of products offered by finance companies and
55
other non-bank financial institutions, which
have
experienced very rapid growth in recent years. In response
to the new developments, Central Bank should follow a
rather pragmatic (eclectic) approach. In the transition to a
new mechanism of monetary control, a pragmatic approach
is important.
5.2 STABILIZATION IMPLICATIONS
The following lessons can be learned from the experience of
inflation stabilization in developing countries. These are
policy implications that can be drawn.
5.2.1 Firstly fiscal adjustment is necessary. In the absence of a
permanent fiscal adjustment inflation does not stay
permanently low. This conclusion is shown clearly from
populist experiences of Chile and Peru, from the experience
of Argentina under a variety of approaches to stabilization,
including both the exchange rate � based orthodox
programs and heterodox programs reviewed.
56
5.2.2 This clearly point out that setting
price-based nominal
anchors such as exchange rate freezes and wage and price
controls is not sufficient for inflation stabilization.
Experience with populism sends this message clearly.
Heterodox elements ( an exchange rate freeze accompanied
by income policies) can be useful supplements to a credible
fiscal program in stabilizing inflation, but they are
dangerous to use.
5.2.3 With sufficient commitment to a permanent fiscal
adjustment, a suspension of indexation and the adoption of
income p[policies can help establish low inflation rapidly
while avoiding the short run damage to economic activity
associated with orthodox adjustment under these
circumstances as demonstrated by both Israel and Mexico.
5.2.4 The danger is that the programs short run success will tempt
policymakers to slide into populism by relaxing fiscal
discipline while relying on wage and price controls for
inflation abatement as in Argentina and Brazil`s heterodox
programs. This path will quickly run into domestic capacity
and foreign financing constraints and is likely to leave the
country in worse conditions than before the attempted
stabilization.
57
5.3 CENTRAL BANK INDEPENDENCE POLICY
IMPLICATIONS
To fulfil the objective of stabilization policies what has
been called upon in the international arena is central bank
independence. Economic policies are only effective if
accompanied by credible and genuine commitment of the
authorities.
5.3.1 In the past, the credibility of monetary policy has been
undermined by the lack of support from fiscal policy, as
well as the lack of consistency in policy implementation.
Strengthening the Reserve Bank of Zimbabwe`s
independence and clarifying its policy objectives should
assist in enhancing its credibility.
5.3.2 The Reserve Bank of Zimbabwe Act Chap 22:15 is the
relevant legislation for the conduct of monetary policy. It is
an adequate piece of legislation that needs no significant
changes. However, the following are suggested
amendments that could enhance the RBZs effectiveness in
the implementation of monetary policy. Amendments to
give the RBZ greater operational independence from the
Ministry of Finance.
58
5.3.3 The current legislation requires the RBZ
to make most of its
decisions in consultation with the Minister of Finance. This
is appropriate on issues relating to the articulation of policy
objectives and targets. This is called goal dependence. It
ensures that monetary policy is pursued in a manner that
helps achieve governments overall objectives. It also
ensures consistency and coordination between fiscal and
monetary policy objectives and targets.
5.3.4 For this reason, few, if any, Central Banks strive for goal
independence. Elected governments are susceptible to
political pressures that often lead them to adopt measures
that are contrary to their stated objectives. Because they are
un-elected, central banks are less susceptible to such
pressures. Therefore, giving them greater operational
independence would insulate them from such pressures and
make implementation of monetary policy more effective.
5.3.5 Thus, once government has set the objectives and targets for
monetary policy, the central bank should be left to design
instruments with which to pursue the objectives without
much interference (or directives) from the Ministry of
Finance. With these developments the central Bank can
adequately address the problem of inflation in Zimbabwe.
Thus, the Reserve Bank of Zimbabwe Act should be
59
amended to remove the phrase in consultation
with the
Minister of Finance where it relates to implementation and
or operational issues.
6. CONCLUSION
This paper has tried to show how monetary economics has
impacted on the central bank activities. The area of focus is
on the transmission mechanism of monetary policy,
stabilisation programmes and central bank independence
and governance. The importance of the study is on giving
insight on how these issues has been used in the
international arena. More important is a reflection on the
Zimbabwean experience and policy conclusions that can be
drawn from these international and Zimbabwean
experiences. It is clear from the study that Central Bank
independence and governance provide a basis for credibility
for central Bank activities and hence help in both the
transmission mechanism and stabilisation programmes to
achieve the needed results.
------------------------------------------------------------------------
60
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