On the Optimal Adherence to Money Targets in a New-Keynesian Framework: An Application to Low-Income Countries

Abstract

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 central 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. This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Money Targeting in a Modern Forecasting and Policy Analysis System: an Application to Kenya

“…However, some discussion of the possible reasons may shed light on the applicability of the framework. One possible reason, explored for example in [Berg et al, 2010], has to do with imperfect information. Money aggregates may contain information about aggregate demand and interest rates that are not readily observable in real time.…”

“…It also allows policymakers to respond to deviations of money growth from its target. The rule is inspired by the analysis by [Berg et al, 2010], who investigate the link between Taylor rules and money growth targets in selected African economies. In this section we begin by presenting operational targets derived from the Taylor rule.…”

“…That is, the money target and expectations of next period's interest rates, given by rule (5), signal the same policy stance. As shown in [Berg et al, 2010], ex ante consistency is a desirable property of regimes with multiple targets because they greatly reduce the tension between these targets. Making money targets consistent with an interest rate rule is also desirable because the former inherit (in principle) the stabilizing property of the latter.…”

“…See[Berg and Portillo, 2008].3 In this regard our paper extends the analysis of[Berg et al, 2010], which studies the degree of optimal adherence to reserve-money targets in selected low-income countries using a similar methodology.…”

“…This money gap differs from another measure that is sometimes used, e.g., in[Berg et al, 2010], which is the difference between real money balances and the level that would hold if the economy was at potential and inflation was equal to target.…”