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Introduction
The last two decades have witnessed profound changes in the conduct of monetary policy in Sub-Saharan Africa. In the mid-1980s, African banking sectors were largely geared towards the financing of government and the extension of subsidized credit to favoured activities. To the extent that there was any discretion, monetary policy was conducted in an environment of substantial fiscal dominance, financial repression and, outside of the CFA countries, exchange controls. Although a number of countries remain in the grip of severe macroeconomic instability, there is, today, much less pressure on central banks on
average to accommodate large domestic fiscal deficits. Central bank independence is now more meaningful, liberalized banking systems prevail in most countries, and exchange controls have been eliminated virtually everywhere on the continent.
Nonetheless, recent years have seen a growing number of African countries struggle with how best to deploy the available instruments of monetary policy in order to manage the macroeconomic volatility they face, while still maintaining a commitment to low and stable inflation. Recent work by the IMF (2005) and Foster and Killick (2006)1 suggests that this struggle is nowhere more intense than in the macroeconomic management of volatile aid inflows, where concerns with the short-run management of aid inflows have threatened to overshadow broader considerations of the medium-term developmental rationale of aid. In extreme cases, these concerns may generate pressures for countries to reduce their reliance on aid flows, even when the medium-term returns to aid remain high and when donors are committing to substantially increase their aid budgets (Eifert and Gelb, 2005). In effect, for those countries not committed to a hard institutional peg, the monetary policy debate has shifted away from a narrow focus on price stabilization to embrace a broader but extremely operational set of questions. These include, for example: How aggressively should the authorities seek to manage the path of the nominal exchange rate, if at all? What is the role for using foreign reserve buffers to smooth the absorption of aid? Should aid-related liquidity growth be sterilized through bond sales? Moreover, how should these considerations be traded off against other concerns that legitimately compete for policymakers’ attention, including concerns about external competitiveness and the development of nascent domestic financial sectors?
In this paper we seek to gain some purchase on these questions by using a stochastic simulation model to assess the properties of alternative monetary policy strategies, with the aim of identifying those strategies which provide for relatively smooth short-run absorption of aid surges, including avoiding excessive real appreciation. Calibrating this model to reflect key characteristics of pre-stabilization and post-stabilization (or mature stablizer) African economies, we show how strategies involving more or less active foreign exchange intervention and reserve buffering designed to smooth the path of domestic deficit financing serve best to influence short-run macroeconomic volatility.
Moreover, our results suggest that for pre-stabilization countries, a managed float, with little or no sterilization of increases in the monetary base, is the most attractive approach.
The remainder of the paper is structured as follows. In Section 2 we provide some motivation for the formal simulation analysis by establishing the main lines of our argument (borrowing freely the ‘spend and absorb’ terminology introduced in
IMF(2005)) and presenting some stylized facts which will shape the calibration of the simulation model. Section 3 then describes the model in detail and Section 4 presents and discusses the simulation results. Section 5 concludes.
Footnote:
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Both studies undertook case studies of aid surges in African countries. The IMF (2005) case studies were Ethiopia (2001-03), Ghana (2001-03), Mozambique (2000-02), Tanzania (2000-03) and Uganda (2001-03). Foster and Killick (2006) extended this list to include Mauritania (1999-2002) and Sierra Leone (2000-02).
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