Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in Rwanda: Application of FAVAR Model

FAVAR model is powerful approach to study reaction of all possible macroeconomic variables arround 120 variables and above to the shock in policy rate.

1. Towards a Full-Fledged Inflation Targeting Monetary
Policy Regime in Rwanda
Application of FAVAR Model
Clement Uwizeye
Master student in AQE
July 2023
Supervisors:
Supervisor 1: Dr. Aristide Maniriho @ University of Rwanda, Rwanda
Supervisor 2: Clemens Knoppe @ Kiel University, Germany
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

2. Outlines
1
Introduction
Background of the study
Problem statement
Research objectives
2
Motivation
3
Data and Methodology
Data
Criticisms
Application FAVAR model
4
Main Results
5
Conclusion & Recommendation
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

3. Introduction
Background of the study:
Inflation targeting dates back to the late 1980s and early 1990s as an
alternative to standard monetary policy techniques.
New Zealand was the first central bank to legally embrace inflation
targeting in 1989, followed by Canada, the United Kingdom, Sweden,
Australia, and a number of other nations (Bryant et al., 2010).
Since 2019, the central bank of Rwanda has shifted from money target
to inflation targeting.
Problem statement:
The effectiveness of inflation targeting in Rwanda’s monetary policy
framework is uncertain due to limited data availability and structural
reforms.
The absence of the FAVAR model in research in Rwanda represents a
missed opportunity to elevate the quality and depth of economic
analysis.
A comprehensive FAVAR model assessment is needed to understand the
benefits, challenges, and improvements for monitoring inflation and
monetary policy transmission.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

4. Purpose of the study
Research objectives:
The goal of this thesis is to measure the effectiveness of monetary
policy towards full-fledged inflation targeting in Rwanda as well as the
effect on certain macroeconomic variables using factor analysis. The
following are the hypotheses:
H1: Keeping inflation between 2% and 8% allows Rwanda to
implement a full-fledged inflation targeting regime.
H2: Changes in monetary policy significantly affect macroeconomic
variables in the Rwandan economy.
H3:The contractionary monetary policy dampens economic growth and
inflation.
H4: Monetary policy actions directly impact real activity, prices, and
the exchange rate.
H5: The effects of monetary policy on macroeconomic variables vary
over time and across different economic conditions.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

5. Motivation
NBR raised the Central Bank Rate (CBR) by 250 basis points
between May 2022 and February 2023 in response to rising
inflationary pressures.
It looks like there is a positive relation between inflation and the
central bank rate before February after adopting the inflation
targeting.
I thought, maybe monetary policy change is responding to other
macroeconomic variables rather than inflation pressure as its main
objective.
I used factor analysis to measure the effect of monetary policy
decisions on macroeconomic variables
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

6. Data and Methodology
Data:
The source of data for macroeconomic variables used in this study is
both the National Bank of Rwanda (NBR) and the National Statistical
Institute of Rwanda (NSIR).
A total of 78 macroeconomic variables were used in the analysis.
The monthly data from 2006 to April 2023 was used in this study.
Methodology:
Sims (1980) argued that no variable is exogenous in vector
autoregressive models with endogenous monetary policy in
forward-thinking agents.
VAR model in levels popularity increases due to resilience and
incorporating sufficient delays.
Hamilton (1994)’s two-step procedure estimates VAR model levels
without considering cointegration.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

7. Data and Methodology
Criticisms:
VAR models frequently suffer from identification issues, as pointed out
by Christiano et al. (1998).
Duncan (2014) warns about endogeneity issues in the cyclicality of
monetary policy, suggesting that VAR models may struggle to capture
the causal link between policy actions and macroeconomic volatility.
To address these issues, Bernanke et al. (2005) proposed and used the
factor-augmented VAR (FAVAR) analysis, which can improve factor
estimates and the analysis of monetary policy impacts.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

8. Application FAVAR model
ˇ
Ft
Yt
˘
=ψ(L)
ˇ
Ft−1
Yt−1
˘
+ut(1)
WhereFtis the collection of variables that is unobservable, whileYtis
observable.
-The estimation of FAVAR model goes through five steps replicated from
Bernanke et al., (2005):
1
Step 1: Extract principal components of allX(includingY).
2
Step 2: Extract principal components of slow variables.
3
Step 3: Clean the PC from the effect of observedY.
4
Step 4: Estimate FAVAR and get IRFs.
5
Step 5: Estimate and interpret table results of FEVD.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

9. Main Results
Table:
Variable Estimate Lower CI UpperCI
Intercept 3.468 3.36 3.57
EquilibriumRealRate 4.568 3.38 5.75
CostPushShock -0.0053 -2.28 2.22
Output 0.049 -2.13 2.26
TargetInflation 5.0 2 8
Source: Author’s computation, 2023
The central bank of Rwanda should target an inflation rate between 2%
and 8% in order to implement a full-fledged inflation-targeting regime.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

10. Impulse response function with Three factors
The top three PCs explain 85% of the total variation, accounting for 68%
for the first, 9% for the second, 8% for the third, and so on.
Figure:
Components with Two-step Bootstrap
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

11. Impulse response function with Five factors
They derive the nonsensical effect of the monetary policy shock compare
to the fewer factors.
Figure:
Principal Components with Two-step BootstrapClement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

12. Forecasting error variance decomposition (FEVD)
Table:
component
No Variables Contribution R2
1 Central bank Rate 0.906 1
2 Industrial production 0.289 0.986
3 Headline inflation 0.28 0.525
4 3m Treasury Bills 0.444 0.654
5 Monetary base 0.191 0.991
6 M2 0.236 0.994
7 Wholesale retail 0.114 0.987
8 Imported inflation 0.085 0.981
9 Government exp 0.042 0.975
10 Fresh food inflation 0.239 0.953
11 National income 0.508 0.994
12 Exchange Rate USD 0.033 0.984
13 Energy inflation 0.142 0.971
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

13. Forecasting error variance decomposition (FEVD)
Table:
component
No Variables Contribution R2
14 GDP per capita 0.507 0.982
15 Lending rate 0.094 0.651
16 Investmentconst 0.189 0.958
17 Core inflation 0.142 0.979
18 Credit to private 0.252 0.997
19 Producer Price 0.107 0.978
20 Capacity utilization 0.103 0.068
21 Commodityexpprice 0.197 0.437
22 Trade openness 0.218 0.82
23 HHD & NGOs exp 0.394 0.986
24 Aggregate Demand 0.42 0.995
25 Wages & salaries 0.335 0.995
Source: Author’s computation, 2023
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

14. Conclusion & Recommendation
Conclusions:
The hypotheses are all significantly achieved, H1 is true where the
estimated value of inflation target is 5.0%, (H2, H3, H4, & H5) are also
achieved in which impulse response generated reveal the significantly
over all effect of monetary policy on macroeconomic variables.
FAVAR addresses the issues of data-rich environments and fuzzy
measurement of economic variables as shown in the study.
Monetary policy FAVAR yields sensible reactions of a broad set of
indicators.
Recommendations:
Improving data availability, quality, and transparency is crucial for
enhancing monetary policy transmission.
Central bank of Rwanda, may keep inflation target 5.0% which
strength the economy.
Further researcher, may keep focus on factor analysis since the
macroeconomic variables are mostly interdependences.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

15. References
Bernanke, B. S., Boivin, J., & Eliasz, P. (2005). Measuring the
effects of monetary policy: a factor-augmented vector autoregressive
(FAVAR) approach. Quarterly Journal of Economics.
Bryant, R., Hooper, P., & Mann, C. L. (2010). Evaluating policy
regimes: New research in empirical macroeconomics. Brookings
Institution Press.
Kamber, G., & Wong, B. (2017). Global Factors and Trend Inflation.
45.
Clarida, R., GAL, J., & GERTLER, M. (2000). Monetary Policy Rules
and Macroeconomic Stability: Evidence and Some Theory.
Christiano, L., Eichenbaum, M., & Evans, C. (1998). Monetary Policy
Shocks: What Have We Learned and to What End? (No. w6400; p.
w6400). National Bureau of Economic Research.
Duncan, R. (2014). Institutional quality, the cyclicality of monetary
policy and macroeconomic volatility. Journal of Macroeconomics, 39,
113–155.
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023

16. Comments & Suggestions
Any contribution to the paper?
ORCiD: https://orcid.org/0000-0003-1459-3196
Google Scholar: https://bit.ly/ClementResearcherRRA
Thank you for your attention.
Murakoze!
Clement Uwizeye (Master student in AQE)Towards a Full-Fledged Inflation Targeting Monetary Policy Regime in RwandaJuly 2023