MONETARY POLICY TRANSMISSION IN ZAMBIA

by

Noah Mutoti

Submitted to the Department of Economics and the Faculty of the

Graduate School o f the University o f Kansas in partial fulfillment
o f the requirements for the degree of Doctor o f Philosophy

/ t
T-----------------------

Date Submitted:

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 UMI Number: 3196055

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 ABSTRACT
Noah Mutoti, Ph.D
Department of Economics
University o f Kansas

This dissertation constructs two small structural empirical models o f the monetary
policy transmission in post-liberalization Zambia. Using the structural cointegrated VAR
framework, the following questions are addressed. What is the role o f money in the
transmission process? W hat is the role of monetary policy shocks in exchange rate behavior?
How important are exchange rate shocks in CPI inflation? Does monetary policy respond to
exchange rate shocks? What is the impact o f foreign price shocks on the domestic economy?
The first model is identified with short run and long run restrictions and the second with
contemporaneous restrictions motivated from rational expectation assumptions.
The empirical results suggest that the impact of monetary policy shocks on output is
temporary' and marginal. Leading indicators o f output are aggregate supply and IS shocks, the
latter more pronounced in the short run, CPI inflation is mainly due to aggregate supply and
exchange rate shocks. Generally, monetary policy has served to dampen inflationary
pressures induced by exchange rate shocks. Foreign price shocks modestly affect short run
output and CPI inflation.
We draw policy implications for monetary targeting from two key observations. First,
a positive monetary policy shock leads to a sharp and persistent rise in money supply. But
this is not translated into strong consumer price response. Second, though the money demand
is stable, money demand shocks have modest role in consumer price and in the short run.
These suggest that reducing inflation further, especially to single digits, under the current
regime is likely to be problematic. This may be due to a weakened link between money and
inflation, giving rise to situations where getting the monetary target does not produce the
desired inflation outcome and where money fails to produce reliable signals o f the stance of
monetary policy. We conclude that since food price has the largest share in CPI and exchange
shocks have dominant role in inflation dynamics, policies meant to increasing domestic food
supply and stabilizing the exchange rate are likely to help Zambia achieve and sustain lower
inflation.

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 ACKNOW LEDGEM ENTS

I am highly indebted to my advisor, professor John Keating for the unreserved

guidance and support he has provided through the development o f this dissertation.

My committee members Ted Juhl, Paul Comolli, Yi Jin and Steve Hillmer

also deserve credit for their valuable suggestions. I would also like to thank my colleagues,

especially Brandon, for various kinds of assistance.

I am also grateful to Dr. A. Mwenda, Dr. D. Kalyalya and Dr. R. Chembe for their

encouragement. Special thanks go to my family for their support, patience and understanding.

Finally, Bank o f Zambia financial support is highly appreciated.

ill

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 CONTENTS

1.0 M onetary Policy Reforms in Z am bia................................................................................ 1

1.1 Introduction...........................................................................................................................1
1.2 M otivation............................................................................................................................. 1
1.3 Financial Liberalization..................................................................................................... 4
1.4 M onetary Policy...................................................................................................................7
1.4.1 Policy Objective and Intermediate Target..............................................................7
1.4.2 Policy Instruments..................................................................................................... 8
1.4.3 Policy Im plem entation............................................................................................. 9
1.5 Macroeconomic Performance,1992-2003..................................................................... 10
1.5.1 M onetary Developments andFinancial Sector G row th ......................................10
1.5.2 Output and Inflation................................................................................................12

2.0 A Cointegrated SVAR Model: Short Run and Long Run Restrictions.................. 14
2.1 Introduction.........................................................................................................................14
2.2 Theoretical M odel..............................................................................................................16
2.3 Econometrics M odel.........................................................................................................21
2.4 Empirical Cointegration Analysis...................................................................................27
2.4.1 Data Properties........................................................................................................ 28
2.4.2 Unit Root T e s ts ....................................................................................................... 28
2.4.3 M odel Specification............................................................................................... 32
2.4.4 Cointegration Rank T esting .................................................................................. 34
2.4.5 Identifying Cointegration R elations..................................................................... 36
2.4.6 Model Stability........................................................................................................ 42
2.5 Structural A nalysis............................................................................................................ 43
2.5.1 Identification............................................................................................................43
2.5.2 Impulse R esponses..................................................................................................46
2.5.3 Variance decom positions.......................................................................................54
2.6 Concluding Comments......................................................................................................59

3.0 A Rational Expectation Structural VAR M odel..........................................................61

3.1 Introduction.........................................................................................................................61
3.2 A Stochastic Rational Expectation Open Economy M acro M odel........................... 63
3.3 Econometrics Strategy......................................................................................................68
3.4 Structural Empirical A nalysis..........................................................................................72
3.4.1 Impulse R esponses..................................................................................................74
3.4.2 Variance D ecom positions......................................................................................80
3.5 Concluding Com m ents......................................................................................................85

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 4.0 Sum m ary................................................................................................................... 87

5.0 References............................................................................................................... 100

LIST OF TABLES

Table 1.1: Key Macroeconomic Indicators (percent) ,1965-1991 .................................. 4

Table 1.2: Key Macroeconomic Indicators (percent), 1992-2003................................ 11
Table 2.1: Perron Unit Root T est....................................................................................... 31
Table 2.2: Zivot-Andrews Unit Root T est.......................................................................31
Table 2.3: Lag Length Selection.........................................................................................33
Table 2.4: Misspecification T ests...................................................................................... 33
Table 2.5: Trace Test for Cointegration R an k ..................................................................34
Table 2.6: Eigenvalues o f the Companion M atrix........................................................... 35
Table 2.7: Test for Weak Exogeneity................................................................................36
Table 2.8: Testing Single Cointegration Relations.......................................................... 37
Table 2.9: Identified Long Run Structure......................................................................... 38
Table 2.10: Estimated Short Run Param eters...................................................................46
Table 2.11: Percentage o f Forecast Error Explained by Shocks.................................... 56
Table 3.1: Estimated Structural Parameters...................................................................... 73
Table 3.2: Percentage o f Forecast Error Explained by Shocks...................................... 82

LIST OF FIGURES

Figure 1.1 : Interest r a te s .....................................................................................................12

Figure 2.1: Variables in Levels..........................................................................................29
Figure 2.2: Variables in First Differences......................................................................... 30
Figure 2.3: Error Correction R elations..............................................................................40
Figure 2.4: Recursive Test for Constancy o f the Identified (5 ....................................... 42
Figure 2.5: Impulse Responses to a Monetary Policy Shock..........................................47
Figure 2.6: Impulse Responses to an Aggregate Supply S h o ck .................................... 48
Figure 2.7: Impulse Responses to an IS Shock.................................................................49
Figure 2.8: Impulse Responses to a Money Demand S h o c k ..........................................51
Figure 2.9: Impulse Responses to an Exchange Rate S h o ck..........................................52
Figure 2.10: Impulse Responses to a Foreign Price Shock............................................. 53
Figure 2.11: Impulse Responses to a Foreign Interest Rate Shock................................ 54
Figure 3.1: Impulse Responses to a Monetary Policy Shock.........................................75
Figure 3.2: Impulse Responses to an Aggregate Supply S h o ck ................................... 76
Figure 3.3: Impulse Responses to an IS Shock.................................................................77
Figure 3.4: Impulse Responses to a Money Demand S h o c k ..........................................78
Figure 3.5: Impulse Responses to an Exchange Rate S h o ck..........................................79
Figure 3.6: Impulse Responses to a Foreign Price Shock............................................... 80

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 1.0 Monetary Policy Reforms in Zambia

1.1 Introduction

Because o f the need to correct huge fiscal deficits, sluggish growth, high inflation,

and weak external position, starting early 1990s, as part of International Monetary Fund

(IMF)/World Bank-supported program, Zambia embarked on financial liberalization. This

was broadly aimed at enhancing financial efficiency through greater reliance on market

forces and improving the effectiveness of monetary policy. To this end, the key reforms

included liberalizing interest and exchange rates, removing credit controls, moving towards

indirect instruments, enhancing competition and efficiency in the financial system,

strengthening the supervisory framework, promoting the growth and deepening o f financial

markets and improving the payments system.

As such measures have implications for the formulation, implementation and

transmission process of monetary policy, this chapter provides a background to the empirical

modeling. Section 1.2 outlines motivation for reforms while Section 1.3 details the specific

measures. The monetary policy strategy is presented in Section 1.4. Section 1.5 discusses the

recent macroeconomic performance.

1.2 Motivation

Until early 1990s, the financial system in Zambia was highly regulated and barely

competitive as it was characterized by interest rate regulations, domestic credit controls,

segmented and undeveloped money market, absence of capital market, international capital

flow restrictions and fixed exchange rates. Interest rate controls, motivated by the desire to

provide low-cost investment funds and to guard against interest rates that were politically

unacceptable, took the form of ceilings on both lending and deposit rates.

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 Credit controls involved credit ceilings on the level or growth o f bank credit. It also

involved directed credit schemes, in particular, the almost automatic access o f state-run banks

to subsidized central bank credit geared to financing priority sector (e.g. agriculture, mining

and manufacturing). The high segmentation o f the financial system was, in part, due to

numerous banking entry regulations. For example, each type of financial institution was

restricted to conducting business within its prescribed sphere, entry o f new institutions into

particular segments was extensively regulated or even prohibited and activities of foreign

banks restricted.

Over time, these restrictions had deleterious effects on financial sector growth and

development, besides monetary policy. Interest rate controls led to financial disintermediation

as savers and investors sought alternative outlets outside the formal financial system. In

setting credit ceilings, the central bank, Bank o f Zambia (BOZ), allocated the scope for a

banks future lending largely on the basis o f its past share in total credit. This imposing of a

status quo (on the market structure) limited inter-bank growth and competition, thereby

inhibiting the development o f new services and instruments. Further, the acceleration of

financial disintermediation resulted in the growth and expansion of unregulated financial

markets, greatly weakening the effectiveness o f monetary controls.

Lack o f established financial markets also had major implications for the conduct of

monetary policy. In particular, it precluded open market operations and thereby the indirect

controls o f interest rates. Monetary policy as a result was implemented through quantitative

credit allocations, credit ceilings and interest rate controls, alongside high reserve

requirement and discount rate.

Monetary policys effectiveness policy was further impaired by the absence of

supportive fiscal policy, reflected in the huge fiscal deficits financed by the central bank.

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 Unsustainable fiscal deficits also hampered the exchange rate as an anti-inflation tool. For

almost two decades (1965 to 1991), fixed exchange rates, alongside price controls (e.g. food

prices), acted as the nominal anchor for inflation expectations. However, for a fixed exchange

rate regime to succeed as an anti-inflation framework, it has to be accompanied by restrictive

credit and fiscal policies, besides other conditions (Mishkin (1999)).'

By mid 1980s, serious macroeconomic imbalances emerged (Table 1.1). The fiscal

deficits increased to an average o f 11.1 percent o f gross domestic product (GDP) in 1980s

from 9.4 percent in 1970s, contributing substantially to money supply (measured as broad

money), and consequently inflation. Annual broad money (M2) growth reached a record high

of 93 percent in 1986. Consumer price (CPI) inflation, in single digits up to 1975, rose

steadily to more than 20 percent in 1985 and 100 percent in 1990, before falling to 92.3

percent a year later. Real output growth, averaging 4 percent during the last half o f 1960s,

dropped to about 2.0 percent in the 1970s and 1.4 percent in the [Link] rising inflation,

banks deposit and lending real rates became negative and this together with the rigid

structure o f the banking system distorted financial intermediation, hindering financial

deepening and growth. For example in 1990, financial depth measured by M2 as percent of

GDP, declined to below 25 percent for the first time since 1974. The external position also

showed no room for comfort. The current account deteriorated from an average surplus o f 3.1

percent of GDP in the 1970s to a deficit of 0.55 percent in the 1980s.

1 Additional conditions for a fixed exchange rate to be more advisable as anti-inflation framework: (i)
the country in question is sm all relative to the rest o f the world; (ii) the bulk o f international trade is
undertaken with the country (or countries) with respect to which it plans to peg its currency; (iii) the
country wishes to have a rate o f inflation similar to that o f the economy it is pegging its currency to;
and (iv) there are institutional arrangements that assure that the commitment to a fixed rate is credible.

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 Table 1.1: Key Macroeconomic Indicators (percent), 1965-1991

CPI
Output Inflation M2 BD/GDP CA /GDP M2/GDP
1965 4.00 1.09 31.02 3.40 15.56 15.12
1966 3.26 2.00 35.13 3.56 14.19 17.13
1967 6.99 2.10 16.59 -3.17 6.15 17.70
1968 2.58 2.31 29.10 -9.92 6.98 20.59
1969 3.18 2.53 28.72 2.73 33.25 21.43
1970 7.70 2.62 26.11 1.92 17.63 29.12
1971 1.15 5.95 -10.42 -16.44 -2.13 26.93
1972 9.16 5.48 19.50 -13.03 1.59 28.19
1973 -0.95 6.46 8.11 -16.74 15.80 25.82
1974 6.73 8.10 7.28 3.41 9.45 23.34
1975 -2.59 10.13 12.03 -21.52 -19.50 31.18
1976 2.67 18.80 26.29 -14.24 5.08 32.89
1977 -1.66 19.78 12.06 -13.16 -2.59 35.18
1978 0.63 16.37 -0.81 -14.42 -3.36 30.79
1979 -3.09 9.72 20.08 -9.06 8.98 31.29
1980 3.09 11.67 9.00 -18.52 -4.02 29.61
1981 6.14 14.00 7.89 -12.90 -12.51 28.08
1982 -2.83 12.46 33.78 -18.59 -8.86 36.42
1983 -1.95 19.66 11.07 -7.83 -1.15 34.78
1984 -0.59 20.01 17.16 -8.39 3.80 34.55
1985 1.90 37.43 23.48 -15.37 0.53 29.75
1986 0.68 51.60 93.07 -21.39 -0.04 30.97
1987 2.67 43.07 54.26 -12.90 4.13 31.68
1988 6.29 55.74 61.63 -8.95 7.33 33.73
1989 -1.02 94.49 65.21 -8.11 5.31 30.32
1990 -0.45 117.35 48.47 -3.05 -0.72 21.92
1991 -0.03 92.30 95.00 -4.96 -2.61 22.19

Note: BD=budget deficit, CA= current account balance

Source: Bank o f Zambia and IMF IFS publications

1.3 Financial Liberalization

The move towards financial liberalization starting early 1990s reflected, in part, the

underpinning view o f the new Government (led by MMD) that excessive controls and

regulations were inappropriate for efficient resource allocation and economic growth.

Negative real interest rates, weak and negative growth, suggested that an overly regulated

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 financial system discouraged savings, created distortions in investment decisions, and

generally failed to intermediate between savers and investors. It was also clear

controlling inflation required more effective means of absorbing liquidity, limiting access to

central bank credit, and financing the government from less inflationary sources.

To provide essential building blocks for the new policy regime (discussed later),

financial reforms (adopted early 1990s) mainly involved interest rate liberalization, supported

by the introduction of a government securities auctioning system. At the outset of these

reforms, in October 1992, interest rate controls and most credit ceilings were removed, and

liquidity credit financing reduced sharply. Four months later, through the 1993 Budget, the

market for public-debt financing, the Treasury bill auctioning system, was established. The

aim was to financing fiscal needs, especially financing maturing securities, without resorting

to central bank credit. Three years later (i.e. 1995), a competitive primary market for bonds

came into existence, further marking a shift from fixed to market pricing o f securities.

Liberalizing domestic financial markets was accompanied by the removal of

exchange controls and the shift towards flexible exchange rates. It is worth noting that

measures to liberalize the foreign exchange market originated from the 1989 reforms that

introduced a Dutch two-tier auction system. That is, a dual exchange rate mechanism in the

sense that an official rate for government transactions and a market rate for other transactions

existing side by side. This process gained momentum early 1992, with the phasing out of the

foreign exchange auctioning, thereby unifying the two rates. October 1992, the Bureaux-de-

Change Legislation was enacted to facilitate market-based exchange rate.2 Also during this

year, non-metal exporters were allowed to retain 50 percent o f foreign earnings. A year later,

2 Under the dual exchange rate system, the market rate was determined by the BOZ-weekly auctioning
while the official was a below-auction rate used for allocating foreign exchange, by the Foreign Exchange
management Committee (FEMAC), for debt-servicing, medical and educational supplies, oil imports, as
well as for Zambia Consolidated Copper Mine (ZCCM) and Zambia Airways (ZA) import requirements.

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 besides introducing the BOZ (foreign exchange) dealing system, the Zambia Consolidated

Copper Mine (ZCCM), the countrys major exporter, was permitted to retain 55 percent of its

earnings. In January 1994, the Exchange Control Act was repealed and all capital controls

abolished, making the Kwacha fully convertible. In 1995, BOZ allowed commercial banks to

hold foreign exchange deposits. April 1996 further marked the significant phase in

liberalizing this market: BOZ increased the retention rate o f export earnings to 100 percent.

Facilitating emergence o f a competitive banking system, a prudent supervisory

system and an efficient payment system required overcoming many structural obstacles. By

enacting the Banking and Financial Services Act o f 1996, measures were undertaken to

reduce obstacles to competition and market segmentation by allowing greater freedom of

banking entry, expanding the scope of permissible business activities for different types of

financial institutions, and relaxing restrictions on activities o f foreign banks. This legislation

also provided for the strengthening of the supervisory framework.

It was also recognized that the design o f payment systems has important implications

for the conduct of monetary policy, the soundness o f financial firms, and the functioning of

the economy. In particular, a better payments system, a more competitive banking system,

and an increased reliance on indirect instruments help to develop a competitive market in

inter-bank deposits. Further an efficient payment system facilitates inter-bank transactions

and active liquidity management, essential aspects of monetary management. In view o f these

operational linkages, payment system reforms figured prominently in structural reforms of

the financial sector. In 1997, the BOZ relinquished control o f the clearing function to the

Bankers Association o f Zambia (BAZ), which established the Transitional Zambia Clearing

House (TZCH). Revised clearing rules were introduced in August 1997. In November 1999,

with the establishment o f the Zambia Electronic Clearing House (ZECH), an automated

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 electronic clearing system was launched. The objectives were to expediting the processing of

payments, reducing the risk and uncertainty associated with non-cash payments, facilitating

the adoption o f indirect instruments, besides fostering financial market development.

1.4 Monetary Policy

1.4.1 Policy Objective and Intermediate Target

The fundamental task o f the BOZ is to achieve price stability upon which the

sustainability o f long-term economic growth can be secured. Explicitly, the ultimate

monetary policy objective o f BOZ is stipulated to be that of ensuring the maintenance of

price stability so as to promote balanced macroeconomic development. This principle,

reflected in the 1996 BOZ Act (Number 43 that repealed the Bank o f Zambia Act Number 24

of 1985), represents an evolution from past practices that gave prominence to multiple

objectives, including supporting economic growth and maintaining fixed exchange rates. As

earlier noted, while attempts to use monetary stimuli may have increased short-run output, it

was at the cost of undesirable inflation, protracted balance o f payments difficulties and

sluggish long-term growth.

This policy objective has been pursued within the new framework, monetary

targeting. Having lost the nominal anchor o f fixed exchange rates and inflation exceedingly

high, Zambia adopted money-growth targeting to guide its conduct o f monetary policy. At the

beginning o f each year, the BOZ establishes an annual growth o f M2 that is announced

(January/February) through the Budget, considering the growth potential and the expected

unavoidable (or exogenous) increases in prices. Short-term factors considered include

possible changes in capacity utilization, developments in the foreign exchange value of the

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 Kwacha, and the velocity of circulation, the latter perceived to represent developments in

money demand.

1.4.2 Policy Instruments

With the financial sector liberalized, the previous reliance on direct instruments o f

monetary control: interest rate ceilings, credit controls and guidelines, reserve requirements

and discount rate, gave way to market-based instruments. Specifically, in response to signals

relating to the future course o f prices, to influence money and credit conditions since late

1993, the BOZ relies more on open market operation: primary securities, short-term deposits

and repurchase agreements.

Aided by the creation of the government securities market, the issue o f primary

securities was the first open market operation to be introduced in 1993. This involves the

outright purchase or sale o f government securities. When monetary policy needs arises,

securities are issued in excess of maturities for purposes of sterilizing excess money supply.

The second open market operation was introduced in 1995, the daily auctions o f short-term

deposits of credits with commercial banks. BOZ invites deposits of say, 14 to 28 days

maturities and offers overnight credits. Such interventions, designed to regulate banking

liquidity via the money market, especially the inter-bank market, are mainly for liquidity

smoothing.

Since September 2000, open market operations under securities repurchase

agreements have become the principal vehicle for short-term reserve management. This

involves the purchase by the BOZ of eligible securities from banks for a specified period with

an understanding that banks will repurchase these securities at the end o f the period. The time

and frequency of such operations, the duration of the repurchase period, the amount of funds

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 to be provided to the banking system, and the rate o f interest charged on the funds are

decided according to liquidity considerations and policy guidelines.

Open market operations for foreign exchange also serve as safety valve for banks

liquidity management, especially during periods of heavy capital inflows and outflows.

Experience has shown that banks tend to sell foreign exchange to the Bank when money is

tight and interest rates are high and buy foreign exchange when liquidity is high and interest

rates are low. Typical transactions are swaps, involving the purchase of, say US dollars,

against Kwacha combined with simultaneous sale o f the acquired dollars in the forward

market. So as not to change the monetary base, foreign currency obtained through such

interventions are sterilized. The Bank also utilizes compulsory reserve requirements to affect

banks reserve positions in rare special circumstances.

1.4.3 Policy Implementation

M onetary policy implementation, that is, controlling the intermediate target, M2,

occurs over the monetary base, defined as the sum o f current accounts and bank notes held by

banks and the general public. During weekly and monthly monetary policy meetings, the

latest economic and financial developments are considered, the appropriateness o f the current

monetary policy stance reexamined and the short-run policy stance adjusted, if necessary.

Specifically, the reserve position of the banking system is assessed and evaluated whether it

is consistent with the current stance o f monetary policy whose immediate goal is to meet the

net domestic asset (NDA) and net foreign asset (NFA) requirements stemming from the IMF

program, the Poverty Reduction Growth Facility (PRGF), and previously, the Enhanced

Structural Adjustment Facility (ESAF). On the basis o f the evaluation o f money market and

general economic conditions, instructions are given to intervene or not to intervene in the

inter-bank market.

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 The effectiveness of indirect instruments, in part, depends on the ability o f the central

bank to project the demand for and supply of reserves and their effects on broader credit and

monetary aggregates. Operationally, this depends on the central banks reserve money

programming framework for managing liquidity it provides to the market to ensure that the

instrument settings are consistent with the policy objectives. Such a framework provides the

central bank with the amount of liquidity to be injected into or withdrawn from the money

market by debt or auctions, respectively. It also increases the scope of the central bank to

affect short-term liquidity conditions as it is a timely and accurate reporting as well as a

short-term information system for early indicators o f monetary and interest rate

developments. Accordingly in 1993, BOZ instituted a framework for reserve money

programming.

1.5 Macroeconomic Performance, 1992-2003

1.5.1 Monetary Developments and Financial Sector Growth

While money growth has decelerated remarkably, it has displayed sizable

fluctuations, especially during the early years of reforms. The abandonment of quantitative

restrictions on bank credit immediately led to an upward shift in the 12-month M2 growth,

increasing to 122.5 percent in 1993 from 95.0 percent in 1992 (Table 1.2). Other major

contributors were the fiscal deficit, which more than doubled and the BOZ reducing the core

liquid asset ratio to 30.0 percent from 42.5 percent, causing reserve money increasing sharply

(138.6 percent).

With the adoption o f an indirect monetary control, however, monetary operations

have enhanced, reflected in the steady decline in money growth in subsequent years, with

fiscal performance playing a major role. M2 growth declined to below 25.0 percent in 1997,

10

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 Table 1.2: Key M acroeconomic Indicators (percent), 1992-2003

CPI
Output Inflation M2 BD/GDP CA /GDP M2/GDP
1992 -1.80 170.31 98.54 -4.20 -4.71 16.88
1993 6.50 188.07 122.50 -9.28 -5.97 14.14
1994 -3.50 53.63 46.05 -7.16 -3.86 12.57
1995 -2.49 34.18 42.54 -3.67 -8.43 12.43
1996 6.59 43.86 28.33 -3.81 -13.01 13.77
1997 3.30 18.60 23.97 -0.19 -6.15 12.84
1998 -1.88 30.60 22.62 -5.60 -23.70 15.31
1999 2.00 36.49 29.21 -3.68 -16.65 19.10
2000 3.50 30.14 71.31 -5.90 -23.99 24.29
2001 4.90 18.68 12.30 -7.22 -22.05 20.92
2002 3.30 26.65 31.26 -5.61 -19.01 22.18
2003 5.10 17.20 22.56 -4.74 -14.03 21.54

for the first time since 1985. During this period, the fiscal deficit declined from 7

percent o f GDP to below 1 percent. In 2000, M2 growth more than doubled, net

claims o f government (NCG) contributing 43 percent (Bank o f Zambia (2001)).

Since 1998, commercial banks have raised lending rates and lowered deposit rates,

thus increasing interest rate spread from less than 10 percent to around 12-15 percent (Figure

1.1). The widening o f interest rate margins reflect in part an attempt by banks to offset the

impact on their financial position o f the difficulties faced by several public and private

enterprises to service their financial obligations to the banking system.

Interest rate spreads can be used as proxy for the efficiency o f financial

intermediation and the level o f competition in the financial sector (Alexander et al. (1995).

Experience indicates that the interest spread initially widens during the transition and then

narrows in the post transition period, suggesting increased efficiency o f services in the

financial sector. The Zambian experience thus characterizes a financial sector still lacking

depth. This is also reflected in financial deepening, as measured by M2/GDP ratio, only

slightly increasing to 21 percent in 2003 from 16 percent in 1992.

11

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 Figure 1.1 : Interest rates

100
- S a v i n g s r a t e Lending rate

60 -

O
<L>

O
Q.
40 -

20 -

1 994 1995 1996 1997 1998 1 999 2000 2001 2002 2003

1.5.2 Output and Inflation

The early period of reforms witnessed an economic downturn, due to negative supply

shocks, mainly affecting agricultural output. Prolonged droughts led to agricultural output

declining by 3.6 percent in 1994 and 11.3 percent in 1995. Consequently, real GDP declined

by 3.5 percent and 2.5 percent, respectively.

During the period 1999-2003, however, economic performance has been impressive,

with real GDP growth consecutively positive and averaging 4.2 percent. This was mainly

attributable to positive supply shocks, reflected in favorable weather conditions, expanding

agricultural output to a record high of 13.7 percent in 1999.

An overview o f post-liberalization inflation leads to four main observations. Annual

inflation, as measured by changes in consumer prices, has declined to unprecedented levels

not seen in more than two decades. The 3-digit inflation, at the beginning o f the reforms, was

cut by more than half to slightly 50 percent in 1994. By the end o f 2003, inflation was just

over 17 percent.

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 Second, inflation has exhibited sizable swings. After dropping to a record low of 18.6

percent in 1997 since 1993, it trended upwards until 2000. Third, there are seasonal

components in the evolution o f Zambias consumer prices. Consumer prices tend to go up in

the first quarter, decrease in the second and third quarters, and increase during the last

quarter.

Fourth, agricultural supply shocks play a pronounced role in consumer price

developments, besides exchange rate and oil price shocks. This o f course, does not imply

inflation (in Zambia) is completely determined by structural factors and beyond the control of

the authorities as there is clear evidence o f monetary accommodation. Money growth has

generally been persistently higher than the rate of increase in consumer price. For example, in

1993, despite a decline in food prices (8.5 percent), exchange rate depreciation falling to 42

percent from over 200 percent the previous year and a lower growth in fuel prices, inflation

increased to 188 percent from 170 percent. At the same time, M2 growth surged to 122.5

percent from 98.5 percent.

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 2.0 A Cointegrated SVAR Model: Short Run and Long Run Restrictions

2.1 Introduction

While the monetary transmission mechanism has been a subject o f much research

over a number of years (e.g. Taylor (1995), Bernanke and Gertler (1995), Christiano, et al.

(1996,1999), Liitkepohl and Wolters (2003)), in most developing countries, especially Sub-

Saharan Africa, very little is known about issues central to underlying monetary policy. In

particular, how the economy responds to shocks, the relative importance o f various

transmission channels, the magnitude and timing of monetary policy effects and the

effectiveness o f various policy instruments. Recently, however, with the deregulation of

financial markets and monetary policy more oriented towards market-based operations, there

has been an interest in understanding the working o f emerging markets as illustrated in

Atingi-Ego (2000) and Mahadeva and Smidkova (2000).

Contributing to this growing literature, the present chapter examines the transmission

mechanism o f monetary policy in post-liberalization Zambia, focusing on the role o f money

and exchange rate. Facing rising inflation early 1990s, as part o f broad International

Monetary Fund (IMF) /W orld Bank-supported reforms, Zambia adopted monetary targets as

a guide to monetary policy. During the early years of this regime, inflation abated and

declined to unprecedented levels not seen in more than two decades. Annualized consumer

price (CPI) inflation, consistently in 3-digit levels in the last half of 1980s, broke at the end of

1994, falling sharply to about 54 percent and subsequently to below 20 percent at the end of

1997. Since then, however, the disinflation process seems to have stalled such that in the past

five years, CPI inflation has stuck within the 17-30 percent range. The question of the effects

o f money supply shocks is highly relevant in this context. With the advent o f flexible

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 exchange rates, whether exchange rate shocks are dominant in inflation dynamics is also of

great empirical interest, especially that the current account has remained in deficits over the

years and the exchange rate has consequently been under persistent pressure to depreciate.

We address these questions within a structural vector error correction model

(SVECM). There have been previous attempts to model Zambias monetary policy, notably,

by Mwansa (1998) and Simatele (2004). None o f these studies, however, applied this

econometrics framework. We also differ from existing analyses by identifying the model with

short run and long run restrictions, in the spirit of Gali (1992). Our study in some aspects

similar to Dhar et al. (2000), aims at constructing a small structural macro model o f variables

thought to play a significant role in the transmission process: money, aggregate income,

consumer price, domestic interest rate and exchange rate. Imported consumer price and

foreign interest rate are also included to analyze the impact o f foreign shocks on the domestic

economy.

The model is based on a small open IS-LM-AS scheme set out in Section 2.2. The

econometrics framework is described in Section 2.3. The empirical analysis begins in Section

2.4, with the testing o f unit roots and existence o f long-run relationships that are theory

consistent. Four stable cointegration relations are identified: money demand, IS, exchange

rate and foreign interest rate relations. Accordingly, money demand, IS, exchange rate and

foreign interest rate shocks are characterized as transitory and monetary policy, aggregate

supply and foreign price shocks as permanent. Effects o f the shocks and their relative

importance are examined by impulse responses and variance decompositions in Section 2.5.

It is concluded in Section 2.6 that a SVECM disciplined by restrictions rooted in economic

theory is a plausible tool to further our understanding o f Zambias monetary policy. Like

results for developed economies (e.g. Bemanke and Mihov (1998), Sims and Zha (1995a)),

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 the impact o f monetary policy shocks, identified as innovation to money, on Zam bias output

is little and temporary. Output is mainly due to aggregate supply shocks. Though the money

demand is stable, monetary policy shocks only modestly impact Zam bias consumer price

and in the short run. Consumer price is mainly due to aggregate supply and exchange rate

shocks, the latter more pronounced in the short run.

2.2 Theoretical Model

This section outlines a well-known macroeconomic model for a small open

economy under flexible exchange rates, the Mundell-Fleming-Dornbusch model, which is

widely used in empirical analyses (e.g. Andres et al.( 1999), Hansen and Kim (1996) and

Dekle et al. (2001)). This model also in the spirit o f Obstfeld and Rogoff (1995), Papell

(1989), Batini et al. (1999) and Svensson (2000) is mainly described by four equilibrium

conditions: one describing the adjustment of prices over time and embodying a long-run

neutrality restriction, one for the goods market and two for the asset market, depicted as

equations (2.1)(2.4):3

(2 .1) ap l, = fa aa c+ 0-~fa )A/v i + fa (y, - y " ) + fa (M + ap *) + n r

(2.2) y, = (R, - Ep tc ) + b2( S ' + p] - p ct ) + rft
(2.3) mt - p, = + c2y t - c2st +
(2.4) s, = /?, ,v, - ( R l - R ll ) + p

Equation (2.1) is an open economy Phillips curve, where Ap \ denotes domestic

consumer price (CPI) inflation, y t domestic output,;/" potential output (and thus ( y t - y " ) is

output gap), st nominal exchange rate (defined as the number of units o f domestic currency

3 All variables are in logarithms, except interest and inflation rates. All parameters are positive.
Following Woodford (2000), expectations are assumed backward looking.

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 required to purchase a unit o f foreign currency), p t foreign CPI and an aggregate supply

shock (e.g. productivity or oil price shock).

Equation (2.2), the open economy goods market (or IS) relation, states that domestic

output falls with the real interest rate ( Rt - Ap \ ) (where Rt is the nominal interest rate) as

higher rates discourage expenditure. It rises with depreciation o f the real exchange rate, i.e.

an increase in (st + p t /?) ) since exports become more attractive and imports more costly.

The former channel is defined over short than long rates for two reasons. First, expenditures

in developing economies are more sensitive to short rates. Second, long-term debt

instruments are almost absent is such economies. The stochastic variable rft denotes an IS

shock (e.g. shifts in tastes, shocks to fiscal policy and foreign output).

The real interest rate in equation (2.2) reflects possible spillover effects from money

demand (2.3) to aggregate demand where mt is nominal money stock. Neoclassical theory

explains inflation solely by means o f growth in the money stock, assuming a stable demand

for money and the controllability of the money stock (by the central bank) at least in the long

run. Empirical research, however, refers mainly to the stability o f money demand (Hansen

and Kim (1995)). Aside from the exchange rate, the money market equilibrium condition

(2.3) can be derived from an optimizing stochastic general equilibrium model (e.g. McCallum

and Nelson (1999)) with real output capturing transaction demand, nominal interest rate

measuring opportunity cost (of holding money) and T}'d denoting a money demand shock

(e.g. velocity shock). Inclusion o f exchange rate is, however, justified to capture currency

substitution effects (Briiggermann (2003)).

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 Another requirement for asset market equilibrium is that domestic assets are perfect

substitutes for securities that pay the world market interest rate R j . This is depicted in the

capital market equilibrium condition (2.4), also describing the international transmission

linkages and fulfilling the uncovered interest rate parity (UIP) condition, assuming world

financial markets are integrated. The stochastic variable defines an exchange rate shock

(e.g. shock to current account).

To solve the system for Ap ct , insert Rt from (2.3) and Ap ct from (2.1) into (2.2) to

yield the reduced-form income equation (2.5):

b\m, - bxp ct - b xc3st + bxcx(j)xE l_xA p ct + bxcx(\-</>x)A p x_x - b xcx<j>2y nt

(2-5) + (ot ,
a +bxcx(f>3Ast + bxcx(j)3Ap] + b2cxqt

where d = cx + bx(c 2 - c x(/)2) , qt = (si + p* p ct ) and the random variable(Dt is a

combination o f 77 , px , p ^ d . Substituting (2.5) into (2.1) gives the price adjustment (2.6):

1 - 0 ,)
( ~ L + bicA ) E ,^A p ^ + ( -*ici 0 01))AP/-t + b \ m t
r2 02

(2.6) ap ; = ~ b\Pc, + bf i st - (bicA + d )y" + 03 -+ b,c, As, + c o , .

d \r02: y

d 1-bxc
u A pt + b2cxq,
+03
V 02 J

This equation posits that CPI inflation is associated with both monetary inflation and

imported inflation. If the exchange rate adjusts immediately to reestablish purchasing power

parity (PPP), however, price shocks from abroad can be completely offset.

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 Suppose money demand does not depend on R, ands( , i.e., c, = c3 = 0 and the

income elasticity in (2.3) is one, i.e. c2 = 1, one gets the monetary targeting oriented inflation

specification (2.7) analogous to that in Hansen and Kim (1996):

(2.7) Ap ct= fa E ^ A p ^ + (1 - $ )Apc,_x + fa [m, - p ct -y"~\ + fa (As, + Ap{ ) + a>,.

The rate of CPI inflation is primarily affected by the deviation o f the real money stock from

potential output (i.e. potential gross domestic product (GDP)). It also depends on imported

inflation, expected inflation and lagged inflation.

Domestic monetary policy is implemented through control o f the nominal money

stock, assumed to follow a first-order autoregressive progress (Walsh (2003), pp491):

(2 .8) mt = r m,_l +r1; ' \

where ?7Jm/7 is a monetary policy shock.4

Foreign monetary policy is implemented through an interest rate instrument:

(2.9) R f = faR{_x + faAp, + p j ,

/ *
where rj, is a foreign interest rate shock. The impact of a foreign price shock ( rj, ) is

analyzed through the specification (2.10):

(2.10) Ap] =(t>Ap,_,+rf,

4 These reflect exogenous shocks to the preferences o f the monetary authority, perhaps due to shifts in
the relative weight given to inflation, output and exchange rate. More generally, they reflect a variety
o f random factors that affect policy decisions, including personalities and views o f members o f the
monetary policy committee, political factors, as well as technical factors like measurement errors in the
data available to the authority when they decide on policy actions (Eichenbaum and Evans (1995)).

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 Similar to Blanchard and Qual (1989), Gali (1992), Bernanke and Gertler (1995),

Eichenbaum (1992) and Sims (1992), Eichenbaum and Evans (1995) and Christiano, et al.

(1999), this model make the following predictions. First, the responses o f output and interest

rate to money supply shocks are consistent with the output and liquidity effects, whereby

interest rate falls and output rises after a monetary expansion.

Second, demand shocks (i.e. money demand, money supply and IS shocks) have (at

least) short-run effects on real output (and other real variables) as a result of slow

adjustments o f nominal variables. Third, output and inflation move in the same direction in

response to demand shocks, but in opposite directions in response to supply shocks. Fourth,

in the presence of price inertia, the exchange rate is expected to overshoot its long run level

after a monetary policy shock, as predicted in the Dombusch model.

Fifth, the implied transmission of monetary policy to inflation works through two

channels. There is a conventional real interest rate (or aggregate demand) channel, operating

through the output gap. A monetary contraction, for example, reduces output and

consequently inflation (through the Phillips curve). In addition, there is an exchange rate

channel, operating through two distinct channels. First, the indirect output gap route running

through net exports and hence onto CPI inflation, contributing to the aggregate demand

channel for the transmission o f monetary policy. Second, the direct exchange rate channel via

the cost o f imported consumption goods.

Finally, foreign shocks have two broad macroeconomic channels o f effects on the

domestic economy. The first channel is financial and works through the impact o f higher

foreign prices and interest rates on domestic interest rates and on the exchange rate. All else

being equal, higher interest rate abroad places downward pressure on the external value o f the

domestic currency. Second, higher foreign prices raise the cost of imports directly. Because

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 some of these imports are inputs into production, the resulting increase in production costs

eventually exerts upward pressure on domestic prices.5

2.3 Econometrics Model

The econometrics model is an adaptation o f Engle and Granger (1987), King et al.

(1991), Johansen (1988, 1991,1995b), Johansen and Juselius (1990, 1994) and many others

including Campbell and Shiller (1988), Amisano and Giannini (1997), Blanchard and Qual

(1989), Keating (1992) as well as Banerjee, et al. (1993).

Consider the structural vector autoregression (SVAR) model:

(2.11) (L )x t = t1i, 6

wherex, is a 7?xl vector o f time series variables, (L ) = 0 O0 ,Z 0 2Z2 ... pLp ,

r|( is a 77x1 vector o f white noise structural shocks and the covariance matrix E{r\tr\t ) = Q .

Pre-multiplying (2.11), also best known as a dynamic simultaneous system o f structural

equations, by 0 ^ ', assuming 0 Ois invertible, obtains the reduced-form VAR:

n (Z)x, = et
(2.12) or
P

x , = Z n <-*/-/+e/
(=1

where El(L) = 0 O'0 ( Z ) and s t is a 77x1 vector o f the one-step forecast errors or VAR

residuals with covariance matrix E ( s ts t ) = E . A mapping o f VAR residuals to the structural

shocks and the contemporaneous structural parameters 0 yields:

5 There is an additional channel o f influence for foreign demand shocks. This operates through the
trade balance: stronger demand in the rest o f the world increases the demand for exports. The
strengthening export sector then acts to stimulate aggregate demand.
6 Deterministic variables such as constant and seasonal dummies are omitted for notation convenience.
They are, however, accounted for in the empirical model.

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 (2.13) ,=~]r/t.

If the determinant polynomial |n (z )| = 0 implies that z = 1 o r [z[ > 1, then the roots

are either equal to one or strictly lie outside the unit circle, implying that x, is composed of

variables that are integrated of order one (hereafter, 1(1)) or order zero (hereafter I(0)).7 At

most, |n ( z ) | contains n unit roots, with f l( z ) = I - ^ ^ 1 1 z ' . Following Watson (1994),

subtracting x t ] from both sides o f (2.12), and rearranging terms, produces the vector error

correction model (VECM):8

p -i

(2.14) Ax, = ]T Of Ax,_, + nx,_j + st,

i= 1

where n = - \ n + ^ ^ 1 4 , . =14(1), and 0 ( = \ . Since x t ~I(1) and

t 1(0), matrix II cannot be of full rank as this would mean inconsistent interpretation of the

model. On the other hand, if El = 0 the model is statistically consistent but there would be no

stationary long-run relations in the data, and (2.14) would be reduced to the standard VAR in

first differences. When the rank o f 14 is r and greater than zero, there exists r linear

cointegration vectors defining the long-run relations. In this case, 44 can be written as:

(2.15) U =a0,

1 By definition, a series X, is said to be integrated o f order d , denoted X, l { d ) if it has a

stationary and invertible autoregressive moving average (MA) representation after differencing
d time, but which is not stationary after differencing only d 1 times (p 84, Barnejee et al. (1993).
8 A cointegrated VAR can also be represented as a Triangular representation or as a common trends
representation. These representations are all isomorphic to each other.

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 where a and f3 are n x r matrices, r < n . Specifically, gives the cointegration relations

and a the loading or adjustment coefficients that measure the feedback o f the cointegration

relations into the differenced variables, Ax( .

Co integrating vectors are often interpreted as economic steady state or long-run

relations.9 To ensure that they conform as far as possible to meaningful relations, testable

restrictions must be imposed. Let Rt be x matrices o f full rank and let H j = R i be

n x S j (y j + y = n) with known elements such that H i is of full rank and satisfies the

restrictions R :H t = 0 . Thus, there are y j restrictions and y parameters to be estimated in the

ith relation. The cointegrating relations are thus estimated to satisfy the restrictions

RiP i = Oor equivalently /? = H i(pi for some y - vector <y , that is

(2-16) P = {H x(pv , H r<pr)

where the matrix expresses linear economic hypotheses to be tested against the

data and is a ( y x r ) matrix o f unknown parameters (Johansen and Juselius (1994)). The

idea is to choose H t so that (2.16) identifies the cointegrating relations. For identifying

restriction it holds that ra n k {R iP ) > r 1. If equality holds the i th relation is exactly

identified and if inequality holds, the i th relation is over identified. In other words, the

system is exactly identified if ra n k {R tP ) = r 1 for all i , and over identified if

rank{R ]P ) > r - 1 for at least one i . Because exact identification can be achieved by linear

9 The concept o f cointegration is a powerful one because it allows us to describe the existence o f an
equilibrium , or stationary , relationship among two or more time series, each o f which is individually
non-stationary. That is, while the component time series may have movements such as mean,
variances, and covariances varying over time, some linearly combinations o f these series, which define
the equilibrium relationships have time-invariant linear properties (Bam ejee et al. (1993)).

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 combinations o f the relations and, hence, the likelihood function does not change, no testing

is involved. Over-identifying restrictions, on the other hand, constrain the parameter space

and hence, change the likelihood function. In this case, the likelihood ratio statistics derived

for such hypotheses are asymptotically ^ 2(v) distributed, where the degree of freedom

v = ]T (m ir + 1 ), and mi is the number o f restrictions on [it .

Granger Representation Theorem (Engle and Granger (1987) and Johansen (1991)),

show that (2.14) has a moving average (MA) representation:

(2.17) Ay t = C (L )e ,

Adding and subtracting C (V)t from the right hand side o f (2.17) and integrating yields the

common trends representation of a cointegrated system (Watson (1994)):

(2.18) x t = x Q+ C (Y )Y J s s + C \ L ) s t ,
s= \

where the long run impact matrix C (l) = fiia .Y [ 5 _ ) a Land a }. /fy are the orthogonal

complements o f a and j 3 , T = 7 - F , - F 2 and C* ( L ) = . Equation (2.18) is also

the multivariate Beveridge-Nelson (1981) decomposition of x t . It decomposes x t into its

permanent component, x0 + C ( l ) ^ ] ( ex and its transitory component, C \ L ) s t .

Inserting (2.13) into (2.17) yields the structural MA (SMA) representation:

Ax = C (Z ) -1^
(2.19) ' 0 '
= n L )r j
where W (I) = C ( Z ) 0 o = ( / + C ,I + C 2L2 + ... + C pLp)& J .

Under what condition is it possible to deduce the structural shocks from the reduced

form errors, et and the matrix o f lag polynomials C (L) ? This is the identification question.

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 Watson (1994) describes the order condition for identification. Since x t is n x l , there are

p n 2 reduced-form parameter elements and n(n + 1)/2 elements in 2 = o'f 2 ( 0 o1) .

Because the structural shocks are independently and identically distributed (i.i.d)10, these

[ p n 2 + n(n + 1)/2~\ parameters completely characterize the probability distribution of the

data. In the structural model (2.11), there are (p + l ) n 2 elements in ( 0 o, 0 j , . . . . , 0 p) and

n{n + 1)/2 elements in Q . Thus, there are n 2 more parameters than are needed to

characterize the likelihood function.

Following King et al. (1991), to identify the permanent shocks, one needs to recover

n 2 elements o f JJ1 by imposing restrictions on the covariance matrix Q and the matrix of

long-run multipliers. It is easy to see that

(2.20) E = 0 1Q ( o1)'.

Using the standard assumption that the structural shocks are uncorrelated and have a unit

variance , i.e. Q = I n (2.20) simplifies to:

( 2 .2 1 ) Z = - '( -')'.

This assumption yields n (n + Y)/2 (nonlinear) restrictions, leaving n{n 1)/2 restrictions to

exactly identify the elements o f j 1. These additional restrictions are derived as follows.

Suppose that there are k n r common stochastic trends driving the n x 1 vector xt .

Partition the vector o f structural shocks ?/, into two components, rjt = (rft , Tj] ) where ?]:'

contains k shocks that have permanent or persistent effects and p t contains the r shocks

10 Formally, a sequence or a collection o f random variables are i.i.d if each has the same probability
distribution as any o f the other and all are mutually independent.

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 that have only transitory or temporary effects. Because /? x(_, ~ 7 (0 ), all the shocks in the

cointegration space have transitory effects (as they die out in the long run). Partitioning (1 )

conformably with T)t :

(2.22) 'F (l) = [A 0],

where A is the n x k matrix o f long-run multipliers for r f and 0 is a n x ( n - k ) matrix of

zeros corresponding to the long-run multipliers for rf( . The matrix of long-run multipliers is

determined by the condition that its columns are orthogonal to the cointegrating vectors and

A tjI>represents the innovations in the long-run components o f x t . While the cointegration

restrictions identify the permanent innovations A r ) , they fail to identify rft because

A rjj = (A P )P ~ '?/() for any nonsingular matrix P . Three sets of restrictions are used to

identify the permanent shocks. First, it is assumed that rjf and 77J are uncorrelated. Second,

the permanent shocks, rfj, are assumed to be mutually uncorrelated. Third, A is assumed to

be lower triangular, which permits writing A = A*K and thus:

(2.23) 'P (l) = [A* K 0 ] ,

where A is a known n x k with full column rank, K is a k x k lower triangular matrix with

full rank and l s on the diagonal and 0 is a n x (n - k ) matrix o f 0s. The covariance matrix

of the structural shocks is assumed to be:

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 The permanent innovations rjf are determined from the reduced form (2.17) as

follows. Using (2.13), (2.17) and (2.19), C (L ) = ' (L )@ ~ \ so that C (l) = Tfyl),;1. Let D

be any solution o f C(1) = A*D [e.g. D = (A* A*)-1 A *C (1)]. Thus, A* D e t = A*Kr/l and

since Erj^rij = Q , DTD = K Q K . Let K* be the unique lower triangular square root of

]/ J/
DTD , and let K and Q./2 C be the unique solutions to K Q = K , where K and ,,
i f 1 W H

satisfy (2.23) and (2.24). Then A = A K and the first k rows o f q1 are given by

G = K 'Z) . Since D is unique up to pre-multiplication by a nonsingular matrix, G is

unique. Finally, T] = t implies that r f = Gsl .

The restrictions so far imposed are enough to identify the common stochastic trends.

But to carry out impulse responses and variance decompositions, additional restrictions are

needed to recover the transitory shocks. This is accomplished by placing contemporaneous

restrictions, e.g., preventing a shock from having a particular effect on a variable because of

known or assumed timing lags, implying restricting some elements o f 0 in (2.19) to be

zero.

2.4 Empirical Cointegration Analysis11

In this section, the long-run relationships between the variables that influence the

conduct and transmission process of monetary policy in Zambia, as suggested by economic

theory (discussed in Section 2.2), are empirically examined.

11 All calculations have been performed using computer packages CATS and RATS

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 2.4.1 Data Properties

The study is based on monthly data over the sample period 1992-2003. All variables

are in logarithms except interest rate. Domestic output ( y t ) is real gross domestic product

(GDP).12 Domestic price ( p \ ) is Zambias consumer price (CPI), whereas the measure of

money stock ( mt ) is broad money defined as the sum o f currency, demand and savings

deposits. Real balances (m t - p t ) are computed accordingly. Domestic interest rate ( R, ) is

the 3-month Zambian Treasury bill rate and the nominal exchange rate ( st ) is between

Zambian Kwacha and South African Rand. Foreign price ( ) is South African CPI. The real

exchange rate is computed accordingly. Finally, the 3-month South African Treasury bill rate

measures foreign interest rate ( R{ ). By implication, foreign influences emanate from South

Africa as it is by far Zam bias most important trading partner.13 Bank o f Zambia (BOZ) and

IMF International Financial Statistics (IFS) publications were the main sources o f the data.

Graphs o f the variables are shown in Figures 2.1 and 2.2.

2.4.2 Unit Root Tests

Recent research has cast some doubt on the ADF unit root test for variables that may

have undergone structural changes. For example, Perron (1989, 1990) and Zivot and Andrews

(1992) show that the existence of structural changes bias the standard ADF test towards non

rejection of the null o f unit root. Perron (1989) develops a unit-root testing procedure

(hereafter referred to as Perron) that considers the hypothesis that a time series has a unit root,

12 Monthly output is interpolated following the Chow-Lin distribution/interpolation procedure (Frain

(2004). Like in Bank o f England (1999) and Stock and Watson (1999), potential output is assumed to
be constant.
13 60 percent o f Z am bias imports come from South Africa.

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 assuming that the structural break is exogenous and a dummy variable taking the value one at

the time o f break. The alternative hypothesis is a trend stationary system, allowing for a

one-time change in the intercept o f the trend function.

Zivot and Andrews (1992, hereafter ZA) criticize this assumption o f an exogenous

break point and transform Perron unit root test (that is conditional on a structural change at a

Figure 2.1: Variables in Levels

15C0-

14.95-
15-
14.90-

14.85-

14.80-

14.75-

14.70-

14.65-

14.60-
1992 1995 1996 2000 2002 1992 1994 1996 1996 2000 2002 2000 2002

-CUpLi - D r r e s b c C tm ir e r R x e

200 - 7.0-

160-
60-
129-
120-
55-
128-
5.0-
127-
4.5-
126-
4.0-
125-

124- 50-
ICtTTESticlrterestFste\ - Nxrinel BchangeRatel

5.6- 52-
5.1-
5.4-

5.2- 18-
4.9-
50- 4.8-

4.8- 4.7- 14
4.6-
4.6-
4.5-
4.4- 4.4

4.2- 4.3-
2000 2002 2000 2002

- Fted B cfB rp eF ^ e; - R re ig i Q ra /T H 'R ic e I - Fcracplrterest F ^ e

29

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 Figure 2.2: Variables in First Differences

.15- .20 -

.03-

.0 2 - . 10 -

.05-
.00

-.01
-.05-
-.0 2 - .0 0 -

-.03- - . 10-

-.04- -.05- -.15-

1996 2000 2002 1994 1996 2000 2002

I CLtputj - D ir e s lic G r a n tr R ia e

120-

. 10 -

-.05-

-. 10 -
-40-
-.15-

-.20 -80-
1992 1994 1996 1996 2000 2002 1992 1994 1996 1996 2000 2002

I f e d Bdarces - D xresticlrterest Ratel I N xrinaiB dH ngeR ate|

\M n

-.01
1992 1994 1996 2000 2002 1992 1994 1996 2COO 2002

- Foragilrterest fe te

known point in time) into an unconditional unit root test. The null hypothesis is a unit root

without any exogenous structural breaks, and the relevant alternative hypothesis is a trend-

stationary process with possible structural change occurring at an unknown point in time.

For comparison purposes, Table 2.1 reports the univariate analyses o f the variables,

corresponding to the Perron unit root test. While the null o f non-stationarity cannot be

rejected for the level o f all series, it is strongly rejected for differenced series at the 5 percent

30

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 Table 2.1: Perron U nit R oot Test

Variable t-statistic
V -0.41
At -6.23
-1.23
pc
Apc -1.37

>t-j
-6.21

7a,
m -1.04
Am -4.02
m- pc -2.17

A ( m - p c) -9.66

R -2.56
AR -11.92
s -2.74
As -3.82
* -2.29
P
Ap* -9.54

Rf -2.26

ARf -8.24

Note : Lag length=4 and t-statistic at 5 % level=-2.882

Table 2.2: Zivot-Andrews Unit Root Test

Break t a, W
y 1998:01 -3.56
pc 1992:12 -3.61

Apc 1993:08 -7.93

m 1992:05 -4.47
m p L 1998:01 -4.65
R 1994:09 -3.01
5 1992:11 -4.82
rer 2001:10 -4.21
p* 2002:07 -4.73

Rf 1999:02 -4.46

t {(A) is the minimum statistics

a
1 % and 5 % Critical values are -5.57 and -5.08 (break in both intercept and trend)

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 level. It appears all the variables are 1(1), except p ct which is 1(2). Table 2.2 reports the

Zivot-Andrews unit root test. In contrast to the Perron test, the unit root in A p : is rejected.

We thus infer that all the variables are 1(1) and by implication the real exchange is 1(1),

rejecting the PPP hypothesis.14

2.4.3 Model Specification

One critical element in VAR modeling is the choice o f the lag length. Demonstrated

by Braun and Mittnik (1993), and many others, statistically, estimates of a VAR whose lag

length is smaller than the true lag length (i.e. under-fitting) are inconsistent as are the impulse

responses and variance decompositions. Though estimates from over-fitting may be

consistent, they are inefficient. Based on the Schwarz (SC) and Hannan-Quinn (HQ)

information criterion, reported in Table 2.3, when the maximum lag length is p msx = 4 , the

appropriate lag length p = 2 .

The theoretical model (i.e. equations (2.1)- (2.4) and (2.8)-(2.10) is thus estimated

with two lags. It also includes a dummy taking a value of one at the time o f break suggested

by the ZA unit root test. As a standard check o f the m odels statistical adequacy, Table 2.4

reports misspecification tests. The Godfrey (1988) multivariate Lagrange Multiplier (LM)

test indicates that there is no evidence o f either first or fourth order residual autocorrelation.

The Jarque-Beta multivariate normality test, on the other hand, strongly rejects the null of

normality. This problem may be associated with interpolated data as well as the small sample.

Because the Jarque-Bera test is -distributed only asymptotically, small sample behavior

may not follow the distribution very closely (Juselius (2003). Univariate tests reveal non-

14 Stationarity is a condition for PPP to hold.

32

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 Table 2.3: Lag Length Selection

p =\ p~ 2 p =3 p - 4
SC -5.13 Tf23 -4L86 -4.62
Hanna-Quinn -6.03 -7.22 -6.59 -6.95

Table 2.4: Misspecification Tests15

M ultivariate tests
Residual
autocorrelation
Z M ,( 4 9 ) 4 4 .9 6(p=0.64)

L M 4( 49 ) 65.23(p=0./6)
Normality_______________________
y 2n 4 '> 114.580=0.00)

Univariate tests
Normality(2) ARCH(2) Skewness Kurtosis p2
Am 3.25 3.01 -0.42 3.19 0.85
Ap c 0.07 3.24 -0.09 3.53 0.82
Ay 17.82 1.79 0.16 1.07 0.68
As 4.38 6.35 0.29 9.50 0.75
R 2.42 2.17 0.25 2.91 0.79
Ap* 4.62 3.08 -0.31 3.38 0.83

ARf 0.49 2.18 0.47 5.02 0.80

A t 5% significance level, critical value fo r x 2(25) = 5.99

normality to be well pronounced in the output equation. Nonetheless, since confidence bands

are generated through Monte Carlo simulations using the DISCO program,

cointegration results are robust to non-normality (Johansen and Nielsen (1993)). It also

appears the nominal exchange rate residuals exhibit autoregressive conditional

heteroscedasticity (ARCH) effects. While homoscedasticity would be desirable, it is not a

15 The Godfrey (1988) LM test for first and fourth order autocorrelation is asymptotically
X ' distributed with n" degrees o f freedom. The Jarque-Beta M ultivariate normality test is

asymptotically distributed with 2n degrees o f freedom. The univariate Jarque-Beta

normality test has a distribution with 2 degrees o f freedom, under the null hypothesis of
normally distributed errors. ARCH test, degree o f freedom equals number o f lags.

33

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 precondition for the validity o f the cointegration tests (Juselius (2003)). With the high R 2 ,

the large part o f the variation o f system variables can be explained by the chosen information

set.

2.4.4 Cointegration Rank Testing

Testing for cointegration implies estimating the rank r from the VECM representation

(2.14), and in essence, dividing the data into r relations towards which the process is

adjusting and the n r relations that are pushing the process. The former (relations) are

interpreted as equilibrium errors (deviations from the steady-state) and the latter as common

driving trends in the system. Table 2.5 reports the estimated trace test,

Trace(i) = , T ln(l - A.) , where A. denotes eigenvalues, and C 095 the 95 percent

quantiles from the asymptotic Table B.3 in Hansen and Juselius(2002). The trace statistic

rejects 7 unit roots (177.51 >123.04) but not 3 unit roots (26.41 <29.34), therefore supporting

a cointegration rank r = 4 .

Table 2.5: Trace Test for Cointegration Rank16

r Trace(i) c *0.9 5
4
0 0.32 177.51 123.04
1 0.27 122.49 93.92
2 0.19 78.65 68.68
J 0.15 48.41 47.21
4 0.11 26.41 29.34
5 0.06 10.00 15.34
6 0.01 1.98 3.84

16 The tests were performed with CATS in RATS, r is the cointegration rank; Trace (i) is the value o f
Johansen s trace statistic; and the C095 reports the 5 percent values o f the trace statistic calculated
from simulation. These were done with the DISCO program (Johansen and Nielsen(1993)).

34

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 Since the sample size is small, 144, the asymptotic tables may not be very precise

approximations. It is argued that when the sample size is small, there is substantial size and

power distortions and the poor approximation o f the trace statistic to the true distribution

(Juselius (2003)). Prior to confirming the cointegration rank, it thus useful to examine all

sources o f additional information, including the characteristic roots o f the model, the

economic interpretation of the data and the graphs o f the cointegration relations, to check

whether estimating under alternative r = ra n k (Y l) is plausible. The last two conditions are

discussed later. Because the estimated eigenvalues are the reciprocal values of the roots o f the

characteristic polynomial o f the model, the eigenvalues should be inside the unit disc or equal

to unit under the assumption o f the cointegrated VAR model (Hansen and Juselius (2002)).

By implication, the number o f common trends in the model corresponds to the number of

roots close to unit in the companion matrix. Table 2.6 shows that the three largest roots are

quite close to the unity, indeed validating r = 4 .

Table 2.7 reports the test statistics for long-run weak exogeneity. This is a test for the

absence of long-run feedback, with the null hypothesis that a variable has influenced the

long-run stochastic path o f the other variables o f the system, while at the same time has not

be influenced by them. The hypothesis is formulated as GCy = 0 , where i = 1 and

r = \,...,n 1. The test is asymptotically distributed as %2( r ) . None o f the variables can be

Table 2.6: Eigenvalues of the Companion Matrix

Real Imaginary Modulus

0.93 0.01 0.93
0.89 0.00 0.89
0.87 -0.13 0.88
0.68 -0.00 0.69
0.61 0.22 0.64
0.61 -0.22 0.64
0.31 0.12 0.34

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 T ab le 2.7: T est for W eak Exogeneity

m *
r y 5 R Rf
PC P >^0.05(^")

1 6.18 5.05 11.50 15.39 2.41 15.39 1.77 3.84

2 8.35 14.07 22.01 19.76 7.21 16.29 2.36 5.99
3 10.33 16.31 22.01 22.41 11.50 16.31 8.62 7.81
4 15.68 23.91 28.32 26.02 22.01 19.04 11.49 9.49
5 18.83 23.93 30.09 31.61 31.43 20.17 15.85 11.07
6 24.26 26.72 34.11 33.28 33.50 28.30 19.48 12.59

considered weakly exogenous for r = 4 is the conclusion.

2.4.5 Identifying Cointegration Relations

Searching for plausible cointegrating vectors commenced with testing alternative

specifications o f the money, income, price, exchange rate and interest rate relations. The

hypotheses are o f the form f i = (H x(j>x, y/ x, y/ 2, ) , i.e. testing whether a single restricted

relation is in the cointegration space, leaving the other three (relations) unrestricted. The test

o f over-identifying restrictions (based on the LR test procedure) is asymptotically distributed

as X 2(y) , where v is the number of over-identifying restrictions. If the hypothetical

relations exit, this procedure maximizes the chance o f finding them (Juselius (1996)).

In Table 2.8, hypotheses 'H, and'H 2 test the existence of the demand for money

relation (2.3) and whether the income homogeneity o f money demand suggested in a number

of empirical studies (e.g. Juselius(1996)) is valid. With a p value = 0.31,'H! is not

rejected, suggesting the existence o f a plausible money demand function. However, an

income elasticity o f one is rejected given thatTT is rejected ( p - v a l u e = 0.01). The result

favors an income elasticity greater than one.

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 17
T able 2.8: Testing Single C ointegration R elations

Money Income Exchange Rate Foreign

Interest
H, 'H2 'H3 h4 'H 5 IF, H7
m 1 1 0 0 0 0 0
-1 -1 0.03 0 0 0 0
Pc
y -1.32 -1 1 1 0 0 0
s 0.93 0.38 -0.03 0 1 1 0
R 0.23 0.15 0.54 0.59 -1 0.006 0
* 0 0 -0.03 0 0 0 -0.92
P
Rf 0 0 0 0 1 -0.003 1
6.09(4) 24.01(5) 20.79 (5) 9.61 (6) 24.12(6) 10.39(5) 5.08(6)
x 2iy )
p - vol. 0.31 0.01 0.00 0.18 0.00 0.17 0.34

'H3 and 'H4 test IS specifications. 'H3is rejected and 'H4 is not, suggesting that output is

only cointegrated with interest rate. Hypotheses TI5 and'H6are motivated by the strong

empirical evidence o f the co-movement between exchange rate and interest rate (Ball (1999)

and Dekle et al. (2001)). The former (i.e. UIP hypothesis) is rejected and the latter is not,

implying some influence o f South African interest rate on the Kwacha/Rand exchange

rate movement. Based on hypothesis'H7, cointegration between interest rate and consumer

price in South Africa is not rejected.

The final step in the analysis o f the long-run structure involves imposing testable

restrictions on the full cointegration space. Statistically, this is a joint testing o f the four

stationary relations o f the form f3r = { H x<px, H x(j)2, j , where the design

matrix H i imposes restrictions on each cointegration vector such that a fully identified

structure is obtained. Table 2.9 reports the results o f the identified structure consisting o f a

modified H ], H A, H b and H n hypotheses and imposing 9 over-identifying restrictions, which

17 All hypotheses o f alternative inflation specifications were rejected.

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 T able 2.9: Identified L ong R un Structure

Cointegrating vectors:
{Standard errors in parentheses)
A A A A
m i 0 0 0
c -i 0 0 0
P
y -1.15 1 0 0
(0.20)
s 0.07 0 1 0
(0.01)
R 0.13 0.52 0.61 0
(0.00) (0.12) (0.00)
77
*
0 0 0 -0.15
(0.05)
Rf 0 0 -0.18 1
(0.00)
{t-values in parentheses)

i a2 3 4
Am -0.06 -0.03 -0.02 -0.003
(-3.51) (-0.41) (-1.18) (-2.38)
Ajrv c 0.05 0.12 0.08 0.00
(3.12) (3.79) (3.88) (-0.38)
At 0.01 -0.02 0.001 0.00
(3.40) (-2.27) (2.30) (1.65)
As 0.14 -0.12 -0.01 0.003
(1.75) (-0.76) (-0.16) (1.08)
AR 0.15 0.04 0.78 0.54
(2.73) (4.99) (4.94) (2.23)
Ap* -0.01 0.02 -0.002 0.00
(-1.39) (1.88) (-2.47) (-0.76)
ARf 0.02 -1.33 0.19 0.06
(0.42) (-1.06) (0.61) (-2.60)
* (9) = 7.80
p - v a l . = 0.36

are acceptable ( p - v a l u e = 0.36).

The first relation resembles a money demand equation:

(2.25) (m - p c)l = 1 .15y,-0.13i?( -0 .0 7 s ,.

All the estimated coefficients are statistically significant and show expected signs: real

balances are positively related to income, and negatively related to the nominal interest rate,

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 capturing the domestic opportunity cost of holding money. Similar to Tseng and Corker

(1991), Hubrich (1999) and many others, the long-run income elasticity coefficient exceeds

one, it is 1.15, suggesting that monetary wealth is growing faster than real GDP or an increase

in the unobservable transaction volume is stronger than the increase in GDP.18 Like

in Bruggermann (2003), there is strong support for currency substitution effects, making

exchange rate an important determinant of long-run money holdings. The loading

vectors also look sensible. Money stock is significantly adjusting to this relation with a

negative sign on the coefficient a n . This suggests that money stock is equilibrium error

correcting to agents demand for money. As can be inferred from a u an d a]2, excess money,

as measured by the deviation from long-run money demand, significantly increases real

aggregate demand and consequently inflation. The rise in interest rate further reflects excess

money demand ( a ]5).

The second relation corresponds to an income specification:

(2.26) y t = -0.52i?( .

It seems generally well defined. Aggregate demand is negatively related to the interest rate.19

As can be inferred from a 23 anda22, deviation from long-run goods market equilibrium is

error correcting and has the expected effects on inflation. The exchange rate, on the other

hand, does not significantly respond to disequilibrium in the goods market. The negative

coefficient a lx is also as expected: Bank of Zambia (BOZ) reacts to excess demand by

monetary tightening (i.e. decreasing money supply growth).

18 Tseng and Corker(1991) argues that an income elasticity o f money demand exceeding one, reflects
higher savings. This has not been established in this study.
19 This specification is justified since in the long run the nominal interest rate equals the real interest
rate.

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 The third relation can be interpreted as an exchange rate relation:

(2.27) s, = -0 .6 1 (i? - 0 . 3 R 1),.

This equation posits a link between the interest differential and nominal exchange rate,

capturing the idea that a rise in the domestic interest rate makes domestic assets more

attractive, leading to an appreciation. The coefficient a M shows that exchange rate is error

correcting, and as expected, excess demand for exchange rate significantly increases inflation

( cr32 )

The relationship between foreign interest rate and foreign price is depicted by (2.28):

(2.28) Rf = 0 A 5 p * .

This resembles South Africa policy reaction function. The loading coefficients suggest that

developments in South African interest rate hardly affect Zambian macroeconomic variables,

in the long run.

Figure 2.3: Error Correction Relations

a) Excess Money

b e t a r *Zk(t)

.6 i
2000

b e t a l ' * Rk(t)

-0 .1 5
-0 .2 0
2001 2002 2003

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 b) Excess Aggregate Demand
b e t a 2 ' * Zk (t)

be a 2 Rk t

c) Excess Foreign Exchange Demand

b e t a 3 * Zk (t)

b e ta 3 * Rk ( t )

998 19 99 2000 2001 2002 2003

d) Foreign Interest Rate

b e t a 4 * Z k (t)
025

020
01 5

000

99 5

b e ta 4 Rk ( t )

1992 1993 19 94 96 1997 1998 1999 2000 2001 2002 2003

Graphs of the identified cointegration relations are given in Figure 2.3. Generally, these

relationships describe long-run sustainable steady-state relations.

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 2.4.6 Model Stability

Figure 2.4 reports the recursive stability test, that is, the test of the constancy of the

cointegration space, /?. The test is asymptotically distributed as with (p\ r)r degrees

of freedom, where p \ is the dimension of /? . Whereas the solid line is based on the Z-model,

the full model, the dotted line is based on the R-model, in which the short-run dynamics are

kept constant. We derive the interpretation on the latter as the former might be unreliable as it

suffers from lack of degree of freedom due to many parameters to be estimated (Vlaar and

Schuberth (1999)). Constancy of the restricted j3 is strongly supported at the 5 percent level.

What are the implications of the cointegration results for the long-run transmission of

Zambias monetary policy to inflation? First, there exits a stable money demand, thus

satisfying one key precondition for the policy of monetary targeting by the Bank of Zambia.

As Juselius (1996) argues, this implies money growth has predictable impact on economic

activity and hence on excess demand in the economy. Second, demand for money is interest

Figure 2.4: Recursive Test for Constancy of the Identified /?

Test of known beta eq. to beta(t)

4.5
BETA_Z

4.0 BETA_R

3.5

3.0

2.5

2.0

.0

0.5

0.0
1998 1999 2000 2001 2002 2003

1 is th e 5% significance level

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 sensitive. This implies that the LM curve is not steep and changes in money supply have

lower effects. Third, inflation is associated with excess demand in the money and goods

market as well as disequilibrium in the exchange rate market, and thus it is not necessary a

monetary phenomena. Fourth, although we do not explicitly identify the money-based rule,

there is a strong feedback between nominal money and inflation. Further, higher price leads

BOZ to lowering money supply. Finally, the impact of developments in foreign interest rate

on domestic variables is insignificant. To what extent shocks to money play a role in the

monetary policy transmission process is the topic of the structural analysis.

2.5 Structural Analysis

2.5.1 Identification

In the notation of Section 2.3, xt = \_p*, y, m, p c, R, s, R j \ . Based on cointegration

analysis, the estimated VECM is driven by three permanent shocks: two domestic shocks (i.e.

aggregate supply and monetary policy shocks) and a foreign shock (i.e. foreign price

shock).20 It is also driven by four transitory shocks (i.e. money demand, IS, exchange rate and

foreign interest shocks). Using (2.19), the 7x7 matrix of polynomial lags ^ ( Z ) s [4 f (Z )],

for i , j = 1,...,7 is the object to be estimated. Suitably transformed, the estimates of 9F(Z)

allow us to analyze the dynamic responses of output, prices, money, interest rates and

exchange rate to the 7 shocks. Formally

(2.29) q ^F iL X ,

20 We consider an aggregate supply shock, real shock; monetary policy, nominal shock; and foreign
price shock, real shock as it changes relative prices.

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 where qt = [p ,y ,m , p c , R , s , R J ] and F = [Fi (L)] for and j = 1,...,7 . Thus, the

coefficients of the polynomial lag Ftj (L ) give the estimated dynamic responses of the vector

/th variable to a one-standard deviation realization in the /th structural disturbance.

Following King et al. (1991), the permanent shocks are recovered by imposing long-

run restrictions, the identifying structure taking the form:

r i 0 0 ^

0 1 0

0 0 1 0 0 ^
'* it
(2.30) A = 1.9xl0 ~4 -1 .3 2 1 *21 *22 0

0 - 1 .9 2 0 V *3I *23 *33 )

0.03 1.17 0

0.15 0 0
V /

where A is a 7 x 3 matrix o f long-run multipliers. In the notation o f Section 2.3, the two

matrices on the right-hand side o f (2.30) are A and K .21 The first shock is a foreign price

shock. In the long run, it is predicted to increase foreign price by 1 percent and foreign

interest rate by 0.15 percentage point. Through an exchange rate relation, it depreciates

domestic currency by 0.03 percent and though a money demand relation increases domestic

consumer price. The second shock is a domestic aggregate supply shock. In the long run, it

leads to a 1 percent increase in domestic output and through an IS relation reduces domestic

interest rate by 1.92 percentage points. Further, through an exchange rate relation depreciates

the nominal exchange rate by 1.17 percent and through a money demand relation reduces

domestic consumer price by 1.32 percent. The third shock is a money supply shock. A one-

21 To obtain A , we re-write the money demand in terms of p c and an IS relation in terms of R .The
construction of K implies that the domestic nominal shock (i.e. monetary policy shock) affect the
price level; the domestic real shock affect the price level and output, but do not affect foreign price; the
real foreign price shock affect both domestic price and output.

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 to-one relation is assumed between money and consumer price. These restrictions have two

major implications. The first one is the small country assumption that foreign price does not

react to domestic aggregate supply and money supply shocks. Second is the neutrality

assumption. That is, output is long run neutral with respect to money supply.

Contemporaneous assumptions are used to identify the temporary shocks.

1). Foreign interest rate does not respond contemporaneously to all domestic transitory

shocks.

2). Domestic price only responds contemporaneously to domestic shocks. This is motivated

by the money demand specification (2.3).

3). Domestic interest rate responds contemporaneously to all the shocks, except the foreign

price shock.

4) Because o f expectations, exchange rate is assumed to respond contemporaneously to all

the shocks.

Equations (2.31)-(2.34) summarize these restrictions:

(2.31) sj = - (p2s y + ( p / t + 77/

(2.32) < = < p tf - cp5fy + [Link] + cp^: + i f; d
(2.33) s f = -<pt s - q>9s yt + (pws st + <pn s f + +<pn e f + Tjjs
(2.34) s, = <pu s " + <pu s y - (pn s? - <pl6s? + cpxls] + <;n e { +

where all the coefficients are positive. This system is estimated by the instrumental variable

(IV) approach. Equation (2.31) is estimated using the instruments 77, 77' and .

Equation (2.32) is then estimated using the instruments 77, 77"^ ,rft and rjj . The

instruments , 77 , 7jt , rjj and ri"'d are employed to estimate equation (2.33). Finally,

(2.34) is estimated with the instruments f]", 77' , rjt , 77/ , rj",d and ?/(/,v. The estimated

45

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 T able 2.10: Estim ated Short Run P aram eters

Coefficient Standard Error

8.1 x 1(T4 1.22 x 10'3
<P\
1.1 x 10'3 2.13 x 10-3
<P2
1.2 x 10-2 7.1 x 10'3**
<P1
0.87 0.38**
<Pa
0.71 0.41**
<Ps
0.13 0.07**
<P6
0.08 0.05**
<Pl
0.03 8.3 x 10~3 *
<P*
<P9 0.01 5.3 x 10-3**
1.9 x 10 2 1.1 x 10 '2**
PlO
1.02 x 10-2 6.13 x 10'3**
<Pu
2.5 x 10~3 3.11 x 10'3
Pn
0.02 5.88 x 10'3*
<Pl3
0.08 4.07 x 102**
<PlA
0.09 4.28 x 10'2**
<PlS
0.06 3.24 x 10'2**
<Pl6
3.55 x 102 4.61 x 10'2
<P\7
2.15 x 10'2 3.73 x 102
oo

Note: * (**) statistically significant at the 5 % (10%) level

results, presented in Table 2.10, suggest that most coefficients are statistically significant at

the 10 percent level.

2.5.2 Impulse Responses

Figures 2.5-2.11 plot the impulse responses of the variables to each structural shock.

Whereas the dark lines represent point estimates of the responses o f the level of each variable

to a one standard deviation shock, the upper and lower dashed lines enclose the 95

percent confidence bands constructed from Monte Carlo integration. With few exceptions, the

responses match theoretical priors and conform to the identification strategy. For example,

46

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 foreign variables hardly respond to domestic shocks. Only aggregate supply, monetary policy

and foreign price shocks have persistent effects.

Figure 2.5 displays the impulse response functions for the effects o f a positive

monetary policy shock, identified as innovation to money supply. Most of these exhibit

familiar patterns. Money supply and real balances persistently rise. Indicating strong liquidity

effects, the nominal interest rate falls significantly for 12 months, inducing a temporary

currency depreciation. Output hardly increases on impact and within a year returns to its pre-

Figure 2.5: Impulse Responses to a Monetary Policy Shock

Output Consumer Price

0.0100 0.08 i
0.0075 0.06 -
0.04 -|
0.0050
0.02 -j
0.0025
0.00 - |-
0.0000 - 0.02

-0.0025 -0.04 -|
-0.0050 -0.06
10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.10 r

0.08

0.03 ; 0.06
0.04
0.02 -j
0.02
0.00 -

-0.01
I -0.02 -|

-0.04 j
-0.02 -0.06
10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04 0.075
0.03
0.050
0.02
;
0.01 0.025

0.00 -r 0.000 -
-0 .0 1 j
-0.025
-0.02 |
-0.03 i -0.050 -
10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price Foreign Interest Rate

0.0125 0.0030 ;
0.0100 0.0025 -i
0.0075 0.0020 -1
0.0050 0.0015
0.0025 0.0010 -
0.0000 0.0005 -
-0.0025 0.0000 - f
-0.0050 -0.0005 -
-0.0075 -0.0010 -

- 0.0100 -0.0015 '

0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

47

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 shock value, satisfying the neutrality assumption. Consumer price rises significantly for 4

months. On impact, it is raised by 0.6 percent and after 4 months records the maximum

response of 1.1 percent. Finally, in line with the small country assumption, foreign price and

interest rate hardly respond to this shock.

Similar to the results in Blanchard and Qual (1989), Gali (1992) and Camerero et al.

(2 0 0 2 ), the impact of a positive aggregate supply shock has the expected sign, permanently

Figure 2.6: Impulse Responses to an Aggregate Supply Shock

Output Consumer Price

0.0100 - 0.08

0.0075 0.06 -
0.04
0.0050
0.02 -
0.0025
0.00 - ._ ____ _ _ ___ _______
0 .0 0 0 0 -
-0.02 -
-0.0025 -0.04 - ~ ...........
-0.0050 -0.06 ............... .. : : i------- T T------ 1- - -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.05 0.10 -r

0.04 - 0.08 -
0.06 -
0.03
0.04
0.02
0.02
0.01
0.00
0.00 -
-0.02 -!
- 0.01 -0.04 :
-0.02 -0.06
10 15 20 25 30 35 40 45 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04 0.075
0.03
0.050
0.02
0.01 0.025

0.00 0.000
-0.01 -
-0.025
-0.02
-0.03 -0.050
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price Foreign Interest Rate

0.0125 0,0030
0.0100 0.0025
0.0075 0.0020
0.0050 0.0015
0.0025 0.0010
0.0000 0.0005
-0.0025 0.0000
-0.0050 -0.0005
-0.0075 -0.0010

-0.0100 -0.0015
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

48

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 increasing output and reducing consumer price (Figure 2.6). On impact, domestic output

increases by 0.27 percent and in the long run by 0.4 percent. Consumer price, which barely

falls on impact records the peak response o f 3.5 percent 15 months later. In the long run,

consumer price is reduced by approximately 2 percent. Following this shock,

money supply persistently rises, suggesting that a beneficial supply shock induces

commercial banks to make more loans (Keating (2000)). A persistent fall in nominal

Figure 2.7: Impulse Responses to an IS Shock

Output Consumer Price

0.0100 - 0.08 -
0.0075 0.06 -

0.0050 -- 0.04 ;
0.02 -i
0.0025
0.00
0.0000 -0.02 -
-0.0025 ; -0.04 -
-0.0050 - L , - > 'I -0.06 -
5 10 15 20 25 35 40 10 15 20 25 30 35 40 45

Money Real Money

0.05 , 0.10
0.04 : 0.08
0.03 0.06
0.04
0.02 -
0.02
0.01 - 0.00
0.00 - -0.02
-0.01 1 -0.04
-0.02 -i- 0.06
0 5 10 15 20 25 30 35 40 45 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04 0.075
0.03 -
0.050
0.02 -
0.01 ; f A 0.025

0.00 ! 0.000
-0.01
-0.02
0.025
-0.03 0.050
10 15 20 25 30 35 40 45 10 15 20 25 X 35 40 45

Foreign Price Foreign Interest Rate

0.0125 0.0030
00100 0.0025
0.0075 0.0020
0.0050 0.0015
0.0025 0.0010
0.0000 0.0005
-0.0025 0.0000 -
-0.0050 -0.0005 -
-0.0075 -0.0010 -
-0.0100 -0.0015
0 5 10 15 20 25 X 35 40 45 5 10 15 20 25 X 35 40 45

49

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 domestic interest rate is recorded, causing a currency depreciation that is initially significant.

Real balances are permanently raised significantly over 9 months. Finally, foreign variables

hardly and temporarily respond to this shock.

Flow variables respond to an IS shock is depicted in Figure 2.7. First, output rises

significantly over 20 months. Second, the nominal interest rate rises (significantly for 8

months), causing a significant currency appreciation over a short period. Third, consumer

price rises significantly recording the maximum response o f 1.3 percent after 6 months.

Fourth, higher interest rate is accompanied by lower nominal and real balances. Fifth, like all

domestic shocks, the impact o f this shock on foreign variables is unnoticeable. Classifying

this shock to have transitory effects is generally unfailing.

Like in Vlaar and Schuberth (1999), in response to a money demand shock, real and

nominal balances significantly rise for over a year (Figure 2.8). Domestic interest rate also

rises significantly for 4 months. Output rises significantly over 8 months, despite higher

interest rate. This result, however, is similar to that in Gali (1992), who argues that output is

raised because money demand shock is a demand shock. This shock increases consumer

price, registering the peak response of 3.8 percent 8 months later. Consistent with

developments in interest rate, domestic currency appreciates significantly for 6 months.

Finally, as expected the effects o f this shock diminish over time.

Figure 2.9 shows that virtually all impulse responses correspond with the predicted

effects of an exchange rate shock. A positive exchange shock temporarily depreciates the

nominal exchange rate significantly for about a year. In response, output and consumer price

increase. Output, which barely rises on impact, registers the maximum response of 2.5

percent within 6 months. On impact, consumer price rises by 0.43 percent and 4 months later

attains the peak response o f 4 percent. The effects o f this shock on both output and consumer

50

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 Figure 2.8: Im pulse R esponses to a M oney D em and Shock

Output Consumer Price

0.100 0.08 ;

0.075 0.06 -j
0.04 ;
0.050
0.02 -
0.025
0.00
0.000 - 0.02

-0.025 -0.04 -|
I
-0.050 -0.06 -J
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.05
0.04 -
0.03
0.02 -
0.01
0.00 -

-0.01

-0.02 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04
0,03
0.050
0.02
0.01
0.025

0.00 0.000
-0.01
-0.025
-0.02
-0.03 - -0.050
0 5 10 15 20 25 30 35 40 45 5 10 15 20 25 30 35 40 45

Foreign Price Foreign Interest Rate

0.0125 0.0030 -r-
0.0100 0.0025
- 0.0075 0.0020 -
0.0050 0.0015 -
0.0025 0.0010
0.0000 0.0005 -
-0.0025 0.0000
-0.0050 -0.0005 -I
-0.0075 - 0.0010 -

-0.0100 -0.0015
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

price completely diminish within 3 years. This shock causes a temporary fall in money supply

and an increase in nominal interest rate, suggesting monetary tightening to dampen the

anticipated price effects. A transitory fall in real balances is also recorded. N ot surprising,

foreign variables barely respond to this shock.

Both foreign price and foreign interest rate rise following a positive foreign price

shock (Figures 2.10). We observe developments in foreign variables, in part, transmitted to

51

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 F igure 2.9: Im pulse R esponses to an E xchange R ate Shock

Output Consumer Price

0.0100 - 0.08

0.0075 - 0.06
0.04
0.0050
0.02
0.0025
0.00
0.0000 -0.02
-0.0025 - -0.04
-0.0050 - -0.06
0 5 10 15 20 25 30 35 40 45 5 10 15 20 25 30 35 40 45

Money Real Money

0.05 0.10 j
0.04 0.08 -|
0.03 0.06 -
0.04 -
0.02
0.02 -
0.01 0.00 -
0.00 -0.02 -
-0.01 -0.04
-0.02 -0.06
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04 0.075
0.03
0.050 !
0.02
0.01 0.025

[Link] ; 0.000
-0.01 .
-0.025
-0.02

-0.03 -0.050 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price Foreign Interest Rate

0.0125 0.0030 -r-
0.0100 0.0025 -!
0.0075 0.0020 -j
0.0050 0.0015 -|
0.0025 0.0010 -
0.0000 0.0005 -
-0.0025 0.0000 i
-0.0050 -0.0005 -
-0.0075 -0.0010 -i
-0.0100 -0.0015
0 5 10 15 20 25 30 35 40 45 10 15 20 25 30 35 40 45

the domestic economy through exchange rate. The domestic currency depreciates, raising

consumer price by a maximum o f 0.85 percent after 3 months and by 0.6 percent in the long

run. Lower money supply and thereby higher domestic interest rate is the reported monetary

policy response. By construction, real balances fall. Since some imports are inputs into

production, the resulting higher production costs lowers domestic output significantly for

52

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 about a year. On impact, output declines by 0.06 percent and after 10 months records the

maximum response o f 0 .1 2 percent.

Figure 2.11 summarizes responses to a foreign interest rate shock. First, in line with

the identification strategy, the effects of this shock is transitory. Second, foreign interest rate

significantly rises for 6 months, decreasing foreign price. Third, domestic output is raised, in

part, on account of increased net exports induced by lower import prices. Specifically, output,

which barely increases on impact, registers the maximum response o f 0.11 percent in the

Figure 2.10: Impulse Responses to a Foreign Price Shock

CXitput Consumer Price

0.0100

0.0075
0.04 -
0.0050
0.02
0.0025
0.00 -
0.0000 -0.02 -

-0.0025 -0.04
-0.0050 -0.06 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.05 0.10
0.04 0.08 -

0.03 0.06 -
0.04 -
0.02
0.02
0.01 0.00
0.00 -0.02
-0.01 -0.04 -
-0.02 0.06
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04 0.075
0.03
0.050
0.02
0.025
0.01
0.00 0.000
-0.01
-0.025 -
-0.02
-0.03 -0.050
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price Foreign Interest Rate

0.0125 0.0030
0.0100 0.0025 |
0.0075 0.0020 i
0.0050 0.0015
0.0025 0.0010 -

0.0000 0.0005
-0.0025 0.0000
-0.0050 -0.0005 -
-0.0075 -0.0010 :

-0.0100 -0.0015 -'

0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

53

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 F igure 2.11: Im pulse R esponses to a Foreign Interest R ate S hock

Q jtput Consumer Price

0.100 0.08
0.075 - 0.06

0.050 0.04
0.02
0.025
0.00
0.000 -0.02 -

-0.025 -0.04
-0.050 -0.06
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.05 0.10 :
0.04 0.08
0.06 -
0.03
0.04 -
0.02 -
0.02 -
0.01 0.00 -j-
0.00 - -0.02 :
-0.01 -0.04 -|
-0.02 - -0.06 ;
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.04 - - 0.075
0.03 -
0.050
0.02 -
0.01 ; 0.025 -

0.00 | " 0.000

-0.01
-0.025 -
-0.02 -j
-0.03 -I -0.050 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price Foieign Interest Rate

0.0125 0.0030 - -
0.0100 0.0025
0.0075 0.0020 -
0.0050 0.0015 -i
0.0025 0.0010
0.0000 0.0005 !
-0.0025 0.0000 -
-0.0050 -0.0005 -I
-0.0075 -0.0010 -
- 0.0100 -0.0015
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

7th month. This output response combined with the loss in external value o f domestic

currency exerts upward pressure on the domestic consumer price.

2.5.3 Variance decompositions

Table 2.10 summarizes the variances of each variable explained by each structural

shock. In the short run (i.e. 12 months), money variance is dominated by both monetary

54

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 policy and money demand shocks, accounting for 11-36 percent and 30-65 percent,

respectively. In the long run money, its variance is mainly due to monetary policy shocks.

The key implication o f this result is that some o f the observed variation in money stock is

endogenous, as one would expect.

In line with SVAR literatures (e.g. Dhar et al. (2000), unanticipated domestic

monetary policy hardly impact Zambian output, contributing less than 10 percent (of its

variance). Much o f output fluctuations are attributable to aggregate supply shocks, accounting

for 40 percent in the short run and 82 percent in the long run (i.e. beyond 60 months). IS

shocks turn out to be the most important demand factor for the business cycle, underlying

utmost 32 percent (of output variance). Money demand shocks also modestly boost short-run

output, contributing utmost 20 percent. The role of foreign price in output is modestly

pronounced in the long run, accounting for 15 percent (of its variance). Consistent with

impulse responses, South African interest rate shocks barely explain Zam bias output.

Zam bias consumer price is mainly driven by aggregate supply, money demand and

exchange rate shocks in the short run, contributing up to 32 percent (of its variance), 41

percent and 34 percent, respectively. At longer horizons, it is mainly due to aggregate supply

shocks and modestly to foreign price shocks. Shocks to South Africas interest rate are the

least indicators o f consumer price in this small Sub-Saharan nation.

The role o f money demand shocks in the variance o f real balances is only very

pronounced in the short run, underlying utmost 36 percent. M odestly important in the short

run are aggregate supply and exchange rate shocks, each explaining up to 15 percent. Overall,

the leading indicators o f real balances are monetary policy shocks, explaining utmost 25

percent in the short run and 80 percent in the long run.

55

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 T ab le 2.11: Percentage o f Forecast E rror E xplained by Shocks

Shocks
Variable Months- Aggre. IS Money Money Exch. Fore. Fore.
ahead Supply Demand Supply Rate Price Rate
1 18.82 0.02 64.84 10.46 2.09 2.09 1.67
Money (0.05) (0.03) (0.10) (0.09) (0.01) (0.02) (0.01)
6 2.47 6.17 46.91 24.69 4.94 6.17 8.64
(0.04) (0.03) (0.09) (0.11) (0.01) (0.02) (0.03)
12 9.96 10.36 29.88 35.86 5.98 1.99 5.98
(0.05) (0.03) (0.07) (0.11) (0.02) (0.01) (0.02)
24 10.08 8.40 15.13 42.02 8.40 7.56 8.40
(0.06) (0.02) (0.06) (0.13) (0.00) (0.03) (0.03)
36 12.42 4.76 5.18 55.90 6.21 9.32 6.21
(0.05) (0.02) (0.03) (0.12) (0.01) (0.03) (0.02)
48 17.91 2.39 1.79 59.70 2.39 13.43 2.39
(0.06) (0.02) (0.01) (0.14) (0.01) (0.04) (0.01)
72 19.67 0.00 0.00 65.57 0.00 14.75 0.00
(0.06) (0.00) (0.00) (0.15) (0.00) (0.05) (0.00)
1 45.72 47.25 0.01 3.81 0.15 3.05 0.03
Output (0.22) (0.10) (0.04) (0.01) (0.01) (0.10) (0.01)
6 40.85 25.14 12.57 1.63 7.86 8.17 3.77
(0.23) (0.09) (0.04) (0.01) (0.03) (0.02) (0.01)
12 40.40 25.25 3.37 8.42 8.42 12.12 2.02
(0.24) (0.10) (0.01) (0.03) (0.02) (0.03) (0.01)
24 42.92 17.17 19.74 10.30 2.58 5.58 1.72
(0.23) (0.11) (0.04) (0.04) (0.02) (0.03) (0.03)
36 61.75 4.94 20.42 0.05 1.32 9.88 1.65
(0.27) (0.03) (0.05) (0.01) (0.01) (0.03) (0.01)
48 73.81 1.77 5.90 0.02 1.18 15.75 1.57
(0.27) (0.01) (0.03) (0.01) (0.01) (0.04) (0.01)
72 82.42 0.00 0.00 0.00 0.00 17.58 0.00
(0.27) (0.00) (0.00) (0.00) (0.00) (0.06) (0.00)
Consumer 1 9.03 9.15 40.91 27.27 13.64 0.00 0.00
Price (0.03) (0.03) (0.15) (0.09) (0.04) (0.00) (0.00)
6 19.32 8.70 28.99 2.42 33.82 3.86 2.90
(0.05) (0.03) (0.14) (0.08) (0.05) (0.01) (0.01)
12 32.05 3.86 30.21 4.83 28.02 3.41 3.38
(0.09) (0.04) (0.11) (0.06) (0.04) (0.01) (0.01)
24 37.81 0.15 14.18 4.73 33.09 5.91 4.14
(0.12) (0.01) (0.10) (0.02) (0.05) (0.02) (0.02)
36 55.74 0.13 10.22 5.57 11.61 11.15 5.57
(0.11) (0.01) (0.07) (0.02) (0.04) (0.02) (0.01)
48 64.56 0.17 1.99 7.45 2.23 17.38 6.21
(0.12) (0.01) (0.03) (0.03) (0.01) (0.03) (0.01)
72 71.05 0.00 0.00 7.89 0.00 21.05 0.00
(0.15) (0.00) (0.00) (0.02) (0.00) (0.04) (0.00)

56

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 Table 2.10 C ontinue

S hocks
Variable Months Aggr. IS Money Money Exch. Fore. Fore.
ahead Supply Demand Supply Rate Price Interest
Rate

Real 1 7.02 21.05 21.05 14.04 15.79 5.26 15.79

Balances (0.04) (0.06) (0.11) (0.08) (0.03) (0.01) (0.03)
6 16.19 2.00 36.19 24.76 14.29 3.33 3.24
(0.05) (0.01) (0.12) (0.10) (0.06) (0.01) (0.02)
12 14.75 3.23 36.87 25.81 9.22 8.29 1.84
(0.05) (0.01) (0.13) (0.18) (0.06) (0.02) (0.01)
24 5.88 4.41 29.41 33.82 13.24 11.76 1.47
(0.04) (0.02) (0.10) (0.19) (0.04) (0.03) (0.01)
36 8.11 0.03 16.21 64.85 5.40 2.70 2.70
(0.05) (0.01) (0.07) (0.18) (0.03) (0.01) (0.01)
48 14.70 0.01 5.88 70.58 2.94 2.94 2.94
(0.05) (0.01) (0.03) (0.21) (0.01) (0.01) (0.01)
72 16.67 0.00 0.00 80.00 0.00 3.33 0.00
(0.05) (0.00) (0.00) (0.27) (0.00) (0.01) (0.01)
1 20.83 33.33 18.75 12.50 4.17 0.00 10.42
In terest (0.13) (0.18) (0.03) (0.09) (0.02) (0.01) (0.03)
6 8.40 25.21 8.40 31.93 10.08 8.40 7.56
(0.06) (0.16) (0.03) (0.11) (0.02) (0.03) (0.03)
12 17.72 10.13 3.80 22.78 17.72 15.19 12.66
(0.09) (0.17) (0.02) (0.10) (0.03) (0.00) (0.04)
24 28.24 2.59 0.94 9.41 21.18 11.76 25.88
(0.10) (0.09) (0.01) (0.08) (0.05) (0.03) (0.05)
36 43.86 2.92 0.29 2.92 0.29 17.54 32.16
(0.11) (0.02) (0.01) (0.01) (0.02) (0.04) (0.04)
48 74.35 1.86 0.19 1.12 0.19 16.73 5.58
(0.13) (0.01) (0.01) (0.01) (0.02) (0.04) (0.04)
72 83.33 0.00 0.00 0.00 0.00 16.67 0.00
(0.15) (0.00) (0.00) (0.00) (0.00) (0.05) (0.00)
Exch. 1 13.13 2.02 19.19 6.56 51.51 6.56 0.03
R ate (0.09) (0.09) (0.03) (0.02) (0.11) (0.01) (0.01)
6 5.33 23.67 8.28 15.38 35.50 8.28 3.55
(0.06) (0.06) (0.04) (0.03) (0.10) (0.02) (0.01)
12 18.22 18.22 4.37 18.22 18.22 18.37 4.37
(0.05) (0.05) (0.01) (0.04) (0.07) (0.04) (0.01)
24 32.45 5.19 2.60 20.77 7.79 31.15 0.05
(0.10) (0.02) (0.01) (0.06) (0.03) (0.05) (0.01)
36 44.74 0.39 0.72 10.74 0.43 42.95 0.04
(0.11) (0.01) (0.01) (0.06) (0.01) (0.08) (0.01)
48 48.38 0.43 0.39 3.87 0.46 46.44 0.03
(0.13) (0.01) (0.01) (0.02) (0.01) (0.11) (0.01)
72 51.02 0.00 0.00 0.00 0.00 48.98 0.00
(0.15) (0.00) (0.00) (0.00) (0.00) (0.13) (0.00)

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 Table 2.10 C ontinue

Shocks
Variable Month Aggreg IS Money Money Exch. Fore. Fore. Rate
s- ate Demand Supply Rate Price
ahead Supply
F o reig n 1 0.07 0.34 0.33 0.32 0.05 88.66 10.23
P rice (0.01) (0.01) (0.01) (0.02) (0.01) (0.29) (0.03)
6 0.02 0.18 0.21 0.17 0.03 77.78 21.61
(0.01) (0.01) (0.02) (0.02) (0.01) (0.31) (0.02)
12 0.14 0.15 13.35 0.15 0.15 74.19 11.87
(0.01) (0.01) (0.03) (0.01) (0.01) (0.32) (0.03)
24 0.17 0.16 15.10 0.17 0.15 83.91 0.34
(0.01) (0.01) (0.04) (0.01) (0.02) (0.33) (0.02)
36 0.19 0.20 0.17 0.16 0.19 98.72 0.39
(0.01) (0.01) (0.01) (0.02) (0.01) (0.34) (0.01)
48 0.19 0.20 0.16 0.15 0.19 98.72 0.39
(0.01) (0.01) (0.02) (0.02) (0.02) (0.36) (0.01)
72 0.00 0.00 0.00 0.00 0.00 100.0 0.00
(0.00) (0.00) (0.00) (0.00) (0.00) 0 (0.00)
(0.36)
F o reig n 1 24.98 0.00 0.00 0.07 0.00 42.83 32.12
In terest (0.09) (0.00) (0.00) (0.01) (0.00) (0.26) (0.05)
6 1.80 0.45 11.24 1.12 13.48 49.44 22.47
(0.01) (0.01) (0.04) (0.01) (0.04) (0.27) (0.04)
12 1.64 0.55 0.66 1.64 13.65 54.59 27.29
(0.01) (0.01) (0.03) (0.02) (0.03) (0.27) (0.05)
24 3.80 0.09 0.09 0.09 0.95 85.47 9.50
(0.01) (0.01) (0.02) (0.03) (0.02) (0.28) (0.05)
36 4.03 0.10 0.10 0.10 1.01 90.63 4.03
(0.02) (0.01) (0.02) (0.03) (0.01) (0.31) (0.01)
48 4.15 0.10 0.09 0.08 1.04 93.46 1.04
(0.01) (0.01) (0.01) (0.03) (0.01) (0.32) (0.01)
72 0.00 0.00 0.00 0.00 0.00 100.0 0.00
(0.00) (0.00) (0.00) (0.00) (0.00) 0 (0.00)
(0.32)
Note: Aggre. Supply ^A ggregate Supply; Exch. Rate =Exchange Rate; Fore. Price=Foreign Price;
Fore. Rate=Foreign Interest Rate

In the short run, the variance of interest rate is mainly due to IS and monetary policy

shocks, underlying utmost 33 percent and 31 percent, respectively. In the long run, it is

mainly due to aggregate supply shocks and modestly to foreign price shocks.

We find exchange rate, aggregate supply, monetary policy and money demand shocks

the main determinants o f nominal exchange rate in the short run. Exchange rate shocks

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 contribute up to 51 percent (to its movement), aggregate supply shocks, 18 percent, monetary

policy shocks, 21 percent and money demand shock, 19 percent. Developments in long-run

exchange rate are mainly explained by aggregate supply and foreign price shocks, each

accounting for about 50 percent o f its variance. Finally, the variances of both foreign price

and foreign interest rate are mainly associated with foreign price shocks.

2.6 Concluding Comments

The transmission mechanism of post-liberalization Zam bias monetary policy is

investigated within a structural cointegrated VAR model over the period 1992-2003 that

corresponds to a monetary targeting regime. Monthly data are used. The estimated model

describes a macroeconomic system o f money, income, prices, interest rates and exchange rate

within which cointegration analysis identifies four steady state relations that influence the

process of Bank o f Zambia monetary policy: money demand, IS, exchange rate and foreign

interest rate relations, and accordingly, money demand, IS, exchange rate and foreign interest

rate shocks are characterized as transitory and monetary policy, aggregate supply and foreign

price shocks as permanent.

The empirical structural model, identified with short run and long-run restrictions,

provide a reasonable description o f important features of the Zambian macroeconomy as they

accord reasonably well with the predictions o f a simple open economy IS-LM-AS model

under flexible exchange rates. In particular, the responses of output and interest rate to a

positive money supply shock are consistent with the output and liquidity effects, whereby

interest rate falls and output rises. Following an unexpected monetary expansion, consumer

price persistently rises and the nominal exchange rate temporarily depreciates. The model

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 also provides sensible predictions on the impact o f aggregate supply, IS, money demand,

exchange rate, foreign price and foreign interest rate shocks.

The estimated model is used to address questions posed at the outset: What is the

relative importance o f money supply shocks in the transmission o f monetary policy? Are

exchange rate shocks key to inflation dynamics? Very little amount o f output variance is due

to money supply shocks. Much o f output volatility is attributable to aggregate supply shocks.

IS shocks are the most important demand factors for the business cycle. M oney demand

shocks also modestly boost short-run output. The role o f foreign price in output is modestly

pronounced in the long run. In the short run consumer price, and by implication consumer

inflation, is mainly associated with aggregate supply, money demand and exchange rate

shocks. In the long run, it is mainly due to aggregate supply shocks and modestly to foreign

price shocks.

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 3.0 A Rational Expectation Structural VAR Model

3.1 Introduction

This chapter estimates a small rational expectation SVAR model, following Keating

(1990), to analyze the transmission mechanism o f monetary policy in post-liberalization

Zambia. Using a simple dynamic structural macro model, Keating shows that if agents have

rational expectations, the dynamic structure o f the economy influences the contemporaneous

SVAR model. Rather than identifying the model with cross equation restrictions, as

demonstrated in standard rational expectation econometrics (e.g. Mishkin (1983), this

approach advocates estimating the structural parameters from VAR residuals.

Departing from Keating (1990), a cointegrated SVAR model is employed. In

addition, a small open-economy provides the relevant theoretical framework, motivating a

number o f questions on monetary policy design .22 What is the role o f monetary policy shocks

in exchange rate behavior? Does monetary policy respond to exchange rate shocks? What is

the impact o f foreign price shocks on the domestic economy? Though vast empirical

literatures present reliable answers to questions pertaining to developed economies (e.g.

Clarida and Gali (1994), Eichebaum and Evans (1995), Cushman and Zha (1997)), there is

little equivalent evidence for countries in earlier stages o f development, like Zambia.

We address these questions by motivating the identifying assumptions from a rational

expectation theoretical model driven by six exogenous shocks: money supply, money

demand, aggregate supply, IS, exchange rate and foreign price shocks. The structural vector

error correction model (VECM) is estimated using monthly data for the period 1992-2003.

22 The model in Keating (1990) is based on a closed economy suitable for modeling an economy like
the US. A small open economy denotes an economy that is too small to affect world prices, interest
rates or world economic activity.

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 Within this framework, the effects o f monetary policy shocks, identified as innovations to

money supply, and their relative importance are examined. Overall, the impulse responses

and variance decompositions are consistent with the standard rational expectation model. In

response to an expansionary monetary policy shock, money supply increases, the nominal

interest falls, output and price rises and the exchange rate depreciates. This absence of

interest rate, price and exchange rate puzzles, suggests the model correctly identifies

monetary policy shocks.

The study makes a number o f contributions. First, it applies the rational expectation

SVAR modeling strategy, to my knowledge, for the first time to a developing economy

context. In particular it shows that estimating structural parameters from VECM residuals is

also a plausible modeling strategy for emerging economies. Second, it adds to the growing

literature on modeling monetary policy in Africa (e.g. Ating-ego (2000), M wansa (1998)).

Like in developed economies (e.g. Cushman and Zha (1997), Sims and Zha (1995a), Clarida

and Gali (1994), Keating (2000)), money supply shocks barely influence output. Output

variability is mainly due to IS and aggregate supply shocks, the former very pronounced in

the short run. The role of monetary policy in consumer price is only modestly pronounced

and in the short run. The leading indicators of Zambia consumer price, and by implication

CPI inflation, are aggregate supply shocks. Second in importance are exchange rate shocks.

There is clear evidence that monetary policy in Zambia responds to exchange rate shocks. In

particular, the Bank o f Zambia tightens policy to curb anticipated inflationary pressures,

emanating from exchange rate shocks. South African price shocks modestly influence

Zambias output and consumer price.

The chapter is organized as follows. Section 3.2 outlines the forward-looking

economic model whereas Section 3.3 presents the econometrics strategy. In Section 3.4,

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 impulse responses and various decompositions characterize the estimated m odels dynamics.

Section 3.5 concludes.

3.2 A Stochastic Rational Expectation Open Economy Macro Model

The theoretical economic model that motivates the identification strategy is in the

spirit o f the new open economy macroeconomics (NOEM). The model also falls within a

class o f open economy dynamic stochastic general equilibrium (DSGE) models (e.g. Obstfeld

and Rogoff (1995), McCallum and Nelson (1999), Svensson (2000), Calvo (1983) and Fuhrer

and Moore (1995). In particular, it is based on a dynamic open-economy macro model that

features rational expectations, optimizing agents and slow adjusting prices. The features of

sticky prices of goods (and services) are plausibly rendered by the assumption o f imperfect

competition (e.g. monopolistic competition) and cost o f adjusting prices. Asset prices, on the

other hand, are assumed to adjust promptly. Following Fuhrer and M oore (1995) and many

others, nominal rigidities are introduced (e.g. through overlapping wage contracts), creating a

role for monetary policy influencing real variables in the short-run. Forward-looking

expectations are crucial to exchange rate, aggregate demand and aggregate supply

determination.

Consider all the variables, except interest and inflation rates, in logs (and all

parameters are positive). Letting each equation to have unconstrained lag structure, the

structural model is summarized as follows:

(3.1) y, = a xE t+Xy, ~ a2 (R, - E, A p L

nX) + a 3 (s, + p, - p L
t ) + f y (lags) + r/'s
(3.2) m , - Pi = 4y, - a 5R>+ f md (las s ) + r ,:d
(3.3) s, = Etst+\ + (R, - R *) + f ilags) + Pi
(3.4) Ap ) = a6E , A p l x + a 1y l + agAst + agAp* + / * (lags) + 77" ,

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 where y, denotes real output, Rt domestic nominal interest rate , s, nominal exchange rate

and p L
t domestic consumer price (CPI), p* is foreign CPI, m t is money stock and R* is

foreign interest rate, r j f , t]'"d, p and //"' are structural shocks whereas / (lags) denotes lags

o f all the variables.

Equation (3.1) is an open economy forward-looking IS curve. Demand for domestic

output is driven by expected output, expected domestic short real interest rate

(Rt - EfA p cl+]) (where E t is the expectation operator conditional on information available at

t ), the real exchange rate (st + p* - p ) ) and an IS shock r / f (e.g. fiscal policy and foreign

demand shock).

Equation (3.2) is a money demand function. It has standard arguments: output

capturing transaction demand and interest rate capturing opportunity cost. The term t)'"d is a

money demand shock, in particular velocity shock.

Expressing (3.2) in terms o f Rt yields:

(3.5) R, = d, ( p ( - m t) + d 2y t + f md(lags) + r j f ,

where d ] = l / a 5, d 2 = a4,/a 5 .

Assuming that the small open economy operates in an environment o f near-perfect

capital mobility, the nominal exchange rate is determined by the uncovered interest parity

(UIP) depicted in (3.3). Specifically, the nominal exchange rate is determined by the

expected exchange rate ( E tst+, ), interest rate differential ( R t Rt ) and an exchange rate risk

premium(/?( ). Assuming that p t is endogenous specifies (3.6):

(3.6) p t = fay, + &R, + fap] + fajrt, + fa5p* + rf,

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 where rft is an exchange rate shock (reflecting other influences such as shock to balance of

payments and investor confidence). Inserting (3.6) into (3.3) produces (3.7):

(3.7) s, = E tst+X - (R t - % ) + (j)xy t ~ 0 2R ,+ (f>2p ct + fam, + fo p ] + / ( l a g s ) + rj, ,

The assumption of p t makes the exchange rate equation unconstrained.

Equation (3.4), defining the supply side, is an open economy expectational Phillips

curve as it relates current domestic CPI inflation ( tsp ct ) to expected CPI inflation ( ElA pi l ),

output, exchange rate, foreign CPI inflation ( Ap t ) and a disturbance term (that captures

aggregate supply shocks, e.g. productivity and oil price shocks). This Phillips curve is a

generalization o f what has been called the New Keynesian Phillips curve, which relies on the

Calvo (1983) pricing model, involving staggered nominal prices set by monopolistically

competitive firms. After imposing the assumption that real marginal cost is positively related

to the output gap, this model leads to an equation relating current inflation to expected

inflation and the output gap. However, due to the economic structure, Fuhrer and Moore

(1995) (in the case o f the US economy, for example), include lagged inflation, giving rise to

an alternative specification, the hybrid model of the Phillips curve (e.g. Gali and Gertler

(1999)). According to this model, only a fraction of firms set prices (as in the Calvo model),

while the rest (of the firms) use a simple backward-looking price rule.

Domestic monetary policy is implemented through control of the nominal money

supply, with the policy reaction function specified as (3.8):

(3.8) m, = + / '" (lags) + rtf

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 where tj p is a monetary policy shock. This equation posits that the exchange rate is the only

information set available to the central bank at period t . This reaction function is in line with

the fact that the central bank intervenes in the foreign exchange market.

Equation (3.9) is a simple foreign price adjustment equation:

(3.9) Ap* = f * (lags)+ ?j*,

$
where r/t denotes a shock to foreign price.

What is the implication of this model for the monetary transmission mechanism? The

impact o f monetary policy on output and inflation is assumed to operate through the real

interest rate (or aggregate demand) channel. As long as the central bank is able to affect the

real interest rate, by changing money supply, monetary policy can affect real output and

thereby inflation through the output gap. This is because changes in the real interest rate

affect consumption and investment. Increases in the real interest rate, for instance, reduce

consumption and consequently aggregate demand. As aggregate demand falls, so does CPI

inflation. This prediction o f the transmission process, however, only holds if the liquidity

effects dominate the income and price effects (Mishkin (1983)).23

There are additional transmission channels due to the exchange rate effects, operating

through two distinct channels. First, an indirect output gap route running though net exports

and hence onto CPI inflation. This is because exchange rate movements alter the relative

price of domestic and foreign goods, impacting aggregate demand. The direct price effects

23
The money stock increase will, over time, have an expansionary effect on both real income and the
price level. This income and price effects will, through the usual argument in the money demand
function, tend to reverse the decline in interest rate. More important for short-run effects on interest
rate, increases in the money stock can also influence anticipations o f inflation. Higher expected
inflation as a result o f money stock increases, would though a Fisher relation, increase nominal interest
rate. This price anticipation effect can thus not only mitigate the decline in interest rate stemming
from the liquidity effect but could also overpower it.

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 are via the cost o f imported goods. Consumer prices will respond to exchange rate

movements since they are indices of domestic currency prices of domestically produced

goods and foreign produced goods.

Like any general standard open-economy framework used for policy analysis, the

real effects o f monetary policy shocks arise in the short run due to nominal rigidities. Over

time, as prices (or wages) adjust, real output, real interest and real exchange rate return to

equilibrium levels that are independent of monetary policy. This long-run neutrality means

that the long run effects of monetary policy shocks fall on prices, inflation, nominal interest

rate and nominal exchange rate. The rate of inflation is thus an appropriate long-run objective

o f monetary policy, while the growth of real output and the level o f the real exchange rate are

not. In the short-run, however, monetary policy shocks can have important effects on the

manner in which real output and real exchange rate fluctuate around their long run levels.

In response to money supply shocks, the nominal exchange rate exhibits slow

adjustment or delayed overshooting rationalized on the assumption that agents have access to

imperfect information (Gourinchas and Torneel (1996)). That is, sluggishly the nominal

exchange rate depreciates and later appreciates, following a positive money supply shock.

Finally, the model predicts that if the exchange rate freely adjusts, it insulates the

domestic economy from foreign price shocks (Walsh(2003)). Putting it differently, in the

open economy with flexible exchange rates, if the exchange rate adjusts immediately to

reestablish purchasing power parity (PPP), price shocks from abroad can be completely

offset.

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 3.3 Econometrics Strategy

The statistical model that generates the data and formulates the rational expectation

hypothesis, assumes that all the variables in the n x 1 vector X t ~ 1(1) and the process

A X t ~ 1(0) belongs to a class of structural cointegrated system:

(3 10)24 4>AXt = a f X t_] + r ; A X t_l + ... + r l lAX,_k+l+TJl,

where A q is an n x n vector o f contemporaneous parameters, ?/, are independent

identically distributed (i.i.d) structural shocks, with mean zero and covariance matrix

Q , r * , i = \ , 2 , . . , k \ are n x n matrices and /?* and a* are n x r matrices of rank

r , 0 < r < n , whereas k is the lag length.

M ultiplying (3.10) by A ^J, assuming it exits, yields the reduced-form vector error

correction model (VECM) in the sense of Granger (1987) and many others:

A X ' = a f i X ' _ l + r iA X l_l +... + r k_lAX'_M + ',

* ,~ W ( 0 , 2 )

where a(3 = A ^ 1a* f ? , T, = A ^ Y \ , Y k-\ = and the n x 1 vector o f reduced-form

disturbances et has a mean zero and covariance matrix E , and is related to the underlying

structural shocks:

(3.12) G =A V

24 Deterministic terms such as exogenous variables and dummies are omitted only for notation
convenience.

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 B y Grangers representation theorem (Granger (1987), Johansen (1995b)), model

(3.11) has a moving average (MA) representation:

(3.13) Ax , = C ( L ) s t.

Inserting (3.12) into (3.13) yields the structural MA (SMA) representation:

(3.14) Axt = ^ ( L ) T j

where ^ ( L ) = A^XC ( L ) .

Imposing restrictions on both A() 1and the covariance matrix o f the structural shocks

identifies the structural [Link] are n2 elements in A0 and n(n + 1)/2 unique elements

in Q , but only n(n + 1 ) / 2 unique elements in E , implying that n1 restrictions are required

for identification. As usually, assuming the structural shocks are orthogonal and setting the

diagonal elements o f Ai: to unity since each structural equation is normalized on a particular

endogenous variable generates n(n + 1 ) / 2 additional restrictions, leaving n ( n - l ) / 2

restrictions to achieve complete uniqueness of the structural shocks. These additional

restrictions are motivated from a linear rational expectation model formed by equations (3.1),

(3.4), (3.5), (3.7)-(3.9), assuming this model has VAR representation estimated with uniform

lags.

By definition,VECM (3.11) is the agent forecast model. That is, it is the reduced-

form solution o f the model through which agents compute conditional expectation. It is clear

that taking expectation of (3.11) conditional on the t 1 information yields:

E ^ A X , = a P 'X t_x +r,A V ,I + ... + r,_,AX,_i+1

(3.15)

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 and thus

(3.16) A X ,- ,_ ,A X , = s r

It is also clear that

x x i+x =a{3 x t + f ]a x , + . . . + r AAX,_i+2 +,7+1

(3.17)

Thus

(3.18) ,AX,+1 =aj3'Xl + r iAXt + ... + r kAXt_k+2,

(3.19) AX ,+1 = a/3Et]X l + T 1X,_1AX, +.. + F j1AX,_a+2,

,AX,+I -,_,A X ,+1 = cc0 (X, - E,_xX , ) + T, (AX, AX,)

(3.20) = a f i \ X t - X ,_ ,-E ,_xX t + X,_,) + T, (A X , A X , )
= ( a ^ ' + r i)ff,,

and generally

(3.21) E lA X ^ l - El_lA X f+l = ( 0 " + r / ' ) ,

/=1

where j is the VAR equation, i is the variable and the j th element for a ft = O .

Applying (3.16) to equations (3.1), (3.4), (3.5), (3.7)-(3.9) produces (3.22)-(3.27), the

contemporaneous innovations representation of the dynamic structural model:

(3.22) s f = a ,(E,yt - E ^ y ^ ) - a 2{s? - (E ,E p ^ - E t_ M J + a 3[ < + A - * ,'] +>7*

(3.23) e1
; = a6(EtAp,+l - Et_xXpct+x) + a r f + a&s ts + age] + r'
(3.24) +
(3.25) s\ ~ (Etst+l - Et_xst+[) + (j)xE[ - (1 + 02) e '/ + ^3t + ^ 4T + (0-5 + (t>dt + V,
(3.26) e ? = - t 6*; + F
(3 .2 7 )

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 Equation (3.22) obtains the result that innovations to output { s x ) are related to

innovations to expected output ( E ty t+] - Et ]y i t,), interest rate ( s f ), expected inflation

( A/ U! - Et | !), nominal exchange rate ( s f ), foreign price ( e *), domestic price ( s p )

and an IS shock, r j f . Equation (3.23) defines innovations to domestic price as related to

innovations to the expected domestic inflation, output, exchange rate, foreign price and a

domestic aggregate supply shock, 77 ,25

Innovations to interest rate are related to innovations to domestic price, monetary

policy ( s'" ), output and a money demand shock, r]d according to equation (3.24). Equation

(3.25) posits that innovations to nominal exchange rate are due to innovations to expected

exchange rate ( E tsl+] E tXst+x), output, interest rate, domestic price, monetary policy,

foreign price and an exchange rate shock, rft .

Equation (3.26) shows innovations to money supply (s ) related to innovation to the

exchange rate and a monetary policy shock, rf^p . Equation (3.27) argues that innovations to

*
foreign price are only contemporaneously linked to a foreign price shock, 77 .

Estimating this system (of contemporaneous VAR innovations) first requires

computing innovations to expected (domestic) output, inflation and exchange rate. Using

(3.21), it is easy to see that subtracting the expected value conditional on the t - 1

information set from the expected value conditional on the t information produces:

25 Following Smal and Jager (2001), it assumed thati?, = 0.5A p( + . . .

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 (3.28)

(3.29)

(3.30)

Since the model has 15 free parameters and the variance-covariance matrix o f the

unstructured VAR disturbances contain 15 elements, it is exactly identified.

3.4 Structural Empirical Analysis

A three-step approach is followed to estimate the structural model. First, VECM

representation (3.11) is estimated to obtain the coefficients and residuals,,? . Second, using

the results in the first step, (3.22)-(3.26) are estimated by the instrumental variable (IV)

approach. This is essentially Blanchard and Watson (1986) approach, with application to a

rational expectation model. Recursively, using rjt from (3.27), as the instrument, (3.26) is

estimated. The instruments rjt and i]"p are then employed to estimate (3.24). Estimating

(3.22) with the instruments r/t ,T}"'P and rj",d follows. We then estimate (3.23) using the

instruments r)*, rj"ip, i)'"d and r]f . Equation (3.25) is the last to be estimated using the

instruments 77, , rj"p , ri"'d , r/ls and 77'. Since in each equation the number o f parameters

equals the number o f instruments, there are no over-identifying restrictions. Finally, impulse

responses and variance decompositions are computed.

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 The estimated structural parameters are presented in Table 3.1. Though coefficients

o f the forward-looking IS curve have correct signs, only the real interest elasticity is

statistically significant at the 10 percent level. On the other hand, estimated parameters of

equation (3.5) are significant at the 10 percent level, translating into income elasticity o f 0.81

and interest elasticity o f 0.35, which look sensible. The structural parameters of the Phillips

curve also seem well estimated. The exchange rate equation is also well estimated, suggesting

that the shock to foreign exchange risk premium is not exogenous. Turning to the policy

reaction function, the exchange rate enters significantly, consistent with the Bank of Zambia

(BOZ) reducing the stock o f money to offset expected inflationary pressures induced by

currency depreciation. Based on these results, imposing rational expectation on the structural

model is justified.

Table 3.1: Estimated Structural Parameters

Coefficient Std. Error
ax 0.03 0.72

a2 0.15 0.08**

a3 0.06 0.21

a6 0.05 0.03**

a7 0.09 0.05**

Cl& 0.12 0.03*

aq 2.5 x 10~3 1.38 x 10'3**

d} 2.86 1.36**

dj 2.31 1.42**
0.04 0 .0 2 **
0\
0.73 0.38**
02
1.13 x 103 6.46 x 104 **
03
1.26 0.71**
0\
1.06 x 10-3 0.73
05
1.25 x 10'2 3.05 x 103*
06
Note: * (**) statistically significant at the 5 % (10%) level

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 3.4.1 Impulse Responses

To assess the m odels properties, especially, the impact o f the policy shock measure,

Figures 3.1-3.6 display the dynamic effects of positive shocks. W hereas solid lines report the

impulse responses, dashed lines denote the 95 percent confidence interval generated through

Monte Carlo simulations. Generally, the results are in accordance with the narrative evidence.

Figure 3.1 reports the dynamic responses of the macroeconomic variables to a

positive shock to monetary policy, identified as innovation to money supply. With few

exceptions, the characterization o f the transmission process accords with our theoretical

priors and with a number o f studies (e.g. Cushman and Zha (1997), Bagliano and Fevero

(1998)). In particular, there is no puzzle about the relationship between a monetary policy

shock, interest rate and exchange rate responses, suggesting the model correctly identifies the

policy shock. Further, consistent with the prediction that the economy is too small to affect

world economic activities, foreign price hardly responds to domestic shocks.

The sharp increase (3.2 percent) in the money stock is accompanied by a significant

fall (about 1.2 basis points) in the nominal interest rate, a significant rise in real balances that

lasts 10 months. Despite a marginal rise in output, consumer price reacts significantly over 10

months, reaching the peak increase of 2 percent 6 months later. Surprise monetary policy

depreciates the nominal exchange rate whereas foreign price hardly responds.

A one standard deviation positive aggregate supply shock significantly raises output

and reduces consumer price (Figure 3.2). Output, which barely rises on impact, attains the

maximum response o f 0.6 percent 10 months later. Consumer price falls significantly over 20

months. We notice the peak response o f consumer price is approximately 4 percent recorded

after 8 months. In the long run, output rises by 0.5 percent and consumer price falls by 2

percent. This shock leads to a rise in real balances. Money supply also rises,

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 Figure 3.1: Im pulse R esponses to a M onetary P olicy Shock

Output Consumer Price

0.010 0.06
0.008
0.04
0.006
0.004 0.02 J - -
0.002 1 ---- 0.00 -
- - ------------------------ - =
0.000
-0.02 -
-0.002
-0.04

-0.006 -0.06 J
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.04 - 0.090

0.03 0.072 r\
\X _
0.054
\> 0.036
0.01 __ ^ 1
0.018
0.00 - - - -
0.000 -
-0.01 -0.018 - --------------
-0.02 -0.036
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.06 __ _______ 0.08 -

0.04 - 0.06 J

0.04
0.02
0.02
0.00 . ... . ____ . . . .. .. .. . -
0.00 -
_____ L E ------------------------------------
_______ . ____
-0.02 -0.02 |

-0.04 - -0.04 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price
0.004 T
0.003 !
0.002
0.001 i
0.000 i * -------
---- ------
-0.001 !
-0.002 !
-0.003
0 5 10 15 20 25 30 35 40 45

suggesting that in the short run, it is primarily driven by commercial banks (Keating (2000)).

In line with development in money, the nominal interest rate falls, inducing currency

depreciation that is initially significant.

A positive IS shock causes higher nominal interest rate, lower money supply and

appreciated domestic currency (Figure 3.3). Like in Gavosto and Pellegrini (1999), the effects

of this shock on output and consumer price are fast and strong. Initially, output increases by

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 F igure 3.2: Im pulse R esponses to an A ggregate Supply Shock

Output Consumer Price

0.010 i 0.06 -
0.008 i 0.04
0.006 ;
0.02 -
0.004 '
0.002 -j 0.00
0.000 -p -0.02
-0.002 ;
-0.04
-0.004 -i
-0.006 : - -0.06
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.04 0.090
I 0.072 -i
0.03 ;
I 0.054
0.036
0.01
0.018
0.00 0.000
-0.018
-0.02 ! -0.036 -
40 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.05 - 0.08 -

0.04 - 0.06 -

0.04
0.02
0.02
0.00 -
0.00 -
- 0.02
-0.02 -

-0.04 -0.04 -
0 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 45

Foreign Price
0.004
0.003
0.002
0.001 -

0.000
-0.001

-0002 -

-0.003
0 5 10 15 20 25 30 35 40 45

0.3 percent and 14 months later records the maximum response o f approximately 0.4 percent.

On impact, consumer price increases by 0.11 percent and 12 months later registers the

maximum response o f 3.5 percent. Real balances fall too.

Figure 3.4 depicts the impact of a money demand shock to be in line with the

literature (e.g. Levin et al. (1999)). Higher real balances and nominal interest rate follow a

one standard deviation positive shock to money demand. As this is considered a demand

shock, output also rises, attaining the peak response of 0.2 percent after 10 months. Consumer

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 F igure 3.3: Im pulse R esponses to an IS Shock

Output Consumer Price

0.010 0 .0 6 -----
0.008
0.04
0.006
0.004 0.02 -
0.002 - 0.00 -j
0.000 - -0.02 J
-0.002 i
0.004 -0.04

0.006 -0.06 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.04 0.090

0.03 0.072
0.054
0.02
0.036
0.01
0.018 -!
0.00
0.000- j -
0.01 - -0.018 -!
0.02 -0.036 '
0 5 10 15 20 25 30 35 40 45 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.06 0.08 -r

0.04 0.06 -

0.04 ;
0.02
0.02 -I
0.00
0.00
0.02 -0.02
0.04 - -0.04
10 15 20 25 30 35 40 45

Foreign Price
0.004
0.003 -
0.002
0.001 -

0.000
0.001

0.002

0.003
0 5 10 15 20 25 30 35 40 45

price reacts significantly over 10 months. On impact, it hardly rises and after 8 months,

reaches the peak response o f 2 percent. Domestic currency appreciates, in part, due

to higher interest rate. Finally, like other domestic shocks, foreign price hardly responds to

this shock.

The main consequences of a positive exchange rate shock are summarized in Figure

3.5. First, nominal exchange rate strongly depreciates. Second, consumer price increases by

0.9 percent on impact and 12 months later records the maximum response of close to 2.3

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 F igure 3.4: Im pulse R esponses to a M oney D em and S hock

Output Consumer Price

0.010 0.06 -
0.008 0.04-
0.006
0.02 :
0.004
0.002 0.00 !
0.000 -0.02H
-0.002
-0.04
-0.004
-0.006 -0.06
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.04 0.090

0.03 0.072
0.054
0.02
0.036 j
0.01
0.018 -
0.00
0.000 -*
- 0.01 -0.018
- 0.02 -0.036 r
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.08

0.04 -
0.04
0.02
0.02
0.00 -
0.00
-0.02 -0.02

-0.04 -0.04 T T T I
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price
0.004
0.003
0.002 -
0.001

0.000
-0.001

- 0.002

-0.003
10 15 20 25 30 35 40 45

percent. Third, output also rises significantly over 8 months. Fourth, money supply falls and

interest rate rises, implying that the Zambian monetary authority adopts a tight policy stance

to dampen the price effects o f this shock. Fourth, real balances fall sharply.

A positive foreign price shock immediately raises South African consumer price

(Figure 3.6). We notice the effects of this shock, in part, transmitted to the domestic economy

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 F igure 3.5: Im pulse R esponses to an Exchange R ate Shock

Output Consumer Price

0.010 0.06 -
0.008 -j
0.04
0.006 ;
0.004 j 0.02
0.002 ' 0.00
0.000 r -0.02
-0.002

-0.004 J -0.04 -
-0.006 - -0.06 -
0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Money Real Money

0.04 ; 0.090

0.03 0.072
0.054
0.02
0.036
0.01 !i 0.018
0.00
0.000 - /
-0.01 !
-0.018
-0.02 -0.036
0 5 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.06 0.08

0.04 0.06

0.04
0.02
0.02
0.00
0.00
-0.02 -i -0.02

-0.04 -0.04 i._

0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45

Foreign Price
0.004 -
0.003
0.002
0.001

0.000
-0.001

-0.002

-0.003
0 5 10 15 20 25 30 35 40 45

through exchange rate. The nominal exchange rate depreciates significantly over 4 months.

This is plausible since the foreign monetary authority raises interest rate, following the rise in

price. Higher interest rate abroad, in turn, places downward pressure on the external value of

the domestic currency. Consumer price barely rises on impact. Domestic output marginally

falls, as higher import costs lower net exports. Money supply falls, implying tight policy

stance to mitigate the price effects o f this shock. Finally, real balances fall.

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 F igure 3.6: Im pulse R esponses to a Foreign P rice Shock

Output Consumer Price

0.010 0.06 -
0.008
0.04 -
0.006
0.004 0.02

0.002 0.00 -

0.000 - -0.02
- 0.002

-0.004 -0.04

-0.006 -0.06
10 15 20 25 30 35 40 45 10 15 20 25 30 35 40 45

Money Real Balance

0.04 - 0.090

0.03 i 0.072
0.054
0.02
0.036
0.01
0.018
0.00 -j-
0.000 -
-0.01 -0.018 -I.
-0.02 - -0.036 ----
10 15 20 25 30 35 40 45 10 15 20 25 30 35 40 45

Interest Rate Exchange Rate

0.06

0.04 0.06 -j

0.04 -I
0.02
0.02 - j
0.00
0 .0 0 J-

- 0.02
-0.02 |

-0.04 0.04 - -
0 5 10 15 20 25 30 35 40 45 10 15 20 25 30 35 40 45

Foreign Price
0.004 -
0.003 j
0.002 !
_
0.001 j
0.000
-0.001 |
-0.002 j
-0.003 --
10 15 20 25 30 35 40 45

3.4.2 Variance Decompositions

Further information on the relevance of these shocks comes from the variance

decompositions, presented in Table 3.2. The confidence bands calculated by Monte Carlo

simulations, and appearing in parentheses, determine that the contributions o f shocks are

statistically different from zero at the 95 percent confidence level for 3 different horizons: 12

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 months ahead (the short-run), 24-48 months ahead (the medium term) and 72 months ahead

(long run).

Much of money variance is due to monetary policy and money demand shocks.

Monetary policy shocks contribute 34-53 percent in the short run and 30 percent in the long

run. Money demand shocks explain 30-37 percent (of money variance) in the short run and

29 percent in the long run.

M onetary policy and foreign price shocks are the least indicators o f Zambian output.

Money demand shocks modestly boost output, underlying 14 percent (of its variances) in the

short run and 18 percent in the long run. Output variability is mainly associated with IS and

aggregate supply shocks, the former very pronounced in the short run (explaining 20-85

percent). The contribution o f aggregate supply shocks (to output variance) at 46 percent in the

short run rises to 100 percent in the long run.

Like money demand, the role of monetary policy shocks in consumer price is modest

and in the short run, explaining less than 20 percent (of its variance). Leading indicators of

Zam bias consumer price are aggregate supply shocks, underlying 39 percent (of its variance)

in the short run and 56 percent in the long run. Second in importance are exchange rate

shocks, contributing utmost 25-46 percent in the short run and 31 percent in the long run. The

role o f foreign shocks in domestic consumer price is mostly pronounced in the long run,

explaining utmost 13 percent o f its variance.

In the short run, the variance of real balances is mainly due to monetary policy and

aggregate supply shocks, the former explaining 20-44 percent and the latter 23-40

percent. In the long run, it is mainly due to monetary policy and modestly to IS and exchange

rate shocks.

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 T able 3.2: Percentage o f Forecast E rror E xplained by Shocks

Shocks
Money Money Aggre. Exch. Foreign
Variable Months Supply Demand IS Supply Rate Price

1 52.81 31.35 1.82 8.25 4.13 1.65

Money (0 .21 ) (0 .00 ) (0 .00 ) (0 .00 ) (0.05) (0 .00 )
6 55.93 26.63 1.46 6.66 7.99 1.33
(0 .20 ) (0.03) (0.03) (0.03) (0.03) (0.03)
12 33.65 36.06 5.05 13.22 7.21 4.81
(0 .21 ) (0.04) (0 .02 ) (0 .02 ) (0 .00 ) (0.03)
24 28.20 32.54 6.72 13.02 13.02 6.51
(0.23) (0.04) (0 .02 ) (0 .01 ) (0.03) (0.04)
36 29.95 28.80 7.37 11.98 14.98 6.91
(0.24) (0.05) (0.03) (0.03) (0 .02 ) (0 .02 )
48 30.81 27.25 6.40 14.22 15.40 5.92
(0.26) (0.06) (0.03) (0.04) (0 .02 ) (0 .02 )
72 30.09 28.94 6.25 13.89 15.05 5.79
(0.27) (0.05) (0.04) (0.03) (0 .02 ) (0 .02 )
1 2.84 3.13 85.29 5.69 1.91 1.14
Output (0 .02 ) (0 .02 ) (0.18) (0.03) (0 .01 ) (0 .01 )
6 1.61 16.13 32.25 32.26 14.52 3.23
(0 .01 ) (0.05) (0.16) (0.13) (0 . 12) (0 .01 )
12 1.44 14.39 28.78 35.97 12.23 7.19
(0 .01 ) (0.06) (0 . 11) (0.14) (0.03) (0 .02 )
24 2.30 11.49 25.28 48.28 6.90 5.75
(0 .01 ) (0.07) (0 . 11) (0.18) (0 .0 1 ) (0 .01 )
36 2.13 21.28 6.37 63.83 4.26 2.13
(0 .01 ) (0.07) (0.06) (0 .21 ) ( 0 .01 ) ( 0 .01 )
48 1.79 17.85 7.13 71.40 1.79 0.04
(0 .01 ) (0.05) (0 .02 ) (0 .22 ) (0 .01 ) (0 .01 )
72 1.75 17.54 7.03 70.18 1.75 1.75
(0 .01 ) (0.06) (0 .02 ) (0.24) (0 .01 ) (0 .01 )
Consumer 1 5.15 1.03 41.24 5.67 46.39 0.52
Price (0.03) (0 .01 ) (0.14) (0 .01 ) (0 .00 ) (0 .00 )
6 20.91 12.78 10.45 34.84 20.91 0.12
(0.04) (0.03) (0.06) ( 0 . 11) (0.08) (0 .02 )
12 13.95 16.74 4.46 39.06 25.67 0.11
(0.03) (0.04) (0 .01 ) (0 . 12) (0 . 10 ) (0 .01 )
24 4.55 11.69 7.79 40.26 27.27 8.44
(0 .0 1 ) (0.03) (0.03) (0.13) (0 . 11 ) (0.03)
36 0.17 0.23 6.97 52.24 28.73 11.67
(0 .0 1 ) (0 .01 ) (0.03) (0 . 12 ) (0 . 11 ) (0.04)
48 0.19 0.20 0.15 55.77 31.60 12.08
(0 .01 ) (0 .01 ) (0 .01 ) (0.14) (0 . 12 ) (0.04)
72 0.18 0.22 0.13 55.46 31.43 12.57
(0 .01 ) (0 .01 ) (0 .01 ) (0.13) (0.13) (0.05)

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 Table 3.2 C o n t....F o reca st E rror Explained by Shocks
Shocks
Months Money Money Aggre. Exch. Foreign
Variable Supply Demand IS Supply Rate Price
Real 1 43.78 16.21 20.42 0.20 19.14 0.25
balances (0.15) (0.04) (0.10) (0.11) (0.05) (0.00)
6 35.49 12.29 9.56 23.55 8.87 10.24
(0.16) (0.05) (0.09) (0.08) (0.06) (0.03)
12 20.07 10.03 11.15 40.13 9.48 9.14
(0.15) (0.04) (0.12) (0.01) (0.06) (0.04)
24 26.95 23.95 8.98 26.05 6.89 7.18
(0.13) (0.06) (0.07) (0.01) (0.03) (0.03)
36 30.67 27.61 14.11 7.36 12.88 7.37
(0.14) (0.05) (0.06) (0.12) (0.04) (0.02)
48 38.46 15.38 18.46 2.31 16.15 9.24
(0.14) (0.05) (0.07) (0.19) (0.05) (0.02)
72 43.94 8.79 20.21 1.41 17.57 8.08
(0.17) (0.04) (0.08) (0.20) (0.05) (0.03)
Exchange 1 4.21 0.10 0.11 0.14 84.21 11.23
rate (0.02) (0.01) (0.01) (0.01) (0.19) (0.08)
6 14.09 16.90 21.13 7.04 33.80 7.04
(0.04) (0.05) (0.05) (0.02) (0.18) (0.04)
12 3.91 17.19 31.25 8.59 25.00 14.06
(0.03) (0.04) (0.06) (0.02) (0.12) (0.05)
24 12.04 24.10 16.87 6.02 21.69 19.28
(0.04) (0.06) (0.05) (0.01) (0.11) (0.05)
36 17.86 10.71 9.52 21.43 21.43 19.05
(0.05) (0.04) (0.01) (0.05) (0.09) (0.05)
48 20.54 5.48 2.74 24.66 24.66 21.92
(0.00) (0.02) (0.01) (0.04) (0.09) (0.08)
72 21.51 3.07 2.79 25.14 25.14 22.35
(0.05) (0.01) (0.01) (0.06) (0.10) (0.07)
Interest rate 1 20.27 2.03 22.52 16.89 20.27 18.02
(0.07) (0.01) (0.05) (0.10) (0.06) (0.03)
6 23.82 11.90 21.43 35.71 2.38 4.76
(0.22) (0.03) (0.07) (0.11) (0.03) (0.02)
12 12.50 11.25 37.50 13.75 20.00 5.00
(0.14) (0.03) (0.09) (0.12) (0.04) (0.02)
24 53.19 10.64 21.28 5.32 6.38 3.19
(0.13) (0.02) (0.07) (0.03) (0.01) (0.01)
36 45.97 2.30 5.75 28.74 14.37 2.87
(0.16) (0.01) (0.02) (0.14) (0.02) (0.01)
48 32.77 9.84 8.20 34.84 12.30 2.05
(0.18) (0.02) (0.02) (0.15) (0.03) (0.01)
72 31.13 10.12 11.67 33.07 12.06 1.95
(0.19) (0.03) (0.03) (0.16) (0.03) (0.01)

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 T able 3.2 C o n t....F o reca st Error E xplained by Shocks
Shocks
Forecast Money Money Aggre. Exch. Foreign
Variable Horizon Supply Demand IS Supply Rate Price
Foreign 1 0.00 0.00 0.00 0.00 0.00 100.00
Price (0.00) (0.00) (0.00) (0.00) (0.00) (0.32)
6 0.05 0.09 0.24 0.08 0.12 99.42
(0.01) (0.01) (0.01) (0.01) (0.02) (0.31)
12 0.05 0.08 0.24 0.05 0.12 99.46
(0.02) (0.01) (0.01) (0.01) (0.02) (0.29)
24 0.05 0.09 0.23 0.06 0.33 99.24
(0.01) (0.02) (0.01) (0.01) (0.03) (0.28)
36 0.05 0.07 0.22 0.05 0.13 99.48
(0.01) (0.01) (0.02) (0.01) (0.02) (0.27)
48 0.05 0.07 0.09 0.14 0.14 99.51
(0.01) (0.02) (0.01) (0.01) (0.03) (0.29)
72 0.05 0.08 0.10 0.14 0.12 99.51
(0.01) (0.01) (0.01) (0.01) (0.01) (0.31)
Note: Aggre. Supply =Aggregate Supply; Exch. Rate =Exchange Rate

Utmost 21 percent o f exchange rate variance is associated with monetary policy

shocks. Like IS shocks, the role o f money demand shocks (in exchange rate behavior) is

mostly pronounced in the short run, accounting for up to 24 percent (of its variance). Other

leading indicators o f exchange rate are aggregate supply, exchange rate and foreign price

shocks, accounting for up to 25 percent, 84 percent and 22 percent (of its variance),

respectively.

The variance of interest rate is mainly explained by monetary policy and aggregate

supply shocks. In the short run, however, IS shocks are the driving forces, with money

demand and exchange rate shocks playing modest roles. Finally, variance in foreign price is

almost on account o f its own innovations.

3.5 Concluding Comments

This study shows that a small cointegrated SVAR model identified with

contemporaneous restrictions motivated from a rational expectation model, following Keating

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 (1990), is plausible strategy to analyze the monetary transmission in post-liberalization

Zambia. There are no interest rate, price and exchange rate puzzles, suggesting the model

specification correctly identifies monetary policy shocksinnovations to money supply. A

domestic monetary expansion generates a decrease in the nominal interest rate, a marginal

rise in output and a depreciated Kwacha/Rand exchange rate.

The estimated results are used to address questions posed at the outset. What is the

role o f money in the transmission process? What is the role o f monetary policy shocks in

exchange rate behavior? Does monetary policy respond to exchange rate shocks? What is the

impact o f foreign price shocks on the domestic economy? M onetary policy shocks have

relatively little impact on Zambian output. Output variability is mainly due to IS and

aggregate supply shocks, the former very pronounced in the short run. The role of monetary

policy in consumer price is only modestly pronounced and in the short run. The leading

indicators of Zambia consumer price are aggregate supply shocks. Second in importance are

exchange rate shocks. There is clear evidence that monetary policy in Zambia responds to

exchange rate shocks. In particular, the Bank o f Zambia tightens policy to curb anticipated

inflationary pressures, emanating from exchange rate shocks. South African price shocks

modestly influence Zam bias output and consumer price.

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 4.0 Summary

What are the research questions?

This dissertation examines the monetary policy transmission in post-liberalization

Zambia to address the following questions:

(1) What is the role of money in the monetary transmission process?

(2) How important are exchange rate shocks in CPI inflation?

(3) What is the role o f monetary policy shocks in exchange rate behavior?

(4) Does monetary policy respond to exchange rate shocks?

(5) What is the impact o f foreign price shocks on the domestic economy?

These questions are crucial to further understanding Zam bias monetary policy for

these considerations:

Question 1

Early 1990s, as part of the IMF stabilization program, Zambia adopted money growth

targeting to guide its conduct of monetary policy. During the early years o f this

regime, CPI inflation declined to unprecedented levels not seen in more than two

decades. Since 1997, however, the disinflation process seems to have stalled such

that in the past five years, CPI inflation has stuck within the 17-30 percent range.

Question 2

Early 1990s, there was a shift from fixed to flexible exchange rates. Whether

exchange rate shocks are important to inflation dynamics is of great empirical

interest, especially that the current account has remained in deficits over the years

and the exchange rate has consequently been under persistent pressure to depreciate.

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 Question 3

This is aimed at assessing the strength o f the exchange rate transmission channel.

Question 4

From time to time, Bank o f Zambia intervenes in the foreign exchange market. The

impact of such interventions, especially to dampen the anticipated price effects of

exchange rate shocks is yet to be established.

Question 5

Since Zambia is a small open economy, examining the impact o f foreign price

shocks, in this case, shocks emanating from South Africa, the countrys major source

o f consumption imports, is vital. We also test the theoretical prediction that if the

exchange rate freely adjusts immediately to reestablish purchasing power parity

(PPP), it insulates the domestic economy from foreign price shocks.

Because effective monetary policy implementation requires, inter alia, the monetary

authority developing a reasonably clear view o f the major shocks that influence the economy,

the study further investigates how the domestic economy responds to:

o domestic aggregate supply;

o IS

o money demand; and

o foreign interest rate shocks.

What is the strategy?

We address these questions by constructing two small structural empirical models o f

the Zambian economy. The sample period, 1992 to 2003, corresponds to a monetary targeting

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 regime. Monthly data are used. The variables are broad money stock, real balances, real

domestic output, domestic consumer price (CPI), domestic 3-month Treasury bill rate,

Kwacha/Rand exchange rate, South African CPI and South African Treasury bill rate.

Nominal money is included as the instrument variable o f the Bank o f Zambia. To this end, a

monetary policy shock is identified as innovation to money supply. South African variables

capture international influences.

With few exceptions, the characterization of the transmission process accords with

theoretical priors and with a number o f studies (e.g. Cushman and Zha (1997)). In particular,

there is no puzzle about the relationship between a monetary policy shock, interest rate and

exchange rate responses, suggesting the models correctly identify a monetary policy shock.

Further, both short- and long-run responses seem plausible for a small open economy.

Model 1: A Cointegrated SVAR Model: Long Run Restrictions

This model is based on an open economy IS-LM-AS scheme and identified by both

short run and long run restrictions. Cointegration analysis characterizes money supply,

domestic aggregate supply and foreign price shocks as permanent and money demand, IS,

exchange rate and foreign interest rate shocks as transitory. The permanent shocks are

identified following King et al. (1991). Contemporaneous restrictions are used to identify the

temporary shocks.

Impulse Responses

Money supply and real balances persistently rise, following a positive monetary

policy shock, identified as innovation to money supply. Indicating strong liquidity effects, the

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 nominal interest rate falls significantly for 12 months, inducing a temporary currency

depreciation. Output hardly increases on impact and within a year returns to its pre

shock value, satisfying the neutrality assumption. Consumer price rises significantly for 4

months. On impact, it is raised by 0.6 percent and after 4 months records the maximum

response o f 1.1 percent. Finally, in line with the small country assumption, foreign price and

interest rate hardly respond to this shock.

The impact of a positive aggregate supply shock has the expected sign, permanently

increasing output and reducing consumer price. On impact, domestic output increases by 0.27

percent and in the long run by 0.4 percent. Consumer price, which barely

falls on impact records the peak response of 3.5 percent 15 months later. In the long run,

consumer price is reduced by approximately 2 percent. Following this shock,

money supply persistently rises, suggesting that a beneficial supply shock induces

commercial banks to make more loans (Keating (2000)). A persistent fall in nominal

domestic interest rate is recorded, causing a currency depreciation that is initially significant.

Real balances are permanently raised significantly over 9 months. Finally, foreign variables

hardly and temporarily respond to this shock.

How variables respond to an IS shock is summarized as follows. First, output rises

significantly over 20 months. Second, the nominal interest rate rises (significantly for 8

months), causing a significant currency appreciation over a short period. Third, consumer

price rises significantly recording the maximum response of 1.3 percent after 6 months.

Fourth, higher interest rate is accompanied by lower nominal and real balances. Fifth, like all

domestic shocks, the impact of this shock on foreign variables is unnoticeable.

In response to a money demand shock, real and nominal balances significantly rise

for over a year. Domestic interest rate also rises significantly for 4 months. Output rises

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 significantly over 8 months, despite higher interest rate. This result, however, is similar to

that in Gali (1992), who argues that output is raised because money demand shock is a

demand shock. This shock increases consumer price, registering the peak response o f 3.8

percent 8 months later. Consistent with developments in interest rate, domestic currency

appreciates significantly for 6 months. Finally, as expected the effects of this shock diminish

over time.

Virtually all impulse responses correspond with the predicted effects of an exchange

rate shock. A positive exchange shock temporarily depreciates the nominal exchange rate

significantly for about a year. In response, output and consumer price increase. Output, which

barely rises on impact, registers the maximum response o f 2.5 percent within 6 months. On

impact, consumer price rises by 0.43 percent and 4 months later attains the peak response o f 4

percent. The effects o f this shock on both output and consumer price completely diminish

within 3 years. This shock causes a temporary fall in money supply and an increase in

nominal interest rate, suggesting monetary tightening to dampen the anticipated price effects.

A transitory fall in real balances is also recorded. Not surprising, foreign variables barely

respond to this shock.

Both foreign price and foreign interest rate rise following a positive foreign price

shock. We observe developments in foreign variables, in part, transmitted to the domestic

economy through exchange rate. The domestic currency depreciates, raising consumer price

by a maximum o f 0.85 percent after 3 months and by 0.6 percent in the long run. Lower

money supply and thereby higher domestic interest rate is the reported monetary policy

response. By construction, real balances fall. Since some imports are inputs into production,

the resulting higher production costs lowers domestic output significantly for about a year.

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 On impact, output declines by 0.06 percent and after 10 months records the maximum

response o f 0 .1 2 percent.

Figure 2.11 summarizes responses to a foreign interest rate shock. First, in line with

the identification strategy, the effects o f this shock is transitory. Second, foreign interest rate

significantly rises for 6 months, decreasing foreign price. Third, domestic output is raised, in

part, on account of increased net exports induced by lower import prices. Specifically, output,

which barely increases on impact, registers the maximum response of 0.11 percent in the

7th month. This output response combined with the loss in external value o f domestic

currency exerts upward pressure on the domestic consumer price.

Variance Decompositions

In the short run (i.e. 12 months), money variance is dominated by both monetary

policy and money demand shocks, accounting for 11-36 percent and 30-65 percent,

respectively. In the long run money, its variance is mainly due to monetary policy shocks.

The key implication o f this result is that some of the observed variation in money stock is

endogenous, as one would expect.

Unanticipated domestic monetary policy hardly impact Zambian output, contributing

less than 10 percent (of its variance). Much of output fluctuations are attributable to aggregate

supply shocks, accounting for 40 percent in the short run and 82 percent in the long run (i.e.

beyond 60 months). IS shocks turn out to be the most important demand factor for the

business cycle, underlying utmost 32 percent (of output variance). Money demand shocks

also modestly boost short-run output, contributing utmost 20 percent. The role of foreign

price in output is modestly pronounced in the long run, accounting for 15 percent (o f its

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 variance). Consistent with impulse responses, South African interest rate shocks barely

explain Zam bias output.

Zam bias consumer price is mainly driven by aggregate supply, money demand and

exchange rate shocks in the short run, contributing up to 32 percent (of its variance), 41

percent and 34 percent, respectively. At longer horizons, it is mainly due to aggregate supply

shocks and modestly to foreign price shocks. Shocks to South Africas interest rate are the

least indicators o f consumer price in this small Sub-Saharan nation.

The role of money demand shocks in the variance of real balances is only very

pronounced in the short run, underlying utmost 36 percent. Modestly important in the short

run are aggregate supply and exchange rate shocks, each explaining up to 15 percent. Overall,

the leading indicators o f real balances are monetary policy shocks, explaining utmost 25

percent in the short run and 80 percent in the long run.

In the short run, the variance of interest rate is mainly due to IS and monetary policy

shocks, underlying utmost 33 percent and 31 percent, respectively. In the long run, it is

mainly due to aggregate supply shocks and modestly to foreign price shocks.

We find exchange rate, aggregate supply, monetary policy and money demand shocks the

main determinants o f nominal exchange rate in the short run. Exchange rate shocks contribute

up to 51 percent (to its movement), aggregate supply shocks, 18 percent, monetary policy

shocks, 21 percent and money demand shock, 19 percent. Developments in long-run

exchange rate are mainly explained by aggregate supply and foreign price shocks, each

accounting for about 50 percent of its variance. Finally, the variances o f both foreign price

and foreign interest rate are mainly associated with foreign price shocks.

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 Model 2: A Rational Expectation SVAR Model

In this model, a small open rational expectation macro model motivates the

identifying assumptions. A three-step approach is used to estimate the structural model. First,

the cointegrated VAR model is estimated to obtain the coefficients and residuals. Second,

using the residuals, the contemporaneous structural parameters are estimated by the

instrumental variable (IV) approach. Third, impulse responses and variance decompositions

are computed.

Impulse Responses

The sharp increase (3.2 percent) in the money stock is accompanied by a significant

fall (about 1.2 basis points) in the nominal interest rate, a significant rise in real balances that

lasts 10 months. Despite a marginal rise in output, consumer price reacts significantly over 10

months, reaching the peak increase o f 2 percent 6 months later. Surprise monetary policy

depreciates the nominal exchange rate whereas foreign price hardly responds.

A one standard deviation positive aggregate supply shock significantly raises output

and reduces consumer price. Output, which barely rises on impact, attains the maximum

response of 0.6 percent 10 months later. Consumer price falls significantly over 20 months.

We notice the peak response of consumer price is approximately 4 percent recorded after 8

months. In the long run, output rises by 0.5 percent and consumer price falls by 2 percent.

This shock leads to a rise in real balances. Money supply also rises, suggesting that in the

short run, it is primarily driven by commercial banks (Keating (2000)). In line with

development in money, the nominal interest rate falls, inducing currency depreciation that is

initially significant.

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 A positive IS shock causes higher nominal interest rate, lower money supply and

appreciated domestic currency. The effects of this shock on output and consumer price are

fast and strong. Initially, output increases by 0.3 percent and 14 months later records the

maximum response o f approximately 0.4 percent. On impact, consumer price increases by

0.11 percent and 12 months later registers the maximum response o f 3.5 percent. Real

balances fall too.

Higher real balances and nominal interest rate follow a one standard deviation

positive shock to money demand. As this is considered a demand shock, output also rises,

attaining the peak response o f 0.2 percent after 10 months. Consumer price reacts

significantly over 10 months. On impact, it hardly rises and after 8 months, reaches the peak

response o f 2 percent. Domestic currency appreciates, in part, due to higher interest rate.

Finally, like other domestic shocks, foreign price hardly responds to this shock.

The main consequences o f a positive exchange rate shock are summarized as follows.

First, nominal exchange rate strongly depreciates. Second, consumer price increases by 0.9

percent on impact and 12 months later records the maximum response of close to 2.3 percent.

Third, output also rises significantly over 8 months. Fourth, money supply falls and interest

rate rises, implying that the Zambian monetary authority adopts a tight policy stance to

dampen the price effects o f this shock. Fourth, real balances fall sharply.

A positive foreign price shock immediately raises South African consumer price . We

notice the effects of this shock, in part, transmitted to the domestic economy through

exchange rate. The nominal exchange rate depreciates significantly over 4 months. This is

plausible since the foreign monetary authority raises interest rate, following the rise in price.

Higher interest rate abroad, in turn, places downward pressure on the external value of the

domestic currency. Consumer price barely rises on impact. Domestic output marginally falls,

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 as higher import costs lower net exports. Money supply falls, implying tight policy stance to

mitigate the price effects o f this shock. Finally, real balances fall.

Variance Decompositions

Much of money variance is due to monetary policy and money demand shocks.

Monetary policy shocks contribute 34-53 percent in the short run (i.e. 12 months) and 30

percent in the long run (i.e. beyond 60 months) Money demand shocks explain 30-37 percent

(of money variance) in the short run and 29 percent in the long run.

Monetary policy and foreign price shocks are the least indicators o f Zambian output.

Money demand shocks modestly boost output, underlying 14 percent (of its variances) in the

short run and 18 percent in the long run. Output variability is mainly associated with IS and

aggregate supply shocks, the former very pronounced in the short run (explaining 20-85

percent). The contribution o f aggregate supply shocks (to output variance) at 46 percent in the

short run rises to 100 percent in the long run.

Like money demand, the role of monetary policy shocks in consumer price is modest

and in the short run, explaining less than 20 percent (of its variance). Leading indicators of

Zambias consumer price are aggregate supply shocks, underlying 39 percent (of its variance)

in the short run and 56 percent in the long run. Second in importance are exchange rate

shocks, contributing utmost 25-46 percent in the short run and 31 percent in the long run. The

role of foreign shocks in domestic consumer price is mostly pronounced in the long run,

explaining utmost 13 percent of its variance.

In the short run, the variance o f real balances is mainly due to monetary policy and

aggregate supply shocks, the former explaining 20-44 percent and the latter 23-40

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 percent. In the long run, it is mainly due to monetary policy and modestly to IS and exchange

rate shocks.

Utmost 21 percent of exchange rate variance is associated with monetary policy

shocks. Like IS shocks, the role o f money demand shocks (in exchange rate behavior) is

mostly pronounced in the short run, accounting for up to 24 percent (of its variance). Other

leading indicators o f exchange rate are aggregate supply, exchange rate and foreign price

shocks, accounting for up to 25 percent, 84 percent and 22 percent (of its variance),

respectively.

The variance o f interest rate is mainly explained by monetary policy and aggregate

supply shocks. In the short run, however, IS shocks are the driving forces, with money

demand and exchange rate shocks playing modest roles. Finally, variance in foreign price is

almost on account o f its own innovations.

What are the answers to the research questions?

The foregoing empirical results lead to the following consensus.

Questions 1 and 2

The impact o f monetary policy shocks on output is temporary and marginal. Output is

mainly due to aggregate supply shocks. IS, money demand, exchange rate and foreign

price shocks also modestly boost short run output. Consumer price is mainly driven by

aggregate supply and exchange rate shocks. This suggests, aggregate supply and

exchange rate shocks to be the leading indicators of CPI inflation.

Question 3

Monetary policy shocks have a modest role in exchange rate behavior.

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 Question 4

There is clear evidence Zam bias monetary policy responds to exchange rate shocks.

An exchange rate shock is accompanied by a fall in money supply and an increase in

nominal interest rate, suggesting monetary tightening to dampen the anticipated price

effects.

Question 5

Foreign price shocks modestly impact exchange rate, domestic consumer price and

output.

What are the contributions to the literature?

Overall, this study adds to the growing literature on modeling monetary policy in Sub

Saharan Africa (e.g. Ating-ego (2000)).

Though there have been previous SVAR studies on Zam bias monetary policy (e.g.

Mwansa (1998) and Simatele (2004)), this is the first attempt to apply the

cointegrated SVAR fram ew ork.

This study also applies the rational expectation SVAR modeling strategy, to my

knowledge, for the first time to a developing economy context.

The study furthers our understanding o f Zam bias monetary policy, offering key

policy implications for the monetary targeting stabilization policy.

o A positive monetary policy leads to a sharp and persistent rise in money

supply. But this not is followed by a strong consumer price response. Though

money demand is stable, money demand shocks only have a modest role in

consumer price. Are these results in line with the hypothesis of stabilization

policy advanced in Friedman and Kuttner (1996), which implies that money

has lost its predictive context not because the central bank has abandoned the

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 attempt to stabilize the economy but because it has largely succeeded in

doing so? No, reducing inflation further, especially to single digits has been

problematic recently. This may be due to the weakened strength of the link

between the intermediate target, monetary aggregate, and inflation, giving

rise to situations where getting the monetary target does not produce the

desired inflation outcome, where monetary aggregates fail to produce reliable

signals of the stance of monetary policy, and where there is no effective

anchor for inflation expectations,

o Another policy lesson is that since consumer price is mainly due to aggregate

supply and exchange rate shocks in the long run, the share o f food price in

CPI is the largest, achieving and sustaining lower inflation, will largely

depend on policies meant to increasing food supply, besides stabilizing the

exchange rate.

Future Research

In view o f these concerns with monetary targeting, examining whether an interest

rate based-rule could be more robust in guiding Zambias monetary policy remains an

important topic o f future research.

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