Journal of Business Management and Economics 3: 9 September (2015).

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JOURNAL OF BUSINESS MANAGEMENT AND ECONOMICS

Homepage: http://innovativejournal.in/jbme/index.php/jbme

Assessing Nonlinear Dynamics of Central Bank Reaction Function: The Case of MENA
Countries
Yosra Baaziz
E-Mail: yosrabaaziz1451@yahoo.fr
DOI: http://dx.doi.org/10.15520/jbme.2015.vol3.iss9.145.pp13-21
Abstract: Empirical evidence suggests that the Taylor rule describing the interest rate setting behavior of four keyMENA central banks (Tunisia,
Egypt, Jordon and Morocco) is non-linear. This is achieved using an empirical framework that allows for regime change over time or more
specifically the time variance in the model parameters.
Using quarterly data from 2000:Q2 to 2014:Q3 to analyze the movement of nominal short-term interest rate of MENA central banks, we find
strong evidence that the real decision-making process followed by these central banks varies from one central bank to another and that it exhibits
nonlinearity. In particular, considerations about economic growth (for Morocco), inflation (for Jordon), stability of REER rate (in Egypt) and
concerns about hitting the zero lower bound of the nominal interest rate (in the cases of Tunisia) seem to be the major drivers of such nonlinear
pattern of monetary policy.

Keywords: monetary policy, MENA central banks, nonlinear Taylor rule.

INTRODUCTION more complex price-setting behavior than those subsumed a

The conventional framework for analyzing monetary policy
rule is mainly established under the assumption that Central
Bank handle in a linear manner interest rate setting. The
theoretical underpinning of this linear policy rule is the
linear-quadratic (L.Q) framework, stemming from the
combination of a linear economic structure and a symmetric
objective preferences of the policymaker. This combination
leads to a linear reaction function. The Taylor rule is
probably the most recognized features of this literature.
After Taylor’s 1993 seminal work, a variants of Taylor-type
regressions have been applied extensively in order to
understand and model the behavior of monetary policy for
many countries. Some Taylor Rule–type equations include a
lagged value of interest rate as an additional explanatory
variable. This process called “inertia” or “gradualism” tend
to move policy rate in a series of small a moderate steps.
[Clarida et al, 1998]. Others augmented version of the linear
Taylor rule enclose other indicators in the conduction
mechanism of monetary policy. In this vein, Svensson
(2003) proposes an extension of the Taylor rule by
incorporating the exchange rate in a rule designed for small
open economies. His conclusion is in line with that of Batini
et al (2001) who show that the descriptive power of the
Taylor rule augmented by the exchange rate variable is
higher than the standard Taylor rule for small open
economies (i.e. UK).
A common feature of the above specifications of the Taylor
rule is that they are linear specifications. However, as cited
above the cogency of such rulesisthat policymakerstend to
treat, symmetrically and with the same magnitude,
deviations (either positive or negative) of the objective
variables from their pre-determined target valuesand that the
aggregate supply or Phillips curve is linear. But, in reality, it
might not be the case; monetary authorities mayhave
asymmetric preferences, and the Phillips curve may reflect
linear specification.
There is a growing literature that relax the quadratic
preference assumption of the central bank and adopt instead
asymmetric preference specification [Nobayand Peel (2003),
Ruge-Murcia (2003), Dolado, Maria-Dolores andRuge-
Murcia (2005), Karagedik and Lees (2004), Surico (2007),
Cukierman and Muscatelli (2008)…].
The not quadratic (asymmetric) preferences imply that the
Central Bank is assigning different weight to upwards and
downwards deviations of aggregates from their expected
values in its loss function. In contrast, what is important in a
quadratic loss function is especially magnitude of deviation
and not its sign. Which means that the Central Bankers put
equal weights on positive and negative deviations of key
macroeconomic variables such as inflation and output from
their target values.
It is also possible that the Phillips Curve can assume many
forms apart from linearity. Such nonlinearity of the Phillips
Curve (PC) implies that the cost of decreasing inflation
would not be the same in a recession and in an expansion.
Often the Phillips Curve seems to be convex, when the
economy is in a recession, further decrease of the economic
activity do not produce much disinflation (the costs
associated with fighting inflation is high). Schalin g (1999),
Nobay and Peel (2000), Dolado et al (2004-2005) among
others provide some evidence for the relevance of
nonlinearity in the Phillips Curve.
To be effective, allowing for nonlinear dynamics can offer a
more realistic specification of the Taylor reaction function
and improves the explanatory power of a dynamic pattern of
central bank reaction functions during macroeconomic
turbulence.While the unawareness of such possible
nonlinearity response may bias the results and lead to
fallacious policy implications.

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 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,
Consequently, this gives Central Bank impetus to reconsider
their monetary policy frameworkin view of specific
circumstances, such as shocks.In addition, most recent
studies focused on nonlinear Taylor rules are limited to
industrialized countries, especially the US (Conrad and Eife,
2012; Lee and Son, 2013; Olsen et al., 2012), the UK, ECB,
Japan and Canada (KempaandWilde, 2011; Kolman, 2013).
In this respect, the aim of this paper is to investigate more
in-depth the possible presences of nonlinear dynamics using
the Smooth Transition Regression (STR) methodology
advocated by Granger and Terasvirta (1993).We established
to that purpose a list offour MENA countries presenting a
great similarity in terms of economic structure, who are,
Tunisia, Egypt, Jordan and Morocco.
The road map of the paper is as follow. Section 2 describes
the econometric methodology. In section 3, we present our
dataset and we review the empirical result. The final section
concludes.
ECONOMETRIC METHODOLOGY
A Taylor Rule-type equation have shown to be a useful
formulation of monetary policy to understand, in simple
terms, the interest rate setting behavior of Central Bank
across the world. Its original form can be specified as
follows:
𝑖𝑖𝑡𝑡 = 𝑟𝑟̅𝑡𝑡 + 𝜋𝜋 ∗ + 𝑏𝑏𝜋𝜋 (𝜋𝜋𝑡𝑡 − 𝜋𝜋 ∗ ) + 𝑏𝑏𝑦𝑦 (𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡∗ ) (1)
𝑖𝑖 𝑡𝑡 represents the nominal short term interest rate, and
𝑟𝑟̅𝑡𝑡 represents the equilibrium real interest rate.
𝜋𝜋𝑡𝑡 is the inflation rate at time t calculated from the consumer
price index (CPI), reflecting cost of acquiring a fixed basket
of goods and services by an average consumer. (𝑦𝑦𝑡𝑡 −
𝑦𝑦𝑡𝑡∗ )refers to the output gap, defined as the difference
between actual output and potential output, which is
measured using the Hodrick–Prescott (1997)'s filter.
𝑏𝑏𝜋𝜋 indicates the sensitivity of the interest rate policy to
deviations of inflation from its target. 𝑏𝑏𝑦𝑦 represents the
coefficient of the reaction of the central bank to the output
gap.
The rule recommends that short-term interest rate should
rise if inflation 𝜋𝜋𝑡𝑡 rise above its predetermined target or if
output 𝑦𝑦𝑡𝑡 increase above its potential level 𝑦𝑦𝑡𝑡∗ .
In equilibrium, the deviation of inflation and output from
their target values is zero and, therefore, the nominal short
term interest rate 𝑖𝑖𝑡𝑡 is the sum of the equilibrium real rate
𝑟𝑟̅𝑡𝑡 plus the target value of inflation.
Some studies extend this linear rule by considering the
effect of additional variables in the conduct of monetary
policy. Following Clarida et al (1998) andRudebush (2002)
among others, we augment the baseline specification by
introducing the lagged interest rate that takes into account
the inertia of monetary policy.
Clarida et al (1998) find that the interest rate smoothing
parameter enters significantly in the Taylor rule. In fact, the
reason of doing so is mainly due to fear to disturbing capital
markets which are too sensitive to policy changes and could
create financial instability via investors herding behavior, or
14
the need to build consensus to support a policy change. We
also augment the conventional Taylor rule by the real
exchange rate (REER). Similarly, Svensson (2003) proposes
an extension of the Taylor rule by incorporating the
exchange rate in a rule designed for small open economies.
His conclusion is in line with that of Batini et al (2001) who
shows that the descriptive power of the Taylor rule
augmented by the exchange rate is higher than the standard
Taylor rule for small open economies (i.e: UK).
There are several reasons to include the REER in the MENA
reaction function. The constant real effective exchange rate
rule provides a buffer against shocks and helps to reduce
volatility in interest rate. This policy is partly out of
concerns for the international competitiveness of MENA
manufacturing exports and in particular for a rise in the
index implies a fall in competitiveness and vice versa.
When dealing with capital flows the authorities confront a
trade-off between currency appreciation and depreciation.
The former has a negative impact of the competitiveness of
exports while depreciation induces losses to MENA central
banksby increasing the country massive debt burden, which
is reflected in a higher debt service.
Thus, the concept of REER goes beyond the weighted
average of currencies to greater significance forMENA
policymakers where sectors are expected to contribute more
to the growth of the economy. Indeed, many researchers
argue that real effective exchange rate has important effects
not only on the general economic performance of a country
and its international competitiveness but also on the
different sectors of the economy.
Given the importance of exchange rate especially in the
context of a small open economy, it is widely agreed to
introduce it as an explanatory variable in the Taylor rule. To
sum up, the inclusion of the REER is consistent with the
objectives of MENA central banksin terms of maintaining
price stability.
The model thus becomes:
𝑖𝑖𝑡𝑡 = 𝑟𝑟̅𝑡𝑡 + 𝜋𝜋 ∗ + 𝜌𝜌𝑖𝑖𝑡𝑡−1 + 𝑏𝑏𝜋𝜋 (𝜋𝜋𝑡𝑡 − 𝜋𝜋 ∗ ) + 𝑏𝑏𝑦𝑦 (𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡∗ ) +
𝑏𝑏𝑞𝑞 𝑞𝑞𝑡𝑡 + 𝑢𝑢2.𝑡𝑡 (2)
qt refers to the REER. bq is the coefficient of reaction of the
Central Bank to change in REER and ρ measures the
degree of interest rate smoothing.
Indeed, in a context dominated by uncertainty, the evolution
of monetary policy setting over longer period is structurally
unstable. The failure to take into account these changes may
bias the results. This opens the way to seek alternative
policy rules that can provide better results even through
macroeconomic structural changes occur continuously
and/or the central bank has imperfect knowledge of the
dynamic of the economy. Therefore, the recent literature
tries to take nonlinearity into account.
To explain this nonlinear behavior, the common solutions
used in the literature are the Markov-switching (MS) model
and the smooth transition regression (STR)
model.Moreover, the STR models have several advantages
over the Markov-switching regime models by allowing
gradual evolution of the model’s coefficients and do not
impose restrictions on the way parameters vary over time. If
 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,

a linear functional form were correct, the STR would
exclude nonlinear effects and the linear specification
outperforms the nonlinear one. Instead, if some nonlinearity
exists, the STR technique allows one to choose both the
appropriate switching variable and type of the transition
function without entailing restrictions on the speed, the
intensity and the persistence of the changes.Consequently,
we follow the STR approach in the current paper.
shows that this identification problem can be circumvented
by approximating the transition function with a third Taylor
expansion around γ = 0 . After reparametrization and
rearrangement the approximation yields the following
regression:
~ ~ ~ ~
it = δ 0 + δ ' Z t + β 1' Z t S t + β 2' Z t S t2 + β 3' Z t S t3 + v t
(3)

Following the work of Teräsvirta(1998), the standard two- Accordingly, the null hypothesis of linearity becomes:
regime LSTRfor a nonlinear Taylor rule could be derived as β 1' = β 2' = β 3' = 0 and a LM-type test with F-
follows:
distribution is used to test this null hypothesis of linearity.
it = ϕZ t + θZ t G (γ , c, St ) + ut ,t=1,…, T(2) Teräsvirta (1998) suggests a linearity test for each candidate
 γ k  transition variable. In terms of this approach, the variable
k ∏ t
where G ( γ , c , St ) = ( 1 + exp− ( S − c ) )− 1 with γ > 0 . with the lowest p-value (strongest rejection of linearity) is
 σ S t k = 1  chosen as the transition variable.
Once the linearity is rejected against LSTR-type
Z t = ( w't , x't ) is a vector of regressors including the nonlinearity we follow Teräsvirtaet al (2004) and consider
exogenous xt = (1, x1t ,..., xkt )
variables, and lagged the following three tests:
0 0
dependent variable, wt = ( yt −1 ,..., yt − p ) . H 02 : β 3 = 0 , H 03 : β 2 = = 0 and H 04 : β 1 = = β3 =
β3 β2
The vectors ϕ = ( ϕ 0 ,ϕ 1 ,...,ϕ n ) , θ = ( θ 0 ,θ 1 ,...,θ m ) The above test statistics are labeled F2 , F3 and F4 ,
represent (( n + 1 ) * 1 ) and (( m + 1 ) * 1 ) parameter respectively and are used to determine the number of
regime shifts among LSTR1 and LSTR2. The decision rule
vectors in the linear and nonlinear parts of the model,
respectively. is that the LSTR1 is chosen if the p-value of H 04 or H 02
is the lowest. Conversely, the LSTR2 is selected if the p-
The disturbance term is iid with zero mean and constant
value of H 03 is the lowest.
variance, ut → iidN (θ , σ ) .
2

G ( γ , c , S t ) is the transition function bounded by 0 and 1, The chosen model can then be estimated and evaluated as
outlined in Eitreheim and Teräsvirta (1996). Several
and depends upon the transition variable S t , the slope misspecification tests are used in the STR literature, such as
parameter γ and the location parameter c . test of no remaining nonlinearity, no residual autocorrelation
and parameter constancy. These tests will be carried out in
In terms of the above equation, the transition variable the empirical section.
increases in tandem with the logistic function. VanDijk et al.
ESTIMATION RESULTS
(2002)demonstrate that as St → 0 (or ∞) , the transition
function becomes abrupt, such that the model becomes Data Description:
indistinguishable from the linear autoregressive model. As we detail in the introduction, our empirical analysis
focuses on MENA countries: Tunisia, Egypt, Jordan and
Teräsvirta (1994) proposes some procedures to build an STR Morocco.
model; these include linearity test, estimation and evaluation Our data set includes quarterly observations, obtained from
of the model. A linearity test is performed for the purpose of Datastream, available from the countries under examination
choosing the appropriate transition variable S t and the most for the interest rate, inflation, industrial production and the
suitable form of the transition function among LSTR1 (with REER.
a single transition variable), LSTR2 (with two transition The sample periods differ slightly across countriesand
variables) and ESTR. In fact, the null hypothesis of linearity covers the period2000. Q2→2014.Q3.
can be formulated as follows: The table1 provides a detailed description of Sample size
used in the analysis.
The null hypothesis of linearity consists in testing Table 1 : Sample size
H 0 : θ = 0 in Equation (2) against the alternative Country Obs Sampleperiod
hypothesis of nonlinearity: H1 : θ ≠ 0 . Tunisia 39 2004. Q4→2014.Q3
Jordan 57 2000. Q2→2014.Q3
Luukkonen et al. (1988) argue that testing for linearity is not
Morocco 24 2008. Q4→2014.Q2
a straightforward task, due to the fact that the model is only
identified under the alternative of nonlinearity. In particular, Egypt 44 2002. Q3→2013.Q2

the parameters c and θ are nuisance parameters and are

not present under the null of linearity. Teräsvirta (1998)

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 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,

Unit-root test: stationarity for inflation, REER and interest rate series for
In order to examine the time-series properties of our data we Tunisia, Jordan and Morocco respectively. That means these
conduct panel unit root tests. Then, on the basis of the series have an unit root problem. Except for output
results reported in table 2, it appears Augmented Dickey- gap,which was found to be stationary in level in all counties.
Fuller test cannot reject the null hypothesis of non There is no need to difference them when estimating.
Table 2: Unit Root Test Statistics

Test Statistic
Tunisia Jordan Morocco Egypt

Output-gap ADF -4.5908*** -4.1225*** -3.423*** -3.5878***

KPSS 0.0712*** 0.0332*** 0.0676*** 0.046***
Inflation ADF -0.4352 -9.8435*** -2.5039*** -0.7317
KPSS 1.2257 0.1232*** 0.2638*** 0.8652
REER ADF -2.4265*** 0.4556 -0.5666 -1.7799***
KPSS 0.5108* 0.4932* 0.6411 0. 312***
Interest rate ADF -1.6906* -1.9445* -0.8577 -1.8692*
KPSS 0.727* 0.1779* 0.7906 0.288***

Note:This table reports the results of ADF and
KPSSstationarity tests. it, πt, yt and qtstand for interest rate,
inflation rate, output gap and exchange rate, respectively.
1% , 5% and 10% Critical values for the ADF test are -2.56 ,
-1.94 and -1.62whereas those of the KPSS test are
0.347,0.463 and 0.739, respectively. ***,** and * indicate
significance at the 1%, 5% and 10% significance levels
respectively.
After examining time properties of different series, we now
turn to the methodology.
Empirical Results:
The evidence from the estimation of the nonlinear monetary
rules is presented in Table 3.
The results for Tunisia, Egypt, Jordan and Morocco are
reported in Columns 1 to 4, respectively, while Figure 1
plots the estimated transition functions and provides
evidence that it is possible to characterize the behavior of
MENA central banks as a two-state Taylor rule.
In general, results are robust in challenging the assumption
of linearity that prevailed the previous studies of these
economies and indicate that the monetary policy followed
by theseMENA Central Banks can best be modelled in a
non-linear fashion.
REER seems to be the major determinant of the change in
the conduct of Egyptianmonetary policy.Finally, for
Morocco, the threshold variable is the output-gap.
In all cases, the selected transition variable provides the
lowest p-value of the computed F-statistics for the rejection
of the null hypothesis of linearity. Thus, the parameter set
changes whenever theseselected transition variables drop
below or rise above some threshold value.Our results
confirm once again our suggestions regarding the
heterogeneity associated with theseMENA countries.
The test for the choice of the transition function is also
presented in the table3; it indicates that an LSTR1 model fits
better the monetary policy conduct for MENA central banks.
This model is often used to capture the asymmetric behavior
of the business cycle in the sensethat booms and busts are
characterized by different dynamics [Teräsvirta and
Anderson, 1992].
By looking at the estimated transition functions, a stronger
response regime takes place when the output gap is positive,
in the cases of Morocco, when the inflation rate is above the
threshold level, for Jordan, when there is a large rise in the
REER rate forEgypt and when the past interest rate
increases beyond the threshold value for Tunisia.

In practice, linearity was tested for several transition
variables for each country under consideration. Our findings
show that there is strong evidence against the linear
specification of the Taylor rule and that the past interest rate
is likely to be responsible for nonlinear behavior of
BCT.While for Jordan,the threshold variable is inflation.The
Table 3 confirms our conjectures; the estimates clearly
reveal the existence of two regimes. It clearly shows the
ex²istence of a special regime that applies only to unusual
economic conditions, in response to which central banks
change their usual policy conduct.

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 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,
Figure 1: Transition Functions for Tunisia, Egypt, Morocco and Jordan
The empirical evidence strongly corroborate the idea of a
nonlinear formulation of the monetary policy rule as both
the transition speed (𝜆𝜆) and the threshold parameter (c) are
statistically significant for all MENA countries included in
our sample.
For Tunisia,The empirical work that is presented in Table 3
clearly shows that the monetary policy followed by the BCT
can be described by a nonlinear Taylor ruleand concerns
about hitting the zero lower bound of the nominal interest
rate seem to be the major determinant of the change in the
conduct of monetary policy across regimes. In particular,
when the lagged interest rateis above the target level of
4.4028%, monetary policy enters the liquidity trap regime
where the policy instrument does not respond in the usual
way to its determinants.These special regimes require
disconnection from the automatic pilot rule of the Central
Bank and policymakers should extensively use their
judgments to make decision.
17
This is consistent with Bruggemann and Riedel (2011) and
Alcidi et al (2011) identification of transition variable. They
identify and use the lagged interest rate as a threshold
variable. Thus the switching between regimes is controlled
by concerns about hitting the zero lower bound of the
nominal interest rate where policy instrument does not
respond in the usual way to its determinants.
Tunisia is not excluded as its economy was also mired in a
slump especially after the revolution of 2011. The first post
revolution days were characterized by simultaneous sharp
drops in demand and supply, accompanied by serious
disturbances in the production system (sit-in, social unrest
with strikes). Similarly, this period was marked by a sharp
decline in foreign currency assets, down under the combined
effect of the fall in the number of tourists visiting the
country and exports of phosphates.
 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,

Table 3: Nonlinear monetary policy rules: Evidence for the MENA central banks (Tunisia, Jordan, Morocco and Egypt)

Tunisia Jordan Morocco Egypt

Linear part

Constant 4.59095*** 0.366 4.9418*** 5.75043**

[1.8673] [0.3612] [0.000] [3.5105]

Inflation 0.5332** 0.037 0.1033 0.775***

[0.1572] [0.066] [0.0687] [0.234]

Output-gap 0.02381** 0.0164*** -0.10424*** 0.0721***

[0.0168] [0.008] [0.2186] [0.0369]

REER -0.0746*** -0.0139 0.0985* -0.1276**

[0.03] [0.0349] [2.062] [0.024]

Interest rate (t-1) 1.552*** 0.873*** 0.395* 0.6662***

[0.4473] [0.0645] [0.4021] [0.2143]

Nonlinear part

Constant -5.0472*** 0.0438 5.354* -4.6947

[1.8968] [0.61] [3.4078] [3.6625]

Inflation 0.53201 0.325** 0.508 0.608***

[72.4067] [0.0358] [0.2509] [0.249]

Output-gap -0.0108 0.0185*** 0.72449** 0.07506***

[0.0177] [0.0215] [0.2071] [0.0196]

REER 0.08502*** -0.01952*** -0.3828** 0.1784***

[0.0306] [0.0251] [0.0549] [0.044]

Interest rate (t-1) 0.839*** 0.10204 0.588*** 0.3725*

[0.4549] [0.61] [0.000] [0.2218]

c 4.4028*** 3.7997*** [0.00] -3.4317*** 110.7319***

[0.0686] [0.00] [0.022]

𝜸𝜸 8.133* 10.00** 0.5*** 10.00*

[45.77] [1.0395] [0.1079] [0.326]

𝑆𝑆𝑡𝑡 Interest rate (t- Inflation Output-gap REER

1)

𝑨𝑨𝑨𝑨𝑨𝑨 -3.305 -1.93 -6.5168 -1.663

𝑅𝑅2 94.68 94.98 87.71 82.74

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴(8) 16.3528 5.3506 (0.7195) 8.6587 (0.3719) 3.136 (0.9255)

(0.0376)

𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽 − 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 33.4632 (0.00) 0.7312 (0.6938) 0.6795 (0.712) 25.414 (0.00)

Note: This table reports the estimates of the nonlinear Taylor rule. Standard errors are between [ ] and p-values are between(). ***, ** and * indicate significance
at the respective significance levels 1%, 5% and 10%.

All these factors have led to a major shock reflected through
the exceptional decline in real GDP growth. This brings the
Tunisian economy to move into a situation of liquidity trap
when cuts in policy rate seem to have little or no impact of
hick-starting demand and output [reduce twice its interest
rate to 50 basis points each in June and September 2011].
This decline in interest rates failed to encourage the
economic actors to lend money. These actors continue to be

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 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,
deaf to calls for consumption and investment as a result of
growing anxiety about the future.
The empirical findings suggest that the monetary policy
followed by Egyptian central bank exhibits nonlinearity and
the dynamics of REER seems to be the main driver of
monetary policy. We attribute this finding to the sequence of
adverse, supply shocks that hit the Egyptian economy.
During, the time spamthat we consider in this paper, Egypt
underwent several shocks: the global financial crisis in 2008
and the effect of political instability with the onset of the
revolution.
When the world financial crisis began, central bankers had
expectations regarding its extent. Unfortunately, a series
ofconsequential shocks to the world economy, such as the
Lehman Brothers bankruptcy, the AIG flop and the crush of
the Reserve Primary Fund (a large money market mutual
fund in the US), spoiled these expectations, leading to the
demolition of the financial system and the economy
(Mishkin, 2011).
Indeed, after the revolution the political instability in the
country had increased uncertainty and led to a systematic
capital outflow the tourism sector, which prior the
revolution had represented 11% of the country’s GDP has
been severely affected as tourism income plunged by 9
percent after January, 25 revolution which took their toll on
the Egyptian foreign exchange reserve.
Our results are consistent with those of Mora and Carvalho
(2010), whose findings support evidence of nonlinear Taylor
rule for Mexico. The authors consider several specifications
of the Taylor rule to examine how monetary policy is
conducted in the sevenlargest economies in Latin America.
They show that the exchange rate is relevant variable for the
interest rate in Mexico,establishing the monetary policy rate
in Chile, Columbia and Venezuela.
In the case of Morocco, The output gap is chosen to be the
threshold variable because of theimportant weight that the
central bank places on this variable.The reaction of the
Morocco's central banktoshocks on these variables changes
depending on whether the level of the output gap is above or
below the threshold value of -3.4317.
Our results are consistentwith those of Castro (2011), whose
findings support evidence of a nonlinear Taylor rule for the
European Central Bank and for the Bank of England.He also
shows that the Fed's monetary policy is better described by a
linear Taylor rule.
Based on these estimates,we can affirm the existence of two
regimes of monetary policy that depend on the values of the
output gap: an initial regime that is close to the linear
specification and a second region, calledthe low output gap
19
regime (recession), which clearly shows the existence of a
special regime that applies only to unusual economic
conditions, in response to which central bankers change
their usual policy conduct.
Finally, in the case of Jordan, the empirical evidence
provides support of a nonlinear specification and it provides
evidence that the Jordanian policy-makers pay close
attention to the inflation rate when establishing
interestrate.These features are in line with the main goal of
the Bank of Jordan.
Building on this view, it is possible to characterize the
behavior of the Jordanian Central Bank as two-state Taylor
rule with different coefficients depending on whether the
inflation rateis below or above the estimated threshold value
of 3.7997%.Our results are consistentwith those ofPeterson
(2007).This later in his paper lays out a framework for how
the Fed handle interest rate setting during the 1985–2005
period using the logisticsmooth transition regression
(LSTR)model that was developed earlier by Teräsvirta
(1998). The study notes the presence of nonlinearity and,
more importantly, argues that once inflation approaches a
certain threshold, the Fed begins to react aggressively to
inflation.
Summing up,the nonlinear Taylor rule appears to be the
appropriate framework to characterize the MENA Central
Banks behavior and the real decision-making process can be
approximated by a two-state Taylor rule, with different
coefficients depending on whether the selected transition
variableis below or above an estimated threshold value.In
particular, while the dynamics of inflation seem to be the
major development driving the behavior of the monetary
authority in Jordan, considerations about economic growth
are crucial for Morocco, concerns about hitting the zero
lower bound of the nominal interest rateare key in Tunisia
and vigilance towards the real effective exchange rate
misalignment would be determinant in monetary authorities’
mindset shifting for Egypt.
In order to check the robustness of our findings, we have
finally applied several misspecification tests (Table 3).The
results of diagnostic tests indicate the absence of an ARCH
effect in the residuals for all countries under consideration
(except for Tunisia). Moreover, testing for omitted
nonlinearity in the estimation results shows that some of the
nonlinearity was absorbed by an LSTR model with two
regimes. So, we come to find evidence for the validity of our
empirical nonlinear model. In addition, the parameter
constancy test shows that the parameters do not vary over
time. All in all, the findings reflect thatthe monetary policy
followed by the MENA Central Banks exhibits some
nonlinearity.
 Yosra Baaziz al, Journal of Business Management and Economics, 3 (9), September, 2015,

Table 4: Robustness Tests

Tunisia Jordan Morocco Egypt

No Remaining Nonlinearity
Transition Variable

F 1.121*10-2 4.3364*10-1 4.8988*10-2 9.7272*10-3

F2 1.6753*10-1 8.478*10-1 6.2157*10-4 2.0861*10-2

F3 2.555*10-3 4.678*10-1 1.23*10-4 5.0462*10-1

F4 3.899*10-1 1.5625*10-1 8.5827*10-1 2.1592*10-2

Parameter Constancy Test

H1 8.7929 2.358 4.0586 1.7544
(0.001) (0.001) (0.0148) (0.144)
H2 7.305 3.6827 3.3618 7.3009
(0.0024) (0.0024) (0.0206) (0.0004)

H3 1.7673 4.1534 3.992 9.3841

(0.5408)
Note: This table reports the diagnostic tests of no remaining linearity and parameter constancy.p-values are between ().
CONCLUDING REMARKS
This paper investigates nonlinear dynamics of Central Bank
reaction function for four keyMENA countries: Tunisia,
Egypt, Jordan and Morocco. More specifically, we extend
the linear Taylor rule to a regime-switching framework,
where the transition from one regimeto another occurs in a
smoothway, using a logistic smooth transition regression
(LSTR) approach.
Using quarterly data from 2000:Q2 to 2014:Q3, we confirm
the occurrence of nonlinearity in the Taylor rulefor all
countries included in our sample.In particular,
considerations about economic growth (for Morocco),
inflation (for Jordan), stability of REER rate (in Egypt)
andconcerns about hitting the zero lower bound of the
nominal interest rate(in the cases of Tunisia) seem to be the
major drivers of such nonlinear pattern of monetary policy.
So far, this paper has provided evidence that it is possible to
characterize the behavior of MENA central banks as a two-
state Taylor rule, with different coefficients depending on
whether the transition variable is below or above an
estimated threshold value. Overall, the evolution of
coefficients portraits a richer picture of MENA conduct
andconfirm once again our suggestions regarding the
heterogeneity associated with thesecountries.
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