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An Extended Taylor Rule for a Small Open African Economy.

Omolara Omotunde Duke , Dominic Opiah , Obioma Asuzu ,

Seyi Saint Akadiri , Aminu Umaru , Peter Offum ,
Ibrahim Abubakar Sani

PII: S2468-2276(24)00020-6
DOI: https://doi.org/10.1016/j.sciaf.2024.e02076
Reference: SCIAF 2076

To appear in: Scientific African

Received date: 11 November 2023

Revised date: 9 December 2023
Accepted date: 9 January 2024

Please cite this article as: Omolara Omotunde Duke , Dominic Opiah , Obioma Asuzu ,
Seyi Saint Akadiri , Aminu Umaru , Peter Offum , Ibrahim Abubakar Sani , An Ex-
tended Taylor Rule for a Small Open African Economy., Scientific African (2024), doi:
https://doi.org/10.1016/j.sciaf.2024.e02076

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 An Extended Taylor Rule for a Small Open African Economy.

Omolara Omotunde Duke

Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: ooduke@cbn.gov.ng

Dominic Opiah
Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: dcopiah@cbn.gov.ng
Orchid: https://orcid.org/0000-0001-8417-470X

Obioma Asuzu
Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: ocasuzu@cbn.gov.ng

Seyi Saint Akadiri12

Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: ssakadiri@cbn.gov.ng
Orchid: https://orcid.org/0000-0001-8901-7965

Aminu Umaru
Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: uaminu@cbn.gov.ng
Orchid: https://orcid.org/0000-0002-8805-2686

Peter Offum
Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: pfoffum@cbn.gov.ng

Ibrahim Abubakar Sani

Research Department, Central Bank of Nigeria, Abuja, Nigeria.
Email: asibrahim4@cbn.gov.ng

Abstract:

1
Corresponding author: Seyi Saint Akadiri (ssakadiri@cbn.gov.ng)
2
The contents of this paper are the authors' sole responsibility. They do not represent the views of any of the
institutions.

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 This paper estimated a monetary policy rule for Nigeria by augmenting the traditional Taylor
rule model, using data spanning 2010Q1 to 2023Q2 in a Dynamic Ordinary Least Square
regression. The results from competing models – the Taylor rule and extended Taylor rule
(exchange rate augmented) – were subjected to forecast evaluation to ascertain their relative
predictive power. Same models were estimated for South Africa for the purposes of comparison,
and the results were consistent with Nigeria’s. The findings indicate the predictors of the policy
rate – monetary policy inertia, inflation, output gap and exchange rate – to be significant and
with the expected signs. Forecast evaluation of the estimated extended Taylor rule model
produced lower Root Mean Square Error (RMSE) and Theil statistics, compared with the
traditional Taylor rule model, reflecting the higher predictive power of the former. The baseline
and unequally-weighted two-quarter-ahead forecast of the extended model predicts a maximum
inflation rate of 20.77% and 21.04% in 2023Q3 and 2023Q4, respectively, suggesting lower
inflationary episode for Nigeria. The implication of the finding is that the extant monetary policy
rule based on the traditional Taylor rule is inadequate in setting the nominal interest rate by the
Central Bank of Nigeria, and recommends the adoption of the extended Taylor rule to enhance
the effectiveness of monetary policy in Nigeria.

Keywords: Extended Taylor rule; monetary policy rate; inflation; small open economy.

JEL Codes: E5; C2; C5; G2.

1. Introduction

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 Central banks across the globe employ interest rate policies to influence the evolution of key
macroeconomic parameters to achieve their peculiar mandates. By adjusting the policy rate,
the monetary authority influences the short-term nominal interest rate, altering dynamics in
the money, goods, and financial markets, with broad implications for consumption,
investment, and growth. Thus, the determination of an appropriate policy rate remains a
critical requirement for the effectiveness of monetary policy. In the central bank of Nigeria
and the Reserve Bank of South Africa, as in most central banks, the traditional Taylor rule is
the benchmark model for determining the monetary policy rate (Carvalho et al, 2021).

Since the 1990s, the Taylor rule has been a prominent guide for central banks in setting
monetary policy rates in most economies. The policy rule has often been credited for low
inflation in in implementing economies (Caporale et al., 2018). In the US, a cumumulative
100 basis points (bps) hike in the policy rate January and September 2023, dampened
inflation by 2.7 percentage points, while a 175bps hike in the UK, lowered inflation by 3.4
percentage points. In the Eurozone, inflation declined by 4.3 percentage points following a
200-bps hike in the policy rate, over the same time horizon. In contrast, the effectiveness of
the policy rule in most developing economies, includiing Nigeria and South Africa, have not
been so evident, as inflation has remained elevated in these economies despite series of
policy hikes. In Nigeria, for instance, despite a cumulative 725 basis points hike in the policy
rate since December 2022, inflation still rose from 21.34 per cent to 26.78 per cent, in
September 2023. Peer countries like Egypt, South Africa, and Ghana, have also been
experiencing high and persistent inflation despite raising rates on different occasions.

It is therefore unclear whether the current policy rule, which is a simple guideline for setting
the nominal interest rate in these countries, is adequate and optimal. The rule has come under
criticism for not capturing the full complexity of the real world; and for oversimplified
assumptions that are detached from the realities in developing economies, among other
criticisms (Fernandez et al., 2010; Nikolsko-Rzhevsky et al., 2021). This was the motivation
for the modification of the Taylor rule in the empirical literature (Taylor & Davradakis, 2006;
Cúrdia & Woodford, 2016; Primus, 2017; Caporale et al., 2018). Consequently, the attraction
for an extended Taylor rule for a small open economy like Nigeria and South Africa lies in its
ability to capture parameters that are specific to the working of these economies, in order to

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 effectively anchor inflation and enhance growth. Forecasts from an adapted Taylor rule
would provide reliable guide for policy in achieving the broad objectives of macroeconomic
policy.

Literature on the on the extended Taylor rule is sparse, with existing studies primarily
focusing on the traditional Taylor rule (Kelikume et al., 2016; Ayinde et al., 2020). Studies
that extend the conventional Taylor rule are rather limited, with Shobande and Alimi (2016)
incorporating export gain. Alekhina and Yoshino (2018) introduced the oil price gap and
suggested that the Taylor rule model performs relatively well in describing the post-financial
crisis monetary policy in Nigeria; while Omotosho (2020) adds exchange rate in an extended
Taylor rule under the Dynamic Stochastic General Equilibrium framework. Ogiji, et al.
(2022) augmented the traditional Taylor rule with inflation, output gap, and oil price. Most of
the studies for Nigeria failed to account for breaks in their estimation (see, Alekhina &
Yoshino 2018; Ogiji, et al., 2022; Kelikume, et al., 2016; Ayinde, et al., 2020), which may
produce biased estimates. This study contributes to the literature by augmenting the
traditional Taylor rule with the exchange rate in both Nigeria and South Africa, and showing
through forecast, the predictive power of the augmented model, relative to the traditional
Taylor rule. The objective of this paper is, thus, to determine a monetary policy rule for
Nigeria, by extending the original Taylor rule model.

The results show that although standard parameters in the Taylor rule model, including output
gap, inflation, and policy inertia, were significant in both models, inflation exhibited a
stronger relationship with the policy rate under the augmented model. In addition, the
augmentation (exchange rate) has the right sign and a significant relationship with the policy
rate. Finally, the paper observed that the augmented Taylor rule model produce more reliable
forecasts compared with the original Taylor rule.

The rest of the paper is organized as follows: the ensuing section presents the methodology.
Section three presents and discusses the estimation results; while section four highlights
policy implications and recommendations, and section five concludes.

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 2. Data and Methodology

2.1 Theoretical Framework

The theoretical framework for this study is anchored on Taylor (1993), which prescribes a
rule on how a central bank should set its policy rate in response to changes in inflation and
output. This rule, which came to be known as the Taylor’s rule, in its original formulation
suggested that:

𝑖𝑡 = 𝜋𝑡 + ∅(𝜋𝑡 − 𝜋 ∗ ) + 𝛾𝑦𝑡 + 𝑅 ∗ (1)

The rule relates the policy interest rate (𝑖𝑡 ) to the equilibrium level of the real interest rate
(𝑅 ∗ ), inflation rate over the previous four quarters (𝜋), inflation target (𝜋 ∗ ), and the
percentage deviation of real GDP from the potential level (𝑦𝑡 ), while ∅ and 𝛾 are associated
parameters for inflation and output gaps.

Simplifying equation 1, we have the original Taylor rule:

𝑖𝑡 = 𝜇 + 𝛼𝜋𝑡 + 𝛾𝑦𝑡 (2)

Where, 𝜇 = 𝑅 ∗ − ∅𝜋 ∗ ; and 𝛼 =1+∅

Based on this rule the policy interest rate is adjusted upward when inflation surpasses the 2%
target or when the real GDP exceeds its trend value. From the inflation target equation
(equation 1) the central bank will raise its policy rate if inflation is above its target or if the
output gap is positive and would lower its rate where the reverse obtains.

The original Taylor rule has come under criticism for some reasons, including being
mechanical, data-dependent, and country-specific, among other shortfalls (Fernandez, et al.,
2010; Nikolsko-Rzhevskyy, et al., 2021). Thus, the rule has been modified by different
central banks to reflect their idiosyncrasies and improve monetary policy outcomes (Ball,
1999; Taylor, 1999; Svensson, 2000; Ghosh, et al., 2016). Some modifications have also
come in the form of alterations to the weight assignments on inflation and output gaps
(Nikolsko-Rzhevskyy, et al., 2019). For this study, the Taylor rule was adopted by removing
the inflation target, since the Central Bank of Nigeria does not target inflation (explicitly);

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 and introducing the exchange rate into the model. The augmentation of the traditional Taylor
rule with the exchange rate is informed by the high exposure of the Nigerian economy to
exchange rate risks and exchange rate dynamics, beckoning the import-dependent and
monocultural nature of the Nigerian economy.

Consequently, equation 2 was adapted to reflect these modifications, in line with Carvalho, et
al. (2021):

𝑖𝑡 = 𝛼𝜋𝑡 + 𝛽𝑖𝑡−1 + 𝛾𝑦𝑡 + 𝛿𝑒𝑟𝑡 + 𝑒𝑡 (3)

In this, augmented Taylor rule, (𝑖𝑡 ) represents the short-term nominal interest rate, and (𝑒𝑟𝑡 )
signifies the nominal effective exchange rate, inflation (𝜋𝑡 ), at time t. The variable 𝑖𝑡−1 is the
smoothing parameter or policy inertia, that captures the property of the policy rate (𝑖𝑡 )
tending to move incrementally and in a series of small moderate steps (Fernandez, et al.,
2010). The parameters of the model are captured by 𝛼, 𝛽, 𝛾, and 𝛿, while 𝑒𝑡 is the error term.
The absence of an intercept in this equation suggests that the Bank neither targets an inflation
rate nor an equilibrium real interest rate, and both interest rates and exchange rates are
measured in relation to their long-term values. A priori, the policy rate is expected to have a
positive relationship with inflation, own-lag, and output gap; but a negative relationship with
the nominal effective exchange rate.

2.2 Data and Preliminary Analysis

This study estimates an augmented monetary policy rule for a small open economy by
accounting for the role of exchange rate for the period spanning 2010Q1 to 2023Q2.
Monetary policy is measured using the monetary policy rate (MPR). Output gap is obtained
as the percentage deviation of actual output from potential output3. Inflation4 is calculated as
the quarterly growth of consumer price index. We accounted for exchange rate using nominal
effective exchange rate. The data on all the variables were obtained from the Central Bank of
Nigeria statistical database.

3
Potential output is derived based on Hodrick and Prescott (1997)
4
Actual inflation rate rather than inflation gap is employed since Nigeria’s monetary policy framework is not
inflation targeting.

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 We present the summary statistics in Table 1 where we observe that the average level of
monetary policy rate was 12.3 per cent, as inflation rate was 13.3 per cent during the review
period. On average, the output gap was negative, while the nominal effective exchange rate
was ₦145.52 per the weighted basket of foreign currencies between 2010Q1 to 2023Q2. The
coefficient of variation indicates that monetary policy rate is the least volatile series while
output gap is shown to be the most volatile. The probability values of the Jarque-Bera
statistics show that all the series, except monetary policy rate are normally distributed.

Table 1: Summary Statistics

MPR YGAP INF NEER
Mean 12.2639 -0.0021 13.2894 145.5223
Std. Dev. 2.5631 0.0633 4.0492 47.5154
Skewness -0.6108 0.2740 0.6628 0.1775
Kurtosis 4.3470 1.8096 2.8505 1.4701
CoV 0.2090 -29.7391 0.3047 0.3265
Jarque-Bera 7.4403 3.8641 4.0044 5.5500
Probability 0.0242 0.1449 0.1350 0.0623
Observations 54 54 54 54
Note: The term Std. Dev. denotes the standard deviation statistic, while CoV. represents the coefficient of
variation, and it is computed as Std. Dev./Mean.
Source: Authors’

The visual plot of the variables indicating the relationship between monetary policy rate and
the predictors of the augmented Taylor Rule is shown in Figure 1. There is evidence of
inverse relationship between monetary policy rate and inflation for most of the quarters until
2022Q1, where both variables have been trending upward (Panel A). The increase in
monetary policy rate has kept pace with the rising inflation which has remained unabated in
recent quarters. We also observe that monetary policy rate has been associated with
appreciation in nominal effective exchange rate for most of the quarters (Panel B), an
indication of the effectiveness of monetary policy in exchange rate stabilisation. We also
observe wild fluctuations in output gap, while the monetary policy rate indicates less
fluctuations (Panel C).

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 Quarterly trends in Monetary Policy Rate and Inflation in Nigeria (2010Q1 -2023Q2) Quarterly trends in Monetery Policy Rate and Nominal Effective Exchange Rate in Nigeria (2010Q1- 2023Q2)
25.0 20
22.5

Monetary Policy Rate (%)

280
16
20.0
240
17.5
12

NEER
15.0 200
%

12.5 8
160
10.0
120 4
7.5
5.0 80
10 11 12 13 14 15 16 17 18 19 20 21 22 23 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Quarters Quarters
MPR NEER
MPR INF

PanelQuarterly
A Panel
trends in Monetery Policy Rate and Output Gap in BNigeria (2010Q1- 2023Q2)
20

Monetary Policy Rate (%)

16

12
.15
Ygap (%)

8
Source: Author’s
.10
.05
compilation
4
.00
-.05
Figure 1: Visual plot of the variables
-.10
-.15
10 11 12 13 14 15 16 17 18 19 20 21 22 23

Quarters
MPR YGAP

Panel C

Figure 1: Visual plots of the series.

2.3 Model Specification

In line with the objective of estimating a monetary policy for Nigeria, the augmented Taylor
rule in equation 5 is represented to capture the variables highlighted in the preceding
paragraphs.

Model 1 – Conventional Taylor rule

𝑀𝑃𝑅𝑡 = 𝛾𝐼𝑁𝐹𝑡 +𝛽𝑀𝑃𝑅𝑡−1 + 𝛿𝑦𝑡 + 𝑒𝑡 (4)

Model 2 – Augmented Taylor rule

𝑀𝑃𝑅𝑡 = 𝛾𝐼𝑁𝐹𝑡 +𝛽𝑀𝑃𝑅𝑡−1 + 𝛿𝑦𝑡 +𝜃𝑁𝐸𝐸𝑅𝑡 + 𝑒𝑡 (5)

Where 𝑀𝑃𝑅𝑡 represents the policy rate. 𝛾 is the coefficient associated with the inflation rate
(𝐼𝑁𝐹𝑡 ), 𝛿 is the coefficient associated with the output gap (𝑦𝑡 ); and 𝜃 is the parameter of the
nominal effective exchange rate (𝑁𝐸𝐸𝑅𝑡 ), and 𝑀𝑃𝑅𝑡−1 is the policy inertia, with its

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 coefficient (𝛽). Upon visual examination of series in Figure 1, there appears to be evidence of
structural shifts in the paths of the policy rates and nominal effective exchange rate variables,
as indicated by the Bai Perron structural break test. Consequently, two break points were
identified at 2012Q1 and 2020Q3 for the conventional Taylor rule, while one break was
identified at 2020Q2 for the extended Taylor rule. However, the breaks were not captured in
the models because the forecast evaluation result in Table 3 shows that the models without
structural break out-performed the ones with breaks, hence, we estimated, interpreted and
forecasted with the preferred models.

Two models were estimated using the Dynamic Ordinary Least Square Method because of
the inclusion of the lag dependent variable on the right-hand side of the model. First is the
conventional or original Taylor rule model for Nigeria, and second is the extended or
augmented Taylor rule model. Following the estimations, two-period ahead forecasts were
made for the policy rate, under the alternative Taylor models.

3. Results and Discussion of Findings

Results from the empirical analysis are presented and discussed in this section.

Table 2: Empirical Outcomes for Conventional and Extended Taylor Rule

Conventional Extended
Variables Coeffi. t-Stat p-Value Coeffi. t-Stat p-Value
MPR (-1) 0.758*** 10.476 0.000 0.604*** 8.174 0.000
*** ***
INF 0.136 3.785 0.001 0.176 8.153 0.000
y 11.574*** 2.739 0.000 7.253*** 3.491 0.002
NEER -0.010** -2.411 0.024
Const. 2.525*** 4.496 0.000 1.269 1.433 0.167
R2 0.852 0.861
R2-Adj. 0.832 0.826
***
F-stat. 423.593 0.000 1710*** 0.000
Break Dates (Bai
Perron)
1 2012Q1

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 2 2020Q3 2020Q2
Note: Variables are significant at 0.01 and 0.05 per cent respectively. Table 1 present estimations report for the
model to determine the sign, size, and significance of the relationship between MPR and its predictors.

3.1 Conventional Taylor Rule

Based on conventional Taylor Rule model the current policy rate has positive and significant
relationship with the policy inertia, which confirms monetary policy rate changes are
incremental and in small steps. It also suggests that the central bank's historical policy
decisions have a lasting impact on its current interest rate decisions. The high coefficient of
the past policy rate at 0.76 indicate a significant level of interest rate inertia. Also, consistent
with a priori expectation, a percentage increase in inflation is associated with a 0.14 per cent
increase in the policy rate and statistically significant at the 5 per cent level. This relationship
could be attributed to the tendency of the Bank to influence inflation through interest rates
adjustments. Similarly, a positive and significant impact of the output gap on the policy rate
is observed. For every one percentage increase in the output gap, the policy rate, under the
conventional Taylor rule increases by 11.57 per cent. The observed positive effect of inflation
and output gap on the policy rate resonates the finding of Caporale et al., (2018) for five
emerging countries. This implies that when the economy operates above its potential, central
banks respond by significantly increasing the policy rate. This response is likely an effort to
cool down the economy and prevent overheating.

3.2 Augmented Taylor Rule

Results from the augmented Taylor rule model, largely mimicked output from the
conventional model. Policy inertia is strongly evident and significant, as a percentage
increase in policy inertia increases the rate by 0.60 per cent. In the same vein, inflation rate
and output gap positively impact the policy rate. However, the magnitude of the impact of
inflation is higher at 0.18 per cent under this specification, compared with 0.14 per cent in the
conventional model. The major distinction between both models is the inclusion of the
nominal effective exchange rate in the augmented model. In consonance with a priori
expectation, the real effective exchange rate is found to be significant, with a negative
relationship with the policy rate. Notably, a percentage depreciation in the nominal effective
exchange rate results in a decline the policy rate by 0.01 per cent. This suggests that the

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 behaviour of CBN is notably influenced by the nominal effective exchange rate. Dynamics in
exchange rate is a major consideration in determining the monetary policy rule for Nigeria, as
exchange happen to be one of the key drivers of inflation in the country.

The adjusted-R2 (R2 adjusted for the number of predictors in the model) under the augmented
Taylor rule is 87.1 per cent, against 85.2 per cent estimated from the original Taylor rule
model. This indicates that the introduction of exchange rate improves the model fit and
enhances the monetary policy rule for Nigeria.

A. Conventional Taylor rule

24
22
20
18
16
14
12
10
8
6
11 12 13 14 15 16 17 18 19 20 21 22 23

MPR MPR (Scenario 1)

B. Extended Taylor rule

20

18

16

14

12

10

6
11 12 13 14 15 16 17 18 19 20 21 22 23

MPR MPR (Scenario 1)

Figure 2: Graphical plots of the models without break dates.

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 Table 3: Forecast Evaluation

Model
Decision

Conventional Taylor Rule without Breaks

RMSE MAE MAPE THEIL
3.67 2.89 16.81% 0.14 Accepted
Conventional Taylor Rule with Breaks

RMSE MAE MAPE THEIL

13.96 10.33 34.57% 0.38 Rejected
Extended Taylor Rule without Break

RMSE MAE MAPE THEIL

2.69 2.31 15.11% 0.1 Accepted
Extended Taylor Rule with Break

RMSE MAE MAPE THEIL

3.37 3.02 18.75% 0.12 Rejected
Source: Authors’ estimation
Notes: RMSE is the Root Mean Square Error, MAE denotes the Mean Absolute Error, MAPE
represent the Mean Absolute Percentage Error and THEIL is Theil Index.

3.3 Forecast Evaluation

The evaluation findings in Table 3 indicate that, in forecasting the monetary policy rate in
Nigeria, the traditional Taylor rule model without break demonstrated superior performance
compared to its counterpart with breaks. This superiority is evident in the lower values of
RMSE, MAE, MAPE, and THEIL coefficients for the conventional Taylor rule model
without breaks when contrasted with the model incorporating breaks. Similarly, the extended
Taylor rule without breaks exhibited better performance than the extended Taylor rule model
with breaks.

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 When considering both the conventional Taylor rule and its extended version, the results of
RMSE, MAE, MAPE, and THEIL suggest that the extended Taylor rule without breaks
outperformed the conventional Taylor rule model without breaks. This underscores the
justification for extending the Taylor rule in Nigeria to incorporate the nominal effective
exchange rate (NEER), given its significant influence on the central bank's decisions to
manage inflation, particularly in the Nigerian context.

3.4 Forecasting Result

After establishing the relationships among the variables, we proceed to forecast the policy
rate over two quarters. The empirical results specifically highlight the responses of the MPR
to changes in inflation and output gap, first, for the conventional Taylor rule, later for the
augmented Taylor rule with exchange rate incorporated. Specifically, the out-of-sample
forecasts were generated for 2 quarters ahead of the in-sample period (that is, for 2023Q3 and
2023Q4). Data employed for the analysis covered 2010Q1 to 2023Q2.

3.4.1 Conventional Taylor Rule: Forecast

To achieve the stated objective, we started by generating (Table 4 and 5) results for the
Conventional and Extended Taylor rule using the baseline scenario - where the predictors are
allowed to follow their natural path. Under scenario 1 the immediate past period is expected
to have the largest impact with distributed weights of 0.5, 0.3, and 0.2 for the immediate past
quarter, two quarters prior, and three quarters prior, respectively. In scenario 2 the immediate
past period is expected to have the least impact with distributed weights of 0.2, 0.3, and 0.5 to
the first, second and third consecutive quarter lags.

Table 4: Forecasting the monetary policy rate using the baseline Taylor Rule
Forecast Unequal weight moving Unequal weight moving
Baseline
Period average (0.5, 0.3, 0.2) average (0.2, 0.3, 0.5)
Average Lower Upper Average Lower Upper Average Lower Upper

2023Q3 19.78 18.07 21.49 19.37 17.40 21.35 19.53 17.78 21.28

2023Q4 20.34 18.30 25.39 19.81 17.35 22.28 20.32 17.93 22.72
Note: For the baseline forecast we employ, the equal Weighted Moving Average to determine the Natural Path
of monetary policy rate (Do Nothing Scenario), we then used unequal weight for the rest of the scenarios.
Source: Authors’ computation

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 From the empirical outcome in Table 4, it is observed that for the baseline model without
structural break dates, where the predictors are allowed to follow their natural path, MPR
should not be hiked beyond 21.49 per cent or reduced below 18.07% in 2023Q3. In scenario
1, where recent quarters were given larger weights, the MPR is expected to remain within the
bands of 17.40 and 21.35 per cent and to average 19.37 per cent in 2023Q3. While in
Scenario 2, where higher priority is accorded earlier periods, the band is 17.78 and 21.28 per
cent and an average of 19.53 per cent in 2023Q3. The forecasts in 2023Q4 are observed to be
higher across the scenarios reflecting pessimism around the key predictors.

3.4.2 Augmented Taylor Rule: Forecast

Forecasts of the extended Taylor rule model are reported in Table 5 under the baseline,
scenario 1 and scenario 2. In the baseline scenario for the 2023Q3 forecast, MPR is projected
to average 19.06 per cent, and to remain within the range 17.71 and 20.41 per cent. The same
weighting rules in the conventional model were adopted in scenarios 1 and 2 of the
augmented model. Under scenario 1, MPR is expected to remain within the band 17.58 and
20.34 per cent, and average 18.96 per cent; while in scenario 2, average forecast is 19.36 per
cent and stay within 17.96 and 20.77 per cent limits in 2023Q3.

Table 5: Forecasting the monetary policy rate using the augmented Taylor Rule

Unequal weight moving Unequal weight moving

Baseline
average (0.5, 0.3, 0.2) average (0.2, 0.3, 0.5)
Forecast
Period Average Lower Upper Average Lower Upper Average Lower Upper

2023Q3 19.06 17.71 20.41 18.96 17.58 20.34 19.36 17.96 20.77

2023Q4 19.22 17.65 20.78 19.19 17.50 20.88 19.32 17.59 21.04
Note: For the baseline forecast we employ, the equal Weighted Moving Average to determine the Natural Path
of monetary policy rate (Do Nothing Scenario), we then used unequal weight for the rest of the scenarios.
Source: Authors’ computation

Quite distinct is the fact that although the same weighting system was imposed on both the
conventional and augmented Taylor Rule models, the augmented model appears to produce

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 lower forecasts values, that seem more realistic. For instance, MPR in 2023Q2 was 18.75 per
cent and the conventional model proposes an MPR band of 18.07 and 21.28 per cent,
compared with a band of 17.71 and 20.77 per cent, under the augmented model. By simple
observation, realised MPR in 2023Q2 is already 68 basis points below the minimum limit and
253 basis points below the maximum forecast value using the conventional model. However,
there is a strong possibility of future MPR falling within the augmented model band (17.72
and 20.84 per cent). It is important to add that the MPR forecasts are notably influenced by
the allotted weights, regardless of the model type.

3.4 Additional Analysis

The conventional and modified Taylor rule models were also estimated for South Africa for
peer country comparison. Notably, the South African Reserve Bank (SARB) implements an
inflation targeting framework, in which it targets an inflation rate within the band of 3-6%.
Using quarterly time series on inflation and inflation target, output and potential output, the
SARB's policy rate (same as its repo rate), and the nominal effective exchange rateof South
Africa, the original Taylor rule in equation 1 and the modified version in the form of equation
5, were estimated under different scenarios. Three scenarios were assumed under the
conventional and augmented Taylor rule models, respectively – scenario 1 (3% - low
inflation target), scenario 2 (4.5% - moderate inflation target), and scenario 3 (6% - high
inflation target).

Table 5: Estimation of the Taylor rule for South Africa

Variables Conventional Taylor Rule Extended Taylor Rule
Scenarios Scenarios
1 2 3 1 2 3
C -0.0749 0.5578*** 0.2414 -0.0069 0.5198** 0.2565
(0.1882) (0.1930) (0.1850) (0.2035) (0.2065) (0.1985)
MPR(-1) 1.0173*** 1.0173*** 1.0173*** 1.0197*** 1.0197*** 1.0197***
(0.0308) (0.0308) (0.0308) (0.0342) (0.0342) (0.0342)
INF- 0.2109*** - - 0.1756*** - -
INFSTAR_L (0.0308) - - (0.0342) - -
INF- - 0.2109*** - - 0.1756*** -
INFSTAR_H - (0.0308) - - (0.0342) -
INF- - - 0.2109*** - - 0.1756***
INFSTAR_A - - (0.0308) - - (0.0342)
y 5.0231*** 5.0231*** 5.0231*** 6.6804*** 6.6804*** 6.6804***
(1.6809) (1.6809) (1.6809) (1.8491) (1.8491) (1.8491)
NEER - - - -0.0065 -0.0065 -0.0065
- - - (0.0066) (0.0066) (0.0066)

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 Note: The values in parentheses are the standard error, while ***, **, and * imply 1%, 5%, and 10% levels of
significance, scenerio1 denotes the lower inflation target, scenerio2 is the upper target, while scenerio3
represents the average target.

The findings (see Table 5) largely mirror the outcomes for Nigeria under the standard and
extended versions of the Taylor rule. The results reveal that all the predictors were significant
(except the exchange rate) and had the expected signs. The previous period's policy rate
(policy inertia), inflation gap, and output gap have a positive influence on the policy rate,
consistent with what was observed in the Nigerian results. Generally, the magnitude of the
impact of the policy inertia, inflation gap, and output gap on the policy rate, were the same
under the scenarios of low, moderate, and high inflation, within the conventional and
augmented models. However, the magnitudes of the impact vary across both models. The
impact of policy inertia and the output gap on policy rate, are higher under the augmented
model, and the output gap appears to be the most prominent predictor of the policy rate in
South Africa (6.68%), as in the case of Nigeria (8.24%). Conversely, the coefficient of the
inflation gap was smaller under the conventional Taylor rule averaging 0.21 percent;
compared with 0.18 percent in the augmented model. Notably, the policy rate appears to be
insensitive to the size of the inflation target in South Africa, as variation of the inflation
targets produced no market changes in the policy rate. Finally, the nominal effective
exchange ratehas a negative relationship with the policy rate, as observed in Nigeria,
however, its significance could not be confirmed for South Africa. This could be attributed to
the relative exposure of Nigeria to exchange rate risk, compared with South Africa.

4. Policy Implications and Recommendations

These findings underscore the importance of inflation, output gap, and exchange rate
movements in formulating monetary policy in Nigeria. The observation that inflation, output
gap, and exchange rate have a significant relationship with the policy rate, has overwhelming
implications for monetary policy in Nigeria. Although this paper observes that the inflation
rate significantly impacts the policy rate, this is understandable, given that the policy rate is
arguably the most potent tool in the Bank in cooling inflation, attracting capital, or
stimulating investment in the economy. However, the extent of the response of targeted
fundamentals, such as inflation to changes reflects the inadequacy or otherwise of the existing

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 Taylor-rule-based model in the Bank. Comparison with the South African economy reveals
the importance and significance of the standard predictors in monetary policy rule in any
economy – output gap, inflation gap, and inflation. However, the augmentation of the original
Taylor rule should be based on the peculiarities of economies, as indicated by the
significance of the exchange rate in the monetary policy rule for Nigeria, and insignificance
in the case of South Africa.

The positive and strong impact of the output gap on the policy rate underscores the
importance of output and productivity for effective monetary policy formulation and the
imperative of policy coordination. The Central Bank of Nigeria should collaborate with other
government agencies (MFin, MB&MP, DMO) and stakeholders to address structural issues
that could influence the path of the output gap, with a feedback loop to its policy rate.
Furthermore, the observed negative impact of the nominal effective exchange rate on the
policy rate suggests that exchange rate management plays a critical role in monetary policy
formulation. This is because exchange rate dynamics in Nigeria do not only affect capital
flows and reserves, it also impact domestic prices. As such, the monetary policy function
should accommodate exchange rate changes in its objectives to attract capital, stimulate
growth, or cool inflation. The results from this study show that by modifying the original
Taylor rule, through the introduction of the exchange rate parameter and accounting for
structural shifts, extant monetary policy rule in Nigeria produced better results. Consequently,
the Bank should consider the estimated augmented Taylor rule in this paper to enhance the
policy formulation of monetary policy in Nigeria and implement policy rates that are in sync
with the fundamentals of the economy and the goals of monetary policy. The adoption of this
Taylor-type rule would ensure transparency and clarity about the policy framework in the
Bank, thus guiding expectations and enhancing credibility.

5. Conclusion

This paper estimates an augmented monetary policy rule for Nigeria using the original Taylor
rule and a circumvented-augmented Taylor rule for Nigeria. The rationale for augmenting or
modifying the original Taylor rule is clear from the literature, and the major argument is
about the mechanical nature of the traditional Taylor rule and its peculiarity to the US
monetary policy rule. For Nigeria, the importance of customizing the rule to reflect the

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 idiosyncrasies of the Nigerian economy by including important variables such as the
exchange rate and the smoothening parameter was established as the major value addition of
this paper.

Two broad models were estimated – the conventional and augmented Taylor rule models –
using the Dynamic OLS method and the output was fascinating. Both models corroborate the
theory regarding the expected relationship between the monetary policy rate and inflation and
the output gap. Considerable inference could be drawn from the observed significant
relationship between the policy and exchange rates in Nigeria, elicited in the augmented
Taylor model. Equally instructive is the finding of greater predictive power of the augmented
Taylor rule. This perspective was further strengthened by the forecast results, as the extended
model produced more realistic forecasts. While it is critical to continuously troubleshoot
monetary policy frameworks in use by the Bank, this paper has provided valuable insights on
the adequacy of the existing policy rule and the need to include the exchange rate, to enhance
the responsiveness of monetary policy framework in Nigeria. Although this paper advances
the augmentation of the Taylor rule in Nigeria through the introduction of exchange rate and
structural shifts, further studies could explore the possibility of adding to the predictors to
further strengthen the policy rule in the Central Bank of Nigeria.

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Author Contribution Statement

Declaration:

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of the manuscript.
Consent to Participate: Not Applicable
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Authors’ contribution: Each author made equal contributions to every stage of the
manuscript, from the conception of the study idea to the completion of the manuscript.
Funding: Authors did not receive funding for the study.
Competing Interests: No competing interest for this manuscript.
Availability of data and materials: We sourced all data from World Bank Development
Database.

Statement of Declaration

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 Conflict of interest: The authors confirm that, there is no conflict of interest for this paper
submission.
Ethics approval and consent to participate: NA
Consent for publication: NA
Availability of data and material: Corresponding authors can provide data used in the study
on appropriate request
Competing interests: There is no conflict of interests reported by the authors.
Funding: This research does not receive any funding.

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