Applying Taylor Rule in a Heterogeneous Currency Union: Case of UMAC

Abstract

Our objective is to show that the Taylor rule is the monetary policy practice of BEAC its effectiveness is limited due to the structural and cultural heterogeneity of the currency union. In this light, we identify the reaction function of BEAC show that it includes additional variables namly, the interest rate and inflation differential with the Euro zone, as well as the currency reserve ratio that must cover at least 20% monetary issue. Given the objectives and instruments used and the reaction function built, we estimate a forward-looking Taylor rule using the GMM, similar to the one proposed by Clarida et al. (2000) and find that the interest rate setting of BEAC could be captured using a Taylor rule. From our estimations using the we actually find that BEAC’s monetary policy or more precisely its interest rate setting can be effectively captured using a modified Taylor rule taking into consideration the specificities of the monetary union and external constraint despite the heterogeneous nature of the union. As seen from the results obtained we can realize that the Central Bank mainly focuses on the fight against inflation and mainly strives at maintaining internal stability in the sub region. This fight can be deemed successful given the low inflation results that are observed in our period of study, even though it can be mitigated with the influence of the region of anchor (the Euro zone) in this stability