Assessing Nonlinear Dynamics of Central Bank Reaction Function: The Case of Mozambique

Abstract

AbstractThis paper sheds some light on the elements governing monetary policy‐making during the period 2000Q1–2015Q1 in Mozambique. We estimate a time‐varying Taylor‐type rule for the BM, using a Markov‐switching (MS) model and a Threshold model. The general finding is that the behaviour of the BM can be characterised by two regimes. In regime 1, only changes in inflation trigger a reaction by the monetary authority. This behaviour is prominent after the establishment of the monetary policy committee in 2007 (CPMO). In regime 2, the BM reacts aggressively both to cool off the economic activity and to curb inflationary pressures. Regime 2 occurred most frequently during 2000–2006, when the fiscal policy might have played an important role in output stabilization. After the establishment of the CPMO, regime 2 occurred in the context of a steep rise in fuel and food prices in 2007–2008 and in 2010. Both the MS model and the Threshold model show similar asymmetric effects. We find evidence that inflation is viewed more seriously by the monetary authorities when it is accompanied by a high output‐gap in the previous period, which triggers a more aggressive response from the monetary authorities.