Optimal policy instrument selection in monetary policy: endogeneity of money supply

Abstract

Purpose- Nowadays, the central bank's primary objective is price stability which is defined as low and stable inflation. The central bank has to fulfill some institutional and operational conditions to achieve this goal. One of the operational conditions is the selection of the appropriate policy instrument to implement the monetary policy. The central bank can choose interest rate or monetary base as policy instrument. The main question of this paper is whether the monetary base the optimal instrument. The choice of monetary base as a policy instrument is dependent on the exogeneity of money supply, which means that the money supply is controllable by monetary base. Methodology- This paper investigates endogeneity of money supply of Turkey for a sample period of 1990-2016 using Johansen cointegration test. Findings- As a research method, the Johansen cointegration test and VECM is used to show long-run relationships and causality between variables and Granger causality test is used to examine short-run causality between the variables. Conclusion- It is seen that CBRT has very limited control over money supply, thus monetary base may not be optimal policy instrument to ensure price stability.