Abstract
Studies on the effectiveness of transmission mechanisms of monetary policy are crucial for an economy. It is essential to understand how effective are the channels of monetary transmission in directing economic activities in Sierra Leone. In this case, particular focus is on the interest rate, exchange rate, and credit channels. The analytical methods used are unit root tests, cointegration test, Granger causality test, impulse responses and variance decomposition. Central to this investigation is the use of the Vector Autoregression (VAR) approach to estimate time series annual data from 1980 to 2012. The cointegration test result revealed that cointegration exists. The Granger causality test showed that gross capital formation Granger causes exchange rate and real interest rate. The impulse response function showed that output responded positively to monetary shocks, as interest rate increased. For exchange rate and private domestic credit, output showed that even in the long run, the effects of the shocks might not be transitory in order to converge towards a steady state. The variance decomposition indicated that fluctuations in gross domestic product per capita (GDPPC) were attributed to itself. While the total contribution of the real interest rate (RIR) and exchange rate (ER) was relatively insignificant. The error forecast of RIR was attributed by itself with an insignificant contribution of GDPPC and none by ER and private domestic credit (PDC). Fluctuations in forecasting ER were greatly attributed to itself and trivial contributions by the other variables. As the trend fell, there was a slight increase in the contribution of the other variables. The results provided evidence of ineffective channels in the Sierra Leone economy.
Highlights
Successful implementation of any monetary policy regime requires an accurate and informed assessment of how fast the effects of policy changes propagate to other parts of the economy and how large these effects are
The Augmented Dickey Fuller (ADF) and Philips and Peron (PP) test results reveal that only the real interest rate (RIR) that is stationary at level I (0) while the KPSS shows that all the series are stationary at level I(0)
The three tests show that the following series: gross capital formation (GCF), exchange rate (ER), private domestic credit (PDC), and gross domestic product per capita (GDPPC) are stationary at first difference I(1)
Summary
Successful implementation of any monetary policy regime requires an accurate and informed assessment of how fast the effects of policy changes propagate to other parts of the economy and how large these effects are. In order to attain such, it requires a thorough understanding of the mechanism through which monetary policy actions and other forms of shocks affect economic activity. Such an understanding should provide an informed assessment of the channels through which monetary policy affects prices and economic activity. Most Centrals Banks that have been successful at controlling inflation and stabilising output within their domestic economies have done so largely through an understanding of these mechanisms [1]. Monetary transmission mechanism refers to the process through which changes in monetary policy instruments (such as monetary aggregates or short-term policy interest rates) affect the rest of the economy and, in particular, output and inflation. Monetary policy impulses transmit through various channels, affecting different variables and different markets, and at various speeds and intensities [2]
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