The economy’s reaction to monetary policy usually occurs with a lag. Understanding this transmission lag and, more broadly, the transmission channels is essential for the design, management, and implementation of monetary policy. With an increasing number of countries basing monetary policy on explicit rules and preannounced targets, there has been a rising interest in the empirical study of the monetary policy transmission mechanism over the last decade or so.
The vector autoregression (VAR) framework pioneered by Sims (1980) has been the workhorse for this analysis. VARs explicitly recognize the simultaneity between monetary policy (such as an increase in the short-term interest rate) and macroeconomic developments (such as changes in output, prices, exchange rates), as well as the dependence of economic variables on monetary policy. By placing minimal restrictions on how shocks affect the economy, the VAR framework allows for a more straightforward and less restrictive approximation of the true reduced form.
The VAR analysis is a particularly useful tool to investigate the monetary policy transmission also in the context of emerging economies, where short data series and structural changes complicate the use of structural models. Examples of studies using VARs to identify the monetary policy transmission mechanism in advanced economies include Christiano, Eichenbaum, and Evans (2000) for the United States, Kim and Roubini (2000) for industrial economies, and Angeloni, Kashyap and Mojon (2003) for the euro area. Applications to non-industrialized economies include Gottchalk and Moore (2001) on Poland, Arnoštová and Hurník (2005) on the Czech Republic, Dabla-Norris and Floerkemeier (2006) on Armenia, Cheng (2006) on Kenya, and Bakradze and Billmeier (2007) on Georgia.
This paper investigates the transmission mechanism of monetary policy in Mauritius using a VAR framework. Following the literature, we start by including the headline consumer price index (CPI) in the VAR analysis, and consider that our benchmark model. Given that some inflation models used for monetary policy such as those used for inflation targeting frameworks filter out volatile and exogenous components from the consumption basket, we also estimate an alternative VAR using a measure of core CPI, which essentially nets out administrative prices and energy prices and may give a more accurate picture of price trends.
For both the baseline an alternative models, we examine how (i) changes to the existing monetary policy instrument the official Bank of Mauritius (BOM) interest rate or repo rate—transmit to real output and the headline/core CPI; (ii) changes in two other policy instruments (the nominal effective exchange rate and money supply) transmit to output and CPI; and (iii) differences in two identification methods of the VAR influence the results.
Contents
I. Introduction
II. Background and Stylized Facts
- A. Monetary Policy Framework in Mauritius
B. Stylized Facts and Recent Developments
III. Empirical Approach
- A. The VAR Model Setup
B. Identification
IV. Estimation Results
- A. Modeling the Data
B. Benchmark Model
C. Alternative Model
V. Conclusion and Policy Implications
Appendix A: VAR Modeling and Diagnostics
Appendix B: Additional Impulse Responses and Variance Decompositions
References
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Monetary Policy Transmission in Mauritius Using a VAR Analysis
