Abstract

The onset of financial sector liberalization in Malawi ushered in a new era in the conduct of monetary policy, which saw the abandonment of direct policy instruments and a corresponding introduction of indirect, more market-friendly instruments. Further, the Reserve Bank of Malawi was given a more direct mandate with respect to macroeconomic objectives of inflation, output and external balance. This study specifies and estimates a monetary policy reaction function for the Reserve Bank of Malawi with the aim of reviewing the conduct of monetary policy in the post liberalization period. The study tests whether the RBM reacts to inflation, output and exchange rate developments in the economy in a consistent and predictable way. The Generalized Method of Moments technique is used to estimate the weights attached to inflation, output, and exchange rate in the RBM’s policy operations. The study finds that inflation has been the most important variable in setting the monetary base, while results on the output gap have largely been insignificant and inconsistent with theoretical expectations. The RBM seems to have reacted to inflation developments more aggressively after the liberalization period than during the liberalization, as evidenced by the larger weights attached to inflation in the former period. Exchange rate developments also appear to moderately influence the setting of the monetary policy instruments. However, the discount rate setting seems to be more influenced by the central bank’s desire to correct a previous disequilibrium than a direct reaction to economic developments.

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School	: School of Law, Economics and Government
Issued Date	: 2007

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