Monetary policy transmission in Zambia

This dissertation constructs two small structural empirical models of the monetary policy transmission in post-liberalization Zambia. Using the structural cointegrated VAR framework, the following questions are addressed. What is the role of money in the transmission process? What is the role of monetary policy shocks in exchange rate behavior? How important are exchange rate shocks in CPI inflation? Does monetary policy respond to exchange rate shocks? What is the impact of foreign price shocks on the domestic economy? The first model is identified with short run and long run restrictions and the second with contemporaneous restrictions motivated from rational expectation assumptions.;The empirical results suggest that the impact of monetary policy shocks on output is temporary and marginal. Leading indicators of output are aggregate supply and IS shocks, the latter more pronounced in the short run. CPI inflation is mainly due to aggregate supply and exchange rate shocks. Generally, monetary policy has served to dampen inflationary pressures induced by exchange rate shocks. Foreign price shocks modestly affect short run output and CPI inflation.;We draw policy implications for monetary targeting from two key observations. First, a positive monetary policy shock leads to a sharp and persistent rise in money supply. But this is not translated into strong consumer price response. Second, though the money demand is stable, money demand shocks have modest role in consumer price and in the short run. These suggest that reducing inflation further, especially to single digits, under the current regime is likely to be problematic. This may be due to a weakened link between money and inflation, giving rise to situations where getting the monetary target does not produce the desired inflation outcome and where money fails to produce reliable signals of the stance of monetary policy. We conclude that since food price has the largest share in CPI and exchange shocks have dominant role in inflation dynamics, policies meant to increasing domestic food supply and stabilizing the exchange rate are likely to help Zambia achieve and sustain lower inflation.