Monetary Policy Transmission Mechanism And Inflation Targeting In Ghana

ABSTRACT 

The primary objective of the study is to assess the effectiveness of the monetary policy rate and the transmission mechanism under the current inflation targeting regime in Ghana. This study shows, in particular, the importance of fiscal dominance on the effectiveness of monetary policy and the role of the four transmission variables in explaining inflation in Ghana. We trace out the eventual effect of the policy rate on the economy; assess the role of the four transmission variables; and assess the separate and combined effects of supply (oil) shocks and fiscal dominance on the effectiveness of monetary policy. Following Bernanke and Blinder (1992) and Sims (1992), this study identifies the monetary policy rate as the direct measure of monetary policy and assumes it is affected by economic variables with a lag whilst affecting all other variables contemporaneously. Therefore, the policy rate and inflation are ordered first and last respectively. This enables us to measure the true structural effects of monetary policy changes and uncover the transmission mechanism without specifying an explicit structural model. We show that fiscal dominance significantly hampers the effectiveness of the policy rate whilst a supply shock renders the policy rate ineffective. We also provide evidence consistent with the view that the monetary policy rate is ineffective in the presence of both supply shocks and fiscal dominance. The two dominant transmission channels are the asset price and exchange rate channels with the latter being the most dominant channel. Our conclusions are robust to alternative Cholesky orderings. Finally, we observed that the two wholesale interest rates (treasury bill and interbank interest rates) are superior to the policy rate; an indication of weak policy credibility. We recommend that additional measures should be implemented to further deepen the financial system and improve financial intermediation in order to improve the transmission process. Also, foreign exchange earnings and retention should be enhanced to manage the exchange rate. New research can be conducted using an explicit structural model among others.