Appropriateness of inflation targeting as monetary policy framework for Zambia

There is now consensus that inflation hampers economic and social development. It is therefore important to have a clearly defined and effective framework of inflation control. Since 1992, Zambia has been using monetary targeting as a framework of inflation control. However, the link between inflation and monetary aggregates is no longer stable and predictable. In this vein, the Bank of Zambia has been considering switching the monetary policy framework to inflation targeting. The objective of this research is to assess the applicability of this framework by investigating the factors that drive inflation. Inflation targeting works best if inflation is demand driven while the effects of supply side factors on inflation are temporary. Further, it must be possible to use a nominal interest rate as a monetary policy instrument. Using annual data from 1992 to 2008, we fit the standard model of inflation targeting by Svensson (1997) and then compare it to the Chand and Singh (2006) model. The Chand and Singh model reformulates the Svensson demand side to what is thought to better depict the economic structure of developing countries. The model recognizes that developing countries usually sustain large fiscal deficits which can be significant in driving inflation. To this end, the policy rule of interest rate should also respond to fiscal deficit ratio. Alternatively, fiscal deficit ratio itself can be used as a policy rule. Moreover, the Chand and Singh model also includes supply side factors with the reasoning that they might be significant in explaining inflation. Our results show that inflation in Zambia can be said to be demand driven and supply side factors are insignificant. However, the interpretation of aggregate demand in terms of output gap was found to be insignificant in driving inflation. Instead, the alternative interpretation, nominal excess demand growth was found to have more explanatory power. Fiscal deficit ratio was found to be insignificant. This precludes the possibility of it being employed as a policy rule. On the contrary, we found a significant, negative and stable relationship between inflation and the Treasury Bill (TB) rate. The main policy implication of the results is that inflation targeting can be adopted and serious attention has to be given to the interest rate that will be employed. The transmission mechanism is not smooth and Government should consider dealing with factors behind this problem. It would also be important to address the problem of information asymmetry in the banking system.

Author dc:creator

• Hangoma, Peter

• Inflation
• Inflation Policy-Zambia

Language dc:language.iso

en

Repository record dc:identifier.uri

http://dspace.unza.zm/handle/123456789/300

OAI identifier oai:identifier

oai:dspace.unza.zm:123456789/300