Monetary Policy Implementation

Until 1991, monetary policy in Zambia was conducted using direct

instruments. The objective of monetary policy was output growth. Inspired by the development theories of the day, interest rates were controlled to keep investment capital costs low. The bias was towards local businessmen so that when lending to indigenous businessmen did not increase, more controls were put in place. Lending was directed and a given percentage of all bank credit was to be given to selected sectors in the economy. The composition of bank boards of directors were to be at least 51% Zambian.

Other controls that affected monetary policy included a fixed exchange rate and capital controls. Exporters had to surrender all foreign exchange earnings to the central bank, which would then redistribute these through commercial banks. During this period, money supply grew mainly as a result of deficit financing. To control the growth of money, the central bank set high statutory ratios and changed these quite frequently.

In 1992, monetary policy reforms began to be implemented. Interest rates were freed and the exchange rate was liberalised the following year. The main goal of monetary policy changed from output growth to the control of

inflation. In terms of actual policy implementation, the reforms entailed shifting the emphasis from statutory ratios to more indirect methods. Efforts towards this were started in 1993 and by 1995, open market operations had replaced the frequent use of statutory ratios as the prime instrument of policy.

The framework used in the post reform period rests on four identities and we discuss each in turn.

The Equation of Exchange

M V =P Y (2.1)

Where M is Money supply, V is Money Velocity, P is the price level and Y is the output. Under classical assumptions, V is assumed to be constant and Y at full employment. This implies that changes in M will translate into changes

in P. In reality, prices respond sluggishly so that in the short run, changes in M translate into changes in both Y and P. Goals for GDP and inflation are set annually assuming a short run situation and a constant annual velocity.

Consolidated Balance Sheet of the Central Bank

where reserve money(Mh) is a sum of net domestic assets (NDA) and net foreign assets (NFA).

M h=N DA+N F A (2.2)

NDA can be broken down into credit to the government (Dc^g), credit to non-government (Dc^p) and other net items (ONI). We can then expand equation 2.2 such that

M h=Dc^g+Dc^p+ON I+N F A (2.3) so that

∆M h= ∆Dc^g+ ∆Dc^p+ ∆ON I+ ∆N F A (2.4) A change in reserve money is an effect of changes in credit to the government, credit to the public and net foreign reserves. The movements in NFA depend on whether there are capital controls or not. With capital controls, the movement of private funds is blocked and the change in reserves equals the trade balance. When capital controls are removed, as was done with the reforms, private funds flow freely and changes in reserves correspond to the net results of the Balance of Payments. A trade surplus (deficit) increases

(decreases) high-powered money.

Balance of Payments Identity

CA= ∆M h−K (2.5)

or

CA=P Y −arbsorption (2.6)

Where CA is current account and K is capital flows.

Given this framework, BOZ sits with the IMF and World Bank representatives and sets growth paths for the key variables in the model. First the target variables (inflation and economic growth) are set. Then the growth rate for broad money is set. Velocity is calculated as Y/M2 and assumed constant through the year. Then the growth rate for reserve money as the operational target is set. The components of reserve money are then broken down and the growth paths for them are also set. Discretionary monetary policy is estimated by subtracting NDA from estimated operating target levels for reserve money.

Before the reforms, the government implemented conflicting policies so that it was not easy to disentangle the operation of the interest rate mechanism.

Keeping interest rates low would trigger increased investment and therefore output. On the other hand simultaneously liquidity was also controlled through the use of statutory ratios. An increase in ratios would trigger a decrease in money supply. The policy process during this period therefore was not very clear, since both interest rates and money supply were being

adjusted, sometimes simultaneously. However, we know from theory that a change in both statutory ratios and the interest rate will affect base money and therefore money supply. This in turn will affect prices and output. We assume that despite the rigidities in the economy at the time, the market was working enough to enable the transmission of monetary policy through interest rates to the macro economy.

After the reforms, BOZ implemented policy based mainly on equation 2.2 above. We can rewrite this equation to emphasise how BOZ can influence movements in reserve money. Reserve money is a sum of currency and reserves. Reserves are comprised of required and excess reserves while banks also hold vault cash to make daily payments. We write this relation in the equation below.

M h=C+RR+ER+V C (2.7)

Where C is currency in circulation, ER and RR are excess and required reserves and VC vault cash. Because currency is negatively related to interest

rates, BOZ can reduce (increase) reserves by raising (lowering) the interest rate through open market operations, the discount window and other indirect methods. BOZ can also influence money supply by adjusting reserve

requirements. The key element in this process is the money multiplier whose relationship with reserve money and money supply can be depicted as below.

M =βM h (2.8)

whereβ= (_cd+rr^cd+1) cd is the currency deposit ratio and rr the required reserve ratio. Given this, BOZ can adjust reserve money in the economy by raising and lowering reserve and other statutory ratios.

In practice, the principal instruments of policy include open market operations with reserve or base money as the instrument. The starting point is forecasting liquidity. Given the end of year broad money targets, desired paths for reserve money are derived. Then individual components of reserve money are arrived at. The projected paths for these variables are then used as the main

benchmark for monetary policy operations. Implementation of policy now takes the form of minimising deviations of the actual paths of these variables from their projected target levels. Daily liquidity control is done through the auctioning of primary government securities, outright purchase and sale of treasury bills and auctioning of term deposits and secured loans. Because open market operations have not always been effective, other policy variables used include statutory ratios, foreign exchange intervention and moral suasion.