How Central Bank Responds to Macroeconomic Shocks? Specification, Estimation and Analysis of Monetary Policy Reaction Function: The case of Ethiopia (2000-2017)

Abstract

This paper designed to identify both the goals and pattern of policy with the two major aims: firstly to know the way how National Bank of Ethiopia systematically responds to macroeconomic shocks and secondly to evaluate the performance monetary policy against its initial objective including assessment of gap analyses in monetary policy frame work. Hence, the model demonstrates that the National Bank of Ethiopia chooses the domestic credit as the most appropriates indicator of monetary policy with the determinants of net foreign assets, consumer price index, fiscal gap, real effective exchange rate and Gross Domestic Products to formulate the reaction function. On top of this the empirical results explain that domestic credit has strong long run & positive relation with net foreign assets & to real Gross Domestic Product. But it has short run relation with consumer price index, real effective exchange rate and real Gross Domestic Product at different lag structure. The NBE followed a combination of both accommodating and stabilization monetary policy. The Coefficients of equilibrating error terms, ECM suggest that the speed of adjustment/ feed back effect towards the long run equilibrium takes many years for full adjustment when there is a shock in the system, indicating the longer lags structure and undeveloped financial sectors resulted in obstacles for the effectiveness of monetary policy. Regarding to the evaluation of monetary policy objectives up on short run dynamics model, Both low inflation rate and reduction of monetization of fiscal deficit can be maintained while achieving the international reserve target is not fully under the control of NBE. Basically, the attempts of NBE to maintain the growth rate of money supply at the rate of nominal GDP growth has been satisfactorily met. The sterilization coefficient revealed incomplete sterilization activities while the offset coefficient tell us a highest degree of monetary control with low degree of capital mobility