By Austin Chiumia
April 2015
Despite immense research on the subject, most researchers and policy makers still remain agnostic on effectiveness of monetary policy and the appropriate choice of monetary policy instruments. This follows enormous divide in empirical findings on the subject in both developed as well as Low Income Countries (LICs). This problem is more pronounced in LICs which not only have underdeveloped financial markets but also lack appropriate tool to model their economies. This study sought to complement existing literature by further examining effectiveness of monetary policy in Malawi Using a Factor Augmented Vector Autoregressive Model (FAVAR) using quarterly data from 1990 to 2013. This helped to control for little information problem inherent in other modelling frameworks. After controlling for structural breaks and broadening the information set using the Principal Component Analysis, the price puzzle results disappears making inflation responsive to changes in money supply and policy rate innovations. This finding is consistent with (Muhanji etal, 2013) and (Mwabutwa etal, 2013). We also show that policy reversal could be responsible for price and liquidity puzzle results in other literature. It takes less time for inflation and GDP to stabilise under interest rate shock than it does under money supply shock. Based on these findings and persistent supply shock together with limitations in data, we conclude that monetary targeting is still useful for Malawi. However, elimination of fiscal dominance and broadening of foreign exchange sources would provide solid base to augment the framework with IT features and deal with the policy signalling challenge inherent in the
Monetary targeting framework and also quick stabilisation of the economy after shocks.