EXPLORING THE ROLE OF THE REAL EXCHANGE RATE IN MONETARY POLICY IN EGYPT

Transcription

1 Draf do no quoe EXPLORING THE ROLE OF THE REAL EXCHANGE RATE IN MONETARY POLICY IN EGYPT INTRODUCTION In recen years, since he publicaion of John Taylor s seminal paper on he ineres rae seing by he Federal Reserve (Taylor 1993), i has become common pracice o describe moneary policy using reacion funcions. In heir iniial formulaion, he rules sugges ha ineres raes would be changed according o he deviaion of inflaion from a arge and an oupu gap. By focusing on he policy responses o hese key variables, he Taylor rule implicily capures he policy responses o he economic facors ha affec he evoluion of hese variables. The empirical lieraure, in he indusrial counry conex and o a lesser exen for emerging marke economies (EMEs), has hus hrived wih he aim of characerizing ex-pos moneary policy. Agains his backdrop, his paper esimaes a forward-looking moneary policy reacion funcion for he Cenral Bank of Egyp (CBE) in order o characerize he sysemaic behaviour of moneary policy. Two ses of issues moivae his invesigaion. Firs, here has been a marked reducion in global inflaion over he pas wo decades (a leas prior o he 2008 food price shock). Ye, Egyp did no ake par in his era of Grea Moderaion. For his reason, i is useful o assess how policy was conduced since 2000 by he CBE. Second, here is a need o assess he role of he exchange rae in he conduc of moneary policy afer he official regime shifed o a floa in Indeed, he analysis inroduces real exchange rae flucuaions in he moneary policy rule o examine wheher ineres raes reac o such movemens. This is paricularly imporan since moneary auhoriies have no been very clear wih respec o he role of he exchange rae in he new moneary policy framework. In paricular, he paper aemps o answer he following quesions: Has he moneary sance been accommodaive of inflaionary pressures? Could he CBE be characerized as an implici flexible inflaion argeer? Does i modify is moneary policy sance o respond o he exchange rae? To answer hese quesions, he paper follows Clarida, Galí and Gerler (CGG) (1998) o esimae a forward-looking ineres rae rule for Egyp using monhly daa beween 2000 and A baseline model is firs esimaed allowing he cenral bank o respond o expeced inflaion, he oupu gap and a lagged ineres rae. The alernaive esimaions ake ino accoun he role of oher poenial explanaory variables for ineres rae seing, namely he exchange rae. The main conclusions of he empirical analysis are as follows. Firs, moneary policy has accommodaed inflaion and has no been forward-looking. Second, he CBE has shown concern for 1

2 Draf do no quoe minimizing deviaions of oupu from is poenial level. Ye, because he coefficien of inflaion was no significan, moneary policy canno be described as (implici) inflaion argeing (IT). Third, here is also evidence ha moneary auhoriies srongly reaced o changes in he exchange rae. Fourh, here is considerable evidence of ineres rae smoohing. Finally, Egyp s de faco exchange rae regime canno be classified as a floa. The paper proceeds as follows. The firs secion presens he lieraure on moneary policy rules wih a paricular focus on he exchange rae issue in emerging marke economies (EMEs). The second secion summarizes empirical findings of previous work. The hird analyses he main characerisics of moneary policy in Egyp. The fourh describes he mehodology used for esimaion boh for he baseline and alernaive specificaion. The final secion deals wih daa issues and discusses he resuls. Having provided a characerizaion of Egypian moneary policy, he paper urns o esimaing a de faco exchange rae regime classificaion for Egyp. I. AN OVERVIEW OF MONETARY POLICY RULES This secion covers four main issues. The firs is a brief review abou he usefulness of rules for he conduc of moneary policy. The second is discussing formulaions of rules for closed economies. The hird is reviewing he unseled debae relaed o he addiion of he exchange rae in open-economy rules. The fourh is he issue of policy rules o he conex of EMEs. 1. The Role of Moneary Policy Rules The lieraure on moneary policy rules daes back o he lae 1940 s wih Friedman s moneary growh rule. Ye, hree imporan developmens occurred as of he lae 1970 s and gave impeus and renewed aenion o he opic. The firs was he idea ha policy rules are superior o a pure discreion, he laer leading o higher long-run inflaion (Kydkand and Presco (1977) and Barro and Gordon (1983)). The auhors observed ha policymakers migh be emped o exploi he shorerm rade-off beween inflaion and oupu. The exisence of a rule, such as one for fixed money growh as suggesed by Friedman, would ie he hands of policymakers and would preven hem from implemening policies o simulae he economy in he shor-erm and would hus eliminae he inflaionary bias. A fixed exchange rae could also be considered as a commimen by he cenral bank o mainain price sabiliy ha can also reduce he inflaion bias from moneary policy. I is worhwhile o highligh ha in pracice, policy rules are no mechanical procedures enirely deprived of judgemen. As defined by Taylor (2000), a moneary policy rule is simply a coningency plan ha specifies as clearly as possible he circumsances under which a cenral bank should change he insrumens of moneary policy. 2

3 Draf do no quoe The second was he emergence of he neo-classical hinking advocaing he idea ha moneary policy can be used effecively o moderae shor-erm flucuaions of employmen and oupu, as noed by McCallum (1999a) and CGG (1999). This line of hough reversed he beliefs based on he Real Business Cycle analysis which denied moneary policy any significan role in affecing cyclical flucuaions in real variables. As noed by CGG (1999) and McCallum (1999a), he neo-classical lieraure incorporaed nominal price rigidiies (as allowed for in he real business cycle heory), which led o an improvemen in he underlying heoreical framework used for moneary policy analysis. A sream of empirical work beginning in he lae 1980 s emerged o invesigae he effecs of moneary policy shocks on macroeconomic variables (Bernanke and Blinder (1992), Galí (1992), Bernanke and Mihov (1998), Chrisiano, Eichenbaum and Evans (1996, 1998)). Third, here has also been a rapprochemen beween boh academic hinking and cenral banking pracice (McCallum (1999a)). Indeed, he emergence of he Taylor rule which expressed policy in erms of an insrumen rule conribued o reducing he gap beween research and cenral bank pracice. Building on his, he conduc of moneary policy has come o increasingly rely on simple analyical macroeconomic models ha ypically include hree componens: (i) a New Keynesian Phillips curve (as a represenaion of he aggregae supply of he economy) ha specifies how inflaion behaves in response o oupu, (ii) an aggregae demand curve or IS ha specifies how ineres rae changes affec aggregae demand and oupu and, (iii) a moneary policy rule by which he ineres rae is adjused in order o achieve he inflaion arge and also o sabilize oupu. The developmen of hese quaniaive macroeconomic models has allowed an improved analysis of he evaluaion of sabilizaion policies (Woodford (2003)). Anoher imporan aspec of he proximiy beween pracice and heory is refleced in he pursui of he goal of price sabiliy. Boh developmens in macroeconomic heory and he Grea Inflaion era (he lae sixies unil he early nineies) rendered ha goal desirable boh from heoreical and pracical sandpoins. Some cenral banks generally expressed heir commimen o price sabiliy while ohers chose o adoped explici inflaion arges. The emergence of inflaion argeing (IT) was accompanied by effors o caegorize i eiher as a policy rule or a discreionary framework. As a resul of his debae, here has been a renewed ineres on issues relaed o he definiion and desirabiliy of rules. This ineres yielded a rich body of heoreical work in he role of moneary policy rules. In fac, he analysis of moneary policy rules has developed along wo lines. A firs srand of research has sough o idenify properies of opimal rules for various macro-models, o analyze heir performance in models wih opimizing agens, search for rules ha exhibi robusness across a specrum of plausible macro-models, analyses of how he opimal calibraion of simple rules varies 3

4 Draf do no quoe wih key characerisics of macro-models and so on. This work includes for insance Isard, Laxon and Eliasson (1999), Rudebusch and Svensson (1998), Levin, Wieland and Williams (2003) as well as Woodford (2001). The second approach consiss in he empirical esimaion of reacion funcions as a means of characerizing moneary policy and inerpreing policy developmens (Taylor (1993) and CGG (1998)), as will be discussed laer in he paper. The presen paper adops he second approach. 2. The Case of Closed Economies The lieraure has proposed several rules in he closed economy conex. In conras o he early work by McCallum (1988) which sressed he advanages of policy rules wih a quaniaive insrumen, he recen suggesions advocae ineres rae-based rules. The Taylor rule (1993) suggess ha he cenral bank changes is policy rae according o he curren period inflaion rae relaive o an implici arge and he oupu gap. I has he following form: i r ( ) x (1) 1 Where i is he policy rae, r is he equilibrium real ineres rae, is he curren inflaion rae, is he inflaion arge and x is he oupu gap. The Taylor rule has known rapid populariy owing o hree main facors. Firs, i is clear and simple, linking he curren policy rae o curren economic condiions and herefore could be used as a communicaion device o explain policy decisions o he general public (Taylor (1996)). I does no require a forecasing model, as required by IT. In fac, he IT rule is derived from he minimisaion of he loss funcion of he cenral bank expressing sociey s preferences abou he shor-erm rade-off beween inflaion and oupu (Svnesson (1997). I is similar o he Taylor rule excep ha i allows for he inclusion of exogenous variables (ha affec inflaion). The second reason for he widespread of he Taylor rule is ha i has provided a good inernal benchmark o assess he moneary policy sance. Several exensions have been made o he iniial Taylor rule formulaion. Of paricular ineres is he specificaion adoped by CGG (1998) and has he following form: i ( 1 ) (1 ) (1 ) x i (2) n 1 where n is he expeced inflaion rae beween periods and +n and i 1 is he lagged ineres rae 1. According o CGG (1998), his rule is a generalizaion of he Taylor rule and could be reduced o a simple Taylor rule if eiher lagged inflaion or a linear combinaion of lagged inflaion and he 1 The derivaion of his rule is presened in deails in secion x. 4

5 Draf do no quoe oupu gap were o provide a sufficien saisic for inflaion. According o he auhors, his more general specificaion has several advanages. Firs, i explicily incorporaes expeced inflaion in he reacion funcion, hus making i easier o dissociae beween he esimaed coefficiens and cenral bank objecives. Second, i assumes a forward-looking represenaion of he economy, meaning ha he cenral bank does no reac o observed inflaion bu o expeced inflaion and ha i considers a broad array of informaion (abou inflaion and oupu) in heir decision. Third, he inclusion of a lagged ineres rae erm in he reacion funcion capures he high degree of persisence in ineres raes or he desire of cenral banks o smooh ineres rae changes. In his case, he cenral bank makes small seps in he policy rae in order achieves he required change in he long-erm rae (Sack and Wieland (1999)). Various moivaions for smoohing ineres raes are reviewed in Sack and Wieland (1999) and CGG (1999). Firs, in a conex of parial adjusmen of policy, marke paricipans expec a small policy change o be followed by addiional moves in he same direcion and hence price heir expecaions ino forward raes. This increases he impac of policy decision on curren oupu and inflaion wihou requiring large changes in he ineres rae Sack and Wieland (1999). This should also avoid excessive volailiy in shor-erm raes. Second, ineres rae smoohing may limi he disrupion of financial markes. In fac, sharp unanicipaed increases in ineres raes can generae capial losses for financial insiuions exposed o ineres rae risk CGG (1999). Third, from a pracical sandpoin, he uncerainy of parameers of he economic srucure (as a resul of imperfec informaion) may induce a smooher pah of he ineres rae. Oherwise, aggressive policy moves may induce disurbances in he economy. Fourh, moderae ineres rae responses are required o accommodae some degree of daa measuremen error (Sack and Wieland (1999)). Oher reasons could include avoiding repuaion risks o cenral banks from sudden reversals of ineres rae direcions (Mohany and Klau (2004)). From an empirical poin of view, reacion funcions of he main indusrial counries esimaed by CGG (1998) and Seyfried and Bremmer (2003) confirm ha he ineres smoohing hypohesis is valid. Boh Taylor (1993) and CGG (1998) show ha he coefficien of inflaion in he reacion funcion ( ) should be above uniy in order o reduce inflaion. This implies ha he cenral bank should adjus he nominal shor-erm rae more han one-for-one wih he inflaion gap. Oherwise, i would fail o increase he real ineres rae. In his case (of an insufficien increase in he real rae), moneary policy would be accommodaing raher han fighing increases in expeced inflaion. Following he emergence of he Taylor rule, here has been an explosion of heoreical and empirical work examining various varians of his policy rule and heir usefulness remains an area of acive research. Iniially, work focused on he Unied Saes (US), providing economeric esimaes of he Taylor rule coefficiens for equaion (1) (Taylor (1993), CGG (2000) and Judd and Rudebusch 5

6 Draf do no quoe (1998)). In essence, hese auhors argue ha during he Grea Inflaion, he Federal Reserve pursued a policy ha accommodaed inflaion (he coefficien was esimaed a 0.5 by Taylor (1993))and induced insabiliy in he economy by lowering real ineres raes when expeced inflaion increased and vice versa. Subsequenly, empirical work sough o esimae ineres rae rules for oher economies. Among he pioneering work was ha of CGG (1998) who esimae a rule (equaion 2) for France, Germany, Ialy, Japan and he UK and he US. They repor ha he cenral banks of Germany, Japan and he US can be aken o have followed flexible implici IT (i.e. hey have raised real ineres raes when expeced inflaion was above arge). A lo of work has also focused on euro area. Peersman and Smes (1999) and Gerlach and Schnabel (1998) find ha beween average ineres raes in counries of he euro area were a funcion of he average oupu gap and inflaion. Oher work include hose of Chorareas (2008), Fendel and Frenkel (2006), Mésonnier and Renne (2004), Nelson (2003), Gerlach- Krisen (2003), Verdelhan (1999)and Huang, Margariis and Mayes (2001). 3. The Case of he Open-Economy: An imporan and sill unseled issue for moneary policy in open economies is how much of an ineres rae reacion here should be o he exchange rae in a moneary regime of a flexible exchange rae, an inflaion arge, and a moneary policy rule. (Taylor (2001)). The iniial research on he design of moneary policy rule before was based on he case of a closed economy. In open economies, Svensson (2000) explains ha he exchange rae allows for several ransmission channels in addiion o he sandard aggregae demand and expecaions channels in closed economies: (i) he real exchange rae affecs he relaive price beween domesic and foreign goods, and hus conribues o he aggregae demand channel, (ii) i also affecs consumer prices direcly via he domesic currency price of impored final goods as well as he price of impored inermediae goods, and hus he pricing decisions of domesic firms. As an asse price, (iii) he exchange rae conribues o making forward-looking behaviour and is hus essenial in forming expecaion abou moneary policy. Finally, (iv) exchange rae flucuaions may also be ransmied o aggregae demand for domesic goods. Ye, he issue of wheher cenral banks should respond o exchange rae movemens when seing shor-erm nominal ineres raes is no fully seled. On he one hand, Dennis (2001) argues ha he exchange rae should be included in a policy rule because i provides imely and relevan informaion for policymakers in ineres seing. On he oher hand, Bernanke and Gerler (2000) argue in a general fashion ha exchange raes severely limi he shor-run discreion of he cenral 6

7 Draf do no quoe bank, eiher o assis he financial sysem or o correc shor-erm imbalances in he economy. They furher argue ha, in a conex of financial crisis, large ineres rae movemens o defend exchange rae depreciaion may worsen he balance shee of firms and make economic conracions more severe. More specifically, Taylor (2001) argues ha adding exchange rae ino he policy reacion funcion may no always improve he performance of he policy rules for wo reasons. Firs, even wihou an explici erm of he exchange rae in he policy rule, he exchange rae sill has an indirec effec on he ineres rae. I will firs influence expeced inflaion, oupu and ineres raes and hen hrough he raional expecaions model of he erm srucure of ineres raes, i will also influence curren ineres raes. Second, in some cases, he changes in ineres raes required o smooh shorerm exchange rae flucuaions may have undesirable effecs on real oupu and inflaion. Naurally, research has surged in order o evaluae he performance of policy rules ha conain an exchange rae erm. In oher words, would a rule ha included some measure of he exchange rae produce beer economic oucomes? Dennis (2001) disinguishes he difference beween responding o exchange rae movemens from argeing he exchange rae. The laer makes he exchange rae a policy goal, whereas he former reas he exchange rae as one furher piece of informaion o be weighed when seing ineres raes. The lieraure reaing he role of he exchange rae in policy rules mainly relies on simulaions of calibraed open-economy macroeconomic models. I can be divided ino wo main broad groups. The firs group does no ake ino accoun he role of model uncerainy. In he second group, models allow for some degree of uncerainy o capure policymakers incomplee undersanding of how he economy operaes and how i responds o exchange rae movemens. This uncerainy may induce policymakers o misakenly respond o exchange rae movemens. In general, he resuls from hese calibraed models are no very conclusive. On he one hand, in he absence of model uncerainy, some work show ha he explici inroducion of he exchange rae erm in he policy rule leads o beer (or a leas no worse) economic oucomes and enhances welfare han if he exchange rae is ignored. Ball (1998) found ha adding he exchange rae o he benchmark policy rule reduces oupu variabiliy (for he same amoun of inflaion variabiliy). The exchange rae is added o he policy rule in wo ways in Ball s analysis. Firs, he policy insrumen is a moneary condiions index (MCI) (a weighed average of he ineres rae and he exchange rae) insead of he shor-erm ineres rae. Second, a suggesed measure of inflaion (combining inflaion and a lagged exchange rae and inerpreed as a long-run inflaion arge) helps filer ou ransiory effecs of exchange rae flucuaions. Ball found ha he weigh on he exchange rae in he MCI should be equal o or slighly greaer han he exchange rae s relaive effec on spending. Ball (1998) also argues ha adoping a sric IT rule in an open-economy 7

8 Draf do no quoe generaes large flucuaions in boh he exchange rae and oupu. Using anoher model wih forwardlooking agens, Svensson (2000) considers a policy rule ha is similar o Ball (1998) in he conex of an IT a small open economy. The suggesed rule explicily akes he exchange rae ino accoun in he policy reacion funcion by placing some weigh on dampening exchange rae volailiy. Svensson (2000) shows ha compared o he Taylor rule, he flexible CPI IT rule yields improved sabiliy in he macroeconomic variables wih he excepion of he ineres rae. Svensson (2000) also menions ha by excluding concern for he exchange rae, he Taylor rule disregards informaion no capured by curren inflaion and he oupu gap. For an open economy, such informaion is likely o be quie imporan. Senay (2001) shows ha adding an exchange rae erm o he ineres rae rule enhances sabiliy in oupu and inflaion as well as leads o a higher welfare. In paricular, he rule conaining he MCI performs well and has beer welfare effecs. Dennis (2000) finds ha he inclusion of he real exchange rae (as a measure of exernal compeiiveness) ends o improve he performance of he Taylor rule and bring i closer o he opimal sae. Dennis (2002) shows ha he moneary auhoriies should opimally focus no jus on inflaion bu also on he real exchange rae and erms of rade in Ausralia o he exen ha impor goods are consumpion goods (and ener he CPI). Resuls of oher work, sill no accouning for model uncerainy, find a more modes role for he exchange rae in he policy rule. CGG (2001) and Baini, Harrison and Millard (2001) argue ha policy rules ha respond o he exchange rae generae lile or no improvemen in he Taylor rule. In he view of CGG (2001), he only characerisic of he open economy is he degree of openness. Despie heir resuls, neiher paper suggess ha policymakers should no respond o exchange rae movemens. In fac, he exchange rae response is capured hrough expeced inflaion, bu he exchange rae iself is no perceived o provide independen informaion abou inflaion and aggregae demand. Oher resuls are mixed like hose of Taylor (1999b) muli-counry sudy, favouring open economy rules for some counries and rejecing heir usefulness for ohers. In he case of Norway, Akram, Barsden and Eirheim (2006) find ha ha responding o exchange rae flucuaions generaes insrumen volailiy which conribues o higher volailiy in general. On he oher hand, papers by Leiemo and Södersröm (2005), Wollmershäuser (2004)) and Guender (2001) fall ino he second group of sudies which accoun for model uncerainy. Leimo and Södersröm (2005) argue ha uncerainy abou exchange rae deerminaion causes policy rules o perform poorly if he model proves incorrec. Guender (2001), in a closely relaed resul, shows ha uncerainy abou he righ response o exchange rae depreciaion can sill occur even wih he correc exchange rae equaion. If here is uncerainy abou oher aspecs of he economy, hen policymakers may respond o exchange rae movemens inappropriaely. Wollmershäuser (2004), however, comes 8

9 Draf do no quoe o he opposie conclusion. Accouning for exchange rae uncerainy leads he policy rule (responding o conemporaneous and lagged movemens in he real exchange rae) o perform reasonably well. Even hough he exchange rae plays a crucial role in he formulaion of moneary policy in an open-economy, he issue on wheher i should be included in cenral banks reacion funcions remains largely unseled. In he absence of model uncerainy, he conclusion from calibraed models is ha including he exchange rae in he policy rule does no worsen economic oucomes. However, once uncerainy is inroduced, exploiing informaion conained in exchange rae movemens may lead o excessive ineres rae and exchange rae volailiy ha can easily be avoided hrough simply no responding o direc movemens in exchange raes. 4. Emerging Marke Economies Conex Compared o indusrial counries, research on moneary policy in he conex of EMEs is of recen origin. Mos research ends o argue agains he adopion of purely discreionary frameworks in EMEs. Calvo and Mishkin (2003) explain ha EMEs require greaer moneary discipline in he conduc of moneary policy as a resul of low policy credibiliy (because of weak fiscal, financial and moneary insiuions, a higher risk of currency subsiuion 2 and liabiliy dollarizaion 3 ). I is in his spiri ha Calvo and Mishkin (2003) sugges ha IT may be well-suied for EMEs because i offers consrained discreion in he sense ha i leads o more ransparency and accounabiliy in insrumen seing, may increase suppor for cenral bank insrumen independence and enhance he credibiliy building process. Taylor (2000) provides anoher reason for adoping a rule-based moneary policy in EMEs, especially hose ha have oped for flexible exchange rae wih an inflaion arge. Moneary policy rules can provide policy makers wih a good overall framework for making moneary policy decisions in he sense ha policy inenions become more ransparen o he privae secor, financial markes and hence he general public. This predicabiliy in policy behaviour should make i easier for he privae secor o form expecaions and should improve he ransmission and effeciveness of moneary policy. Ye, a common complicaion in EMEs is ha moneary policy ofen pursues muliple objecives besides inflaion (Mohany and Klau (2004)). In paricular, he exchange rae is an imporan objecive and ineres raes may ofen be used o smooh flucuaions, as concluded by Calvo and Reinhar (2002). In a recen sudy, Ho and McCauley (2003) show ha EMEs ha miss heir inflaion arges are generally he ones experiencing sharp exchange rae volailiy. This suggess 2 This means ha firms and individuals in EMEs urn o use a foreign currency for ransacions insead of he local currency Calvo and Mishkin (2003). 3 This means ha he obligaions of banks, he privae secor and he governmen are denominaed in foreign currency while heir revenues are denominaed in local currency Calvo and Mishkin (2003). 9

10 Draf do no quoe ha cenral banks may be ready o raise raes when faced wih large currency depreciaions. Bu hey may, a he same ime, preven sharp conracion of he economy even a he cos of missing he inflaion arge. In fac, EMEs end o pay aenion o he exchange rae because hey are more vulnerable o excessive flucuaions. Morón and Winkelried (2005) find ha real exchange rae flucuaions are he source of more srucural volailiy in financially vulnerable economies. More generally, EMEs are more vulnerable o sudden sops of capial inflows which could lead o exchange rae collapses. More generally, excessive exchange rae swings could also have undesirable domesic consequences. Firs, large exchange rae depreciaions ofen resul in a high inflaion. Second, such shocks end o be persisen and in more exreme cases, currency crisis can cause severe recessions especially if coupled wih a banking crisis Kaminsky and Reinhar (1999). Many auhors have highlighed he conracionary effec of depreciaions, paricularly in counries wih a high degree of dollarizaion (Eichengreen (2002) and Morón and Winkelried (2005)). Furhermore, raising he ineres rae o defend he exchange rae from depreciaing may cause oupu losses. Calvo and Reinhar (2000) also emphasize ha oupu losses can occur as a resul of sudden sops in he access o exernal financing available o EMEs which provokes real depreciaion, driving consumers o limi heir expendiure in non-radable goods. Fourh, in many EMEs, exchange rae flucuaions may harm financial sabiliy Sone e al. (2009) and Ho and McCaulay (2003). A depreciaion followed by a sudden sop of capial ouflows can hur he solvency of firms and individuals wih ne foreign currency liabiliies bu may also harm he banking sysem. Fifh, hin exchange markes in EMEs are vulnerable o speculaion and herd behaviour, which may require more inervenion o miigae hese effecs. Because of he imporan place ha he exchange rae coninues o occupy in EMEs, here have been several views jusifying an ineres rae response o exchange rae shocks depending on a variey of facors including he naure of he shock causing he depreciaion, he availabiliy of alernaive (inervenion) insrumen and poenial impac on inflaion. Firs, moneary policy should no respond o depreciaions caused by a permanen real shock (a secular decline in he erms-of-rade or a negaive produciviy shock). Indeed, one of he main benefis of having a flexible exchange regime is ha i allows fas adjusmens in relaive prices in he face of real shocks, hus reducing heir coss. Therefore, i is unlikely ha ineres raes will need o be moved in he face of exchange rae movemens ha are a response o real shocks, since i is unlikely ha hey will have an impac on inflaion (De Gregorio and Tokman (2005)). Second, he exen o which moneary policy responds o exchange rae shocks should also depend on he naure and persisence of he exchange rae shock and wheher i impacs inflaion. For example, here should be no moneary policy responses o emporary shocks, as hey will no produce lasing effecs and herefore will no modify inflaion expecaions in 10

11 Draf do no quoe he policy horizon. A high pass-hrough o inflaion could herefore jusify some inervenion. However, if credibiliy is low, emporary shocks will have more persisen effecs on inflaion, as he public will expec auhoriies o accommodae o higher inflaion. Conversely, he effecs will be minimised if he public perceives ha moneary policy will be ighened if inflaionary repercussions are significan. Also, movemens in he exchange rae ha respond o adjusmens in he equilibrium real exchange rae will have smaller inflaionary effecs han movemens ha are no a response o changes in fundamenals. On he oher hand, aemping o arge a misaligned exchange rae, o arificially reduce inflaion, may only bring coss. Finally, ineres rae response also depends on wheher he auhoriy has alernaive insrumens, such as foreign exchange inervenion. As Lahiri and Végh (2001) sugges, foreign exchange inervenions may be cos-effecive in he presence of large shocks, as heir fixed coss are lower han he coss associaed wih ineres rae policies for large shocks. If auhoriies reac by ighening moneary policy when facing a ransiory and significan exchange rae shock, hey may need o undo he ighening afer he shock has passed. This would undermine he effeciveness and credibiliy of moneary policy as he volailiy of he exchange rae increased and he ransmission o marke ineres raes, especially long ones, diminished. Research aiming o evaluae ineres rae rules for EMEs sill remains scarce. Because of heir less developed financial markes, Taylor (2000) suggess some general modificaions in he moneary policy rules concerning he choice of he insrumen (a moneary aggregae raher han an ineres rae), he variables in he rule (a greaer role for he exchange rae) or in he size of he response of he insrumen o economic evens (o deal wih less developed long erm securiies markes). Like he case of developed economies, he resuls from calibraed models are inconclusive. On he one hand, one avenue of research in EMEs has focused on wheher he inclusion of he exchange rae may be jusified in financially vulnerable economies 4. The reply of Morón and Winkelried (2005), Céspedes e al. (2004), Cavoli and Rajan (2006) and Roger e. al (2009b) suppor his argumen. In paricular, Céspedes e al. (2004) argue ha in economies wih a higher degree of dollarizaion and consrained access o inernaional borrowing marke, he exchange rae may give rise o srong balance shee effecs. Morón and Winkelried (2005) find ha he opimized rules for a vulnerable economy place much less weigh on smoohing oupu and more weigh on dampening exchange rae han in a financially robus economy. Roger e. al (2009b) furher argue ha his hybrid approach may lead o slighly beer oupu and inflaion performance since hese economies are much more exposed o risk-premium disurbances han heir financially robus counerpars. All four sudies find ha he opimal weigh on he exchange rae is low. In paricular, Roger e. al (2009b) indicae ha puing more han a modes weigh on dampening exchange rae volailiy is likely o 4 Defined as counries where a depreciaion causes an increase in he risk premium (Céspedes e al. 2004). 11

12 Draf do no quoe significan worsen economic performance. Morón and Winkelried (2005) furher sugges a non-linear fear of floaing rule hrough which moneary policy will only reac o real exchange rae depreciaion ha exceeds a cerain hreshold. Using a sylized sochasic general equilibrium model Pakisan, Choudhri (2006) also finds ha real shocks (o raded goods produciviy) creae a rade-off beween inflaion and exchange rae variabiliy may serve as a jusificaion for an ineres rae response. On he oher hand, However, Baini e al. (2007), using a model of he fairly heavily dollarized Peruvian economy, conclude ha no weigh should be pu on he exchange rae in a financially vulnerable economy. They furher argue ha because dollarizaion weakens he oupu gap ransmission channel relaive o he exchange rae channel, here should be no reacion o limi he flexibiliy of he exchange rae in order o achieve he inflaion arge. Ravenna and Naalucci (2008) find ha significan smoohing of he exchange rae has adverse macroeconomic consequences when here are subsanial Balassa-Samuelson effecs resuling from differenial produciviy growh in he radables and nonradables secors. Laxon and Peseni (2003) also find a very small role for he exchange rae in ransiion economies, leading hem o conclude ha i is counerproducive for moneary policy o reac srongly o movemens in he exchange rae, he informaion conen of which is already capured by eiher curren or expeced CPI inflaion. Oher avenues of research explore he consequences of a larger role for he exchange rae in he policy rule. On he one hand, Lahiri and Végh (2001) sugges ha an exchange rae band may be appropriae if nominal exchange rae movemens and higher ineres raes have oupu coss and if inervenion is cosly. On he one oher, McCallum (2006) finds ha an exchange rae based approach o IT may be beneficial in a very open economy such as ha of Singapore. In fac, as he degree of openness increases, an exchange rae based approach of IT (using he exchange rae raher han he policy rae as he main policy insrumen) yields beer oucomes in sabilizing oupu wih no adverse consequences on inflaion variabiliy. To recapiulae, while a rule-based moneary policy is required o promoe credibiliy in EMEs, boh he heoreical and empirical lieraure have no provided firms answer wih respec o he ype of ineres rules ha would yield he bes oucomes in EMEs. So far, evidence poin ou ha he ineres rae response o he exchange rae may in some insances be warraned no only as i is an imporan deerminan of inflaion bu because i may have adverse effecs on oupu and financial sabiliy. This is especially he case of financially vulnerable economies. II. REVIEW OF EMPIRICAL FINDINGS 12

13 Draf do no quoe This secion briefly illusraes some of he recen sudies ha esimaed open-economy reacion funcions. This work esimaed he weighs of inflaion, oupu and he exchange rae o provide a characerisaion of ex-pos policy. Mos empirical work suggess ha he ineres rae is used o sabilize he exchange rae in open-economy indusrial economies. Clarida and Gerler (1997) find a response from he Bundesbank o a depreciaion of he real exchange rae. CGG (1998) also found a small bu significan reacion of he nominal ineres rae of he Bundesbank ( ), he Bank of Japan ( ) and he Bank of England ( ) o he real exchange rae. Similar resuls are repored by Kim (2002) for a number of European economies ha paricipaed in he exchange rae mechanism. Chadha e al. (2004) reach a more general conclusion: ineres raes in Japan, he UK, and he US reac o exchange rae and asses. Moreover, cenral banks also offse deviaions of exchange raes and asse values from heir fundamenal values. In a very ineresing paper, Kharel, Marin and Milas (2010) esimae a flexible non-linear moneary policy rule for he Unied Kingdom (UK) in which he response o real exchange rae deviaions is only eviden above a cerain hreshold (more han 4 percen for underdevaluaions and more han 5 percen over-valuaions). Resuls of oher works are less conclusive. Gerlach and Smes (2000) find a policy insrumen response o he exchange rae, beween 1992 and 1997, in he cases of he Reserve Bank of New Zealand and he Bank of Canada (relying on an MCI) bu no for he Reserve Bank of Ausralia. Similarly, Lubik and Schorfheide (2007) presen evidence of an ineres rae response o he exchange rae in England and Canada bu no in Ausralia and New Zealand beween he early 1980 s and early 2000 s. Gerdesmeier and Roffia (2003) find ha in he case Germany, France, Ialy, Spain, he Neherlands and he UK, he response of he ineres rae o he exchange rae is saisically insignifican. In he conex of IT, Hüfner (2004) found ha he exchange rae erm in he policy rule is only significan for he UK and New Zealand. However, Bjǿrnland and Halvorsen (2008) find evidence of sysemaic policy responses o exchange rae depreciaions in Ausralia, Canada, New Zealand, Norway, Sweden and he UK. In a more general conex, he empirical esimaion of moneary policy rules was used o es wheher IT represened a change in moneary policymaking. Seyfried and Bremmer (2003) es his hypohesis for Ausralia, Canada, Finland, Israel, New Zealand and he UK who inroduced IT in he early 1990 s. They find evidence of IT in all counries excep Finland. However, Muscaelli, Tirelli and Trecroci (2002) demonsraed ha significan changes in moneary policy behaviour have occurred in a number of OECD economies (paricularly in he G-3) bu no in counries who had adoped IT. 13

14 Draf do no quoe In he case of EMEs, research on moneary policy rules has been growing over he pas few years bu sill remains scan. Some work esimaes reacion funcions for moneary auhoriies in he case of a closed economy conex (Corbo, Landerreche and Schmid-Hebbel (2002)). Esimaions also poined ou ha under IT, moneary policy had a non-accommodaive sance owards price shocks ((Corbo e.al (2002) and Mohany and Klau (2004)). While ohers find ha backward-looking rules generally provide beer forecasing han forward ones in he Lain American and Caribbean (LAC-7) group, meaning ha pas inflaion sill plays a role in inflaion expecaions (de Carvalho and Moura (2008)). However, wha is of ineres here is he work carried ou for open-economy EMEs. Empirical work confirms ha cenral banks in EMEs respond very srongly o exchange raes and ha his response is even greaer ha o eiher inflaion or he oupu gap (Aizenman, Huchinson and Noy (2008), Mohany and Klau (2004), Ades e al. (2002) and Filosa (2001)). However, Aizenman e al. (2008) find ha he response o he real exchange rae is much sronger in non-it economies, suggesing ha IT places a consrain on he pursui of an exchange rae arge. They furher find ha he response o he real exchange rae is sronges in commodiy-exporing economies. Edwards (2006) invesigaes he deerminans of he exchange rae response in he Taylorrule regressions and finds ha counries wih a hisory of high inflaion, and wih hisorically high real exchange rae volailiy, end o have a higher coefficien (response) o he real exchange rae. Oher cross-counry sudies are unable o generalize hese findings o all he counries. In heir paper, de Carvalho and Moura (2008) confirm his finding for wo counries (Peru and Mexico) ou of seven. Similarly, Schmid-Hebbel and Werner (2002) find ha he effec of exchange rae depreciaions on real ineres raes has no been significan in Brazil, Chile, and Mexico following he adopion of IT. Ye, hey are able o show ha hese counries exhibi a emporary fear of floaing during paricular periods, as evidenced in a srong reacion of ineres raes o exchange rae shocks. Hsing (2009) finds ha cenral banks in he Philippines and Thailand reaced o boh he curren and lagged real exchange rae whereas cenral banks in Indonesia and Malaysia did no reac a all. Osawa (2006) and Yazgana and Yilmazkuday (2007)) find no evidence of an ineres rae response o he exchange rae in Asian crisis-affeced economies and Turkey and Israel, respecively. On individual counry sudies, Capuo (2004), and Schmid-Hebbel and Tapia (2002) show ha he policy response o he exchange rae was significan in Chile. The same conclusion was reached for Korea by Parsley and Popper (2009) and Eichengreen (2004) leading he laer o conclude ha he Bank of Korea cares abou he movemen of he real exchange rae above and beyond is use in forecasing fuure inflaion. In oher counries, here is no evidence of a srong ineres rae response o he exchange rae as Turkey (Berumen and Taşçi (2004)) and Taiwan (Chang (2005)). 14

15 Draf do no quoe In he case of Egyp, only wo sudies esimaed reacion funcions for he moneary auhoriies. In a muli-counry sudy including Egyp, Jordan, Kuwai, Saudi Arabi and Tunisia, El- Erian and El-Gamal (2002) esimae Taylor rules boh in a closed and open-economy conex during he 1990 s. For Egyp, hey repor a feedback parameer of on inflaion and 0.34 on he oupu gap. In is augmened-form, he Taylor-rule had he following coefficiens: for curren inflaion, 0.21 for he oupu gap and 9.69 for he real exchange rae. In boh forms, he ineres rae responded negaively o curren inflaion. I also responded posiively o he oupu gap bu he coefficien was no significan. The inclusion of he exchange rae yields a significan posiive coefficien. Moursi, El- Moussallamy and Zakareya (2006) calibrae a simple closed economy Taylor rule in an opimizaion macroeconomic framework for he period They repor a coefficien of he inflaion gap in he reacion funcion ha is slighly below uniy (0.93). Empirical esimaions of moneary policy rules (boh in heir iniial and augmened forms) have been used o describe ex-pos moneary policy firs in indusrial economies hen EMEs. In he case of Egyp, research in his area is slighly oudaed and esimaed Taylor rules in heir iniial formulaions. No sudy esimaed a forward-looking rule (wih expeced inflaion) wih ineres smoohing along he lines proposed by CGG (1998) using he Generalized Mehod of Momens (GMM), which is he aim of his paper. III. MONETARY AND EXCHANGE RATE POLICIES IN EGYPT This secion briefly describes he insiuional framework in which he CBE operaes. There has been a firs shif in he conduc of moneary policy in he early 1990 sin he conex of an Economic Reform and Srucural Adjusmen Program. Key elemens of he reform included a large fiscal adjusmen, an exchange rae anchor and some price liberalisaion. These reforms, aided by a credible nominal anchor (being an exchange rae peg), helped refocus (albei implicily) moneary policy owards disinflaion (Selim (2011)). Moneary policy has benefied from furher improvemens in is underlying framework since For insance, he 2003 Banking Law declared price sabiliy o be he overriding objecive of moneary policy. The CBE also announced is inenion o move o an IT regime in Shorly aferwards, a moneary policy saemen was issued reieraing commimen o his medium-erm goal (CBE (2005)). Prior o he adopion of he Law, moneary policy did no have a mandae for price sabiliy. Ye, he simple legislaion of he law did no preven moneary policy from pursuing oher objecives a he expense of price sabiliy (Selim 15

16 Draf do no quoe (2011)). However, despie hese improvemens, he framework sill lacks some ransparency wih respec o an official nominal anchor, which is absen since More specifically, here has no been a redefiniion of he role of he exchange rae under his new framework. Afer a long hisory wih fixed exchange raes and following some pressures on he official peg, a floa was announced in January The de jure floa allows he CBE o inervene in he foreign exchange marke only o couner major imbalances and sharp swings in he exchange rae. The esablishmen of a foreign exchange inerbank marke in December 2004 eliminaed he parallel foreign exchange marke and sabilised he nominal exchange rae as from December Ye, he exchange rae only exhibied limied movemens despie several exernal shocks (srong capial inflows during he period and some ouflow in he afermah of he crisis) (figure 1). This raised he quesion of wheher his is he oucome of inervenion. In general, because exchange rae managemen policy is no ye fully ransparen, i is less clear o he public if and how moneary policy manages he exchange rae. This lack of ransparency may have been confusing especially ha he exchange rae appreciaion may have been indirecly affeced by he 2008 ineres rae hikes, especially ha he CBE has remained silen on any official inervenion in he foreign exchange marke. In fac, higher ineres raes; which were necessary o conrol rising inflaion since 2007, susained he reserve accumulaion and exacerbaed he upward pressure on he exchange rae. Moneary policy ighening led o a vicious circle hrough which higher ineres raes coninued o arac foreign inflows, which exered pressure on he exchange rae, hus forcing he CBE o resis such pressures (figure 1). However, Selim (2011) showed ha he moneary auhoriies have been inervening hrough serilized inervenion (peaking a 7.4 percen of GDP in FY08) in order o offse he susained reserve accumulaion during (around US$ 15 billion). Furher research (Selim (2010) showed ha he CBE s moneary policy is characerized by fear of floaing and he laer is moivaed by a high exchange rae pass-hrough o domesic inflaion, as suggesed by Calvo and Reinhar (2002). Figure 1: Real exchange rae, overnigh deposi rae and inflaion 5 For more informaion on developmens in he moneary policy framework, please see Selim (2011). 16

17 Draf do no quoe M07 06M01 06M07 07M01 07M07 08M01 08M07 REALER ODR CPIINF Prior o 2005, he CBE did no rely on ineres raes o conduc moneary policy. During he 1970 s and 1980 s, i operaed primarily hrough adminisraive insrumens (such as credi raioning, fixed loan o deposi raios...ec). In a conex of fiscal dominance, nominal ineres raes were se a low levels (o mainain boh he fiscal posiion and he solvency of he banking secor) yielding negaive real ineres raes. Naurally, ineres raes did no have much impac on he growh of credi (Abou El-Eyoun (2003). This sysem was able o prevail during his period wihou big flucuaions in eiher he ineres rae or he nominal exchange rae (excep for a few devaluaions in he end of he 1980 s). A combinaion of igh capial conrols wih relaively underdeveloped financial markes made his possible. In he early 1990 s, direc conrols on foreign exchange ransacions and credi ceilings were removed and ineres raes were liberalized. A he beginning of he reform programme, all ineres raes were high and declined in andem wih inflaion bu in general here has been a disconnec in he movemens of ineres raes and inflaion saring he lae 1990 s. Wih he reform program, moneary policy urned o indirec measures. Serilised inervenion (hrough use of T-bills) was widely used o manage he nominal exchange rae and also o provide a non-inflaionary means of financing he budge defici. Bu since he exchange rae was largely fixed, here was relaively limied scope for he ineres rae o independenly respond o exchange rae flucuaions. A he ime, here was no policy rae o idenify he moneary policy sance. A discoun rae exised and an effor was made o link i o he -bills rae bu i had ceased o respond o i since 1995 (Abou El-Eyoun, 2003). An overnigh domesic currency inerbank marke was creaed in 2001 bu i was hin and shallow, which rendered he iner-bank rae volaile (figure 2a). In general, he moneary auhoriies were no ransparen abou ineresed decisions. Oher shor-erm raes such as he hree-monh -bills rae, he hree-monh deposi rae and he one-year lending rae also exised (figure 2b). In general, hese rae were no responsive o he discoun rae (Abou El-Eyoun (2003). 17

18 Draf do no quoe (a) Figure 2 : Ineres raes and inflaion (b) DISCOUNT INTERBANK TBILLS EGYINF CPIINF DEPRATE LENDRATE In order o prepare he implemenaion of a formal full-fledged IT, an aemp o conduc a sysemaic or rule-based moneary policy has been inroduced wih he launch of he new policy raes as he main operaing arge in June These raes have become he key policy raes and are supposed o help he CBE mee an implici inflaion arge. By seing hese raes, he CBE deermines he corridor wihin which he overnigh rae can flucuae. A Moneary Policy Commiee (MPC) was esablished o revise hem every six weeks. Figure (3) suggess ha he cenral bank sysemaically raised nominal shor-erm raes in periods of high inflaion. Ye, i would seem ha in many cases policy decisions ofen lacked a forward-looking vision, reacing o developmens only afer hey occur. Policy ighening was ofen also insufficien o curb rising inflaion. For insance, he acceleraion of inflaion since March 2006 was only me wih policy ighening in November 2006 and December And as inflaion surged again from January 2008, he CBE ighened moneary policy six consecuive imes beween February and Sepember In boh cases, he CBE mainained an expansionary sance since real overnigh deposi raes remained negaive and declined. More generally, saring mid-2007 (excep for a few monhs in end-2007), he CBE kep shor-erm raes below inflaion rae. Real shor-erm raes accordingly hovered around zero or below. Figure 3 : New policy raes and inflaion The CBE 4 does no announce a arge level 0 05M07 06M01 06M07 07M01 07M07 08M01 08M07 CPIINF ODR OLR 18

19 Draf do no quoe of ineres raes. Raher, i signals changes in he sance of moneary policy and les ineres raes be adjused by he marke. While i has been ofen claimed ha he pass-hrough of policy raes is low, he 3-monh deposi rae seems more responsive o he changes in he new policy rae (figure 5) M07 06M01 06M07 07M01 07M07 08M01 08M07 DEPRATE ODR In summary, he framework ha guides he conduc of moneary policy in Egyp has formally improved since I has he medium-erm objecive of mainaining price sabiliy and relies on an ineres rae insrumen o reach an implici inflaion arge. Ye, he exchange rae managemen policy has no been clear since he official announcemen of he floa. Previous analysis has shown ha moneary policy exhibis fear of floaing and has confirmed CBE inervenion in he foreign exchange marke o offse he effec of reserve accumulaion. Ye, resuls of his work were less clear cu abou he role of ineres raes. This is because changes in ineres raes could be made eiher o manage he exchange rae or in response o expeced inflaion or boh. I would hus be useful o assess wheher he policy rae is influenced by exchange rae consideraions. No work has however empirically addressed his issue. IV. A FORWARD LOOKING MODEL SPECIFICATION This secion presens he specificaions of he rule o be esimaed firs for he baseline case in which he cenral bank adjuss is shor-erm ineres rae in response o expeced inflaion, he oupu gap and a lagged ineres rae erm. I hen presens he alernaive specificaion ha allows he cenral bank o respond o oher variables, namely he exchange rae. This CGG rule specificaion is believed o provide a good descripion of moneary policy, paricularly since 2003 for several reasons. Firs, he esimaion of his rule requires ex-pos daa, including he measure for expeced inflaion, which is useful in he Egypian case since here is no published inflaion forecas. CGG (1998) considers ha he year-ahead forecas o be a good indicaor of he medium-erm rend of inflaion. Moreover, he esimaion of his rule also provides an esimae 19

20 Draf do no quoe for he inflaion arge. Second, he alernaive specificaion also permis a es of he forward-looking versus he backward-looking specificaions of he reacion funcion. Third, i allows o es wheher addiional policy variables may explain he ineres rae seing behaviour of he moneary auhoriies. Namely, he inclusion of he exchange rae erm in he rule is believed o be perinen in he case of Egyp since i may sill be acing as an exernal consrain on moneary policy. This inuiion could be he naural resul of a high and quick pass-hrough from he exchange rae o inflaion and due o he fac ha shocks o he exchange rae are persisen, as seen in Selim (2010a and 2010b). 1. Baseline model The baseline case assumes ha he cenral bank has some degree of auonomy over moneary policy and ha he laer is no subjec o an exernal consrain (an exchange rae arge). The framework also assumes some degree of nominal rigidiy in wages and prices so ha moneary policy can affec real variables in he shor-erm. I also assumes ha he cenral bank has a arge for he shor-erm nominal ineres rae ( i ), which is he main operaing moneary policy insrumen. The cenral bank aims a mainaining he inflaion rae equal o a pre-specified arge level (for example zero) and keeping he economy as close as possible o a neural cyclical posiion. More specifically, he cenral bank ses he arge shor-erm ineres rae condiional on he sae of he economy and ha he shor-erm ineres rae, on he deviaion of expeced inflaion and oupu from heir respecive arges: i ) ( E y y ) i ( E (3) n where i is he long-run equilibrium nominal ineres rae, n is he rae of inflaion beween periods and +n, y is real oupu, is he inflaion arge and y is he poenial oupu, defined as he level ha would arise if wages and prices were perfecly flexible. In addiion, E is he expecaion operaor and is he informaion se available o he cenral bank a he ime i ses he ineres rae. The implied arge for he ex-ane real ineres rae could be wrien as follows: r n i E (4) Rearranging equaion 3, we obain: r ) ( E y y ) r ( 1)( E (5) n 20