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This paper benefited from helpful comments from Alfredo Cuevas, Norbert Funke, Issouf Samake, and Norbert Toé.
Inflation expectations are estimated based on the rational expectations hypothesis, the adaptive expectations hypothesis, and a standard autoregressive moving average.
This requires a 1 percent increase in money growth in all four quarters.
Including the Gambia, Ghana, Nigeria, and Sierra Leone. Guinea and Liberia were excluded due to data constraints.
Inflation is used as a proxy for the return on real assets. Tucker (2004) also includes dummies for seasonality and economic reforms.
He adds that open market operations should be accompanied by financial market development and increased private sector participation to make monetary policy more effective.
A civil war started in 1991 when the Revolutionary United Front embarked on its campaign against the government in the Eastern Province of Sierra Leone. By 1995 the war had spread across the whole country.
Even annual real sector data are often unreliable in the immediate years following the end of civil war.
The term “structural VAR” denotes a model with identifying restrictions, as explained below.
This implies one nonlinear restriction on the matrix Г1, because the variance-covariance matrix for the reduced form Σu is linked to its structural counterpart by
We used world average crude prices in US$/barrel from International Financial Statistics.
We chose reserve money instead of broad money because the central bank has more control over it.
We also considered the nominal effective exchange rate and found little qualitative difference; we preferred the bilateral exchange rate against the U.S. dollar, because use of the US dollar is common in Sierra Leone and policy discussions of exchange rate issues always focus on the bilateral Leone/US dollar exchange rate.
The VAR model in level nevertheless, allows implicitly for cointegration relationships. Even without cointegration, it is not necessary for VAR analysis to difference variables because each equation in the model contains lags of the endogenous variable, which makes the model relatively robust against ‘spurious regression’ concerns.
Standard information criteria suggest a lag length of one, but with only one lag the model displays signs of severe non-normality.
We also impose the standard orthogonality restriction. The short-run restrictions are implemented using the Choleski decomposition.
Assuming the central bank would not sterilize the impact of its sale of foreign exchange on money supply.
Monetary policy shocks dominate the variation in reserve money, which would suggest that most monetary policy actions are discretionary; however, this likely reflects in part the incomplete specification of the monetary policy reaction function because of lack of data on government financing requirements.
Note that the response of most variable dies out after about 12 to 18 months; the limited variation at longer horizons reduces the economic significance of the variance decompositions for these horizons.
To obtain a better interpretation of the structural shocks, we found it useful to compute the historical decomposition for all variables in the system. These results are available upon request. Historical decomposition for oil prices shows, for example, that the model attributes the sharp drop in oil prices in the second half of 2006 to oil price shocks, and the role of the deterministic component of oil or other shocks in the model is minimal.
Figure A.3 in the Appendix depicts the response of the variables in our model to a permanent oil price shock: a permanent increase in oil prices raises the domestic price level permanently, whereas inflation, after an initial increase, returns to its baseline in the long run.
More precisely, the central bank deviated from its monetary function by expanding reserve money along its trend path even though high oil prices would have called for a reduction—this deviation from the monetary reaction function is captured by the model as an expansionary monetary policy shock.
Detailed results are available upon request.
Oil prices continue to decline in early 2007; together with the previous decline in 2006 this led to a reduction in inflation in the first half of 2007. In the second half, this effect receded as oil prices increased again.