The transmission mechanism of monetary policy in Botswana

Macroeconomic stability is one of the most important national objectives in any country. However, economies are often subjected to a number of shocks (internal and external), which can be destabilising, produce volatility and make it difficult to achieve and maintain economic stability. Consequently, various policies are used to help deal with the various shocks that may affect the economy. Of all the available policies, monetary policy appears to have been ever more at the centre of macroeconomic policymaking. Meanwhile, for monetary policy to be effective, there is a need for a better understanding of the transmission mechanism, i.e., the process through which monetary policy decisions are transmitted into changes in real output and inflation. Whereas extensive research on the transmission mechanism has been conducted in developed countries, such work in developing countries, especially in Africa is lacking. This could be due to the fact that it was not long time ago, around the 1990s that countries in Africa started adopting the more modem central bank operations in a market-based economic and financial system characterised by indirect monetary policy. Such operations require an understanding of the transmission mechanism. Lack of empirical analysis of the monetary transmission mechanism in Botswana and developing countries of Africa in general, is the main motivating factor behind this thesis. The main objective of this thesis is, therefore, to estimate the transmission mechanism of monetary policy in Botswana. Three different, but complementary techniques (the Narrative Approach, Vector Autoregression (VAR) analysis and the Structural Approach involving the estimation of a small structural model for Botswana economy) are used. Results from these methods tell a consistent story and indicate that monetary policy in Botswana affects real output and inflation through the interest rate channel, while the exchange rate channel is not operational. The credit channel is also active but not strong. The structural approach also indicates that devaluation is contractionary in Botswana, but more research is necessary before firmer conclusions could be made