Policy Study 01/2015

Money as a leading indicator of inflation in Belarus and its implications for monetary policy

High inflation is one of the most acute problems of the Belarusian economy in recent years. It undermines the foundations of macroeconomic stability, introduces a significant uncertainty in the activity of enterprises and households, and creates difficulties for private business development. Therefore, at the moment the reduction of inflation is a key issue for economic policy in Belarus. In order to stabilize high inflation and make monetary policy more effective, the National Bank of Belarus (NBB) in 2015 moved to a regime of monetary targeting. However, the usage of monetary targeting requires clear-cut and stable relationships between the variables used as the operational, intermediate and final target. The absence or weakness of such links makes a monetary targeting regime actually ineffective in reducing inflation.

In this paper we evaluate the empirical foundations of monetary targeting in Belarus using relevant comprehensive econometric techniques. We use econometric approaches based on the cointegrated vector autoregression model (cointegrated VAR) to analyze the relationships between the operating and the intermediate target and estimate the real money demand function. The obtained money demand function allows us to identify disequilibrium on the money market in the form of the real money gap. This estimated unobservable variable, along with the short-run dynamics of the money supply is used as the main explanatory variables in the P*-model of inflation in order to assess the impact of monetary factors on its dynamics. Such an approach allows to consistently empirically testing the existence of necessary conditions for monetary targeting in Belarus.

There is econometric evidence that the operational target, intermediate target and final target are related in the right manner for monetary targeting in Belarus. Such relationships are confirmed for a rather long period: 1995Q–2014Q4. The monetary base and M3 are cointegrated. Monetary base is strongly exogenous related to M3. The intermediate target is controllable by the operational target. Thus, the first requirement for monetary targeting is fulfilled.

Money and prices are homogeneous, so the usage of real money is an appropriate option. In a nominal system, money and prices are interrelated, which is a good prerequisite for monetary targeting and P*-modeling of inflation. There is quite a stable money demand function for real M3. Thus, the second requirement for monetary targeting is relatively fulfilled. However, the absence of relevant opportunity cost indicator (beside inflation) makes real money demand function for M3 less informative concerning the behavior of economic agents.

The cointegrating vector from the real money demand function is used for construction of the real money gap, reflecting disequilibrium on the money market. The real money gap (with one lag) and changes of M3 are statistically significant in a P*-model of inflation. Thus, the third requirement for monetary targeting is equally fulfilled.

To sum up, monetary targeting in Belarus can be justified from an econometric point of view using relatively long historical data.

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