Central Bank of Russia

An Empirical Analysis Of The Monetary Policy Rules For Russia.

The objective of this paper is to discover the key goals of the Central Bank of Russia (CBR) and describe the monetary policy rules. I will focus on the period during 1993 - 2008. This time range was chosen because of the availability of the data as well as the fact that there is no such research on this subject during this particular period.

Previous analysis of the problems of monetary policy in Russia showed that the process, which determines the equilibrium in the money market, the relationship between the real and the financial sectors of the economy and the dynamics of prices have changed[1]. Therefore, a more in depth analysis of the different aspects of the monetary policy should be prepared.

There are very few papers (both theoretical and empirical) written on the monetary policy rules for Russia in the recent years. Most of the articles on this subject covered the period before 2000. Therefore, we must mention that most of the relevant empirical research is out of date so these papers should be used only when describing the general theory of monetary policy and its rules.

1 Literature Review

1.1 Introduction

The main problems of studying the monetary policy are the questions of following particular rules, the Central Bank independence, the relation between goals and instruments of the monetary policy. Theoretical discussions on these subjects began in the works of Keynes, Friedman, Lucas and Sargent, but many questions still do not have a certain answer. The key problem is the choice of the optimal monetary policy in a particular economic environment. Depending on the situation, different goals and instruments are chosen, the preference to certain rule is given, the limits of the monetary policy and its relationship to fiscal policy are described. Because the monetary policy is one of the key instruments of the country in order to regulate the economy, its strategic goals are the same as the macroeconomic goals of the country, namely constant economic growth, low inflation, high employment and stability in the financial sector. However the Central bank cannot directly control these goals. In order to achieve them different intermediate targets are set, such as interest rate, monetary aggregates or exchange rate. And then to achieve these targets the Central bank uses its instruments - open-market operations, reserve requirements and the discount rates[2].

In practice, the behaviour of the Central bank can be described by a monetary policy rule, which relates the changes in the intermediate target variables to the key goals. Finding such rule is very important as the knowledge of the central bank's reaction to changes in the economic picture allows for better understanding and forecasting the economic processes in a country. We should also note that sometimes the official reports of the Central bank do not reflect its actual actions, and in order to find these differences we use an econometric analysis.

1.2 Theoretical Models

There are some theoretical papers on the choice of different goals and instruments of the monetary policy. At the same time, although there are number of such papers, most of them have similar context. For the purpose of this Literature review, let us look, as an example, at the basic model of monetary policy rule, proposed by Svensson[3]. He suggested that usually the main goal is achieving low inflation rate, but because of the inertia the Central bank can only control the expected rate of inflation. In addition, he showed that the policy of targeting money supply and exchange rate was less efficient than inflation targeting. Although this is true in the case of developed countries, we must bear in mind the fact that Russian economy is in a transition stage.

Therefore the general rules may not be efficient for our paper's analysis. This information is of great importance, and as Voronina and Vdovichenko[4] observed even though the Central bank claimed that the monetary policy goal was targeting the inflation rate, in reality it was not the case. They argued that the real exchange rate was more significant. The study focused on a very short period of time (1999-2003) and therefore the results obtained may be a bit suspicious.

In an article by Dabrowski, Paczynski, Rawdanovicz[5], which attempted to analyze the aspects of the inflation rate in Russia in 1996-2001, it is stated that during this period the CBR used such monetary policy which combined both money supply and exchange rate targeting. They also pointed out some weaknesses of this strategy.

Another theoretical paper on this subject is by Balino, Hoelscher, Horder[6]. Again, the information about Russia's monetary policy and its instruments is rather extensive, but due to short time period horizon and the fact that the data during the first years of the transmission period was not reliable[7], we must not fully rely on the conclusion that after the collapse of the Russian economy in early 1990-s, the country recovered in a fairly short time.

1.3 Empirical models
1.3.1 Backward looking models

The first empirical paper on the rules of monetary policy based on backward looking theory was written by Taylor[8]. He made a conclusion that in order to reach the key goals more efficiently, the Central bank should react to changes in price level and GDP by changing the interest rate. Taylor mentioned that economists usually look at three empirical models. The first is the reaction of the interest rate on the deviation of the money supply target, the second - on the exchange rate and the third - on both the inflation rate and GDP. The efficiency of a model was ranked on the degree to which the key goals were reached. He showed that the last one is the best fit to the reality of the Central bank behaviour. To prove this rule (which is now called Taylor rule), he used USA as an example. This is the main reason why, though his rule grasps the reality of the monetary policymaking decision for most developed countries quite well, it fails to reflect the cases of transition economies, such as Russia. In his later paper Taylor [9] himself drew a conclusion that for emerging markets and developing countries the Taylor rule in its original form was not efficient. Furthermore, the rule had to be modified in the selection of the instruments.

Evans [10] demonstrated several alternatives of the Taylor rule. In addition, he used a modified Taylor rule, which instead of GDP had the level of unemployment. We should note that in his work not all the data that he intended to apply was actually used due to lack of availability and the one that was used was the first published data. This problem was also present in earlier papers. For example, Orphanides[11] uses real-time and ex post revised data in two separate models in order to show that the outcome will clearly depend on the type of data.

A different study of Taylor rule was carried out by Nelson[12] . He estimated this rule for the UK monetary policy during 1972-1997 both as a whole time horizon and as a several intervals. Clarida, Gali, Gertler [13] also examined the UK monetary policy rule during roughly the same period, but the divided into only two sub-periods. The results in both cases are that Taylor rule explained the reaction of the Central bank quite well. Yet we cannot consider it as a general conclusion, as we still have to find out if it applies to transition economies and emerging markets.

Mohanty, Klau[14] estimated the model for several Latin American, South African and East European countries. They studied the implication of Taylor rule for emerging markets and the results indicated that it explained the changes in monetary policy well even for emerging market economies. This, however, contradicts with the general theory of emerging market economies.

An alternative to Taylor rule was proposed by McCallum[15] . The rule suggests the use of money supply as an instrument instead of interest rate. The two rules do not exclude the existence of one another; they just reflect the reaction of monetary policy in different states of the economy. But this raises a question why Central Banks in almost all developed countries uses the interest rate as an intermediate target and then in what cases would the use of money supply be a good policy.

Another alternative to Taylor rule was suggested by Ball[16] . In his paper he argued that in the case of a closed economy Taylor rule may capture the real picture, but if we extend our discussion to an open economy this rule was no longer efficient. Ball made two very significant points. “First, the policy instrument is a ‘Monetary Conditions Index' - a weighted average of the interest rate and the exchange rate. Second, on the right side of the rule, inflation is replaced by ‘long-run inflation', a variable that filters out the transitory effects of exchange-rate movements” (Ball, 1998, p.2). This model is a hybrid model, which combines features of both Taylor and McCallum rules.

Evanov , Merkl, de Souza[17] evaluated the monetary policy rules for Russia during 1993- 2002. Authors showed how the Central Bunk of Russia reacted to the changes in output, inflation and exchange rate using three models with backward looking variables - Taylor rule, McCallum rule and Ball rule. The first as we mentioned earlier uses short term interest rate as an instrument, the second uses money supply and the last model combines both of them. The results showed that McCallum rule explains the best the reaction of CBR. The results seem realistic and consistent with the theory of the development of the Russian monetary policy.

1.3.2 Forward looking models

One of the most famous articles on forward looking monetary policy rules models was written by Clarida, Gali, Gertler[18]. It suggested that the major instrument of the policy is the short term interest rate. At any particular state of the economy the Central bank selects the target interest rate, which is determined by the deviation of the expected output and inflation from their desired levels. Theoretically, this rule is similar to Taylor rule, although Taylor used a rule based on actual levels of intermediate targets that have occurred, and the rule proposed in this paper is based on the expected levels. Clarida, Gali, Gertler estimated two models, comparing different groups of countries. The result was that inflation targeting policy was more efficient than the policy of fixing exchange rates.

The paper by Woodford[19] was devoted to the studying of the application of Taylor rule and the optimal monetary policy. The objective of this work was to observe how well Taylor rule can be applied in practice and to what degree this model fits the reality. In his model Woodford combined IS, AS equations and a modified Taylor rule. The possible weaknesses of this model are the possibility of not reaching stable price level and the spiral effect, namely the fact that an increase of the expected inflation will lead to a lower real interest rate, which will stimulate the Aggregate Demand, and this, in turn, will lead to a rise in inflation.

Drobyshevsky, Kozlovskaya[20] analysed a different monetary rule with the consideration of the Central Bank's expectations. They used short term interest rate as an instrument. The paper was dedicated to the study of the Russian monetary policy rules during 1994-2001. The period was divided into two intervals- before and after the crisis in 1998. The results indicated that during the first sub-period the Central Bank of Russia focused mainly on targeting the money supply grow, whereas during the second - it shifted towards targeting the exchange rate. We must note that these results contradict with the results of Esanov, Merkl, de Souza[21], which as mentioned earlier showed that the CBR targeted monetary aggregates during the same period, and that it is assumed that the Central Bank cannot target exchange rate and money supply simultaneously. Probably, the differences in the obtained results can be explained by the nature of the approaches taken. The backward looking approach should have reached more reasonable results as it better reflects the actual monetary policy in Russia.

One of the most recent studies dedicated to the analysis of the monetary policy in Russia is the paper by Vdovichenko, Voronina[22]. The empirical part aimed to establish a rule of such policy for the period since 1998 and verify if it is a good fit of what actually happened. The authors stated that the main goals of the policymaking are not only inflation and output, but also exchange rate. The argument behind this choice of variables was probably the fact that the dynamics of the exchange rate had a significant influence on the inflation process and on the Russian economy as a whole. Furthermore, it was argued that along with the interest rate, money supply growth was also used as an intermediate target. The main result of the paper was that the CBR's management of the monetary policy focused on targeting inflation and exchange rate.

1.3.3 VAR models

In the past few years many economists began supporting the view that the main goal of the central bank should be maintaining low stable inflation. Clarida, Gertler[23] in their work tried to figure out to what degree the economic environment influences the decisions of the Central bank. The objective was to discover the main procedures of maintaining low inflation and analyse costs and benefits of minimizing price level growth. They investigated the monetary policy of the German Central bank, which at the time of writing was conducting a policy of inflation targeting and its main instrument was short term interest rate. Initially, Clarida, Gertler had to understand which variables to choose as intermediate targets. One of the problems that they had to overcome was the fact of dependence between these variables. For instance, in setting the interest rate target the Central bank uses the information about the exchange rate, but the interest rate, in turn, have an effect on the dynamic of the exchange rate.

Clarida, Gertler believed that in VAR model the current policy is affected by lagged versions of all variables. But the current variables can be determined by the policy instruments of the same time period[24] or they can be independent of current level of these instruments[25]. In theory, the Central bank can choose any variable of the first group as a policy instrument. The analysis of macroeconomic shocks showed that the short term interest rate goes up as a result of increasing prices up to the point when the real interest rate reaches its target level. The results of the Central bank reaction to shocks in output and inflation are the same. Moreover, it was discovered that the Central bank reacts to changes in exchange rate in a counter-cyclical way. This means that a decrease in exchange rate leads to an increase in both nominal and real short term interest rate, but this boost in short term interest rate will reduce the output level and will lead to an increase in exchange rate in the short period. The authors showed that the Bundesbank raises the interest rate as the inflation or the output level increase. The results explained that this reaction was rather quick as only the first lagged coefficient was significant.

Similar models were used for estimating monetary policy rules by many other authors. Chinn, Dooley[26] investigated the decisions of the Central Bank of Japan by applying a variation of this model. The only difference is that in this paper the amount of bank credits is incorporated in the model. Despite this change, the results were not much different. The Central Bank of Japan reacted to macroeconomic shocks by changing the interest rate.

1.4 Conclusion

To sum up, we reviewed different papers on studying the monetary policy rules and finding the actual targets of Central Banks. In most of the articles authors used models, in which the intermediate target was set to be the level of interest rate. However, there were articles, in which these targets were money supply and exchange rate. Furthermore, we discovered that models were also different in the variables that were used as key goals of Central Banks.

The key goals of Central Banks in developed countries were only inflation and output. Therefore, the most popular monetary policy rule was Taylor rule. At the same time, rules which describe the monetary policy in developing countries or emerging market economies also included exchange rate, money supply growth, foreign interest rate and other variables.

The majority of the literature written on this subject is on monetary policy rules in developed countries. However, the methodology in these papers, with few modifications, can be also used to analyse the policymaking in developing countries. Although the Russian economy is one of the fastest growing among developing counties, the choice of methods to study the monetary policy of this country needs a special attention.

2 References

1) Aslund, A., (2001) The myth of output collapse after communism. Carnegie endowment for international peace.

2) Balino, T., Hoelscher, D., Horder, J., (1997) Evolution of monetary policy instruments in Russia. IMF Working paper 180.

3) Ball, l., (1998) Policy rules for open economies. Reserve Bank of Australia: Research Discussion paper 9806.

4) Chinn, M., Dooley, M., (1997) Monetary policy in Japan, Germany and the United States: Does one size fit all? NBER Working paper 6092.

5) Clarida, R., Gertler, M., (1996) How the Bundesbank conducts monetary policy. NBER Working paper 5581.

6) Clarida, R., Gali, J., Gertler, M., (1997) Monetary policy rules in practice: some international evidence. NBER Working paper 6254.

7) Clarida, R., Gali, J., Gertler, M., (1998) Monetary policy rules and macroeconomic stability evidence and some theory. NBER Working paper 6442.

8) Dabrowski, M., Paszynski, W., Rawdanowicz, L., (2002) Inflation and monetary policy in Russia: transition experience and future recommendations. Center for social and economic research: Warsaw.

9) Dobryshevsky, S., Kozlovskaya, A., (2002) Insight aspects of the Russian monetary policy. IET Working paper, 45.

10) Esanov, A., Merkl, C., de Souza, L., (2004) Monetary policy rules for Russia. BOFIT Discussion paper 11.

11) Evans, C., (1998) Real-time Taylor rules and the Federal funds future market. Economic Perspectives, Federal Reserve Bank of Chicago.

12) McCallum, B., (1997) Issues in the design of monetary policy rules. NBER working papers 6016.

13) Mohanty, M., Klau, M., (2004) Monetary policy rules in emerging market economies: issues and evidence. BIT Working papers 149.

14) Nelson, E., (2000) UK Monetary policy 1972-1997: a guide using Taylor rules. Bank of England Working paper.

15) Orphanides, A., (1997) Monetary policy rules based on real-time data. Board of Governors of the Federal Reserve System: Finance and economic discussion paper 03.

16) Svensson, L., (1996) Inflation forecast targeting: Implementing and monitoring inflating targets. NBER Working paper 5797.

17) Taylor, J., (1993) Discretion versus policy rules in practice. Carnegie-Rochester conference series on public policy 39, pp195-214.

18) Taylor, J., (2000) Using monetary policy rules in emerging market economies. 75th anniversary conference at the Bank of Mexico.

19) Vdovichenko, A., Voronina, V., (2004) Monetary policy rules and their application in Russia. Moscow: EERC Working paper 04/09.

20) Woodford, M., (2001) The Taylor rule and optimal monetary policy. The American Economic Review, Vol. 91, No. 2, pp232-237.

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[1] Svensson, L., (1996) Inflation forecast targeting: Implementing and monitoring inflating targets. NBER Working paper 5797.

[2] Svensson, L., (1996) Inflation forecast targeting: Implementing and monitoring inflating targets. NBER Working paper 5797.

[3] Svensson, L., (1996) Inflation forecast targeting: Implementing and monitoring inflating targets. NBER Working paper 5797.

[4] Vdovichenko, A., Voronina, V., (2004) Monetary policy rules and their application in Russia. Moscow: EERC Working paper 04/09.

[5] Dabrowski, M., Paszynski, W., Rawdanowicz, L., (2002) Inflation and monetary policy in Russia: transition experience and future recommendations. Center for social and economic research: Warsaw.

[6] Balino, T., Hoelscher, D., Horder, J., (1997) Evolution of monetary policy instruments in Russia. IMF Working paper 180.

[7] Aslund, A., (2001) The myth of output collapse after communism. Carnegie endowment for international peace.

[8] Taylor, J., (1993) Discretion versus policy rules in practice. Carnegie-Rochester conference series on public policy 39, pp195-214.

[9] Taylor, J., (2000) Using monetary policy rules in emerging market economies. 75th anniversary conference at the Bank of Mexico.

[10] Evans, C., (1998) Real-time Taylor rules and the Federal funds future market. Economic Perspectives, Federal Reserve Bank of Chicago.

[11] Orphanides, A., (1997) Monetary policy rules based on real-time data. Board of Governors of the Federal Reserve System: Finance and economic discussion paper 03.

[12] Nelson, E., (2000) UK Monetary policy 1972-1997: a guide using Taylor rules. Bank of England Working paper.

[13] Clarida, R., Gali, J., Gertler, M., (1997) Monetary policy rules in practice: some international evidence. NBER Working paper 6254.

[14] Mohanty, M., Klau, M., (2004) Monetary policy rules in emerging market economies: issues and evidence. BIT Working papers 149.

[15] McCallum, B., (1997) Issues in the design of monetary policy rules. NBER working papers 6016.

[16] Ball, l., (1998) Policy rules for open economies. Reserve Bank of Australia: Research Discussion paper 9806.

[17] Esanov, A., Merkl, C., de Souza, L., (2004) Monetary policy rules for Russia. BOFIT Discussion paper 11.

[18] Clarida, R., Gali, J., Gertler, M., (1998) Monetary policy rules and macroeconomic stability evidence and some theory. NBER Working paper 6442.

[19] Woodford, M., (2001) The Taylor rule and optimal monetary policy. The American Economic Review, Vol. 91, No. 2, pp232-237.

[20] Dobryshevsky, S., Kozlovskaya, A., (2002) Insight aspects of the Russian monetary policy. IET Working paper, 45.

[21] Esanov, A., Merkl, C., de Souza, L., (2004) Monetary policy rules for Russia. BOFIT Discussion paper 11.

[22] Vdovichenko, A., Voronina, V., (2004) Monetary policy rules and their application in Russia. Moscow: EERC Working paper 04/09.

[23] Clarida, R., Gertler, M., (1996) How the Bundesbank conducts monetary policy. NBER Working paper 5581.

[24] For example, short term interest rate, exchange rate and long-term interest rate.

[25] For example, economic activity and prices.

[26] Chinn, M., Dooley, M., (1997) Monetary policy in Japan, Germany and the United States: Does one size fit all? NBER Working paper 6092.

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