Essays on financial reforms and monetary policy in Malawi

Abstract

The thesis contains three essays that investigate the effects of macroeconomic reforms on the Malawian economy between 1980 and 2010. Specifically, the thesis tries to answer three broad questions. First, what is the effect of financial reforms on consumption behavior in Malawi? Second, how did monetary transmission mechanism in Malawi change over time following the implementation of financial reforms? Last, how did the monetary policy respond to foreign aid increases following the implementation of financial reforms in the country? Although answers for these questions are available for other developing countries where abundant research has been conducted, this is not the case in Malawi. Existing research on Malawi has not accounted for the effects of the reforms on consumption behavior, the evolution of the transmission mechanism over time and the monetary policy impact of aid on the economy. Yet such information is very useful in the design and proper implementation of financial and monetary policies that contribute to price stability and economic growth. The first essay assesses whether financial reforms has had a statistically significant effect on Malawi consumption behaviour. More specifically, the essay starts by examining the existence of Permanent Income Hypothesis (PIH) and then proceed to assess whether the reforms have affected consumption behaviour by reducing liquidity constraints. The essay presents a robust account of the financial reforms and constructs financial reform indices for the country. These indices are then used to exam the effects of the reforms on consumption. The essay finds that the PIH does not hold in Malawi. Most consumers are current income consumers (rule-of-thumb). They consume from “hand to mouth” and very little is left to smooth consumption in their life time. The reforms did not shift current income consumers to permanent income consumers. Empirical evidence from the thesis shows that the main failure of the PIH hypothesis is due to liquidity constraint which is manifested in the under development of the financial market and unstable macroeconomic conditions in Malawi. Weak financial institutions, both structural and operational have impacted negatively on the accessibility of financial resources for most Malawians despite the reforms. This is a bigger lesson for policy makers to consider in the preparation of future broad based financial reforms. The second essay provides an empirical analysis of the lag effect of implementing financial reforms on price stability and economic growth. We use the monetary transmission mechanism framework based on the time varying parameter vector autoregressive (TVP-VAR) model with stochastic volatility. It is becoming clear from literature that financial reforms can change the transmission mechanism by changing the overall impact of the policy or by altering the transmission channels overtime. Therefore, the impact of monetary policy on price stability and output growth can vary and portray delayed effects overtime. The essay finds that inflation, real output and exchange rate responses to monetary policy shocks vary over the period under review. Importantly, beginning mid-2000, the monetary policy transmission performed consistently with predictions of economic theory and there is no evidence of price puzzle as found in the previous literature on Malawi. In the last essay, a Bayesian Dynamic Stochastic General Equilibrium (DSGE) model for Malawi is developed and estimated to account for the short-run monetary response to aid inflows in Malawi between 1980 and 2010. The model incorporated the rational expectations of economic agents based on micro foundations. The estimated model showed that monetary authorities reacted to foreign aid inflows. Based on how aid was spent and absorbed in Malawi, aid inflows appeared to be associated with depreciations of the exchange rate rather than the expected real appreciation. There is also evidence of limited impact of a positive aid shock on depreciation and inflation when RBM targets monetary aggregates compared to when the authorities use the Taylor rule and incomplete sterilisation. On the other hand, the thesis found that the implication of increased aid inflows became more prominent in an economy comprising of few economic agents having access to financial assets. Furthermore, the monetary policy responses are much clear consistent with economic theory in a market with less controls over prices and open capital account. The contribution of the thesis to the literature is that, firstly, this looks into the effects of macroeconomic reforms on economic activities in the context of a Sub-Saharan Africa country, Malawi. The thesis enhances the understanding of the effects of macroeconomic reforms on consumption, evolution of monetary policy overtime and the impact of aid inflows on the conduct of monetary policy in Malawi in ways that have not been done before. Secondly, the thesis takes advantages of multivariate econometric methodologies in an attempt to capture both the dynamics of time series data and the relationship among key macroeconomic variables. The thesis develops and estimates a DSGE model for Malawi which is derived from microeconomic foundations of optimisation problem, making it less susceptible to the Lucas critique and thus suitable for policy analysis. The results will help policy makers and development partners such as the IMF and the World Bank in the design of policies and programs that aim at improving the financial sector that is accommodative of achieving price stability and economic growth in Malawi.