The Stability of Money Demand in Rwanda and its Implication on Monetary Policy
The level and stability of the demand for money has received enormous academic attention because an understanding of its causes and consequences can usefully inform the setting of monetary policy. Over the last couple of years, the Rwanda economy has suffered major shocks such as foreign exchange pressures, huge import bills and domestic oil shortages that place extra pressure on prices to rise. As a result, some of these shocks suffered by the economy have contributed to the stability of prices being out of targeted range. The general objective of this study to analyze the stability of money demand in Rwanda and its iM2lication on monetary policy, over the time period 2000 2017. This study was used both descriptive and analytical research design. Ordinary Least Square (OLS) method will employ in analyze time series data captured over the period under study. Granger casualty test was used to test causality relationship between stability of money demand and its implication on monetary policy. The study was used secondary data analysis. The data is an annual time series data spanning from 2000 to 2017. The annual data was extrapolated into annual series. In order to understand very well and to expose the bi direction between stability of money demand development and its implication on monetary policy, researcher decided to learn on statistical analysis for catching up the relationship between two variables. The econometric techniques used, such as statistical analysis, econometric graphs and the diagnostic test was Carried out to ensure that the data is reliable and is was not affect by such as serial correlation or heteresdostecity. Researcher was used different methods of overcoming the problem of spurious regression arising from using no stationary time series. Augmented Dickey Fuller (ADF) Unit root Test. The findings of the ECM, which incorporate the money demand and its implication on monetary policy, estimated through ECM testing approach. As such, real income (3.602411) interest rate (0.112121) and inflation (2.381232) are statistically significant relationship on monetary policy. It shows that money demand stimulates the economic activities and development process in the country to a greater extent, which is obvious from the higher positive value of its coefficient. The result shows that all independent variables have positive effect monetary policy. All coefficients of variables have positive sign. This shows that money demand has been contributed positively on the monetary policy from 2000 2017. R (0.022003) this show the goodness of fit the model. The co integration test illustrates that the variables were co integrated and implying that a long run relationships exists between money demand and monetary policy in Rwanda. Therefore researcher accepts H1#0 and fails to reject H0. In order to strengthen the financial sector, the Central Bank of Rwanda has to encourage the introduction of more financial instruments that are flexible enough to meet the risk preferences and sophistication of operators in the financial sector. 1. Background of the Study A good understanding of the determinants of the demand for real money balances in the economy by investigating the behavior of the money demand function is crucial for the formulation and iM2lementation of an effective monetary policy (Adam, 2007) Moreover, the identification of a stable relationship between the demand for money and its determining variables provides empirical evidence that the monetary targeting is an appropriate framework for economic stabilization policy. The level and stability of the demand for money has received enormous academic attention because an understanding of its causes and consequences can usefully inform the setting of monetary policy. It is vital to investigate and test the stability of money demand since its instability is a major determinant of liquidity preference (Poole, 2007) Interest rate should be targeted if liquidity preference is unstable while the money supply should be targeted if the investment savings relationship is unstable and the demand for money is stable. It is necessary to select the correct monetary policy instrument since selecting the wrong instrument may result in large fluctuations in output. Most economists and policymakers agree that the overall aim of monetary policy is to advance the economic wellbeing of the country,,s citizens| (Hubbard, 2007) By economic well being, Hubbard (2008) emphasizes an economy that performs and creates an economic environment providing maximum benefits to all citizens. To accoM2lish this, any monetary authority must formulate and conduct an adequate monetary policy. (Mishikin, 2007) highlight price stability as being the overriding objective of monetary policy so as to provide a sustained and favourable macroeconomic environment for economic agents. The implementation of financial reforms in many countries has raised doubts about the use of monetary aggregates to stabilize inflation rates. Since the 1980s and following countless deregulation and liberalization policies, central banks in many advanced economies switched between instruments of monetary policy by moving away from policies that influence the money supply towards those which influence the bank rate. A large number of developed country case studies show that the demand for money has become unstable due to financial reforms and hence support the targeting of the rate of interest by central banks (Haug et al. 2008) Central banks in many developing economies have followed suit and switched towards monetary policies directed at the bank rate. A major part of this policy switching is grounded on the view that their own financial market reforms and liberalizations might have contributed to the instability in their own money demand functions. However, recent studies Paper ID: ART20192691 DOI: 10.21275/ART20192691 530 International Journal of Science and Research (IJSR) ISSN: 2319 7064 Index Copernicus Value (2016) 79.57 Impact Factor (2017) 7.296 Volume 7 Issue 11, November 2018 www.ijsr.net Licensed Under Creative Commons Attribution CC BY have raised doubts about the validity and strength of central bank interest rate targeting in developing economies (Bahmani Kumar, 2009) Getting monetary policy right is crucial to the health of any economy (Mishkin, 2009) Monetary policies, over the years, have developed to better achieve economic targets such as increasing the growth of real output, the reduction in unemployment, stability in exchange rate markets and the attainment of low and stable price levels. The different kinds of monetary policies that economies have used over time had been designed to solve economic challenges at the time and had been reviewed based on the results of some key indicators such as the rate of inflation. The argument in favour of an important role for money demand in monetary policy starts from the observation that, when there is an expected future increase in productivity and the central bank follows a standard Taylor rule, the economy may experience "boom bust episodes" where sharp movements in asset prices affect all nominal and real variables. The key point here is that nominal wage rigidity is transformed into real wage rigidity by an in nation targeting central bank. This point is developed analytically by (Christiano Rostagno, 2007) When wages are rigid, in nation targeting reduces to real wage targeting and this interferes with the ability of real wages to allocate resources efficiently. Monetary authorities however, can avoid the booms and busts by responding to movements in credit variables since this makes the economy react to the shocks in a way that corresponds more closely to the efficient response. Owing to the contradictory evidence presented in previous studies with some studies suggesting stable money demand while others suggest otherwise, this study re examines the stability of the money demand function in Kenya. A clear understanding of the stability of money demand is crucial given its implications for monetary policy formulation. Currently, in Kenya, broad money, M3 is the intermediate target variable of monetary policy. The choice of an intermediate target variable to conduct monetary policy is based on the understanding that the demand for the monetary aggregate is stable (Qayyum and Nishat, 2007) Demand for money in Rwanda Rwanda"s financial system is still little developed: six commercial banks, a development bank, and savings and credit cooperatives are the key players in the Rwandan financial sector. Only three commercial banks were in operation before 1995, Today are eleven licensed commercial banks in Rwanda (BNR, 2017) Private enterprises have no other source of funding than bank loans. The financial assets available on the market include interestbearing fixed term deposits in commercial banks, development bills and Treasury bills. Until 2016, the volume of the last two types of assets was limited and their acquisition was essentially reserved for commercial banks, non banking financial institutions and some state owned companies. It thus appears that except for physical assets and possibly foreign currency, substitutes for money are limited in the Rwandan economy (Randa, 1999) The lower the Rwandan population"s income, moreover, the more limited are the changes in the coM2osition of their portfolio. In view of these peculiarities of the Rwandan economy, in order to estimate the money demand function in Rwanda. This study seeks to examine the stability of money demand in Rwanda and its implication on monetary policy from 2000 2016. 2. Statement of the problem The incorporation of monetary aggregate targeting in the inflation targeting regime in Rwanda has not been worked on in recent literature. For Rwanda, this has become a new area of concentration for monetary policy. Over the last couple of years, the Rwanda economy has suffered maj