Oman's monetary policy transmission process under the fixed peg: some empirical puzzles

Abstract

This paper highlights that an open economy, like Oman, could often enjoy partial monetary policy independence despite operating with a fixed peg, which may appear as a clear violation of the ‘macroeconomic trilemma'. While explaining the country-specific factors that create the scope for partial monetary policy independence, the paper underscores that for meaningful use of this partial monetary policy independence to attain domestic goals of inflation and output, the transmission mechanism of monetary policy must work effectively. Empirical analyses presented in this paper for Oman, however, suggest the presence of not only the ‘interest rate puzzle’ but also the ‘IS puzzle’ and the ‘Phillips curve puzzle’, which together signal the presence of significant transmission weaknesses. The paper, thus, concludes that costs stemming from loss of any monetary policy independence because of the fixed peg may not be very significant for Oman, and hence, any alternative exchange rate regime cannot be viewed as appropriate just on the grounds that an alternative regime could deliver greater monetary policy independence.

Keywords:

• monetary policy transmission
• Oman
• interest rate puzzle
• IS puzzle
• Phillips curve puzzle
• monetary policy independence
• fixed peg

Acknowledgements

Views presented in this paper are the personal views of the author, and not of the organizations in which he may be working as a professional economist. The author is grateful to Professor Ashima Goyal and an anonymous referee for their insightful comments on the earlier version of this paper.

Notes

 1. As noted by Goodhart (2003), monetary policy independence could be viewed either in terms of ability to independently change the quantity of money in circulation, or the cost of money (i.e. the interest rate), even though one could be the dual of the other. Ability of a central bank to control the money supply in a manner consistent with the inflation and output objectives has weakened considerably, leading to general abandonment of monetary targeting by most central banks (even though money could still have a reference value). The weaknesses of monetary targeting primarily stemmed from financial innovations (making near money substitutes available, and concepts of money used for policy such as RM/M1/M2/M3 etc. were not enough, not even Divisia Indices which aim at generating a weighted average of money components based on their moneyness characters), unstable money demand functions (so that the exact relationship between money, output, and prices became increasingly obscured), Goodhart's Law (i.e. whenever a government seeks to rely on a previously observed statistical regularity for control purposes, that regularity will collapse), and the endogenous money supply process. Monetary policy independence, in the contemporary world, thus, could be seen only in terms of ability to set domestic interest rates independent of international interest rates.

 2. Lottery draw dates are big events in Oman, and commercial banks give wide coverage to such draws to attract more and more deposits. For information on one of the mega draws, please see http://www.bankmuscat.com/global_bk_news_press156.shtml, as an example. For details on the structure of such lottery linked deposit schemes, please see http://www.bankmuscat.com/almazyona_home.shtml

 3. Muscatelli and Trecroci (2003) found in the case of the UK that there was a positive relationship running from real interest rates to aggregate demand (i.e. β₂ > 0), which they referred to as the ‘IS puzzle’.

 4. It may be noted that the Phillips curve relationship in Equation (2) has been augmented by using Okun's law. The conventional Phillips curve relationship is presented as

which suggests that rate of inflation at time t can be explained by expected inflation at time t [i.e. E_t (Π _t )] and the deviation of the actual rate of unemployment u_t from the natural rate . Okun's law in turn is generally specified as: , which suggests that there exists a negative correlation between unemployment-gap and the output-gap (which in other words explains the relationship between excess demand in the factor market and the excess demand in the goods market). The most conventional Phillips curve relationship may relate to wage rates (w) and not to inflation, but using the argument of mark-up pricing the relationship is generally stated in relation to inflation (Π _t ). Thus, even though the original Phillips curve presented the relationship between wage rates and unemployment rate, more policy relevant representations hypothesize the relationship between inflation and output.

 5. According to Ball (2005), it is sometimes called the ‘New Neoclassical Synthesis’ and sometimes the ‘New Keynesian Synthesis’ – the model is so hot that the Keynesians and Classicals fight over who gets credit for it. As noted by Goodfriend (2005, 250), ‘The modeling of expected future income in the IS function and expected future inflation in the aggregate supply function reflects the introduction of rational expectations into macroeconomics by Robert Lucas in the 1970s.’

 6. The coefficient γ₂ should be positive, implying a positive relationship between output-gap and inflation, this is because the Equation (2) type relationship is derived from the original short-run aggregate supply equation [Y = Y∗ + a(P – P∗)], which suggests that in the short run higher inflation could raise output. Rearranging the equation one gets [P = P∗ + (Y – Y∗)/a], which is nothing but Equation (2), and hence the positive sign of theγ₂ coefficient in the theoretical specifications, even though in actual empirical estimates the coefficient could turn out negative.

 7. The problem with empirical estimates of Equation (2) is that they can give rise to faulty conduct of monetary policy, that is, the tendency to raise output through higher inflation. Sargent (1999) explains the Great Inflation episode in the USA during 1965–82 highlighting the scope for policy misinterpretation of the Equation (2) type model estimates.

 8. According to Nelson (2003, 146), ‘If prices were perfectly flexible – so that output equaled potential each period (given the emphasis of monetary policy on aggregate demand, assuming static supply) – the output gap would be zero every period, and so would not help at all in predicting inflation. Money growth and inflation, on the other hand, would continue to fluctuate together. Money growth would explain many (or all) of the movements in inflation, and the output gap would not explain any. If, on the other hand, the degree of excess demand were the only determinant of inflation, and if the degree of nominal rigidity in the economy were constant, the output gap would have a perfect relationship with inflation, and money growth would provide no extra information. In practice, economies may behave between these two extremes, with the degree of price stickiness varying over time. … Money growth may therefore provide auxiliary information about inflation not present in the output gap. Money growth may also enter estimated inflation equations alongside the output gap if the empirical measure of the output gap is a poor approximation of the true output gap series’.

 9. It is the lack of control over money stock that to some extent gave way to interest rate as the key controllable target for conduct of monetary policy. As noted by Tobin (1978), ‘I clearly do not subscribe to the prevalent view that what the central bank does is to control the money supply, which in turn determines money income and prices. I would say instead that the central bank controls some short-term money-market interest rates and/or reserve aggregates and that these variables simultaneously affect other interest rates and financial quantities, GNP expenditures, and monetary aggregates.’

10. According to Mervyn King (2003, 86), ‘My own belief is that the absence of money in the standard models which economists use will cause problems in future, and that there will be profitable developments from future research into the way in which money affects risk premia and economic behaviour more generally. Money, I conjecture, will regain an important place in the conversation of economists.’

11. In the assessment of sources of inflation, segregating demand shocks from supply shocks may not be easy. According to Mahadeva and Sinclair (2003, 5) ‘… inflationary demand-side shocks are associated with a rise in temporary output that leaves long-run or potential output unaffected, whereas inflationary supply-side shocks are associated with a fall in potential output with actual output falling or constant. Monetary policy should react to the shocks that are identified as inflationary on the demand side, whereas it is likely to respond to supply-side shocks only if the inflationary threat outweighs the output costs of responding.’

12. Consistent data on the CBO policy rates (such as CBO CD and repo rates) are available only since 2001, whereas information on Oman's lending rates and LIBOR are available for the full period 1980–2005, which is the period taken for the structural model. Prior to 2001, different instruments were used such as discounting/re-discounting of commercial papers, use of Government TBs and Government Development Bonds (GDBs), discounting of CDs/TBs/GDBs, swaps, etc., and hence, no consistent time series data on policy rate for the period 1980–2005 could be generated.