The Effects of Monetary Policy on Prices in Malawi

Evidence on the transmission mechanism of monetary policy is quite non-uniform, particularly across countries with different economic structures. Complications to theoretical propositions tend to arise when economies are less market-oriented and less sensitive to policy interventions, when monetary authorities are not adequately independent, or when market-based and administrative policy instruments are used concurrently. It is important, therefore, to appreciate the unique dynamics of the transmission mechanism in any jurisdiction, in order to understand and possibly predict the macroeconomic effects of monetary policy. This study assessed the effects of monetary policy in Malawi by tracing the channels of its transmission mechanism, while recognizing several factors that characterize the economy: market imperfections, fiscal dominance and vulnerability to external shocks. Within the environment of vector autoregressive modelling, Granger-causality and block exogeneity tests as well as innovation accounting analyses were conducted to describe the dynamic interrelationships among monetary policy, financial variables and prices. The study established the lack of unequivocal evidence in support of a conventional channel ofthe monetary policy transmission mechanism, and found that the exchange rate was the most important variable in predicting prices. Therefore, the study recommends that authorities should be more concerned with imported cost-push inflation rather than demand-pull inflation. In the short term, pursuing a prudent exchange rate policy that recognizes the country’s precarious foreign reserve position could be critical in deepening domestic price stability. Beyond the short term, price stability could be sustained through the implementation of policies directed towards building a strong foreign exchange reserve base, as well as developing a sustainable approach to the country’s reliance on development assistance.