Economic Liberalization, Monetary Policy and Money Demand in Rwanda: 1980–2005

The objective of this study was to estimate a long and short run money demand function in the Rwandan economy. Using the Johansen approach, this paper established that there was a stable long-run equilibrium relationship between the demand for real money balances, real income, the rate of return on foreign financial assets (Libor-London interbank offered rate) and the expected depreciation of the Rwandan franc (RWF). The short-run dynamic model confirmed the stability of this relationship. These results suggest that the monetary aggregate used in this study, M2, is the appropriate monetary target in the Rwandan economy for monetary policy purposes and economic stabilization. The significance of the return on foreign financial assets and of the expected depreciation of the domestic currency demonstrated the importance of the external determinants of money demand in Rwanda and confirmed the hypothesis of currency substitution in the Rwandan economy. Attempts to include various interest rates in the money demand function revealed that these rates were not significant .This was not surprising because interest rates were controlled for most of the sample period. Moreover, the excess liquidity in the banking system in recent years made the interest rate ineffective as an instrument of monetary policy. Finally, another significant finding of this research is the speed of adjustment of the demand for money, following deviation from its long-run equilibrium. As the short-run dynamic model showed, this adjustment period amounts to about three years, which is an indication of the persistence of monetary disequilibrium in the Rwandan economy.