Monetary policy decisions in selected Organization of Petroleum Exporting Countries economies: does Taylor's principle matter?

• DOI: http://doi.org/10.1111/opec.12097
• Date: 01 June 2017
• Published date: 01 June 2017
• Author: Mustapha A. Akinkunmi

Monetary policy decisions in selected

Organization of Petroleum Exporting

Countries economies: does Taylor’s

principle matter?

Mustapha A. Akinkunmi

Ministry of Finance, Lagos State Government Secretariat, Alausa, Lagos, Nigeria. Email:

maakinresearch@gmail.com

Abstract

Many OPEC countries heavily rely on the hydrocarbon sector as the lifeblood of their economies.

The uncertainty of crude oil price environment makes them vulnerable to external shocks.

Therefore, knowledge about drivers of economic policies especially monetary policy designed to

accommodate shocks calls for empirical research with the recent global oil environment. This

study examines the drivers of monetary policy rate in selected OPEC economies and tests whether

these factors follow Taylor’s rule using monthly time series data from 1990 to 2015. Its finding

reveals that inflation gap and output gap are effective in influencing policy rate in Indonesia,

whereas only inflation gap influences the policy rate in Nigeria. In addition, the level of policy rate

in Saudi Arabia and Venezuela is determined by the level of output gap in the baseline Taylor

model. The outcome of the augmented Taylor model supports the smoothing behaviour of the

monetary authorities in the economies. In conclusion, none of these economies follow Taylor’s

principle in their monetary policy decisions.

1. Introduction

Over the years, the main goal of monetary policy in many economies is to address the

issue of inflation. The performance of monetary policies in different countries is captured

by the ability of such policies to curtail inflation. Therefore, conventional studies defined

monetary policy reactions in terms of inflation and the output gap. The crucial segment

of monetary policy that serves as the backbone of a reaction function, depends on the

inflation as the policy goal and a rediscount rate as an instrument (Cushman and Zha,

1997). The monetary policy targets and instruments significantly determine the

performance of monetary policy. The outcomes of any monetary policy are limited to

the number of targets and available instruments. Therefore, in any economy, the

effectiveness of monetary policy is linked with targets, and strategies required to meet

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the targets as well as the existence of available measures to implement such policy.

Taylor (2000) pointed out that there is a trade-off between exchange rate targeting and

inflation targeting.

The Taylor principle suggests that monetary authority has to raise the nominal

interest rate beyond one to one relationship with inflation in order to increase real interest

rate as inflation rises. The fundamental reason is that central banks that adopt inflation

targeting pay more attention on the inflation goal in the conduct of their monetary policy

compared to other monetary policy goals.

However, thebasis for any monetary policy isto focus on clear and quantifiable reaction

functionsfor the inter-temporal instrument.These reaction functionsprovide a good channel

through which interest rates are determined (Torres, 2002). The concern goes beyond the

instrument choice by including an inter-temporal instrument variation. After choosing the

interest rate,the next question that needs to be answered is what determines the variations in

the instrument over time. The adjustment of interest rate could be carried out in order to

address thedisequilibrium relationshipbetween the target and actual inflationrate, exchange

rate, or output/employment level.

Since the 1990s, several central banks around the world have adopted an inflation

target framework (Bernanke and Mishkin, 1997). This is thought to have several

advantages, namely: (i) leading to more independent central banks; (ii) reducing inflation

and making monetary policy more credible; (iii) mitigating uncertainty about the

expected level of inflation; and (iv) improving communication between policymakers

and the public, and making monetary policy more transparent (Bernanke and Mishkin,

1997; Svensson, 2000; Gemayel et al., 2011).

Many studies have investigated the policy reactions in relation to the interest rate in

both advanced economies and developing economies. However, scanty research has

been conducted in the case of Organization of Petroleum Exporting Countries (OPEC)

members that are highly vulnerable to external shocks. From the mid-year 2014 to 2016,

OPEC countries were adversely affected by several shocks such as oil price shocks,

exchange rate crisis, fiscal crisis and economic recession. The huge fall in crude oil

prices poses a negative influence on the world economic growth. Growth in oil-

producing economies substantially reduced as most depend on oil revenue to a

significant extent. The negative net impact of lower oil prices on growth is recorded

through a considerable fall in capital expenditures.

In the light of this, the aim of this study is to investigate monetary policy rules

among selected OPEC countries in relation to Taylor’s rule. Specifically, the study:

•Examines the impact of inflation and output on the level of policy rate in the selected

OPEC economies;

OPEC Energy Review June 2017 ©2017 Organization of the Petroleum Exporting Countries

116 Mustapha A. Akinkunmi