Exchange Rate Channel of Monetary Policy Transmission Mechanism in Rwanda

Abstract

Understanding the channels of the monetary policy transmission mechanism is crucial for the proper implementation of monetary policy. For low-income countries and Rwanda in particular, with the recent history of economic reforms, including modernization in the monetary policy framework and ongoing financial sector development, there are questions on the strength of monetary policy transmission and which channels actually work. This study aims at assessing the exchange rate channel in the case of Rwanda. Using quarterly data from 2006 to 2022, empirical results reveal that the transmission of monetary policy via the exchange rate channel exists. First, evidence confirms the first stage of transmission, as an increase in the Central Bank rate influences the exchange rate by reducing the rate of depreciation of Franc Rwandais. Furthermore, results from Bayesian VAR estimation suggest that this transmission works mostly via the direct channel, as this effect from policy rate on the Franc Rwandais exchange rate is transmitted to inflation, and the peak impact is attained after four quarters. Meanwhile, the indirect channel, which implies the effect of monetary policy on inflation via the effect of the exchange rate on output, is quasi-ineffective, as the output response, though in the right direction, is not statistically significant. We argue that this is likely due to the limited impact of exchange rate movement on the export sector and subsequently the current account; thus, ongoing economic structural reforms, financial sector development, and policy implementation would be critical for enhancing the potency of NBR monetary policy.