Monetary Policy and Inflation Tolerance Ranges: Applications to Rwanda

Abstract

This paper studies the use of inflation tolerance ranges in the conduct of monetary policy. In doing so, the paper examines the appropriateness of the current official inflation tolerance band of the National Bank of Rwanda (5± 3%). In a stylized New Keynesian Model calibrated to Rwanda, the study adopts a state-dependent policy rule approach, in which monetary policy operates under two regimes: the lower-boundary regime (when inflation is below 2 percent) and the upper boundary regime (when inflation exceeds 8 percent). Within this framework, a controlled tolerance parameter is used to compare the 5± 3% tolerance range against wider inflation tolerance ranges, relying on impulse response functions to analyze the behavior of monetary policy in reaction to an unexpected inflation shock. We deliberately exclude narrower ranges from our analysis to avoid the pitfalls of unanchored inflation observed in the empirical data. We find the following main results across different iterations. First, higher inflation tolerance magnifies the asymmetric response of monetary policy, where it reacts aggressively to deviations from the upper boundary than in the lower boundary regime. Second, higher inflation tolerance reduces the likelihood of inflation convergence back to the benchmark target (middle value of a range) following an inflation shock. Third, we find that higher tolerance is costly, as the central bank must later compensate with aggressive measures to bring back inflation to the benchmark target, leading to a larger output loss. Compared to wider tolerance ranges, these results suggest that the 5± 3% tolerance range remains appropriate for Rwanda.