Monetary Policy and Macroeconomic Shocks in Ethiopia Specification, Estimation and Analysis of Monetary Policy Reaction Function

This study examines the response of monetary authority to macroeconomic shocks by employing a VECM Cointegration VAR model that considers domestic credit as the most appropriate indicator of monetary policy performance. The main findings of the study are as follows: Both net foreign asset and GDP are statistically significant and positively influence domestic credit in the long run dynamics model. It is only consumer price index that has a positive impact in the short run dynamics. All other explanatory variables negatively influence domestic credit in the short-run dynamics model. The effect of monetization of fiscal deficit on monetary policy depends on the endogeneity and exogeneity of fiscal deficits in the long run dynamics model. Moreover, the speed of adjustment or feedback effect towards long run equilibrium takes many years to make a full adjustment when there is a shock to the system. However, the speed of adjustment is inconsistent comparing with the short run dynamic analysis in this regard. The sterilization coefficient reveals incomplete sterilization activities while the offset coefficient tells us a high degree of monetary control with low degree of capital mobility. Therefore, the study recommends that the monetary authority should exercise its full discretionary power and focuses on financial sector development, secondary market and economic monetization in order to timely respond to macroeconomic shocks through market-based policy instruments