THE EFFECTIVENESS OF MONETARY POLICY IN A SMALL DEVELOPING OPEN ECONOMY: THE CASE OF SIERRA LEONE

ABSTRACT

This study examined the implications of openness for the effectiveness of monetary policy in Sierra Leone using quarterly data from 2002 to 2018. In addition, it investigated the role of the demand for money in monetary policy formulation in Sierra Leone. It also explored the effect of monetary policy rate on market rates and the transmission channel of monetary policy to real economy in Sierra Leone. The autoregressive distributed lag model was employed to investigate the role of the demand for money and the implication of openness on monetary policy in Sierra Leone. The choice of this model was based on the fact that it was appropriate for the objectives of the study and it was applicable in addressing the problem of endogeneity among variables with small sample size. The ordinary least squares technique was employed to examine the effect of the monetary policy rate on market interest rates. This approach was considered appropriate because it is unbiased, efficient and consistent in handling small sample data. The non-recursive structural vector autoregressive technique was employed to identify the channel of monetary policy transmission to the real economy. This technique was considered appropriate because it has two-way or bidirectional causal effects among endogenous variables and ordering of endogenous variables are considered flexible. Analysis of data shows that the demand for money was stable based on the cumulative sum of recursive residuals and cumulative sum of squares of recursive residuals. In addition, the exchange rate channel was found to be appropriate in transmitting monetary policy effect to real economy based on the results of impulse response and variance decomposition analysis. Also, the results show that a higher degree of openness of the economy weakened the effect of monetary policy on both output growth and exchange rate, but strengthened the effect on inflation. In light of the xvii empirical findings, the study recommends that in a bid to have an effective monetary policy, the channel of monetary policy transmission and the implication of openness for monetary policy should be taken into consideration in the design of monetary policy in Sierra Leone.