The Effectiveness of Transmission Mechanisms of Monetary Policy in Sierra Leone

Abstract

Studies on the effectiveness of transmission mechanisms of monetary policy are crucial for an economy. It is essential to understand how effective are the channels of monetary transmission in directing economic activities in Sierra Leone. In this case, particular focus is on the interest rate, exchange rate, and credit channels. The analytical methods used are unit root tests, cointegration test, Granger causality test, impulse responses and variance decomposition. Central to this investigation is the use of the Vector Autoregression (VAR) approach to estimate time series annual data from 1980 to 2012. The cointegration test result revealed that cointegration exists. The Granger causality test showed that gross capital formation Granger causes exchange rate and real interest rate. The impulse response function showed that output responded positively to monetary shocks, as interest rate increased. For exchange rate and private domestic credit, output showed that even in the long run, the effects of the shocks might not be transitory in order to converge towards a steady state. The variance decomposition indicated that fluctuations in gross domestic product per capita (GDPPC) were attributed to itself. While the total contribution of the real interest rate (RIR) and exchange rate (ER) was relatively insignificant. The error forecast of RIR was attributed by itself with an insignificant contribution of GDPPC and none by ER and private domestic credit (PDC). Fluctuations in forecasting ER were greatly attributed to itself and trivial contributions by the other variables. As the trend fell, there was a slight increase in the contribution of the other variables. The results provided evidence of ineffective channels in the Sierra Leone economy.