## _wp08271

## Source details

**Canonical URL:** [_wp08271](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08271.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08271.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08271.pdf.json)

---

### Introduction and context
- Understanding inflation dynamics is critical to the design of Fund programs to help stabilize economies.
- Data limitations in many low-income countries—particularly real sector data—hamper inflation analysis.
- The paper presents a small vector autoregression (VAR) model using only widely available nominal data and exchange rates.
- Sierra Leone case:
  - inflation was double-digit during the long period of conflict;
  - after a brief decline as the conflict was ending in 2000, there was persistent inflation above 10 percent starting in 2003.
- Civil conflict introduces a severe structural break, restricting analysis to the post-conflict period.

### Purposes of the VAR model
- Three uses of the model:
  - (i) analyze causes of the sharp decline in inflation in the second half of 2006;
  - (ii) generate an out-of-sample forecast for 2007 and evaluate it against 2007 developments;
  - (iii) generate a medium-term out-of-sample forecast for 2008–10.
- For (i) and (ii) the sample is truncated at end-2006 to simulate real-time analysis; for (iii) the full-sample model uses data until end-2007.

### Model specification and identification
- Reduced form VAR specification: y_t = B*(L) y_{t-1} + B*_0 X_t + u_t (notation per source).
- Structural form and identification:
  - Γ_0 y_t = Γ(L) y_{t-1} + Γ_0*deterministic + e_t; structural shocks e_t orthogonal.
  - Short-run restrictions imposed (Choleski decomposition); four structural shocks identified:
    - oil price shock (world oil prices exogenous);
    - price shock (harvest-type domestic supply disturbance);
    - monetary policy shock;
    - exchange rate shock.
- Short-run contemporaneous restrictions summarized:
  - Oil price variable responds contemporaneously only to its own shock.
  - Domestic prices respond contemporaneously to oil price shock but not to reserve money or exchange rate shocks.
  - Reserve money responds contemporaneously to oil and price shocks but not to exchange rate shocks.
  - Exchange rate responds contemporaneously to all other variables.

### Empirical model, data, and diagnostics
- Variables (monthly, seasonally adjusted, natural logs):
  - International oil prices (world average crude prices in US$/barrel).
  - Sierra Leone CPI index.
  - Reserve money.
  - Nominal Leone/U.S. dollar exchange rate (bilateral).
- Sample:
  - initially 2001:1 through 2006:12; extended to December 2007 for forecasting.
- Deterministic components: constant and trend (trend statistically significant).
- Lag length: three.
- Diagnostics:
  - All roots of characteristic polynomial lie inside the unit circle — model stable.
  - Multivariate Chow tests: p-values significantly higher than 5 percent — cannot reject no structural breaks.
  - LM tests: some serial correlation at first 3 lags; higher lags show no serial correlation.
  - Joint normality tests: p-value higher than 5 percent — residuals are normally distributed.
  - Heteroskedasticity: mixed individual component results; joint test rejects null of no heteroskedasticity.

### Impulse response findings (responses in percent deviations)
- Oil price shock (one-standard-deviation):
  - Oil prices increase on impact by about 6 percent.
  - CPI increases after about six months by about 1 percent, then declines slowly to baseline.
  - Reserve money declines (monetary tightening).
  - Nominal exchange rate depreciates; real exchange rate appreciates by about 0.5 percent.
  - Annual inflation rate peaks after about six months then declines.
  - Permanent increase in oil prices implies permanent effect on price level (first-round effects allowed; second-round effects prevented).
- Domestic price shock (harvest-type):
  - Immediate CPI increase of about 10 percent, receding to insignificance after about 10 months.
  - Monetary policy initially accommodates, then leans against shock after about three months by reducing money below baseline; monetary tightening more persistent than for oil shock.
  - Nominal and real appreciations; real appreciation about 1 percent immediately.
- Monetary policy shock:
  - Initial increase in reserve money of about 2.5 percent which quickly dissipates.
  - Interpreted as short-lived discretionary actions often reversed.
- Exchange rate shock:
  - Nominal Leone/US dollar depreciates by about 1 percent on impact.
  - After about three months, prices higher by about 0.4 percent; effect persistent.
  - Real exchange rate: higher prices limit real depreciation.
  - Monetary policy expands money supply in response, contributing to persistence.
- General timing:
  - Expansion in reserve money leads to an increase in the price level; full price effect takes about six months.
  - Peak effect of a monetary-policy-induced price change: 0.5 percent at their peak (as stated).

### Pass-through estimates (Text Box 2)
- Method: impulse responses transformed to show CPI level and annual inflation response to permanent 1 percent shocks.
- Oil price pass-through:
  - 1 percent permanent increase in oil prices → CPI level increase of about 0.3 percent and a temporary inflation increase of the same magnitude.
- Exchange rate pass-through:
  - 1 percent permanent depreciation → CPI and inflation response of about 0.3 percent.

### Variance decomposition — selected contributions (table values preserved)
- Price level contributions:
  - 1-month horizon: Oil Price Shock 1.0, Price Shock 99.0, Monetary Policy Shock 0.0, Exchange Rate Shock 0.0
  - 6-month horizon: Oil Price Shock 22.9, Price Shock 49.5, Monetary Policy Shock 21.1, Exchange Rate Shock 6.5
  - 12-month horizon: Oil Price Shock 30.9, Price Shock 33.3, Monetary Policy Shock 28.2, Exchange Rate Shock 7.6
  - 18-month horizon: Oil Price Shock 31.8, Price Shock 30.5, Monetary Policy Shock 29.5, Exchange Rate Shock 8.2
  - 24-month horizon: Oil Price Shock 31.7, Price Shock 30.1, Monetary Policy Shock 29.7, Exchange Rate Shock 8.5
- Inflation contributions:
  - 1-month horizon: Oil Price Shock 1.0, Price Shock 99.0, Monetary Policy Shock 0.0, Exchange Rate Shock 0.0
  - 6-month horizon: Oil Price Shock 22.9, Price Shock 49.5, Monetary Policy Shock 21.1, Exchange Rate Shock 6.5
  - 12-month horizon: Oil Price Shock 30.9, Price Shock 33.3, Monetary Policy Shock 28.2, Exchange Rate Shock 7.6
  - 18-month horizon: Oil Price Shock 27.8, Price Shock 39.6, Monetary Policy Shock 26.0, Exchange Rate Shock 6.6
  - 24-month horizon: Oil Price Shock 30.5, Price Shock 35.8, Monetary Policy Shock 27.5, Exchange Rate Shock 6.3
- Reserve money contributions:
  - 1-month horizon: Oil Price Shock 0.1, Price Shock 2.0, Monetary Policy Shock 97.8, Exchange Rate Shock 0.0
  - 6-month horizon: Oil Price Shock 9.3, Price Shock 3.5, Monetary Policy Shock 79.6, Exchange Rate Shock 7.5
  - 12-month horizon: Oil Price Shock 11.9, Price Shock 6.8, Monetary Policy Shock 72.7, Exchange Rate Shock 8.7
  - 18-month horizon: Oil Price Shock 12.6, Price Shock 7.6, Monetary Policy Shock 70.4, Exchange Rate Shock 9.5
  - 24-month horizon: Oil Price Shock 12.5, Price Shock 7.7, Monetary Policy Shock 69.5, Exchange Rate Shock 10.3
- Exchange rate contributions:
  - 1-month horizon: Oil Price Shock 0.3, Price Shock 0.0, Monetary Policy Shock 5.7, Exchange Rate Shock 94.0
  - 6-month horizon: Oil Price Shock 4.8, Price Shock 1.0, Monetary Policy Shock 18.6, Exchange Rate Shock 75.6
  - 12-month horizon: Oil Price Shock 8.3, Price Shock 0.7, Monetary Policy Shock 24.7, Exchange Rate Shock 66.4
  - 18-month horizon: Oil Price Shock 8.2, Price Shock 0.8, Monetary Policy Shock 25.4, Exchange Rate Shock 65.7
  - 24-month horizon: Oil Price Shock 7.6, Price Shock 1.2, Monetary Policy Shock 25.0, Exchange Rate Shock 66.2
- Real exchange rate contributions:
  - 1-month horizon: Oil Price Shock 1.1, Price Shock 47.0, Monetary Policy Shock 3.0, Exchange Rate Shock 48.9
  - 6-month horizon: Oil Price Shock 7.8, Price Shock 39.3, Monetary Policy Shock 2.7, Exchange Rate Shock 50.1
  - 12-month horizon: Oil Price Shock 9.5, Price Shock 36.0, Monetary Policy Shock 2.1, Exchange Rate Shock 52.4
  - 18-month horizon: Oil Price Shock 8.7, Price Shock 33.4, Monetary Policy Shock 2.4, Exchange Rate Shock 55.5
  - 24-month horizon: Oil Price Shock 8.0, Price Shock 31.5, Monetary Policy Shock 3.1, Exchange Rate Shock 57.4

- Key variance decomposition interpretations:
  - Short run (over six months): price shocks dominate price variation.
  - Longer term: variation depends roughly equally on oil, price, and monetary policy shocks.
  - Reserve money variation dominated by monetary policy shocks.
  - Exchange rate variation mostly due to exchange rate shocks, with monetary policy playing a secondary role.
  - Real exchange rate variation significantly influenced by price shocks and nominal appreciation from monetary tightening.

### Historical decomposition — decline in inflation in 2006
- Observed: annual inflation declines from about 13 percent in early 2006 to about 6 percent in summer 2006.
- Deterministic (underlying) inflation estimated at approximately 9 percent in 2006.
- Drivers of decline from March 2006 (13 percent) to August 2006 (6 percent):
  - Volatile oil prices:
    - Strong increase in oil prices between 2004 and summer 2006 raised consumer price inflation; a plunge in oil prices in the second half of 2006 curtailed domestic inflation.
    - Permanent oil price increases have transitory effect on domestic inflation: initial increase then later fall as price level stabilizes at higher level.
  - Monetary policy shocks:
    - Expansionary monetary policy in late-2005/early-2006 contributed to higher inflation; subsequent tightening helped the decline.
    - Historical decomposition of reserve money shows central bank did not sufficiently limit reserve money growth in response to high oil prices in early 2006.
  - Price and exchange rate shocks did not have much influence on the drop in inflation in the second half of 2006.

### Forecasting performance and medium-term outlook
- Out-of-sample forecast (model estimated to end-2006):
  - Predicted inflation increasing to about 9 percent by early 2008 (deterministic component level).
  - Actual: inflation was above 10 percent in early 2007 and reached 13 percent at end-2007.
- Forecast error sources:
  - Bulk of initial forecast error from unexpected developments in oil prices, money, and the exchange rate.
  - Re-estimation through 2007 shows adverse price shocks (possibly poor harvests) drove up inflation in 2007, offsetting tight monetary conditions and earlier favorable oil price developments.
  - Stochastic component swung from around -5 percent in H2 2006 to +1 percent in final months of 2007.
- Deterministic component revision:
  - Upward adjustment of 2½ percentage points at end-2006 due to higher actual inflation in 2007.
- Medium-term forecast (model to end-2007):
  - Predicts a sharp increase in inflation in 2008 tied to large oil price increases in late 2007.
  - Noted oil price movement: in final quarter of 2007 oil prices increased by about 20 percent relative to the third quarter (almost 50 percent year-over-year).
  - Given pass-through estimate of 0.3 to domestic inflation, this accounts for the bulk of predicted 2008 spike.
  - By June 2008, observed inflation in Sierra Leone had reached 16.5 percent.
  - Longer term: model predicts a return of inflation to about 12 percent (model estimate of underlying deterministic inflation).

### Institutional constraints and policy-relevant findings (Text Box 1 summary)
- Bank of Sierra Leone (BSL) targets reserve money growth to maintain low inflation.
- Monetary policy conduct hampered by:
  - Lack of instruments for open market operations: large stock of noninterest-bearing, nonnegotiable government securities; insufficient treasury bills and treasury bearer bonds.
  - Fiscal policy occasionally conflicted with reserve money targets, leading to passive monetary policy and overshoots of intermediate targets.
  - Deficit financing via foreign grants and borrowing from central bank increases money supply absent sterilization.
  - Sales of foreign exchange for sterilization constrained by BSL priorities: (i) building reserves; (ii) avoiding undesirable exchange rate fluctuations.
- October 2006 MoU between BSL and Ministry of Finance: timetable for converting part of noninterest-bearing, nonnegotiable paper into treasury bills to (i) replenish prescribed minimum paid up capital of the central bank; and (ii) provide instruments for open market operations.
  - BSL favored gradual implementation to avoid sudden upward pressure on nominal interest rates and government interest bill.

### Conclusions and applicability
- VAR modeling is useful for analyzing and forecasting inflation in Sierra Leone despite data limitations.
- Main takeaways:
  - Short-run inflation variation largely driven by domestic price shocks.
  - Oil price shocks and monetary policy shocks importantly affect medium-term inflation variation.
  - Reserve money changes transmit to prices with a lag of about six months.
  - Exchange rate shocks have persistent pass-through to prices; monetary accommodation can reinforce persistence.
  - Deterministic trend component provides a proxy for underlying inflation; stochastic component attributes deviations to identifiable shocks.
- Methodological caveats:
  - Model does not incorporate fiscal dominance due to data constraints; central bank reaction function may be incomplete.
  - The approach may be useful for other countries with data limitations as a statistical underpinning for inflation analysis.

*Source: _wp08271 - References*

### References..............................................................................................................

### References

### Introduction and context
- Understanding inflation dynamics is critical to the design of Fund programs to help stabilize economies.
- In many low-income countries, lack of data, particularly for the real sector, hampers inflation analysis.
- This paper presents a small vector autoregression (VAR) model for inflation that can be used for forecasting inflation and analyzing its causes while using only widely available nominal data and exchange rates.
- The model has been estimated for Sierra Leone, where:
  - inflation was double-digit during the long period of conflict;
  - after a brief decline as the conflict was ending in 2000, there was persistent inflation above 10 percent starting in 2003.
- Data limitations arise because of civil conflict—which introduces a severe structural break in the data, restricting analysis to the post-conflict period—and the lack of statistical capacity, especially regarding the collection of real sector data.

### Purposes of the VAR model in this study
- The paper uses the inflation model for three purposes:
  - (i) analyze the causes of a sharp decline in inflation in the second half of 2006;
  - (ii) generate an out-of-sample forecast for 2007 and evaluate it against inflation developments in 2007;
  - (iii) generate a medium-term out-of-sample forecast for 2008–10.
- For task (i), the historical decomposition technique of VARs is used; to simulate a real-time analysis, the sample period is truncated at end-2006.
- The truncated sample period is also used for generating the out-of-sample forecast for 2007 (task ii).
- The medium-term forecast (task iii) is based on the full-sample model with data until end 2007.

### Methodology, model specification, and structure of the paper
- Section II reviews the literature to set this study in context.
- Section III discusses the VAR methodology, the specification of the model for Sierra Leone, and estimation results.
- Section IV utilizes the model for the three tasks described above.
- Section V draws conclusions.

### Tables, figures, boxes, and appendices listed
- Tables
  - 1. Sierra Leone: Results for the Variance Decomposition ...............................................26
- Figures
  - 1. Sierra Leone: CPI Index and Its Determinants ............................................................15
  - 2. Impulse Response Functions........................................................................................21
  - 3. Historical Decomposition of Inflation in Sierra Leone, 2002-06 ................................28
  - 4. Contribution of the Individual Structural Shocks ........................................................30
  - 5. Out-of-Sample Inflation Forecast (model estimated until end-2006) ...........................31
  - 6. Inflation Model up to December 2007.........................................................................32
  - 7. Out-of-Sample Inflation Forecast (model estimated until end-2007)..........................33
- Boxes
  - 1. Sierra Leone: Monetary and Fiscal Policy Coordination.............................................10
  - 2. Sierra Leone:  Pass-through of Oil Prices and Exchange Rates ..................................24
- Appendix Tables
  - 1. VAR Residual Serial Correlation LM Tests ................................................................37
  - 2. VAR Residual Normality Tests ...................................................................................37
  - 3. White Residual Heteroskedestacity Tests ....................................................................37
- Appendix Figures
  - 1. Roots of Charecteristic Polynomial .............................................................................35
  - 2. Chow Test Results .......................................................................................................35
  - 3. Cumulative Impulse Response Functions ....................................................................36

*Source: _wp08271 - References*

### conclusions.

### conclusions.

### II. PREVIOUS STUDIES — Inflation in Sierra Leone
- Kallon (1994): structural equation for inflation using two-stage least squares (1967 Q1–1987 Q4). Variables: growth of narrow money, growth of real government expenditure, real GNP growth, import price inflation, percentage change in the treasury bill rate, change in the interest rate differential, and inflation expectations.
  - Finds: a 1 percent increase in money growth would lead to a ½ percent increase in inflation over four quarters and 1.3 percent in the long run.
  - Real GDP growth and inflation expectations also lead to higher inflation.
  - Inflation is insensitive to import price inflation or increases in government expenditures.
  - Policy implication: use monetary restraint and other aggregate demand policies to counter inflation.
- Tucker (2004): cointegrating VAR for West African Monetary Zone (1981 Q1–2000 Q4). Variables: real broad money balance, real GDP, three-month deposit rates, three-month treasury bill discount rates, and inflation (proxy for return on real assets).
  - Finds long-run stability of money demand; relationship between money balance, real GDP, and T-bill rates stable in the long run.
  - Concludes a proposed West African Central Bank could conduct a single monetary policy to achieve price stability within the zone.
  - Recommends open market operations be accompanied by financial market development and increased private sector participation.
- Kovanen (2006): highly disaggregated price data, cross-section and time-series regressions.
  - Finds inflation is less persistent in Sierra Leone than in mature economies.
  - Price changes are frequent due to uncertainty about inflation and low value-added content of domestic products.
  - Fraction of items subject to price changes is very high and volatile; timing of repricing is state-dependent.
  - Concludes reduction of monetary surprises and supply constraints would reduce fraction and frequency of repricing, lowering level and volatility of inflation.
- Synthesis: literature suggests monetary policy (direct effect of money growth and indirectly via inflation expectations) and supply-side factors are important for inflation.

### II. PREVIOUS STUDIES — Vector Autoregression (VAR) context
- VAR standard tool for examining monetary transmission; expanded to open-economy applications with external shocks included (current account, terms of trade, real/nominal exchange rate, commodity prices, US Federal funds rate).
- Variable choices for Sierra Leone constrained by data availability and limited time series due to civil war interruptions.

### III. MODELING INFLATION IN SIERRA LEONE — Data Shortcomings
- Focus period: since economic recovery began in 2001 due to civil war interruptions.
- Use monthly data to compensate for short sample; no reliable real sector statistics at monthly or quarterly frequency.
- Included variables limited to price data, monetary statistics, and international prices.
- Lack of real sector statistics:
  - Precludes models identifying aggregate demand disturbances (e.g., Blanchard and Quah (1989) structural VAR).
  - Prevents reliable measurement of the output gap.
- Can model price shocks (pass-through of international prices, domestic supply conditions); international oil prices and exchange rate considered.
- Supply shocks (harvest conditions) not directly measured; unexplained price shocks interpreted as harvest-type supply shocks expected to fade within a year.
- Model captures two central bank objectives: inflation and the exchange rate.
  - BSL seems committed to targeting a single-digit inflation rate; stabilizing the real economy is secondary due to lack of real data.
  - Debate exists whether BSL pursues an exchange rate target; authors do not think so, but BSL is concerned with exchange rate volatility.
- Missing crucial variable: government financing requirements.
  - Model assumes central bank control of reserve money, but fiscal policy and administrative constraints can interfere.
  - No long-run monthly time series for government financing requirements; monetary policy reaction function incomplete, possibly complicating identification of monetary policy shock.
- Empirical results display broadly plausible responses to monetary policy shock despite data shortcomings.

### Text Box 1 — Monetary and Fiscal Policy Coordination (summary of institutional constraints)
- BSL targets reserve money growth to maintain low inflation.
- Conduct of monetary policy hampered by institutional weaknesses and fiscal needs:
  - Lack of instruments for open market operations; large stock of noninterest, nonnegotiable government securities (zero face value); insufficient treasury bills and treasury bearer bond to conduct meaningful open market operations.
  - Fiscal policy stance at times conflicted with BSL’s reserve money target, leading to passive monetary policy and frequent overshoots of intermediate monetary target contributing to persistent high inflation.
- Deficit financing through foreign grants and borrowing from the central bank increases money supply absent sterilization.
- Alternative sterilization (sales of foreign exchange) was constrained by BSL priorities: (i) building up comfortable reserve cover, and (ii) concern that sales could cause undesirable exchange rate fluctuations.
- October 2006 Memorandum of Understanding (MoU) between BSL and Ministry of Finance: timetable for conversion of part of noninterest-bearing, nonnegotiable government paper into treasury bills to (i) replenish prescribed minimum paid up capital of the central bank; and (ii) provide instruments to conduct open market operations.
  - BSL favored gradual implementation to avoid significant sudden upward pressure on nominal interest rates and on the government interest bill.

### III. MODELING — VAR Methodology (key methodological points)
- Reduced form VAR: y_t = B*(L) y_{t-1} + B*_0 X_t + u_t (notation per text).
- Structural form: Γ_0 y_t = Γ(L) y_{t-1} + Γ_0*deterministic + e_t; structural shocks e_t are orthogonal (standard identifying restriction).
- Identification requires transforming reduced form to MA presentation and imposing short- or long-run restrictions; short-run restrictions used given short sample period.
- Structural shocks interpreted as exogenous primitive forces; model assessed by:
  - Impulse response functions.
  - Variance decomposition.
  - Historical decompositions.
- Short-run restrictions chosen for Sierra Leone model (implemented via Choleski decomposition) and standard orthogonality imposed:
  - Oil price variable responds contemporaneously only to its own shock (world oil prices exogenous).
  - Domestic prices can respond contemporaneously to oil price shock but not to shocks from reserve money or the exchange rate (reflects delays in monetary/exchange rate transmission).
  - Reserve money can respond contemporaneously to oil and price shocks but not to exchange rate shocks (central bank unlikely to respond instantaneously to exchange rate movements).
  - Exchange rate can respond contemporaneously to all other variables.
- Model identifies four structural shocks: oil price shock; price shock (harvest-type domestic supply disturbance); monetary policy shock; exchange rate shock.

### III. MODELING — Empirical Model for Sierra Leone (variables and sample)
- Four variables in VAR:
  - International oil prices (world average crude prices in US$/barrel from International Financial Statistics).
  - CPI index for Sierra Leone.
  - Reserve money (chosen because central bank has more control over it).
  - Nominal Leone/U.S. dollar exchange rate (bilateral rate preferred because US dollar use is common in Sierra Leone and policy discussions focus on Leone/US dollar rate).
- Data: monthly, seasonally adjusted, natural logarithms.
- Sample: initially 2001:1 through 2006:12; extended to December 2007 for out-of-sample forecasting and medium-term inflation forecast.
- Deterministic components: constant and trend included (trend statistically significant).
- Lag length: three (chosen for parsimonious model with well-behaved residuals; standard information criteria suggested one lag but one lag produced severe non-normality).
- Model diagnostics:
  - All roots of characteristic polynomials lie inside the unit circle — model stable.
  - Multivariate Chow tests: p-values significantly higher than 5 percent — cannot reject null of no structural breaks.
  - Lagrange Multiplier (LM) tests: some serial correlation at first 3 lags; higher lags show no serial correlation — lag length set to three.
  - Joint normality tests: p-value higher than 5 percent — residuals are normally distributed.
  - Heteroskedasticity tests: mixed results for individual components; joint test rejects null of no heteroskedasticity.

### III.D Estimation Results — Impulse Responses (summary)
- Responses interpreted in percent deviations since variables in logarithms.
- Response to a one-standard-deviation oil price shock:
  - Oil prices increase on impact by about 6 percent (Panel 1).
  - CPI increases after about six months by about 1 percent, then declines slowly to baseline (Panel 2).
  - Monetary policy tightens: reserve money declines (Panel 3).
  - Nominal exchange rate depreciates (Panel 4) while exchange rate appreciates in real terms by about 0.5 percent (Panel 5).
  - Annual inflation rate peaks after about six months and then declines; in long run all variables return to baseline.
  - Permanent increase in oil prices (cumulative impulse responses in Appendix) implies permanent effect on price level — consistent with allowing first-round effects while preventing permanent second-round effects.
  - Interpretation: cost-push shock with pass-through dampened by tighter monetary policy and real exchange rate appreciation.
- Response to a domestic price shock (harvest-type supply shock):
  - Immediate increase in CPI by about 10 percent, receding to statistical insignificance after about 10 months.
  - Monetary policy accommodates initially then leans against shock after about three months by reducing money supply below baseline; monetary tightening is more persistent than for oil-price shock.
  - Nominal and real appreciations occur; real appreciation reaches about 1 percent immediately.
  - General response similar to oil-price shock but with more persistent monetary policy response.
- Response to a monetary policy shock:
  - Initial increase in reserve money of about 2.5 percent which quickly dissipates.
  - Monetary policy shock interpreted as short-lived discretionary actions often reversed once more information becomes available.
- Response dynamics summary:
  - Expansion in reserve money leads to an increase in the price level; it takes about six months for the price effect to take full effect (figure panels illustrate timing and magnitudes).

*Source: _wp08271 - conclusions.*

### 0.5 percent at their peak. The nominal exchange rate depreciates approximately in line with

### _wp08271 - 0.5 percent at their peak. The nominal exchange rate depreciates approximately in line with

### Response to Monetary Policy Shock
- Expansionary monetary policy raises prices with some delay and induces nominal exchange rate depreciation.
- Real variables: monetary policy is neutral in the long term; the real exchange rate is broadly unchanged except for an initial real depreciation.
- Peak effect on prices: 0.5 percent at their peak (as stated in the content unit).

### Response to Exchange Rate Shock
- Impact on nominal exchange rate: Leone/US dollar depreciates by about 1 percent on impact.
- Persistence: the nominal depreciation is relatively persistent, returning only slowly to its baseline.
- Pass-through to prices: after a delay of about three months, prices are higher by about 0.4 percent; this effect is persistent.
- Real exchange rate: higher prices limit real exchange rate depreciation.
- Monetary accommodation: monetary policy expands money supply in response, contributing to the persistence of the shock.
- Interpretation: central bank is not actively pursuing an exchange rate target in the short run; otherwise it would sell foreign exchange and induce monetary contraction.
- Market structure note: central bank is a relatively minor actor in the foreign exchange market, which is dominated by transactions related to diamond mining.
- Footnote assumption: assuming the central bank would not sterilize the impact of its sale of foreign exchange on money supply.

### Text Box 2 — Pass-through of Oil Prices and Exchange Rates
- Methodology: in VAR analysis, impulse response functions are transformed to show response of CPI level and annual inflation to a 1 percent permanent increase in oil prices and a 1 percent permanent depreciation in the exchange rate respectively.
- Oil price pass-through:
  - A 1 percent permanent increase in oil prices leads to an increase in the CPI level of about 0.3 percent and a temporary increase in inflation of the same magnitude.
- Exchange rate pass-through:
  - A constructed 1 percent permanent depreciation yields a CPI and inflation response of about 0.3 percent.

### Variance Decomposition — Key Results
- Price shocks:
  - Dominate price variations in the short run (over six months); recede in importance as new harvests come in.
- Monetary policy shocks:
  - Have a negligible effect on the real exchange rate, confirming the neutrality hypothesis.
  - Dominate the variation in reserve money (noted as likely reflecting discretionary monetary actions and partial model specification).
- Contributions to variance in prices and inflation:
  - Short run: variation in prices is caused mostly by price shocks.
  - Longer term: variation depends in about equal measure on oil, price, and monetary policy shocks.
  - Inflation decomposition gives more weight to price shocks.
- Exchange rate variations:
  - Mostly due to exchange rate shocks and to a lesser extent monetary policy shocks; prominence may reflect factors not in the model (e.g., supply of foreign exchange from diamond exports).
- Real exchange rate variations:
  - Depend significantly on price shocks (price shocks have large effects on the price level, leading to a real appreciation).
  - Monetary policy also plays a role: tightening induces nominal appreciation that reinforces real appreciation.

### Table 1 — Selected Variance Decomposition Contributions (as reported)
- Price level contributions:
  - 1-month horizon: Oil Price Shock 1.0, Price Shock 99.0, Monetary Policy Shock 0.0, Exchange Rate Shock 0.0
  - 6-month horizon: Oil Price Shock 22.9, Price Shock 49.5, Monetary Policy Shock 21.1, Exchange Rate Shock 6.5
  - 12-month horizon: Oil Price Shock 30.9, Price Shock 33.3, Monetary Policy Shock 28.2, Exchange Rate Shock 7.6
  - 18-month horizon: Oil Price Shock 31.8, Price Shock 30.5, Monetary Policy Shock 29.5, Exchange Rate Shock 8.2
  - 24-month horizon: Oil Price Shock 31.7, Price Shock 30.1, Monetary Policy Shock 29.7, Exchange Rate Shock 8.5
- Inflation contributions:
  - 1-month horizon: Oil Price Shock 1.0, Price Shock 99.0, Monetary Policy Shock 0.0, Exchange Rate Shock 0.0
  - 6-month horizon: Oil Price Shock 22.9, Price Shock 49.5, Monetary Policy Shock 21.1, Exchange Rate Shock 6.5
  - 12-month horizon: Oil Price Shock 30.9, Price Shock 33.3, Monetary Policy Shock 28.2, Exchange Rate Shock 7.6
  - 18-month horizon: Oil Price Shock 27.8, Price Shock 39.6, Monetary Policy Shock 26.0, Exchange Rate Shock 6.6
  - 24-month horizon: Oil Price Shock 30.5, Price Shock 35.8, Monetary Policy Shock 27.5, Exchange Rate Shock 6.3
- Reserve money contributions:
  - 1-month horizon: Oil Price Shock 0.1, Price Shock 2.0, Monetary Policy Shock 97.8, Exchange Rate Shock 0.0
  - 6-month horizon: Oil Price Shock 9.3, Price Shock 3.5, Monetary Policy Shock 79.6, Exchange Rate Shock 7.5
  - 12-month horizon: Oil Price Shock 11.9, Price Shock 6.8, Monetary Policy Shock 72.7, Exchange Rate Shock 8.7
  - 18-month horizon: Oil Price Shock 12.6, Price Shock 7.6, Monetary Policy Shock 70.4, Exchange Rate Shock 9.5
  - 24-month horizon: Oil Price Shock 12.5, Price Shock 7.7, Monetary Policy Shock 69.5, Exchange Rate Shock 10.3
- Exchange rate contributions:
  - 1-month horizon: Oil Price Shock 0.3, Price Shock 0.0, Monetary Policy Shock 5.7, Exchange Rate Shock 94.0
  - 6-month horizon: Oil Price Shock 4.8, Price Shock 1.0, Monetary Policy Shock 18.6, Exchange Rate Shock 75.6
  - 12-month horizon: Oil Price Shock 8.3, Price Shock 0.7, Monetary Policy Shock 24.7, Exchange Rate Shock 66.4
  - 18-month horizon: Oil Price Shock 8.2, Price Shock 0.8, Monetary Policy Shock 25.4, Exchange Rate Shock 65.7
  - 24-month horizon: Oil Price Shock 7.6, Price Shock 1.2, Monetary Policy Shock 25.0, Exchange Rate Shock 66.2
- Real exchange rate contributions:
  - 1-month horizon: Oil Price Shock 1.1, Price Shock 47.0, Monetary Policy Shock 3.0, Exchange Rate Shock 48.9
  - 6-month horizon: Oil Price Shock 7.8, Price Shock 39.3, Monetary Policy Shock 2.7, Exchange Rate Shock 50.1
  - 12-month horizon: Oil Price Shock 9.5, Price Shock 36.0, Monetary Policy Shock 2.1, Exchange Rate Shock 52.4
  - 18-month horizon: Oil Price Shock 8.7, Price Shock 33.4, Monetary Policy Shock 2.4, Exchange Rate Shock 55.5
  - 24-month horizon: Oil Price Shock 8.0, Price Shock 31.5, Monetary Policy Shock 3.1, Exchange Rate Shock 57.4

### Historical Decomposition — Decline in Inflation in 2006
- Observed decline: annual inflation declines from about 13 percent in early 2006 to about 6 percent in summer 2006.
- Deterministic component:
  - Interpreted as underlying inflation in the absence of shocks; estimated underlying inflation was approximately 9 percent in 2006.
- Stochastic component: accounts for variations around the deterministic trend.
- Identified drivers of the decline from March 2006 (13 percent) to August 2006 (6 percent):
  - Volatile oil prices:
    - Strong increase in oil prices between 2004 and summer 2006 raised consumer price inflation; a plunge in oil prices in the second half of 2006 curtailed domestic inflation.
    - Permanent oil price increases have only a transitory effect on domestic inflation: inflation initially increases but later falls as the domestic price level stabilizes at its higher level.
  - Monetary policy shocks:
    - Discretionary monetary actions contributed: inflation rose as monetary policy turned expansionary in early 2006 but later declined as it tightened.
    - Historical decomposition of reserve money shows expansionary monetary policy in late-2005/early-2006 was due to the central bank not limiting growth of reserve money in response to high oil prices sufficiently.
  - Price and exchange rate shocks:
    - Did not have much influence on the drop in inflation in the second half of 2006.

### Forecasting Inflation for 2007
- Out-of-sample forecast (model estimated to end-2006):
  - Forecast predicted inflation increasing to about 9 percent by early 2008 (the deterministic component level).
  - Actual: inflation had already bounced back above 10 percent in early 2007 and reached 13 percent at the end of 2007.
- In-sample forecast using actual values for oil prices, money, and the exchange rate produced a much more accurate forecast.
- Source of forecast error:
  - Bulk of initial forecast error stems from unexpected developments in oil prices, money, and the exchange rate.
  - Re-estimating the model through 2007 and computing historical decomposition shows adverse price shocks (possibly related to poor harvest conditions) drove up inflation in 2007, more than offsetting relatively tight monetary conditions and initially favorable oil price developments.
  - Result: stochastic component swings from around -5 percent in the second half of 2006 to +1 percent in the final months of 2007.
- Deterministic component revision:
  - Increase in actual inflation in 2007 leads to an upward adjustment in the deterministic component: cumulative upward revision of 2½ percentage points at end-2006.
  - The profile of the stochastic component remains unchanged; the shift reduces its size (shifts it downwards).

### Forecasting Medium-term Inflation (2008–10)
- Model estimated to end-2007 predicts:
  - A sharp increase in inflation in 2008, likely driven by large increase in oil prices in late 2007.
  - In the final quarter of 2007, oil prices increased by about 20 percent relative to the level in the third quarter (almost 50 percent year-over-year).
  - Given the pass-through estimate of 0.3 to domestic inflation (Text Box 2), this accounts for the bulk of the predicted inflation spike in 2008.
  - By June 2008, inflation in Sierra Leone had already reached 16.5 percent.
  - Longer term: the model predicts a return of inflation to a level of about 12 percent, corresponding to the model estimate of underlying (deterministic) inflation.

### Conclusion and Methodological Notes
- VAR modeling proved useful for analyzing and forecasting inflation in Sierra Leone despite data limitations.
- Model features and findings:
  - Does not incorporate fiscal dominance for monetary policy because of data limitations.
  - Impulse-response functions show generally plausible economic responses to structural shocks.
  - Variance decomposition identifies shocks that account most for inflation variability.
  - Deterministic component from historical decomposition provides guidance for forecasting by proxying underlying inflation; the stochastic component attributes changes to specific shocks.
- Applicability: the method may be useful for other countries with data limitations by providing statistical underpinning for inflation analysis.

*Source: IMF working paper content provided in the input PDF excerpt.*

### References

### _wp08271 - References

### References

- Blanchard, Olivier, and Danny Quah, 1989, “The Dynamic Effects of Aggregate Demand and Supply Disturbances,” American Economic Review Vol. 79 (4), pp. 655–673.
- Calvo, Guillermo, and Carmen Reinhart, 2002, “Fear of Floating,” Quarterly Journal of Economics Vol. 117 (2), pp. 379–408.
- Catalán, Mario, and Ruy Lama, 2006, “Fiscal Policy and External Balance in Spain,” IMF Country Report No. 06/213 (Washington: International Monetary Fund).
- Cheng, Kevin C., 2006, “A VAR Analysis of Kenya's Monetary Policy Transmission Mechanism: How Does the Central Bank’s REPO Rate Affect the Economy?” IMF Country Report No. 06/300 (Washington: International Monetary Fund).
- Christiano, Lawrence, Martin Eichenbaum, and Charles Evans, 1999, “Monetary Policy Shocks: What Have We Learned and to What End?” in Handbook of Macroeconomics, ed. by John B. Taylor and Michael Woodford. Vol. 1A, pp. 65–148 (North Holland: Elsevier).
- Kallon, Kelfala M., 1994, “An Econometric Analysis of Inflation in Sierra Leone,” Journal of African Economies, Vol. 3 (2), pp. 199–230.
- Kim, Soyoung, 1999, “Do Monetary Policy Shocks Matter in the G-7 Countries? Using Common Identifying Assumptions About Monetary Policy Across Countries,” Journal of International Economics, Vol. 48, pp. 387–412.
- Kim, Soyoung, and Nouriel Roubini, 2000, “Exchange Rate Anomalies in the Industrial Countries: A Solution With a Structural VAR Approach,” Journal of Monetary Economics, Vol. 45, pp. 561–86.
- Kovanen, Arto, 2006, “Why Do Prices in Sierra Leone Change So Often? A Case Study Using Micro-Level Price Data,” IMF Working Paper 06/53 (Washington: International Monetary Fund).
- Krueger, Anne, 1991, “Issues in Policy Reform in Developing Countries,” Special Lecture at the 61st Annual Meeting of the Southern Economic Association (Nashville: Tennessee).
- Kuijs, Louis, 2002, “Monetary Policy Transmission Mechanisms and Inflation in Slovakia,” IMF Working Paper 02/80 (Washington: International Monetary Fund).
- Mwase, Nkunde, 2006, “An Empirical Investigation of the Exchange Rate Pass-Through to Inflation in Tanzania,” IMF Working Paper 06/150 (Washington: International Monetary Fund).
- Pattillo, Catherine, Helene Poirson, and Luca Ricci, 2002, “External Debt and Growth,” IMF Working Paper 02/69 (Washington: International Monetary Fund).
- Sims, Christopher A., 1972, “Money, Income, and Causality,” American Economic Review, Vol. 62 (4), pp. 540–52.
- Sims, Christopher A., 1980, “Comparison of Interwar and Postwar Business Cycles: Monetarism Reconsidered,” American Economic Review, Vol. 70 (2), pp. 250–57.
- Sims, Christopher A., and Tao A. Zha, 1998, “Does Monetary Policy Generate Recessions?” Federal Reserve Bank of Atlanta Working Paper 98–12.
- Stavrev, Emil, 2005, “Macroeconomic Implications of Domestic Credit in Latvia,” IMF Country Report No. 05/277 (Washington: International Monetary Fund).
- Svensson, Lars, 1998, “Open-Economy Inflation Targeting,” NBER Working Paper 6545 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Tucker, Joseph Ansu, 2004, “The Stability of Money Demand in the West African Monetary Zone—Implications for the Conduct of a Single Monetary Policy,” Bank of Sierra Leone Bulletin, July–December 2004 (Freetown: Bank of Sierra Leone).

*Source: _wp08271 - References*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08271.pdf_