The Efficacy of Monetary Policy under Dollarization: A Time-Varying VAR Analysis of Liberia

Abstract

The study assesses the mechanisms of transmission of monetary policy in Liberia from 2006 to 2024, under conditions characterized by competing dollarization, very little monetary autonomy, and structural fragility stubbornly persisting such as these ones. These uncertainties call for an assessment of the efficaciousness of any conventional monetary policy instrument since it cannot be presumed that such effectiveness shall not also vary over time. In this regard, we will do the analysis using a time-varying parameter vector autoregressive (TVP-VAR) modelling approach that can allow for a varying impact of monetary policy shocks on inflation and real output through different macroeconomic circumstances, institutional constraints, and external disturbances as they vary over time.
The empirical analysis is structured along three main monetary policy transmission channels: the exchange rate channel, the money supply channel, and the bank lending channel. The results show that inflation in Liberia has become a very persistent process, characterized by a strong inertia and expectation-driven properties. But over the years, inflation has become increasingly sensitive to the movements of the exchange rate, especially during the currency pressure episodes, thereby signifying an exchange rate channel with greater influence in an import-driven, highly dollarized economy. The money supply and bank lending channels, however, were found to be quite weak and thus not able to transmit policy impulses into the real economy effectively; yet another manifestation of shallow financial intermediation, excess liquidity in the banking system, poor interest rate pass-through, and limited access to formal credit.
The implications of these findings for policymaking are that they provide a case for taking steps to enhance the credibility and communication strategy of monetary policy, maintain stabilization of the exchange rate, and deepen the banking system for effective transmission of monetary policy. By providing time-varying evidence in a fragile, dollarized economy, the research will contribute to the broader literature on monetary transmission within low-income countries and generate actionable insight for maintaining price stability and fiscal resilience in Liberia.