The Moorish Wanderer

Inflation, Output Gap and Monetary Policy in Morocco

Posted in Dismal Economics, Moroccan Politics & Economics, Morocco, Read & Heard by Zouhair ABH on January 17, 2011

What is to be discussed about money in Morocco? First, perhaps an attempt to correct some misconceptions about currency, monetary base and inflation. Read on twitter: “If money supply doubles, prices will double as well, holding physical output fixed”. The statement is mathematical, in these sense that it appeals to only one outcome out of two: true or false. The statement also asserts the old-style quantitative theory of money. By the way, the author of such sentence is not to blame, and I am grateful to them for providing me the opportunity, ney, the inspiration to write about something.

There’s indeed a popular misconception, which partially-educated journalists and politicians like to spread, about the kind of relationship between money supply, GDP and level of inflation. As far as Morocco is concerned, the new monetary theories hold particular in favour of my case. Milton Friedman once stated that “Inflation is always and everywhere a monetary phenomenon”. He was right at the time. The global trend this last year does not support the evidence. In the 1970’s (at times of high inflation, as we will see later on), that was true. But then again, that was the case because monetary supply was, for the better or the worse, restricted to greater proportions compared to nowadays. In fact, it is foolish to mistake the inflation/money supply relationship as a ‘post hoc ergo propter hoc‘ one. Inflation was quite high (due to other parameters that are too numerous to delineate here) and some economists -as well as policy-makers– thought, with some reasons, that high level of inflation was to be lived with, and that the Philips curve being considered to be very flat, any anti-inflationist policies were too expensive in terms of social and labour cost.

Inflation trend in Industrialized and Emerging countries

As it turned out, late 1970’s and through out the 1980’s, policies were quite aggressive against inflation, and, at the price of durable recession (but not deflation) reversed the trend, and with the 1990’s, the great moderation, i.e. a sustained low level of inflation was such that OECD countries enjoyed near-uninterrupted growth over two decades. On the other hand, monetary base expanded substantially over the same period. Graphs are quite enough to prove that, after the Volcker-style policies in disciplining inflation expectations, the world never had it so good with low inflation rates, and at the same time, credit allowances and monetary base grew at near-exponential rates. At the end of the day, our day, doubling money supply does not double prices. (even in Morocco)

Credit & Monetary base, on the other hand, exploded to exponential proportions

I mentioned in a previous article something about output gap and potential output. There were some interesting comments about how the results were obtained, and on second thoughts, I wondered if they were that well-founded. These results were a rough estimate; and a bad one too, not least because I did not proceed properly with the computations (I’d keep it very superficial) as it turned out.

So I will make it up to the reader by redoing the computations in a more rigorous way. The self-pride of a would-be economist is at stake. (it would also definitely deter me from following advices about writing short pieces…) The strict definition of potential output is : ‘the total gross domestic product (GDP) that could be produced by an economy if all its resources were fully employed’. Now the Cobb-Douglas function remains a reasonable starting point. There was a comment on how unlikely the parameters a and b are to remain constant, so that’s how we will proceed: a). We maintain the assumption GDP output is produced by means of Cobb-Douglas function, Capital and Labour are the main inputs, and Total productivity factor (also called Solow Residual) can be inferred from empirical data. Because of the discrepancies in available databases, we should focus on growth rates rather than actual figures. Used data is the World Bank Data.

b). Because we considered Cobb-Douglas, the logarithmic transformation is a good proxy for the growth rate of each component

ε term is there for statistical purposes, as it captures 'white noise'

its growth rate is the sum of labour and capital growth, and the growth rate in the Solow residual

When regression is run on output growth, labour and capital, results show that labour has a important part of output growth. Results also show that in facts, output production over the considered time period has increasing returns to scale, a result that is confirmed by academic papers on growth in emerging countries. There is therefore a residual of 2.2% accounting for growth that can be considered part of the Solow residual (the total productivity factor, or technical innovation). It must be pointed out however, that the estimation of the total productivity factors is less accurate than the coefficient α and β, but nonetheless, its quality is such that the coefficient can be trusted to render meaningful results. To sum up, the estimated parameters, while certainly not constant across time, do not change significantly too, and the obtained coefficients are significant, in the sense that future computations on that basis are going to deliver meaningful results as well.

The table shows the model to have a very high R², and estimated coefficients for both labour (l) and capital (k) show increasing return to scale (as 0.941+0.28>1)

Now, let us move to estimating the potential GDP. It is always difficult to estimate certain components of the potential output, so the method that suited us quite well in getting coefficients is going to be put to use, once more. Estimating Potential GDP, then.
so potential GDP is the level of output produced when the economy is at full employment, i.e. when the level of unemployment is at its feasible lowest (so-called natural unemployment rate) without triggering inflation (What is called NAIRU, or Non-accelerating inflation rate of unemployment). A much simpler way is to compute the growth rate of labour stock (which I did). Now that all the parameters have been computed to be of readable content (thanks to traditional econometric tools), we can therefore compute the output gap for the period, so as to move further in our quest for monetary policy.

As the graph shows, output gap in Morocco was quite hectic over the past two decades, and even though we did enjoy significant positive output (that are overall quite good for the economy) the volatility is such that benefits were immediately wiped out after a while. However, when recomputed into a normal frequence (i.e. fitted into a Gauss-Laplace distribution, regardless of time frame), the normalized  average over 20 years was -1.46 point of GDP (i.e., we lost, every year on average, 1.46 GDP growth because productivity was not full). Quite an indictment for the regime’s eulogist, considering that the loss of productivity could have taken the current GDP per capita from $ 2900 to $ 4400 (roughly the same wealth in Peru or Jamaica, and above Tunisia) and thus moves us from lower middle-income to middle income emerging markets.

Over the early 2000’s, output gap was positive on average, the trend next years is likely to be a period of negative output gap, which threatens with risk of recession

How could the monetary policy have accounted for such growth? First, it must be stated that the next batch of computations is even more sketchy, but that is due to the sparse information I have to scramble for. In monetary policy settings, it’s usually up to output and inflation targeting to define the announced rate. For the benefit of  the profane, the standard policy tool central bankers around the world is the Taylor Rule. J-B Taylor wrote in 1993 a paper assessing the Fed’s interest rate policy, and end up, by means of econometric computations, with an equation bringing together inflation targeting and output gap as follows:

Where the set interest rate is the real Hicksian interest rate and weighted gaps in expected inflation and output.

As I said before, it is difficult to verify the Taylor rule for Morocco, mainly because of patchy data on the targeted inflation rate (if there ever was, that is), but also because at the time there was little independence to be enjoyed from government (it is still the case, but the governor enjoys a wider margin). We can however get a good proxy of the equation as three-quarters of it is more or less within reach. Output gap has already been computed, there remains the equilibrium interest rate (for which a proxy can be found later on) Regular computations give the following results:

Starting from 2001, interest rates have been too low with the Taylor rate

The Taylor rule has limited effect here, mainly due to the abscence of inflation targeting for many years (to my knowledge, the Central Bank started only a couple of years ago)

I guess one of the exogenous reasons why there’s a wild discrepancy between computed and actual rates is due to the fact that we are not entirely free of our monetary policy, due to foreign trade. Morocco tries (or tried) to synchronize with significant European partners, and in order to get the best out of it, synchronized their interest rate with the ECB. That’s a good move, but then it makes us more dependent on France and Spain, at a time they are facing considerable challenge.

There’s also another danger to the current level of interest rates: it might sound very conservative, but there is a need for BAM to take interest rates to a higher level. I mentioned the conservatism cliché because left-wing economists in emerging countries tend to favour lower interest rates (for consumption stimulus purposes). But in this particular case, low rates profit to real estate speculators, and not the households struggling to buy their first home.