The transmission of Central Bank policy instrument to market interest rates in Botswana

Abstract

The overall objective of the study is to examine the transmission of the central bank policy instruments to market interest rates. The study employed a vector error correction model on quarterly data from the period 1995Q1 to 2013Q4. Two models are estimated, the first model uses Bank rate as the policy instrument, while the second model uses the Bank of Botswana certificates rate. The market interest rates were proxied by the prime lending rate and the 91 day deposit rate. Results from both models show that long-run equilibrium relationships exist between the market interest rates and the monetary policy rates. The model where the Bank rate was the policy rate produced better results than the one that used Bank of Botswana certificates rate. However, the results were quantitatively similar. Both the long-run model and the generalized impulse response functions show that the pass-through to the prime lending rate is stronger than to the deposit rates. For instance, a 1 standard deviation shock to the Bank rate (which is about 0.4 percent) led to an immediate 0.4 percent jump in the prime lending rate as compared to the 0.2 percent response of the deposit rate. The effect on the prime lending rate increases to read a maximum of 0.8 percent by quarter 8 while that for the deposit rate reaches a maximum of 0.5 by the same period. The high or strong pass-through to the prime lending rate indicates that the transmission to market interest rates is strong. This result is confirmed by the forecast error variations which show that much of the variations in prime lending rate shocks are accounted for by the unexpected variations in the Bank rate.