STUDY CASE ASSOCIATE AND REFERENCE

Corporate Board: Role, Duties & Composition / Volume 7, Issue 3, 2011
65
MONETARY POLICY RESPONSES TO THE
GLOBAL FINANCIAL CRISIS: A CASE STUDY OF EGYPT
Monal Abdel-Baki*
Abstract
Among the triggers of the Arab Spring are the declining living standards of the middle and lower
income groups. Undoubtedly, the global financial crisis (GFC) is to be partially blamed for
weakening the economies of these nations. But was monetary policy ineffective in combating
inflation and reducing the meltdown? This paper employs a dynamic stochastic general
equilibrium model to assess the effectiveness of the monetary policy in the wake of the GFC.
Egypt is selected as a case study due to its overdependence on imported food, the prices of which
are relentlessly soaring. The results of the study reveal that the ideal operating targets for the
Central Bank of Egypt are the overnight rate and legal reserve requirements. Interest rates are
more suitable for long-run impact on the ultimate goals of growth, price stability and job
creation. The study culminates in designing a framework to enhance central bankers’ political
independence and transparency, which is imperative for nations with high levels of corruption.
The study is not only informative to the new Egyptian policymakers, but also to other developing
and emerging economies that suffer from symptoms of chronic inflation and looming socio-
political turmoil.
Keywords: Monetary Policy, Interest Rate Policy, Balance Sheet Policy
JEL Classification: E40, E52, E58, E60
* Department of Economics, School of Business, The American University in Cairo, AUC Avenue, P.O.Box 74, New
Cairo11835, Egypt
Tel.: (202)2615-3248,
Fax:: (202)2795-7565,
Email: monalbak@aucegypt.edu
1 Introduction
As economic fragility and financial weakness become mutually reinforcing during the global financial
crisis (GFC), prompt policies were globally undertaken to undermine the virulence of the meltdown
(ECB, 2009). But conventional monetary policy instruments were unable to solely reverse the meltdown.
First, waning consumer spending reduced the money supply multiplier, attesting to the fact that severe
economic shocks may not have a time-invariant Gaussian distribution, but rather demonstrate excessive
kurtosis or fat-tail risk (Kim et al, 2005). Second, in view of the decline in collateral values, dysfunctional
financial intermediation has been primarily blamed for aggravating the impact of credit market frictions
and reinforced the propagation of the adverse feedback loop (Mishkin, 2010). Third, the global recession
was triggered by factors responsible for subduing real microeconomic performance, hence slowing down
potential macroeconomic growth.
While emerging market economies (EMEs) did not experience the slide of nominal interest rates towards
the theoretical zero bound, lower discount rates did not trigger economic growth. This was experienced
especially in nations that were heavily dependent on food imports.
In 2006, food prices soared well above the new equilibrium level. Numerous factors were responsible for
the overshooting of prices, namely financial speculation on food commodities, rising demand by the
populous emerging markets, higher fuel and transportation costs, export restrictions, depreciation of the
US dollar, and environmental conditions that led to reductions in grain stocks (Headey, 2011). With the
resurgence of the crisis at the dawn of 2011, food prices recorded new peaks exceeding the historical

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2006-2007 levels. As a result, governments in the developing world have been rocked by protests, many
of which led to ousting autocratic regimes.
People‘s dissatisfaction with their living standards and the persistent food insecurity contributed to the
recent uprisings in the Middle East (Breisinger et al, 2011). One of the triggers of the Arab Spring was
the oversight of the autocratic regimes in regard to using short term fire-fighting measures such as raising
public servants‘ salaries, increasing subsidies, devaluing domestic currencies and building up stocks of
strategic food items (Brinkman and Hendrix, 2010). In accordance with the theory of democratic
transitions, whereby transient economic shocks give birth to a ―democratic window of opportunity‖, the
elected governments of the Arab Spring nations are commendably placing much emphasis on
transitioning towards democracy and eradicating cronyism and corruption (Arezki and Bruckner, 2011).
However, this does not suffice in nations that are overly dependent on food imports. While an equitable
and transparent economic system is imperative for economic development and political stability, the
governments of EMEs should prioritize designing long-term solutions to improve the living standards of
their citizens. Fighting inflation is among the prime factors that are apt to enhance the purchasing power
of households. Hence, the design of an efficient monetary policy is among the most effective tools to
combat persistent inflationary pressures (Kletzer and Spiegel, 2004).
Undoubtedly, the global financial crisis is to be partially blamed for weakening the economies of these
nations. But was monetary policy ineffective in combating inflation and prompting GDP growth? This
study utilises a dynamic stochastic general equilibrium (DSGE) benchmark model incorporating features
of middle-income open market economies to assess the effectiveness of monetary policy in meeting the
ultimate goals of price stability, GDP growth and job creation. Being the Arab nation with the largest
population and chief geostrategic importance, Egypt is selected as a case study. Indeed, one of the prime
triggers of the Egyptian Revolution was the untamable inflation that was held responsible for the
declining purchasing power and deteriorating living standards of the middle and lower income segments
of the Egyptian populace. In view of the massive reshuffling of Egyptian policymakers and central
bankers, it becomes imperative to assess the efficiency of monetary policy in achieving its goals and
targets. The policy implications of the study are intended to alert the newly elected Egyptian
policymakers to the best operating tools to achieve the inflation and growth targets. This research could
be also informative to other developing nations and emerging economies that suffer from symptoms of
chronic inflation and looming socio-political turmoil. The rest of the paper is designed as follows. Section
2 reviews how the goals of monetary policy have evolved since the seventies. Section 3 elucidates the
stance of monetary policy in Egypt. Sections 4 and 5 detail the DSGE model and the last section
concludes with policy implications.
2 The Evolution Of Monetaryn Policy Goals
The seventies marked a major paradigm shift from Keynesianism towards monetarism (Hall, 1993). Since
the same period stood witness to high inflation rates, interest-rate policy and inflation targeting became
the central methods for containing business cycle fluctuations (Bernanke and Mishkin, 1997). But one
major consequence of these policies was asset-price volatility and housing bubbles, culminating in booms
and busts similar to the American slowdown of 1991 and the 1997-Asian equity market crashes (Barro,
2006).
Asset market drains and economic downturns could not be solely circumvented through the establishment
of sound legal systems and prudent regulatory supervision, but monetary policy is the most important
instrument that can reduce the impact of deflationary contractions (Clarida et al, 2000). With these
mounting concerns Bernanke, Gertler and Gilchrist (1999) introduced the financial accelerator model,
which does not only emphasize how the ailing firms‘ balance sheets constrain their ability to obtain
investment funds, but also elucidates the monetary policy tools needed to arrest the recessionary dynamic.
Ironically, this is exactly when central banks in western economies panicked into massive interest rate
cuts by the dictates of fragile markets (English et al, 2003). With the gloom of an imminent asset market
crash, the proposals of alternatives to conventional monetary policy arose, where most of these schemes
were triggered by the interest rates being constrained at their zero-bound (Bernanke et al, 2004).
Since EMEs do not suffer from the drawbacks of zero-bound interest rates, and since they are more
affected by their home-grown financial crises, different fiscal and monetary tools were used to mitigate
the crises (Allen et al, 2002). Us (2004) utilizes a small model combining the short-term real interest rate

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and the real effective exchange rate as the monetary policy instrument. But in the case of high interest
rates, it is best to revert to methodologies such as those proposed by Clarida et al (1999) using a dynamic
general equilibrium model to derive the optimal monetary policy under discretion. Svensson (2000)
builds a forward-looking aggregate demand-aggregate supply model for a small open economy.
As the world economy is climbing out of the financial meltdown and since the problems that policy goals
are meant to be addressing have changed, the global community is embarking on another paradigm shift
(Taylor, 2009). Instead of focusing on a nominal policy anchor, the international community has called
for the largely conflicting goals of strict financial supervision, price stability, augmented economic
activity and job creation (Champonnois, 2009). Indeed, the main criticism of the DSGE technique is its
weak modeling of financial markets, limiting stress testing in financial stability exercises (Tovar, 2008).
However, two factors make this model highly applicable to the case of emerging market economies. First,
the DSGE model has been successfully utilized to detect the sources of business cycle fluctuations and to
explain the cross correlation between output and inflation (Smets and Wouters, 2007). Secondly, the
prudent control by the CBE legitimizes the use of this model for Egypt, an economy that has been largely
sheltered from the assaults of financial sector precariousness due to its recent banking reform.
3 The Stance Of Monetary Policy In Egypt
As a reaction to the waves of non-performing loans (NPLs) between 1997 and 2003, the Central Bank of
Egypt (CBE) adopted the Banking Reform Plan (BRP) in 2004, which rested on four pillars: imposing
stringent controls on banks to enhance and consolidate the banking sector; reforming state-owned banks;
rigorous capital adequacy compliance; and settling NPLs. Also, in accordance with the surge in food and
oil prices and the thirty-year record inflation rate of 23.6 per cent as of August 2008, the CBE espoused
on inflation targeting as its nominal anchor, whilst maintaining an implicit annual GDP growth goal of 5-
7 per cent.
Prior to the BRP the CBE neither had an explicit monetary policy tool nor a specific operating target;
sometimes it used interest rate and exchange rate targets, while at other times it targeted inflation. The
CBE was obliged to follow a managed-peg, leading to the serious predicament of the exchange rate
overshadowing the inflation target as the nominal anchor. This problem resulted in the accumulation of
huge foreign reserves as an endeavour to stabilize the exchange rate. Consecutively, this culminated in
expanding monetary aggregates and inflationary pressures. As credit conditions tightened, investment and
consumer spending were depressed which, in turn, fed back to a further tightening of credit conditions
and the adverse feedback loop emanated (Jonas and Mishkin, 2003).
Ever since the instigation of the BRP, the CBE adopted the overnight inter-bank rate as its operational
tool; inflation as its nominal anchor; and price stability, investment and GDP growth as its ultimate goals;
as clarified in figure 1.
Figure 1. CBE Monetary Policy subsequent to the BRP
Figure prepared by the researcher
Due to the declining living standards and the recurrent protests in Egypt, the CBE responds to two factors
only: (1) widening output gaps, and (2) inflation. On the other hand, in nations with deep financial
markets and/or aggressive speculation on assets, central banks respond principally to fluctuations in asset
prices. In order to allow fluctuations within a given band, the CBE applies the corridor system, where the
ceiling and the floor are the overnight lending and deposit rates respectively. This has successfully
narrowed the historical interest rate spread from 2 per cent to 1.5 per cent in 2008 (CBE, 2010). By

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relentlessly raising the discount rate, the CBE managed to reduce inflation to 11 per cent, as detailed in
figure 2.
Figure 2. Comparison of Core Inflation and CPI
Source: Central Bank of Egypt (2010) Monthly Statistical Bulletin, CBE, Cairo.
3.1 Monetary Policy and Asset Price Fluctuations
The consensus among economists is that conventional monetary policy is a very helpful instrument, albeit
being insufficient, when attempting to contain the damaging effects of fluctuations in asset prices
(Mishkin, 2007). The first element of monetary policy is interest rate signalling mechanisms; the second
uses the central bank‘s balance sheet to render that policy stance effective. Since this normally involves
managing the amount of central bank funds in the system, these policies have come to be known as
―liquidity management operations‖ (Borio and Disyatat, 2009). A number of central banks habitually used
these liquidity management operations, dubbed ―balance sheet policies‖ to help boost their economies.
For example, at the twilight of the millennium, Bank of Japan bought long-term illiquid government
bonds instead of short-term bills, to pump liquidity into debt and equity markets. In this case the channel
through which a central bank can affect economic activity is either by altering the balance sheet of private
sector agents, or through influencing expectations. However, the fiscal agent could mete out the same
effect if it issues government bonds and uses the proceeds to retire the less liquid outstanding bonds
(King, 2004).
3.2 Balance Sheet Policies in the Aftermath of the Crisis
Specifically at the dawn of the GFC in August 2007, many Western central banks elicited the deployment
of a target interest rate, which has dropped to near zero. Yet, towards the end of 2007 it became apparent
that the reduced discount rates in most western economies were not delivering results. This tempted
central banks to inject liquidity into the economy through purchases of toxic assets. Some central banks
went as far as injecting equity into financial institutions to ease deleveraging pressures (Adrian and Shin,
2008). Figure 3 shows that most central banks drastically swelled their balance sheets, with the highest
expansion being undertaken by Bank of England and the European Central Bank. Similar to most EMEs,
the extent of the intervention by the CBE was minimal, where it expanded its balance sheet by 25 per cent
amidst the crisis, compared to 152 per cent by the Federal Reserve Bank. This is due to the fact that the
impact of the global recession on the highly sheltered and heavily regulated banking sectors of most
EMEs was not as drastic as in mature financial systems.

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Figure 3. Changes in Sizes of the Balance Sheets of Selected Central Banks (2004-2010)
Source: Various publications of Central Banks.
3.2 The Response of the Central Bank of Egypt: Quantitative and Qualitative
Easing
The prohibition of the issuance and trading in asset-backed securities and collateralised debt obligations
kept the balance sheets of Egyptian banks devoid of toxic assets. Yet, the decline in global demand led to
the reduction in the Suez Canal receipts, workers‘ remittances and tourist revenue by more than 25 per
cent. It was the hefty domestic demand, mainly triggered by a colossal population, which came to the
rescue of the economy allowing GDP to slow down from 7 per cent prior to the recession to the much
acceptable rate of 4.7 per cent in 2009.
In response to the crisis, the CBE mainly swelled its balance sheet by pumping much needed liquidity
into the Egyptian banking sector and the real economy by introducing a new overnight auction lending
outlet. Second, it purchased government bonds to finance the LE 15.5 billion (US$3.5 billion) fiscal
stimulus package. Yet, a close examination of figure 4 reveals that the main expansion of the balance
sheet of the CBE stemmed from its accumulation of huge foreign reserve balances that it placed with its
foreign correspondents. Most of the foreign currencies were purchased from the local market to augment
the Egyptian pound in order to make the seven million tonnes of annually imported wheat less costly.
Also, the CBE implemented new measures to revive the repo market to manage liquidity for both
depository institutions and primary dealers, rendering the CBE rescue tools milder than those of western
nations.
In addition to quantitative easing, the CBE purchased riskier assets and corporate securities at their lowest
levels and reaped capital gains. Also, spurred by the increasing risks and fluctuations in the foreign
exchange rates, it diversified its holdings of foreign currencies and acquired commodities and precious
metals to maintain the 20 per cent targeted safety level of foreign reserves to GDP. But as benign as these
actions may appear, have they managed to meet the multiple targets or were they simply spontaneous
reactions? In order to answer this question, the impact of these interventions is gauged in the next two
sections by the DSGE model.

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Figure 4. Changes in the Assets and Liabilities of the CBE in Response to the GFC
Source: Central Bank of Egypt (2009) Annual Report (2008-09), Cairo: Central Bank of Egypt.
4 The Empirical Model
Several central banks employ the DSGE model to establish a theoretical framework for macroeconomic
analysis (Smets and Wouters, 2003). The appeal of this new-Keynesian framework is that it utilizes the
IS-LM model, while grounded in the dynamic general equilibrium theory. To detect the efficacy of the
Egyptian monetary policy during the GFC, the study constructs a DSGE model for a small open economy
in accordance with Clarida et al (1999) during 1993:01-2010:04.
To expand money supply, the CBE is currently exempting banks from the 14 per cent legal reserve
requirement (LRR) for loans extended to small and medium enterprises (SMEs), which are responsible
for the bulk of job creation in the economy (IMF, 2010). Hence, the LRR could be treated as an implicit
short term or operational policy tool that was adopted by the CBE in the wake of the global recession.
The CBE employs both the auction window as well as open market operations (OMO) to influence the
market interest rates. Moreover, with short-term nominal price rigidity, the overnight rate will be
influenced by OMO. The intermediate targets were altered to comprise of M2 monetary aggregate (M),
the real effective exchange rate index (s) in addition to the core inflation rate (πc), which excludes
commodities with either highly volatile and/or regulated prices. The monetary authority does not target a
particular level of the exchange rate, but it simply reacts to large changes in the effective exchange rate,
which is calculated according to the price of the Egyptian pound against the weighted average of a basket
of the currencies of Egypt‘s main trade partners. The core inflation is used to separate temporary from
persistent price fluctuations. On the other hand, the ultimate goals primarily include changes in the annual

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growth rate of output (x), the yearly increase in the consumer price index (π) and changes in the
unemployment rate (U). Figure 5 summarizes the temporary shift in the monetary policy paradigm in the
wake of the financial crisis.
Figure 5. Alterations in CBE‘s Monetary Policy Stance in the Wake of the GFC
The fit step in constructing the DSGE model is to specify the key economic players: households,
businesses, the CBE and the rest of the world. Households decide on the level of consumption and
savings and each household supplies a different type of labour. The monopolistic competition market
comprises of businesses producing an array of products, setting prices, and deciding on inputs to employ.
The baseline model representing the economy is presented using the traditional Keynesian IS-LM model
and the Phillips curve. Equations 1-4 summarise the model, where the first two equations represent the
product market and the last two capture the money market. All equations reflect expectations of the future
stance of monetary policy. They contain disturbance terms (ε), which is a collection of independent and
identically distributed independent and identically distributed (i.i.d.) random variables.
Equation 1 represents the short-run aggregate supply curve or the Phillips curve. πg is the CPI gap.
Producers index prices to lagged inflation rates to increase the persistence of inflation. This is especially
important for Egypt where inflation has been a relentless problem since the outbreak of the Global Food
Crisis in 2006. The import-oriented nature of the Egyptian economy culminated in huge balance of
payments deficits amounting to 15.7 per cent of GDP. Hence, there is a negative relationship between the
effective exchange rate (st) and the inflation gap.
0 1 2 3 1 1g t t ta a x a s a      
(1)
Equation 2 is the aggregate-demand schedule embedding the variables determining the output gap. These
comprise the real interest rate (ir), which measures the opportunity cost of investment; the real balance of
money supply (M2); the expected effective exchange rate; and the future expected output during the
following business cycle.
1 10 1 2 3 4 1 22
t
t tt r tx b bi b M b s b x       
(2)
Equation 3 captures the money demand function, which is determined by the output, the price level, the
exchange rate and the real interest rate. The expectations of inflation tempt individuals to prefer holding
assets, which leads to a negative relationship with money demand. Usually, the future inflation depends
on the past expectations of current inflation.
110 1 2 3 1 4 3ttt rtd c s c iM c c x c       
(3)
Finally, the money supply schedule reflects how the CBE uses OMO to affect the corridor interest rate,
hence arises the positive relationship between the monetary base (B) and money supply (Ms). Also, as

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previously mentioned, the CBE has implicitly used LRR (R) to affect money supply. The amount of cash
holdings (M0) curtails the growth of Ms indicating a negative relationship. The last determinant of money
supply for Egypt is the real interest rate.
110 1 2 3 4 40 tt t ts rM d d B d R d M d i       (4)
As summarized in figure 4, the ultimate long-term goals of the CBE are: (1) a targeted rate of GDP
growth; (2) a specific CPI; and (3) a precise unemployment rate. In fact, these goals are specified in
accordance with the quarterly deliberations and consensus of the summit level economic group. Equation
5 reflects the loss function or the cost to the CBE for the implementation of these three goals. The CBE
endeavours to minimize these costs by ensuring the credibility of its policies in accordance with the
constraints of the above equations.
var var vart t tL x U      (5)
5 Results
Quarterly data is collected from the CBE and CAPMAS databases over the period 1993:01-2010:04. The
software used is MATLAB. The effectiveness of the new monetary policy shifts are first tested by
measuring the correlation coefficients between the operational targets, intermediate targets and ultimate
goals. The least squares method is used to regress each operating target on intermediate targets and
ultimate goals. Consequently, the three ultimate goals are regressed on the intermediate goals.
5.1 Cointegration Tests
After running unit root tests, variables were found to be homogeneous and non-stationary of degree one.
To rank the efficacy of monetary tools, cointegration tests are run among the operating targets and the
nominal anchors, operating targets and ultimate goals and finally, nominal anchors and the ultimate goals.
Using Akaike Information Criterion, 4 lags sufficiently obtain a general dynamic model with residuals of
no significant autocorrelation.
Table 1. Cointegration Results of Intermediate Goals and Operating Targets
i LRR
πc +0.56 - 0.28
M2 +0.45 - 0.38
s +0.84 - 0.22
Values at 5% significance level
Table 1 summarizes the results of the long-run Johansen and Julius (1990) JJ-cointegration tests. The
intermediate goals and operating targets are cointegrated, with no lags.
Table 2. Cointegration Results of Ultimate Goals and Operating Targets
i LRR
x -0.36 - 0.51
π +0.09 - 0.26
U 0.02 - 0.07
Table 2 shows that output is affected by interest rates with one lag and by the LRR after 2 lags, while
inflation is affected after only one lag. The impact on unemployment is minimal.

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Table 3. Cointegration Results of Ultimate Goals and Intermediate Targets
πc M s
x - 0.99 + 0.69 + 0.88
π - 2.91 + 0.33 - 0.97
U 0.83 - 0.12 - 0.11
Table 3 shows that the intermediate targets and the ultimate goals are cointegrated. The results are
consistent with theory and the prime goal of price stability, where a revaluation of the Egyptian pound
lowers the cost of production lowering inflation and expanding GDP. But the effect on unemployment is
less pronounced with 2 lags.
Table 4. Summary of Policy Rules for Operating Targets
M2 s
i -1.9894 (0.9925) 4.2879 (1.1128)
Log likelihood -524.1269 Akaike info. criterion 6.3256
LRR -0.8345 (0.4673) -0.2361(0.2387)
x π U Constant
i -3.4219 (0.0469) 4.2381(2.4589) 1.1534 (0.1983) -22.71971 (7.0512)
Cointegrating coefficients in parentheses
Finally, table 4 shows the normalized cointegrating equations and summarizes the policy rules for the
operating targets. The priority of the operating targets is the overnight rate followed by the LRR, while
the nominal anchor is selected as M2 and the effective exchange rate.
5.2 Testing the DSGE Model
The equations of the DSGE model are estimated using the least squares method and the lag values are
selected from the results of the cointegration equations; variables are specified as under adaptive
forecasts. One-period forecast is run using the maximum likelihood method with ex-post forecasts. Table
5 shows the DSGE model and Equations 6-9 demonstrate the structural form of the linear space empirical
model. All state variables (SV) are recursive except for SV1, SV5, SV11, SV16 and SV19, which are random
walk state variables, while all others are recursive state variables. Corresponding to the random state
variables are the variances exp[C(3)] to exp[C(7)]. Equation (10) shows the overnight interbank
overnight rate (i) as the operating target since the model is not converged when the LRR is used as the
operating target. Figure 6 shows the simulations of the endogenous variables: x, π, i, M0, M2 and B. The
disturbance terms of the equations are not correlated excluding the risk that the equations suffer from
simultaneity bias.
πg = C(1)xt-1 + C(2)Δ st + SV1 (6)
xt = SV2 ir + SV3M2 – SV4(st – st-1) + SV5 (7)
Md = SV6+ SV7 xt-1 – SV8 (πt-1) + SV9 (st-1) + SV10 (it-1) + SV11 (8)
Ms= SV12 (Bt-1–Bt-2) – SV13 (Rt-1–Rt-2) – SV14 (M0t-1) + SV15 (it-2) + SV16 (9)
i = SV17 (M2t-1- M2t-2) + SV18(s t-1) + SV19 (10)

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Figure 6. Historical Simulations
Figure 6 shows the historical actual and simulated paths of endogenous variables during 1997:01-
2010:04. This period is selected to capture the financial distress emanating from the Asian Crisis and the
NPLs, currently counting for 14.7 per cent of the loan portfolio as of 2009 (IMF, 2010). If the DSGE
model is successful in forecasting the performance of the economy in the short to medium run, then it
should be able to replicate the past behaviour of the variables. The model captures most turning points in
real GDP, money demand and money supply. The size, direction and magnitude of fluctuations of are
well reproduced over the whole period.
Table 5. DSGE Model
Estimation Method: Maximum likelihood (Marquardt)
Coefficient S.E. z-statistic Probability
C(1) 0.1914 0.1766 1.2883 0.1899
C(2) -0.1014 0.0713 - 1.6213 0.0933
C(3) -0.1811 0.2256 - 1.9989 0.0312
C(4) 2.8914 0.1703 11.4412 0.0000
C(5) 11.4379 0.2175 45.1167 0.0000
C(6) 1.1257 0.5614 7.1288 0.0000
C(7) 12.7845 0.6739 25.6701 0.0000
Final State Root M.S.E. z-statistic Probability
SV(1) 1.9763 0.8956 2.9981 0.0021
SV(2) - 0.1212 0.6714 - 0.1701 0.7912
SV(3) 0.0312 0.3157 0.1278 0.8912
SV(4) - 0.0061 0.4289 - 0.0148 0.8711
SV(5) 1.2927 19.8812 0.0912 0.8127
SV(6) - 2.1086 34.2218 - 0.0616 0.8012
SV(7) - 0.0109 33.1221 - 0.0191 0.9918
SV(8) - 0.0121 19.1195 - 0.0816 0.9128
SV(9) 0.0419 0.3572 0.1107 0.8485
SV(10) 0.0038 0.0304 0.1207 0.8714
SV(11) - 0.0374 7.5840 - 0.0019 0.9812
SV(12) - 2.3991 14.1761 - 0.0685 1.0000
SV(13) - 4.0189 2.3861 - 1.8138 0.9191

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SV(14) - 5.2971 55.8927 - 0.0009 0.9318
SV(15) - 6.3909 75.9018 - 0.0007 0.9728
SV(16) 2.6439 22.2875 0.0118 0.9889
SV(17) - 0.3871 0.9479 - 3.0198 0.9981
SV(18) 2.5755 12.3319 0.0011 0.9995
SV(19) - 0.0389 0.3519 0.1219 0.9998
Log likelihood -2911.14
Parameters 7
Diffuse priors 18
Akaike information criterion 54.1892
Schwarz criterion 53.9912
Hannan-Quinn criterion 54.0085
6 Concluding Remarks
The Arab Spring is yet at its dawn, but signs of a democratic transition are already unfolding. Egypt is
gradually undergoing a political transformation that has strengthened parliamentary democracy,
undermined the role of the police state, and diminished cronyism and corruption. These political reforms
are steadily allowing moderate Islamists to peacefully and democratically co-exist with secular groups
and elites. While the political triggers of the popular leaderless Revolution are being adequately
addressed, the economy has been badly impacted. The CBE has utilized more than half of its foreign
reserves to support the Egyptian pound and to meet import needs. The constant labour strikes have
substantially decreased industrial production by more than 15 per cent. Many foreign investors have fled
the country and the stock exchange has lost around half of its capitalisation. In spite of the slowdown in
consumption, inflation is still staggering at around 10 per cent (The World Bank, 2011). The elected
government needs to focus on rapidly revamping the economy, promptly introducing structural all-
inclusive reforms and forcefully addressing the inflationary pressures.
6.1 Policy Implications
As such, investigating the efficacy of monetary policy adopted by the Central Bank of Egypt is imperative
during this transitional period. This research has studied the impact of the shifts in monetary operational
tools, nominal anchor and ultimate goals in response to the global meltdown using the DSGE model to
provide guidelines for future actions. The results of the study could be summarized as follows:
 Targeting core inflation instead of the CPI is not useful to control inflationary pressures, albeit being
more effectual for both output and unemployment.
 If the operating targets are to be ranked, interest rates are the most effective.
 Interest rates have a large impact on both core inflation and the effective exchange rate. But the
impact on unemployment is minimal, which indicates the need for the utilization of additional tools
to solve this stringent problem.
 The revaluation of the Egyptian pound lowers the cost of production, hence curbing inflation and
expanding GDP. Thus, inflation targeting dictates the usage of this tool to face price hikes.
 The employment of the LRR as an operational target has minimal stabilising effects and is ineffectual
in curbing inflation. The costliness of exempting funds loaned out to SMEs from the LRR rests on
them crowding out other sectors which could have been more capable of generating higher GDP
growth. It is recommended that this operating target be immediately discontinued. Yet, given the
importance of SMEs in generating jobs, the CBE should request national and intergovernmental
developmental agencies to provide subsidized loans to small business and social entrepreneurs so that
they could directly benefit from credit availability and lower costs of production.
 Given the import-oriented nature of the Egyptian economy, the negative relationship between the
LRR and the effective exchange rate should be addressed. Future studies require more investigation
of the effect of REER in the short run to see if the CBE could encompass this as a tool to stabilise
monetary disturbances.
Lastly, one must enter the caveat that the study has not investigated the method of phasing out NPLs from
the balance sheets of Egyptian banks; hence this issue has to be carefully planned out. The following are
the specific monetary policy implications for future central bank actions in the post-Revolution context in
order to meet the multiple goals of curbing inflation and enhancing growth:

76
 The priority of the operating targets employed by the CBE should be the overnight rate followed by
the LRR.
 The nominal anchor should be selected as follows: (1) M2 and (2) the effective exchange rate.
 Interest rates are more suitable for long-run impact on all ultimate goals of output, inflation and job
creation.
6.2 Proposed Framework for the Accountability and Political Independence of the
Central Bank
To ensure that the aforementioned goals are adequately met, there should be a substantial restructuring of
the institutional and regulatory framework. If the new constitution is to grant the CBE independence,
then it is equally imperative to ensure utmost transparency and accountability of the central bankers and
the Monetary Policy Committee (MPC). Currently, the MPC simply publishes a concise note via its
website announcing the result of each of its monthly meetings in regard to interest rates only. In view of
the fact that the CBE is not following the optimal operating targets and nominal anchor, more
transparency and accountability are needed at the various stages of monetary policy implementation.
Figure 7. Proposed Framework for Monetary Policy Transparency
Figure 7 proposes a framework to increase the level of transparency so that the central bank could
transform its actions from mere policies to tangible outcomes.
 The CBE needs to explicitly outline its political and economic motives. The preceding Egyptian
monetary agents have been heavily criticized for not announcing an explicit inflation target, which
has rendered their policies sporadic and unsystematically geared towards installing political stability
and extinguishing social turmoil (Awad, 2008). In the spirit of the need to address the collective
societal goals and attain higher standards of living, the CBE has to vigilantly calculate the price level
that would ensure an acceptable living standard for Egyptians. But what it historically did was to
succumb to political pressures and to ensure the longevity of the ancien régime. Hence, the new
constitution needs to specifically identify (1) the domain of political influence that could be exerted
on central bankers and (2) the incentive schemes and remuneration of the CBE Board of Directors.
 In this vein, the theoretical and analytical processes utilised to select the nominal anchor and the
operational targets have to be published on the website of the CBE.
 The CBE has to explain all of its policy decisions whenever any of the conventional monetary tools
are used, instead of solely issuing a concise briefing including solely the discount rates.
 Similarly, utmost transparency has to be promptly exercised whenever the CBE uses any of the
unconventional monetary tools such as balance sheet policies or bailouts of financial institutions.
 Derived from these requirements, central bankers have to invite and encourage the feedback and
input of specialists by issuing periodical consultative documents prior to introducing any major
policy amendment. Thus, the CBE needs to (1) publish monthly detailed technical reports explaining
the rationale behind monetary policy decisions; (2) disclose forecasts and analyses of both backward-

77
looking and forward-looking analyses including the assumptions made by the CBE researchers about
key macroeconomic variables; and (3) issue consultative documents
 The final outcome and impact of the policies adopted have to be evaluated and assessed in order to
take necessary and prompt corrective actions to meet the societal aspirations.
Such a framework is intended to strike a balance between maintaining the political independence and
impartiality of the central bank, whilst simultaneously ensuring the highest levels of transparency and
accountability. This balance is specifically important for nations with high levels of cronyism and
corruption such as Egypt (Adly, 2009). The encouraging signal is that the CBE has already taken strides
since January 2011 to establish codes of corporate governance for banks and restructured the composition
of its Board of Directors to be void of private bankers to eradicate conflicts of interest and to reduce the
principal-agent problem.
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