Understanding and predicting monetary policy framework choice in developing countries

Abstract

We examine the choice of monetary policy framework (MPF) of 87 countries over three decades (1985–2017). We confirm the importance of a range of factors including financial development, trade networks, strength of democracy, and size of the economy. We improve upon previous work on MPF choice by testing the model’s prediction accuracy on out-of-sample data, and addressing endogeneity. We also split the factors that determine MPF choice into three thematic groups: optimum currency area (OCA), financial strength, and political/institutional strength. This is the first paper to provide insight into which factors determine MPF choice for developing countries, utilising a relatively new MPF classification. We achieve an average prediction accuracy of approximately 67%, using two different cross-validation methods. This outperforms a naïve model, which assumes all countries belong to the most common category (discretion), and is good at predicting the less common categories as well.