WP/20/167 Tunisia Monetary Policy Since the Arab Spring: The Fall of the Exchange Rate Anchor and Rise of Inflation Targeting by Mariam El Hamiani Khatat, Nicolas End, and Rym Kolsi IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 2020 International Monetary Fund WP/20/167 IMF Working Paper Middle East and Central Asia Department Tunisia Monetary Policy Since the Arab Spring: The Fall of the Exchange Rate Anchor and Rise of Inflation Targeting Prepared by Mariam El Hamiani Khatat, Nicolas End, and Rym Kolsi1, 2 Authorized for distribution by Chris Geiregat August 2020 Abstract In this paper, we argue that inflation targeting could be the future of Tunisia’s monetary policy. Monetary targeting has proven to be ineffective due to the composition of reserve money, structural liquidity deficit, and higher instability of the money multiplier after 2010. Exchange rate targeting is no longer feasible due to the level of international reserves, current account deficit, and inflation differentials with main trading partners. The Central Bank of Tunisia has already made important progress toward inflation targeting. The paper evidences the existence of increasingly effective interest rate transmission as well as the changing exchange rate passthrough to inflation with the gradual move toward further exchange rate flexibility. JEL Classification Numbers: E4, E5, E61, F31, F32 Keywords: monetary policy framework, inflation targeting, monetary transmission, monetary operations, foreign exchange interventions, exchange rate passthrough, external shocks. Authors’ E-Mail Addresses: melhamianikhatat@imf.org; nend@imf.org; rym.kolsi@bct.gov.tn 1 Central Bank of Tunisia. 2 The authors acknowledge the valuable guidance of Taline Koranchelian and Björn Rother, and thank Chris Geiregat, Alexei Kireyev, Rima Turk, and Geneviève Verdier for their detailed comments and suggestions. The authors are also grateful to Marouane El Abassi, Governor of the Central Bank of Tunisia, as well as Moez Lajmi and the other participants of the workshop organized in May 2020 with the Central Bank of Tunisia, the Tunisian Ministry of Finance, and the Tunisian Prime Minister Office, for their comments, corrections, and feedback. IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 3 Contents Page Abstract ..................................................................................................................................... 2 I. Introduction ............................................................................................................................ 6 II. Literature Review ................................................................................................................. 7 III. Tunisia’s Monetary Policy History: The Legacy of the Arab Spring ................................. 9 A. The Fall of the Nominal Anchor and Emerging Structural Liquidity Deficit ........ 13 B. The Gradual Loss of Control over Monetary Aggregates ...................................... 14 C. Monetary Policy Orthodoxy to the Rescue over 2018–19 ...................................... 16 IV. Monetary Policy Transmission ......................................................................................... 19 A. Monetary Transmission to Inflation and Output .................................................... 19 B. Passthrough from the Policy Rate to the Money Market Rate ............................... 22 C. Exchange Rate Passthrough to Inflation ................................................................. 22 V. The Way Forward: Moving Toward Inflation Targeting ................................................... 24 A. The Case for Inflation Targeting ............................................................................ 24 B. Next Steps to Support the Transition to Inflation Targeting .................................. 25 VI. Conclusion ......................................................................................................................... 27 Tables Table 1. Significance Level of the Policy Rate Coefficient .................................................... 20 Figures 1. Exchange Rates and Foreign Exchange Interventions ...........................................