Adverse Weather Shocks and Monetary Policy in Rwanda

ABSTRACT This paper examines whether a central bank should stabilize CPI or core inflation (CPI excluding agriculture prices) following an adverse weather shock. We analyse this question in a two‐sector small open economy calibrated to reflect key characteristics of the Rwandan economy. We first empirically demonstrate that an adverse weather shock in Rwanda leads to higher agriculture prices and reduced agriculture output, consistent with the mechanisms embedded in the macroeconomic model. We then show that a central bank can minimize its losses—measured by a loss function based on CPI inflation—by stabilizing core inflation rather than headline CPI inflation in response to an adverse weather shock. Additionally, we show that CPI inflation is relatively insensitive to changes in labour mobility between the agriculture and nonagriculture sectors, changes in the elasticity of substitution between agriculture and nonagriculture goods, and changes in land maintenance costs.