Problem Statement
The global economic crisis that began in 2008 has yet to show a robust recovery, as adverse shocks continue to impact countries across all continents Additionally, the risk of the European debt crisis remains a persistent concern from 2011 to the present.
In 2011, Vietnam's Government implemented Resolution 11/NQ-CP to combat inflation and ensure macroeconomic stability, emphasizing the careful application of monetary and fiscal policies throughout the year The banking system and credit institutions, regulated by these policies, serve as the primary source of capital mobilization and distribution in the economy Consequently, monetary policy is vital for directing investment capital flows and shaping business strategies It not only supports working capital for businesses but also enables those with effective strategies to pursue long-term development through investment Additionally, monetary policy is essential for maintaining price stability, managing foreign trade through exchange rate policies, and ensuring liquidity in international payments.
Because of the above reasons, the understanding of monetary policy and their effect on the macro-economic stability is becoming significantly important to Vietnamese authorities
As Vietnam becomes more open and developed, its economy is increasingly susceptible to international influences.
The Asian crisis of 1997 and the ongoing global financial crisis since 2008 have significantly impacted the economy, highlighting the need for a robust monetary policy framework As the economy becomes increasingly sensitive to global fluctuations, it is essential to develop effective monetary policy tools to navigate economic downturns, particularly during recessions.
Economic theories and empirical studies indicate that monetary policy shocks can influence output and inflation through various channels However, the specific effects of these channels on the Vietnamese economy have not been quantitatively analyzed, particularly regarding the impact of monetary policy on inflation in urban and rural areas, as well as nationwide This gap complicates policymakers' ability to implement effective strategies tailored to each region's needs Therefore, a timely and necessary empirical study examining the relationship between monetary policy channels and macroeconomic variables, such as real output growth and inflation across different areas of Vietnam, using updated data from May 2005 to June 2012, is essential.
Significant of the study
The interplay between monetary policy and economic outcomes, including real output growth and inflation, is a topic of significant theoretical and empirical debate Despite extensive research, opinions remain divided on how macroeconomic variables are influenced by monetary policy across various countries.
Recent studies on monetary policy in Vietnam, such as Hoang (2010), indicate that changes in money supply significantly affect real output and inflation, albeit to a limited extent Camen (2006) explored the influence of both external and policy factors on inflation fluctuations While some research has examined the impact of exchange rate changes on output, there remains a gap in understanding how monetary policy shocks specifically influence real output and inflation across urban and rural areas Bui (2011) focused on the relationship between money growth and inflation, while Nguyen (2012) clarified the role of credit within Vietnam's monetary mechanism However, these studies fail to address the urban-rural inflation impact and rely on outdated data, as most research is based on information available only until the end of 2010, neglecting recent inflation trends and the effects of the global financial crisis on macroeconomic policies.
This study is crucial for Vietnam's current economic landscape, providing insights for policymakers to effectively manage monetary policy aimed at enhancing real output growth and controlling inflation It also serves as a foundation for future research on monetary policy across various regions, including rural and urban areas, thereby deepening the understanding of Vietnam's money market evolution Additionally, the findings contribute to the broader knowledge of the monetary transmission mechanism both within Vietnam and in other countries.
Research objectives
The main objectives of this thesis is:
• to clarify the relationship between monetary policy and real economy (real output growth and inflation) of Vietnam
• to clarify the difference of impact of monetary policy on inflation of the urban and the rural area ofVietnam separately
This article aims to analyze the effects of the three primary monetary channels—interest rate, credit, and exchange rate—on Vietnam's real economy, specifically focusing on real output growth and inflation.
Research questions
This thesis aims at answering the following research questions:
• Do real output growth of Vietnam and inflation rate of the urban area, the rural area and all over of Vietnam affected by monetary policy?
The article examines the impact of monetary policy changes by the State Bank of Vietnam on real output growth and inflation rates across urban and rural areas, as well as nationwide It seeks to determine the direction of these changes and their significance in the context of Vietnam's economic landscape.
The impact of monetary policy changes on real output growth and inflation rates in Vietnam varies across urban and rural areas Understanding the time lag between these policy adjustments and their effects is crucial for assessing economic performance nationwide This analysis highlights the differences in response times and magnitudes of change in both urban and rural contexts, providing valuable insights into the overall economic landscape of Vietnam.
• On the basis of research results, what is the most useful channel that is being used by the State Bank of Vietnam?
Thesis Structure
The thesis comprises six chapters, beginning with a problem statement, the study's significance, research objectives, and questions The second chapter reviews relevant literature, while the third provides an overview of Vietnam's economic performance, financial system, and monetary policy tools Chapter four details the methodology employed in the regression model, presents estimated results, and discusses their policy implications for Vietnam The final chapter summarizes the study, highlights its policy implications and limitations, and suggests areas for future research.
LITERATURE REVIEW
Theoretical literature review
2.1.1 Mechanism of the impact of aggregate demand to output and price level
Both monetarists and Keynesians agree that the aggregate demand curve is downward-sloping and responds to changes in the money supply However, monetarists attribute shifts in the aggregate demand curve solely to changes in the money supply, while Keynesians recognize additional factors such as fiscal policy, net exports, and "animal spirits" as significant contributors Although Mishkin (1995, 1996, 2001) does not explicitly address changes in output and price levels, we can infer these changes using the AD-AS model In this model, an increase in the money supply shifts the aggregate demand curve from AD1 to AD2, moving the economy from point E1 to E2, resulting in an increase in output from Y1 to Y2 and a rise in the price level from P1 to P2 (Mishkin, 1995).
Figure 2.1: Keynesian AS-AD model tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
2.1.2 Traditional Keynesian IS/LM model
The traditional Keynesian IS-LM model illustrates the relationship between interest rates and output When the central bank implements a tight monetary policy by reducing the money supply, the real money balance decreases, causing the LM curve to shift left This shift indicates that the demand for money exceeds its supply, prompting individuals to sell bonds for cash, which subsequently raises interest rates Higher interest rates increase the cost of capital for production, leading to a decline in investment spending and net exports Consequently, the new equilibrium in the IS-LM model reflects a decrease in output, as summarized by Mishkin (1995) in the schematic connection: "Ms! + i j + 1!, NX! + Y !"
The notation \( M \) represents the money supply, while \( i \) denotes the interest rate Additionally, \( I \) stands for investment, \( NX \) indicates net exports, and \( Y \) signifies output.
Further studies confirm that beside businesses' investment spending, a fall in investment could also be understood as a postponement in consumers' residential housing and consumer durable expenditure
The Mundell-Fleming Model enhances the traditional IS/LM framework by incorporating the impacts of international trade and finance, thereby providing a comprehensive understanding of how output responds to monetary policy shocks in an open economy characterized by imperfect capital mobility This model suggests that when a central bank implements an expansion in the money supply, it influences economic output in a global context.
Then, the real money balances will increase, shifting the LM curve to the right
When interest rates fall below the global benchmark, capital tends to flow out of the economy This shift leads to increased investment in foreign markets, heightening the demand for foreign currency and resulting in the depreciation of the domestic currency Consequently, this depreciation makes domestic goods more affordable compared to foreign products, stimulating net exports and boosting overall output.
Tobin's theory of investment establishes a systematic relationship between stock prices, business investment, and output In his 1969 paper, Tobin defines "q" as the ratio of the market value of shares (V1) to the unit of capital (K1), expressed as \( q_1 = \frac{V_1}{K_1} \) An increase in interest rates (r) raises the opportunity cost of holding shares, making them less attractive compared to bonds This leads financial investors to sell shares in favor of bonds, resulting in a decline in the market value of shares (V1) Consequently, a drop in share prices reduces the value of q, which in turn diminishes the marginal benefit of investment At the optimal investment level, the marginal dividend forgone is balanced by the additional capital gain on shares A lower market valuation of q for an extra unit of capital limits a firm's ability to invest, as the cost of additional capital may exceed the benefits As a result, firms may refrain from purchasing new investment goods when q is low, leading to decreased investment and a subsequent decline in output This connection between the value of q and investment is highlighted by Mishkin (1996) in the context of the monetary transmission mechanism.
Monetary transmission mechanism is defined as "the route by which monetary policy is translated into changes in output, employment, prices and inflation"
In Vietnam, monetary policy impacts the economy primarily through three channels: the interest rate channel, the credit channel, and the exchange rate channel Given the underdeveloped state of the Vietnamese stock market, which is highly susceptible to speculation, and the absence of a housing index, this thesis does not address the equity price channel or the real estate channel.
In this part, three main channels mentioned above will be presented in greater detail as following:
Taylor (1995) highlights the significance of interest rates in the monetary transmission mechanism, illustrating their impact on the economy He describes a cyclical relationship between real GDP, inflation, and short-term interest rates Changes in short-term interest rates influence long-term rates and exchange rates, although they are not the sole determinants Economic rigidities, such as price stickiness, cause fluctuations in nominal interest and exchange rates, which subsequently affect real interest rates and real exchange rates These real rates, in turn, influence real investment, consumption, and net exports—key components of GDP—ultimately leading to changes in real GDP In the long run, real variables stabilize when wages and prices are flexible.
In tum, the change in real GDP and inflation will also have effect on the short rate
A zero nominal interest rate can still stimulate the economy through a decrease in the real interest rate, influenced by expected price levels and inflation An increase in broad money raises expected price levels, leading to higher expected inflation Consequently, the real interest rate declines, resulting in increased investment, net exports, and overall output This relationship is represented by the notation: Msj ~ Pej ~ nej ~ ir-1 ~ Ij, NXj ~ Yj The evidence strongly supports the notion that interest rates serve as a significant monetary channel impacting economic output.
Expansionary monetary policy, as noted by Mishkin (2006), leads to an increase in the money supply (M5), resulting in a decrease in the real interest rate (CIR) This reduction in the cost of capital encourages businesses to boost their investment spending and prompts consumers to enhance their expenditures on housing and durable goods, which are also classified as investments Consequently, this rise in investment spending (I) contributes to an increase in aggregate demand and a subsequent rise in output (Y).
Mishkin (1996) identified three key reasons highlighting the significance of credit channels in the economy Firstly, credit market imperfections significantly influence firms' decisions regarding inputs and outputs, including workforce and machinery Secondly, empirical evidence shows that small businesses facing credit constraints are more susceptible to monetary policy changes compared to larger firms Lastly, he emphasized that asymmetric information within imperfect credit markets aids in understanding various economic phenomena.
The notations Pe and 1te represent the expectations of price levels and inflation, respectively.
Bemanke and Gertler (1995) likened monetary policy transmission to a "black box," expressing concerns over the insufficient empirical evidence supporting the interest rate channel They proposed that the credit channel plays a significant role in elucidating the effects of monetary policy on the economy, suggesting that the interplay between the external finance premium and interest rates could provide a clearer understanding This credit channel addresses agency problems stemming from asymmetric information and the costly enforcement of contracts in financial markets, and it is further categorized into two distinct channels: the bank lending channel and the balance sheet channel.
The bank lending channel illustrates how monetary policy impacts the economy by altering the availability of bank loans In the credit market, banks are crucial in addressing asymmetric information issues, as bank loans are not perfect substitutes for other funding sources.
Large firms can directly access stock and bond markets for credit, bypassing banks In contrast, small and medium-sized firms primarily rely on bank loans for their investment needs.
Previous empirical studies related
Numerous studies have explored the relationship between monetary policy tools and macroeconomic indicators, supported by various theories Notable research includes the work of Bernanke and Blinder (1992) and Bernanke and Gertler (1995) focusing on the United States, while other studies have applied similar methodologies to different countries For instance, Disyatat and Vongsinsirikul (2003) developed a VAR model for Thailand, Morsink and Bayoumi (1999) examined Japan, and Hsing (2004) analyzed data from Venezuela.
In VAR-based research, short-term interest rates are often viewed as key indicators of monetary policy, exemplified by Bernanke and Blinder's (1992) assertion of the Federal Funds Rate's role as the primary tool of the Fed for over three decades However, the interest rate transmission mechanism remains contentious, with limited evidence regarding its quantitative impact through the neoclassical cost of capital Dimitriu et al (2009) found that in Romania, inflation significantly responded to interest rate shocks, while industrial production also reacted notably to interest rate fluctuations In contrast, Boivin and Giannoni (2002) highlighted a declining responsiveness of real output to the interest channel in the U.S since the 1980s.
Empirical studies on the "Tobin's q" formulation have shown limited success Consequently, researchers like Bernanke and Gertler (1995) propose that factors beyond interest rates, such as the credit channel, play a significant role in the transmission of monetary policy.
The research on response of output to exchange rate also receives different results
Edwards (1986) analyzed twelve developing countries over 16 years, establishing a model linking real output to money growth surprises, fiscal deficits, export-import price ratios, and real exchange rates He concluded that devaluations negatively impact output in the short term, but positively affect it in the long run, with a neutral effect when other variables are constant Similarly, Dumitriu et al (2009) found that inflation and industrial production in Romania significantly respond to exchange rate shocks Additionally, Al-Mashat and Billmeier (2007) demonstrated in Egypt that the exchange rate channel is crucial for transmitting monetary policy effects through a VAR model.
Most other channels are quite weak
Research on the impact of monetary policy tools on output growth and inflation in Vietnam reveals significant findings Vo et al (2001) highlight that changes in exchange rates have notably influenced the Granger-causality among money supply, inflation, and output growth While nominal exchange rates have occasionally acted as a leading indicator for output growth, this relationship has proven to be inconsistent Furthermore, current inflation and real industrial output growth are primarily driven by their historical trends Notably, real depreciation rates positively affect output growth, although the extent of this impact varies significantly.
Le and Wade (2008) developed a VAR model to explore the relationships between money, real output, price level, real interest rate, real exchange rate, and credit Their findings indicated that monetary policy significantly influences real output and price levels, with the strongest impact on output observed after four quarters, while the effects on price levels emerged between the third and ninth quarters However, the significance of each channel was limited, with credit and exchange rate channels being the most impactful Similarly, Hoang (2010) analyzed the monetary transmission mechanism in Vietnam using a VAR approach, revealing that monetary policy has a notable, albeit low, effect on real output and price levels, with credit significantly influencing output, while interest and exchange rates did not significantly affect either output or price levels Bui (2011) further examined the effects of money growth on inflation in Vietnam from 2004 to 2010, finding a significant positive relationship between money growth and inflation in both the long and short run.
The credit channel is crucial for monetary transmission in Vietnam, with interest rates exhibiting bi-directional causality with both inflation and money supply However, the relationship between the lending channel and monetary policy remains relatively weak Nguyen (2012) highlights that independent variables do not show Granger causality with money supply in classical markets, indicating that money supply can predict most dependent variables without credit, except for the lending rate In contrast, in augmented markets, domestic credit significantly predicts money supply.
Price levels and lending rates can help predict money supply, but they are ineffective in classical markets Additionally, the lagged value of money supply does not forecast credit, output, or lending rates In classical markets, particularly during tightening monetary policy, output and refinancing rates respond to money policy shocks after one lag Output is quite sensitive to these monetary shocks, while the lending channel's responses are short-lived and occasionally abnormal In Vietnam, the credit channel plays a crucial role in the monetary policy mechanism.
Endogenous Variables Real output, Nominal money, Fiscal deficit, Terms of trade, Real exchange rate, Government expenditure
Consumer Price Index, M1, M2, Federal Funds rate, three-month Treasury bill rate, ten-year Treasury bond rate,
Industrial production, Capacity utilization, Employment, Unemployment rate, Housing starts, Retail sales, Consumption, Durable-goods orders
Real GDP, GDP deflator, index of commodity prices, Federal funds rate, Final demand, Inventory investment
Real Private Demand and its 4 components, Consumer Price Index, Overnight call rate and Broad Money, Loan and Holdings of security
Research Method Time series data
Use VAR model in reduced form
Use Structural VAR model to analyze the Granger causality tests, variance decompositions, and impulse response functions
Use VAR model in reduced form to analyze impulse response functions
In the short run, a devaluation leads to a decrease in aggregate output However, after one year, it begins to have an expansionary effect on output Ultimately, in the long run, devaluations do not impact output.
The federal funds rate serves as a key indicator of monetary policy, with nominal interest rates effectively forecasting real economic variables It is important to recognize that the federal funds rate is particularly informative Monetary policy influences the composition of bank assets, where tighter monetary policy leads to a short-term sell-off of banks' security holdings, minimally impacting loans The similar timing of responses in loans and unemployment to changes in monetary policy suggests that this channel is active, despite the lack of a Granger-causal relationship between loans and unemployment.
Monetary policy has a strong impact on durable goods spending The large and rapid response of housing investment to change in monetary policy
Both the balance sheet and bank lending channels have played important roles in the housii!K market
Monetary policy and the balance sheets of banks are significant sources of economic shocks, with banks playing a vital role in transmitting these monetary shocks to overall economic activity Business investment is particularly responsive to changes in monetary policy.
Exchange rate, Monetary aggregates (currency in circulation CU, M1, and M2), Real industrial output, Consumer Price Index
Output, inflation, and interest rates
Consumer Price Index (PRICE), and 14-day repurchase rate (RP14), private consumption, investment, exports, and imports, bank credit, real effective exchange rate (REER), asset prices, interest rate
Real GDP, real M2, real government deficit, real exchange rate, inflation rate
Official exchange rate (OER), Selling interbank exchange rate (SER), parallel selling exchange rate in Ho Chi Minh City (SSER), parallel selling exchange rate in Hanoi (HSER)
UseVAR models, Co- integration techniques, Error Correction Model (ECM) and simple Lucas-type production function
Use VAR model in reduced form and Structural VARs
Use VAR model to analyze variance decompositions, and impulse response functions
Use V AR model to analyze
World output, world crude price oil variance decompositions, and impulse response functions
The rate of changes in ERs has altered significantly the Granger-causality between output growth, inflation, and money growth
Nominal exchange rates, including official and shadow exchange rates, have shown inconsistent trends as leading indicators for output growth, with this relationship lacking stability Current inflation and real industrial output growth are primarily influenced by their historical trends Additionally, real depreciation rates positively affect output growth, although the extent of this impact varies significantly.
The alteration in the propagation mechanism has significantly reduced the variability of macroeconomic variables This shift is also linked to a decreased impact of monetary policy shocks on both output and inflation.
The stylized facts about the response of the economy to a tightening of monetary policy:
+ The aggregate price level initially responds very little, but starts to decline after about a year and quite persistently so
+ Output follows a U- shaped response, bottoming out after around 4-5 quarters and dissipating after approximately 11 quarters
+ Investment appears to be the most sensitive component of GDP to monetary policy shocks
Real GDP positively reacts to shocks in real M2, government deficit spending, and real exchange rate depreciation Conversely, lagged real output significantly responds negatively to shocks in the inflation rate.
Real (distributed) GDP, Wholesale Price Index, Monetary Policy Stance Index and Nominal Effective Exchange Rate, Interest rate (three- month deposit rate), Domestic credit, Asset Price, Reserve Money
Real Industrial Output, Consumer Price Index, Broad Money, Real Lending Rate, Index of the Real Effective Exchange Rate and Domestic Credit
Consumer Price Index, Exchange Rate (ROL/EUR), Industrial
Production, Money supply (M2), Non- Government Credit, Three month offered interest rate from Romanian
World Oil Price, World Rice Price and Federal Funds Rate
Use VAR model in reduced form to analyze the Granger causality tests, variance decompositions, and impulse response functions
Use VAR model in reduced form to analyze the Granger causality tests, variance decompositions, and impulse response functions
The VAR model is utilized to examine variance decompositions over specific time periods In the first year, government deficit spending and the inflation rate, alongside lagged output, emerge as the most significant variables Beyond the first year, real M2 and the real exchange rate become more influential, demonstrating longer-term effects.
The exchange rate channel plays an important role in the transmission of the monetary stance Most other channels are quite weak
Chapter remarks
This thesis focuses on the impacts of monetary policy on macroeconomic variables in which two variables output and inflation are concentrated and clarified in details
The Keynesian AD-AS model illustrates that an increase in the money supply shifts the aggregate demand curve rightward in the short term, leading to a new equilibrium characterized by higher output and price levels This thesis explores Aggregate Demand through the Traditional Keynesian IS-LM model, the Mundell-Fleming Model, and Tobin's q theory It employs the VAR model to analyze the impact of monetary policy on the economy, focusing on three primary channels: interest rate, credit, and exchange rate channels The study specifically examines the effects of monetary policy on the Vietnamese economy from May 2005 to June 2012.
ECONOMY PERFORMANCE, FINANCIAL SYSTEM
Economy performance
Year ,._Economic Growth (Real GOP growth)
Source: IMF (2012) tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
Since the 1986 reform, Vietnam has experienced remarkable economic growth, with an annual growth rate of 7.5% during the 1990s and peaking at nearly 10% in 1995 and 1996 From 2000 to 2007, the growth rate averaged 7.6%, making it one of the highest in East Asia During this period, Vietnam's real GDP growth consistently ranked among the top 30 in the world, according to the Central Intelligence Agency (CIA).
Between 2008 and 2010, Vietnam experienced a significant decline in growth, averaging 6.1% In 2009, the GDP growth rate was forecasted at just 5.3%, marking the lowest level in a decade This downturn was primarily driven by the global financial crisis and recession, which severely affected Vietnam's economy, particularly in the areas of exports, investment, and tourism.
Since 2011, Vietnam's economic situation has deteriorated, with the growth rate declining from 5.9% in 2011 to just 5.03% in 2012 This decline is attributed not only to the global financial crisis and recession but also to significant weaknesses in organizational and macroeconomic management, particularly in monetary policy and banking administration These issues have led to increased uncertainty regarding risks associated with the banking system and state-owned enterprises According to a recent report by Moody's, Vietnam's average real GDP growth rate is projected to remain around 5% per year over the next two years.
Vietnam experienced hyperinflation in the second half of the 1980s and early 1990s
In the years 1987 to 1991, the annual inflation rate was above 40% It was then followed by a reduction of the inflation rate to 32% in 1992 and closed to 10% in
In 1996, Vietnam implemented stringent monetary and fiscal policies aimed at controlling inflation effectively.
Year -Real GDP growth rate -Inflation
Figure 3.2: Inflation and real GDP growth rate
These policies were successful to keep inflation rate under 10% since 1996 It even went far above expectation as there was a slightly deflation in the year 1999 and
Since 2002, inflation rates remained below growth rates, aligning with the key macroeconomic goals of the Socio-Economic Development plan However, in 2008, inflation surged again as a consequence of the recent global financial crisis.
Finacial system and the role of Central Bank in Vietnam
Since 1988, Vietnam has undergone a significant transformation in its banking sector, shifting from a mono-bank system to a two-tier banking system This system comprises the State Bank of Vietnam (SBV), which operates under government oversight and is responsible for regulating the financial market and supervising commercial banks through monetary tools The SBV holds a monopoly on currency printing, providing legal tender to the government Additionally, the system includes Specialized Commercial Banks and other financial institutions that perform essential banking functions, such as borrowing and lending to individuals and businesses.
The banking sector, especially the State Bank of Vietnam, has made significant progress in its development However, amidst the unpredictable global and national economic landscape, certain drawbacks within the banking sector and the central bank remain inevitable.
The Vietnam Communist Party and Government emphasize the necessity of reforming the State Bank of Vietnam to function as a modern central bank, aligned with international standards and the socialist-oriented market mechanism This reorganization aims to enhance macroeconomic stability, control inflation, and boost the purchasing power of the Vietnamese currency, ultimately supporting the nation's economic development However, a significant challenge remains: defining what constitutes a modern central bank, a question that has yet to receive a satisfactory answer.
In developed nations like the USA, Canada, Europe, Switzerland, New Zealand, and Japan, organizational models operate independently from government influence In contrast, Vietnam's organizational model is directly governed by the state.
A study by the International Monetary Fund (IMF) in December 2004 categorizes central banks worldwide into four levels of independence: independence in setting operational objectives, independence in establishing performance targets, independence in choosing operating instruments, and limited independence.
The first level of independence in setting operational objectives allows the central bank to make autonomous decisions regarding monetary policy and exchange rates, as mandated by law This represents the highest degree of independence for a central bank, with the United States serving as a prime example.
The second level of central bank independence involves the authority to establish performance targets, allowing the bank to determine monetary policy and the exchange rate regime Unlike the first level, this level specifies a key operational objective in legislation, such as the European Central Bank's (ECB) primary goal of "maintaining price stability."
The third level of monetary policy involves independence in selecting operational instruments, where the Government or National Assembly sets monetary policy targets after discussions with the Central Bank Once approved, the Central Bank is tasked with achieving these targets, empowered to choose the most suitable monetary tools Notable examples of this model include the Reserve Bank of New Zealand and the Bank of Canada.
The fourth level of independence, known as limited independence, represents the lowest degree of autonomy for a central bank In this framework, the government acts as the primary decision-making authority regarding both operational objectives and performance targets, often intervening in the execution of monetary policy This governmental involvement restricts the central bank's effectiveness, particularly in achieving its goal of maintaining monetary stability Currently, the State Bank of Vietnam exemplifies this situation, as the limitations and shortcomings of this level of independence have become increasingly apparent.
Recent discussions on central bank reform in Vietnam suggest adopting an independent central bank model The primary rationale is that greater independence from the government facilitates the achievement of low inflation targets, a concept supported by economic theory.
Moreover, some different researches have also come to the conclusion that countries whose central banks have a high level of independence often have low inflation rate (Eijffinger and DeHaan, 1996)
Research indicates that central banks should be entrusted with the formulation, decision-making, and implementation of monetary policy A professional and independent central bank, focused primarily on maintaining price stability, enhances the effectiveness of policy outcomes and bolsters the credibility of policymakers.
The State Bank of Vietnam should be granted greater autonomy in its policy-making processes, free from interference by state agencies or political influences Additionally, it must have the authority to manage all tools that impact monetary policy objectives, particularly in controlling inflation and limiting direct financing of government budget deficits.
Monetary policy
The Government is responsible for preparing an annual monetary policy plan that includes projections for inflation and growth, which is submitted to the National Assembly The National Assembly sets the annual inflation and growth targets in alignment with the state budget and economic growth objectives outlined in the Socio-Economic Development Plan Additionally, the Government organizes the implementation of monetary policy, including determining the liquidity to be injected into the economy, and is required to report these activities to the National Assembly, which supervises the monetary implementation.
The primary function of the State Bank of Vietnam (SBV) is to prepare and implement monetary policy through various tools while managing all banking activities This process involves not only the SBV but also the National Assembly, the Government, and the National Monetary Policy Advisory Board, which play crucial roles in setting objectives and supervising the SBV's activities However, the Government's strong involvement can limit the independence of monetary policies Research by Radzyner and Riesinger (1997) indicates that central banks in transition economies, such as the CEEC-5, have maintained independence in formulating and implementing monetary policy since the early 1990s, with the exception of Poland The Czech National Bank, the National Bank of Hungary, the Bank of Slovakia, and the Bank of Slovenia are required to design monetary policy independently, although significant issues are often addressed collaboratively with the Government The study concludes that the independence of a central bank can significantly impact the effectiveness of its policies.
The State Bank of Vietnam (SBV) aims to stabilize the currency's value, which includes maintaining the exchange rate, controlling inflation, and promoting socio-economic development However, the Vietnamese government's actual economic policy indicates that economic growth is the primary focus, as highlighted by Camen (2006).
The State Bank of Vietnam plays a crucial role in shaping macroeconomic policy by utilizing various monetary policy tools to achieve its annual objectives, which include managing the exchange rate and regulating total liquidity (M2) and credit within the economy Key instruments for controlling the money supply are employed to effectively implement these monetary policies.
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Figure 3.3: Interest rate in Vietnam
Source: SBVand World Bank website (2012, accessed on November 10, 2012)
Since the mid-1990s, interest rates have been progressively liberalized, with the implementation of a positive real interest rate policy beginning in late 1992 This policy has been flexibly adjusted in accordance with the inflation rate The State Bank of Vietnam establishes three primary interest rates.
Base rate, Discount rate and Refinancing rate
The base rate has served as the reference rate for other bank interest rates since August 5, 2000, following Decision No 242/2000/QD-NHNN issued by the State Bank of Vietnam This rate has remained relatively stable, being fixed at approximately 7.5% for over three years.
From 2002 to 2005, the interest rate was maintained at 8.25% for nearly three years, despite significant fluctuations in other rates Figure 3.3 illustrates the base rate and lending rate from August 2000 to August 2012, revealing an increasing gap between the two This widening disparity suggests that the base rate may no longer effectively signal lending rates for commercial banks.
The refinancing and discount rates serve as the upper and lower limits for lending by the State Bank Recently, these rates have been utilized as tools of monetary policy to enforce a tightening monetary stance.
Since July 2000, the State Bank has utilized a tool for trading securities with credit institutions, primarily through volume or interest rate auctions Commonly traded securities include government bonds, State Bank bills, and other securities selected by the State Bank Initially, only short-term securities were available, but since 2003, auctions have also included securities with maturities exceeding one year This tool has recently become crucial in managing the total liquidity injected into the economy.
The required reserve is a fraction of deposits that commercial banks must maintain as vault cash to mitigate the risk of bank crises By adjusting the reserve requirement rate, the State Bank of Vietnam can influence the amount of money commercial banks can lend, thereby indirectly affecting the money supply in the country This requirement applies to all types of deposits, whether in domestic or foreign currency Although this tool has been in use since 1991 and was once crucial, the State Bank of Vietnam now primarily focuses on interest rates, making the required reserve a relatively less significant tool in the current economic landscape.
According to the International Monetary Fund (IMF), Vietnam's exchange rate regime is classified as a managed-floating or intermediate system Following the economic reforms initiated in 1986, Vietnam transitioned from a system with multiple exchange rates, including two official rates, to a single fixed exchange rate established by the State Bank of Vietnam (SBV) in 1989 This shift marked a significant change in the country's monetary policy since the unification in 1989.
The determination of exchange rates has shifted towards a more market-oriented approach, particularly since 1991 when a narrow band system was introduced around an official exchange rate, transitioning from a pegged to a managed-floating exchange rate In addition to the domestic currency, the Vietnamese Dong (VND), the US Dollar (USD) is also commonly utilized, with the bilateral VND/USD exchange rate being crucial as it serves as a key nominal anchor.
Chapter remarks
In recent years, Vietnam has relied heavily on a growth model focused on capital investment, particularly from public and state-owned enterprises (SOEs) This approach has created a trade-off between growth and inflation, resulting in increased macroeconomic instability and an inflationary spiral To combat rising inflation, Vietnam implemented a tightening monetary policy starting in 2011, which successfully curbed inflation but also led to liquidity tensions in the banking system, higher interest rates, and an increase in bad debts Consequently, the asset markets, including securities and real estate, have faced significant impairment.
In light of Vietnam's current economic situation, in-depth research on monetary policy is crucial for policymakers This analysis enables them to effectively manage monetary policy to achieve key objectives related to inflation control and macroeconomic stability.
RESEARCH METHODOLOGY
Model specification
This thesis employs vector autoregression (VAR) models to analyze the effects of monetary policy on output and inflation in Vietnam VAR models are advantageous as they can estimate the interrelationships among multiple endogenous variables simultaneously However, they lack a foundation in economic theory Given the uncertainty surrounding the monetary transmission mechanism in Vietnam, this methodology allows for minimal restrictions on the impact of monetary shocks on the economy The decision to use a VAR approach is also supported by a substantial body of empirical literature, as discussed in Chapter II, which examines the monetary transmission mechanism through reduced-form relationships between monetary policy and output with a limited number of variables.
A reduced-form V AR model can be written including three variables as follow:
• OUTPUT, CPI, M2 are endogenous variables
• a, ~'yare the vectors of constants
• u; is the vector of serially uncorrelated disturbances that have zero mean and a time invariant covariance matrix
The model estimation process consists of three steps First, a basic reduced-form VAR model will be estimated using three variables: output growth, consumer price index, and money supply, to analyze the impact of monetary policy changes on the real economy In the second step, the consumer price index for urban and rural areas in Vietnam will be alternately incorporated into the basic model to assess the effects of monetary policy on inflation in these regions Finally, different variables, including lending rates, domestic credit, and exchange rates, will be added to the base model to evaluate their individual effects on output growth and inflation in the economy.
Besides the V AR, the Dickey Fuller test is used to test for stationarity of the variables.
Data availability and description
This thesis utilizes monthly data from May 2005 to June 2012 to analyze how real output growth and inflation respond to various monetary policy tools.
The data set contain the following variables:
+ GROWTH: Real industrial output growth of Vietnam is used as a proxy for output growth of the economy (GROWTH, 1994 based, measured in%)
+ CPI: Consumer price index (CPI, 20050, measured in%)
+ CPI_UB: Consumer price index of the urban area of Vietnam (CPI UB, 20050, measured in%)
+ CPI _ RR: Consumer price index of the rural area of Vietnam (CPI RR, 20050, measured in%)
+ M2: Broad money or high-powered money (measured in billions ofVND)
+ LR: Lending rate (measured in % )
+ CREDIT: Domestic credit (measured in billions ofVND)
The Real Effective Exchange Rate (REER) is measured in percentage terms and is based on data from 2005M50.
The data for these variables is sourced from the International Monetary Fund's International Financial Statistics (IMF's IFS), with the exception of the Real Industrial Output used for calculating the GROWTH variable, as well as the Consumer Price Index (CPI), CPI Upper Bound (CPI UB), and CPI Real Rate (CPI RR), which are obtained from the General Statistics Office (GSO) Additionally, the exchange rate variable E is calculated based on a basket of exchange rates from the top 25 countries that have the largest trade share with Vietnam, incorporating data from the IMF's Direction of Trade (DOT), OECD.Stat, and the U.S Federal Reserve.
The formula for growth, defined as \$\text{GROWTH} = \left(\frac{\text{OUTPUT}_t - \text{OUTPUT}_{t-1}}{\text{OUTPUT}_{t-1}}\right) \times 100\$, represents the percentage change in Real Industrial Output, serving as a proxy for economic output growth calculated at constant 1994 prices Real industrial output growth is preferred over real GDP growth due to the unavailability of comprehensive output data for the entire study period Additionally, real output growth is favored over nominal output growth because nominal figures are not adjusted for price level fluctuations, which can distort the true representation of output changes By adjusting for the Consumer Price Index (CPI), real output growth provides a more accurate reflection of changes in output growth.
The Consumer Price Index (CPI) at constant 2005 prices serves as a key indicator of inflation across Vietnam, sourced from the General Statistics Office (GSO) While various inflation measures exist, including the GDP deflator, the State Bank of Vietnam (SBV) primarily relies on the CPI as its main inflation metric.
CPI_UB (constant price in 2005) serves as an indicator of inflation in urban areas of Vietnam, while CPI_RR (constant price in 2005) represents inflation in rural areas These data are accessible through the General Statistics Office (GSO) websites.
M2, defined by the IMF as broad money or high-powered money, encompasses both money and quasi-money.
The State Bank of Vietnam (SBV) regulates two key lending facilities: the discount rate and the refinancing rate, which together establish a band for lending rates The refinancing rate acts as the ceiling, while the discount rate serves as the floor, making the lending rate a crucial proxy for the interest rate channel in monetary policy Although the SBV sets a base rate, it rarely changes and does not accurately reflect the money market's supply and demand Instead, it primarily serves as a reference for commercial banks in determining their deposit and lending rates, rendering it less significant for modeling Vietnam's monetary policy.
Domestic credit serves as a crucial channel for monetary policy to impact output growth and is a key annual target set by the State Bank of Vietnam (SBV) in alignment with government objectives The significance of incorporating domestic credit into monetary policy studies is supported by research conducted by Vo et al (2000), which highlights the essential role of money supply in economic analysis.
The Real Effective Exchange Rate (REER) serves as a key indicator of monetary policy through the exchange rate channel, representing the weighted average of a country's currency against a basket of major currencies, adjusted for inflation The weights are derived from the relative trade balances of the country's currency compared to others within the index The detailed formula for calculating REER can be found in financial resources.
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In time \( t \), the import revenue from trading partner \( i \) is denoted as \( IM_1 \), while the export revenue to the same partner is represented by \( EJf_1 \) The total trade between the domestic country and trading partner \( i \) during this period is expressed as \( IM_1 + EJf_1 \).
Total exports from the domestic country to all trading partners at time \( t \) are represented by \$E'i=J(IM J\$, while total imports from all trading partners at the same time are denoted as \$E'i=J(EJf J\$ The overall trade between the domestic country and its trading partners during this period is expressed as \$E'i=J(IM 1 + EJf J\$.
• CP 1 1 : consumer prices index of trading partner i in time t
• CP IVN 1 : consumer prices index of the domestic country in time t
• Ei 1 : is the exchange rate index for currency i in time t (constant rate in base time) expressed as domestic currency per foreign currency unit: E~ = ( iet ) x ebase
• ei 1 : exchange rate between domestic currency and currency of country i in timet (domestic currencies in 1 foreign currency)
• ei base : exchange rate between domestic currency and currency of country i in base time (domestic currencies in 1 foreign currency)
REER > 1: Domestic currency is assumed to be at low pnce and foreign currencies at high price, domestic goods and services are cheaper, net export increase, trade balance improves
REER < 1: Domestic currency is assumed to be at high pnce and foreign currencies at low price, foreign goods and services are cheaper, net export decrease, trade balance worsens
The Real Effective Exchange Rate (REER) is equal to 1 when the purchasing power of domestic currency matches that of foreign currencies.
To calculate the Real Effective Exchange Rate (REER), it is essential to determine the selection of foreign countries that will serve as trading partners, assess their relative trade weights, and identify the price indices for comparison This process is outlined in five detailed steps.
Test for stationary property"
In a conventional VAR model, it is essential for variables to be stationary This thesis employs the Augmented Dickey Fuller (ADF) test using Eviews6 software to assess the stationarity of macroeconomic variables within the VAR framework Determining the appropriate lag length for the ADF test can be challenging; insufficient lags may lead to regression residuals that do not exhibit white-noise characteristics, while excessive lags can diminish the test's ability to reject the null hypothesis of a unit root.
Table 4.2: Stationary tests for variables in level
VARIABLE EXOGENOUS AUGMENTED DICKEY-FULLER
CPI UB Constant, Linear trend -1.719326 0.7342
CPI RR Constant, Linear trend -1.660688 0.7600
Source: Author's calculation by using of data set introduced in this chapter
The ADF test results indicate that the GROWTH variable is stationary at level, while the variables CPI, CPI_UB, CPI_RR, M2, LR, CREDIT, and E are non-stationary Consequently, I opted to transform these non-stationary variables to ensure proper analysis.
growth rate {percentage change) to eliminate non-stationary by taking 1st differences of the natural logarithm ofthe non-stationary variables and multiplying by 100
Table 4.3: Stationary tests for variables in percentage change
VARIABLE EXOGENOUS AUGMENTED DICKEY-FULLER
DL CPI Constant, Linear trend -4.319073 0.0048 (