PHÁT TRIỂN TÀI CHÍNH VÀ HIỆU lực CỦA CHÍNH SÁCH TIỀN tệ tt anh

Specific objectives are: Firstly, testing the Taylor curve theory; secondly, developing and establishing the efficient frontier of the monetary policy for countries on the basis of the

MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HO CHI MINH CITY

The thesis is completed at:

University of Economics Ho Chi Minh City

Supervisor: Prof Dr Tran Ngoc Tho

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to the economies However, there is little evidence of the effects that the financial development puts on the effectiveness of the monetary policy in the current period of time

Although there are some authors doing research on the same

topic, they still encounter some pending issues First, the

measurement of the Monetary Policy Effectiveness has not covered all the objectives of the monetary policy of Central

Banks (Ma & Lin, 2016, Carranza, Galdon-sanchez &

Gomez-biscarri, 2010) Second, they have not paid attention to factors

affecting the monetary policy effectiveness (Cecchetti, Lagunes & Krause, 2006; Olson & Enders, 2012; Olson, Enders

Flores-& Wohar, 2012) Third, they have only considered role of some

certain aspects of the concept of the financial development on the effectiveness of monetary policy (Akhtar, 1983; De Bondt, 1999; Cecchetti & Krause, 2001, 2002; Georgiadis & Mehl, 2016; Bernoth, Gebauer & Schäfer, 2017) without considering the whole role of the financial development

Starting from both academic and practical perspectives, it is necessary to do research on the monetary policy effectiveness and the impact of the financial development on the monetary policy effectiveness in order to overcome limitations of previous researches, aiming at producing scientific understandings on the management of the monetary policy in new context

1.2 Objectives

Evaluate impacts of the financial development on the monetary policy effectiveness

Specific objectives are: Firstly, testing the Taylor curve theory;

secondly, developing and establishing the efficient frontier of the

monetary policy for countries on the basis of the Taylor curve

theory and measures the monetary policy effectiveness; thirdly,

studying the effects of the financial development (with respect to various aspects) on the effectiveness of the monetary policy in the countries of the research sample

1.3 Research questions

1.4 Subject and Scope of study

This research studiesthe impact of the financial development on the monetary policy effectiveness in G-7 developed countries (including Canada, France, Germany, Italy, Japan, United Kingdom, and United State) from 1951 to 2017 (depending on the data availability)

1.5 Methodologies and data

1.6 Contributions

1.7 Thesis’s structure

CHAPTER 2 – THEORETICAL FRAMEWORK AND

EFFECTIVENESS

2.1 Monetary Policy

2.2 Monetary Policy Effectiveness and Taylor Curve Theory

2.2.1 Taylor Curve Theory

The Taylor curve theory describes permanent trade-off between output volatility and inflation volatility in implementing the monetary policy (Taylor, 1979), and it is an important guiding principle in many studies on the monetary policy (see more,

Taylor, 1994; Fuhrer, 1997; Orphanides et al., 1997; Chatterjee,

2002; Taylor & Williams, 2011; Olson, Enders & Wohar, 2012) The Taylor curve is considered as the efficient frontier of the monetary policy, showing the position on which the monetary policy is optimal towards the inflation volatility and the output is

at lowest level corresponding to central bank’s taste with regards

to whether price stability or business cycle stability is prioritized (Taylor, 1979; Friedman, 2010)

Basic principle of the Taylor curve is based on Central Bank’s optimizing behavior in implementing monetary policy to minimize loss to the economy against unexpected effects of shocks Loss function measuring weighted total costs of inflation volatility and output volatility against their target levels:

of shocks – aggregate demand shock (d) and aggregate supply shock (s) and these two types require policy response The

aggregate demand shock causes output and inflation change in the same direction and aggregate supply shock causes in opposite direction Because monetary policy can affect output and inflation in the same direction, it can completely offset the effect

of the aggregate demand shock In contrast, the aggregate supply shock will require monetary agencies to encounter a trade-off between output volatility and inflation volatility (Taylor, 1979,

Clarida, Galí & Gertler, 1999; Cecchetti & Krause, 2001)

Fig 2.1 The Taylor curve

The trade-off relationship is modeled by a downward sloping curve, convex to the origin on a two-dimensional graph (output volatility – inflation volatility) The efficient frontier of monetary policy traces points at which the inflation volatility cannot be achieved at lowest level without causing any increase in the output volatility (Taylor, 1979; Cecchetti, FloresLagunes & Krause, 2006) This efficient frontier is called Taylor curve (Taylor, 1994; King, 1999; Bernanke, 2004; Friedman, 2010; Olson & Enders, 2012) Figure 2.1 illustrates the efficient frontier

of monetary policy according to Taylor (1979) If the monetary policy is optimal, the economy will be on this curve When the policy is below optimal level, the economy will not be on this curve Instead, the efficient point will be above on the right side with the fact that the inflation volatility goes beyond other feasible points Movements of the efficient points to the frontier

signal that the policy effectiveness is improved

2.2.2 Monetary Policy Effectiveness

The monetary policy effectiveness is the capability of central banks to achieve their objectives, stabilize impacts of the shocks

on the economy and reduce macroeconomic volatility by implementing monetary policy with available instruments (Boivin & Giannoni, 2006, Cecchetti & Krause, 2001, Cecchetti

et al., 2006, Mishkin & Schmidt-Hebbel, 2007, Taylor, 1979)

2.2.3 Factors affecting the effectiveness of monetary policy

2.3 Financial Development

2.3.1 Role of financial system in monetary transmission mechanism

2.3.2 Financial Development

Financial development includes improvement in the functions of financial system such as (i) aggregating savings; (ii) appropriating capital for production; (iii) monitoring such investments; (iv) diversifying risks; and (v) exchanging goods and services (Levine, 2005)

Financial development involves in competitive and efficient issues in the financial sector; scope of services provided; variety

of financial institutions in the financial sector; volume of credit granted by financial intermediaries along with the right to access financial services and financial stability (Svirydzenka, 2016)

2.3.3 Measuring Financial Development

The best way to measure financial development is to measure the degree to which five functions of the financial system are improved However, it is a great challenge to have a direct measurement for the functions Levine (2005) pointed out that such empirical variables do not normally measure exactly concepts coming from theoretical models

Many studies on the financial development towards economic growth; inequality or poverty and economic stability have developed different measures for the financial development (Svirydzenka, 2016) Some studies focus on the development in banking sector, some others focus on the development in stock market, whereas the others compile them in an indicator

2.4 Theory of the impacts of the financial development

on the monetary policy effectiveness

Theory of the impacts of the financial development on the monetary policy effectiveness has been developed very early with different aspects on money supply, money demand and

monetary transmission mechanism (see Gurley & Shaw, 1955, 1967; Vanhoose, 1985; Lown, 1987; Taylor, 1987; Modigliani & Papademos, 1989; Hendry & Ericsson, 1991; Arestis, Hadjimatheou & Zis, 1992, etc.)

2.4.1 Impacts of the financial development on money supply control

The financial development makes it more difficult to determine money aggregates Characteristics of the financial development such as the continuous appearance of new instruments and products make the determination and differentiation of

“moneyness” and “liquidity” of the instruments becomes inaccurate, and thus, it is difficult to define which instrument to

be included in money aggregates Simultaneously, the appearance of non-cash payment methods and electronic money types put impact on the velocity of money circulation, making it difficult for central banks to control money supply (Akhtar, 1983;

2.4.3 Impacts of Financial Development on monetary

transmission mechanism

The monetary transmission mechanism can be modeled into 2

phases as can be seen from Figure 2.3

Figure 2.3 Factors impacting monetary policy transmission mechanism

Source: Loayza & Schmidt-Hebbel (2002)

First phase: any change in monetary policy will be transmitted

to change in market interest rate and price of other financial assets in a quicker and closer manner if the financial system has

a greater variety of financial institutions and financial products This is because at this time, the more competition among financial institutions will cause the market operating in a more efficient way In contrast, in a financial system where some financial institutions obtain monopoly power or denominate the market and there are few of substitutes for financial products, such institutions can determine the interest rate and market price independently of central banks Therefore, the impact of monetary policy on interest rate depends much on the structure

of financial system (Loayza & Schmidt-Hebbel, 2002)

The relationship between the financial development and speed and ability to respond and adjust bank lending interest rate towards change in policy interest rate can be explained in four different ways (Cottarelli & Kourelis, 1994):

- Adjustment Costs and the Elasticity of the Demand for Loans

- Adjustment Costs and Uncertainty about Future Money Market Change

- Non-Profit-Maximizing Behavior

- Oligopolistic Competition Models

Second phase: the consumption and investment decisions of

households and firms appear more sensitive to market price and interest rate when such households and firms are engaged in no financial constraint The depth and structure of the financial system affect financial constraint conditions of the households and firms, and therefore, the transmission mechanism of the best match is selected When the financial system is shallow and not diverse (which means, it relies on a small number of banks, asset price channel will be less important (due to low stock market capitalization) and interest rate channel will be weak (due to monopoly power of banks) Instead, credit channel will prevail, with moral hazard and adverse selection which are characteristics

of shallow financial system (Loayza & Schmidt-Hebbel, 2002) Exchange rate channel does not normally show the importance in

a financially underdeveloped economies because such countries tend to impose control on foreign exchange transactions However, when the financial system develops and becomes more diverse,

asset price channel, interest rate channel and exchange rate channel will become more important (Cecchetti & Krause, 2001)

2.5 Overview of previous empirical studies

2.5.1 Studies on Taylor curve and monetary policy effectiveness

2.5.2 Studies on the impact of the financial development on the monetary policy effectiveness

2.6 Summary and motivations of the study

CHAPTER 3 – TESTING THE TAYLOR CURVE THEORY

3.1 Objective

The objective of this chapter is to test the trade-off relationship between output volatility and inflation volatility encountered by monetary agencies in making monetary policy, i.e testing the Taylor curve theory If the theory held at the sample of countries during the study phase, it can be used for monetary policy effectiveness measurement in the next chapter

3.2 Methodology

3.2.1 Model

Following Mishkin & Schmidt-Hebbel (2007); Olson, Enders & Wohar (2012); Rudebusch & Svensson (1999), Cecchetti, Flores-Lagunes & Krause (2006), I test the relationship between output volatility and inflation volatility by using dynamic aggregate demand and supply model with variance parameterization process of 2 variables of output and inflation by GARCH-BEKK model:

equation (3.2) represents a Phillips curve (aggregate supply

curve), in which y is output, 𝜋 is inflation, i is interest rate and

oil is oil price, with removal of trends Ht is a matrix of variance

Based on Lee (1999, 2002, 2004); Olson et al (2012), the

assumption of the trade-off relationship between output volatility

and inflation volatility is tested with the bivariate GARCH–

BEKK model, as discussed by Engle & Kroner (1995) In

particular, I keep track with dynamic behaviors of inflation

volatility and output volatility which are unable to be directly

observed with the estimation of conditional variance of inflation

and output in accordance with the structure model of (3.1), (3.2)

curve relationship The assumption of the trade-off relationship

between output volatility and inflation volatility is tested by

elements have negative signs, the Taylor curve theory is

determined The lag of independent variables in the mean

equation is selected on the basis of testing F with the estimation

of (3.1) and (3.2) by seemingly unrelated regression (SURs) beginning with six lags of each variable

3.2.2 Data

I use monthly data of 7 countries of the sample for a period from

1951 to 2017 subject to the data availability of each country The data are collected from the IMF (International Financial Statistics) and Federal Reserve Bank of St Louis’s Database The data include Industrial Production Index (IIP), representing economy output; inflation rate (which means percentage change

in consumer price index in comparison with the same period of the previous year); short term nominal interest rate is money market interest rate, representing the monetary policy perspective; world oil price which means WTI crude-oil price with the unit price of USD/barrel, representing supply shock

3.3 Results of Taylor curve relationship test

3.3.1 Result of stationarity test

The result of stationarity test shows that only interest rate variable integrates at level (1), the other variables integrate at level (0)

3.3.2 Taylor curve relationship

Table 3.3 reports the estimation result of the

at 5% and 1% in most of the study countries This indicates that there exists a signal of the trade-off relationship according to the Taylor curve theory However, the fact that how large the trade-off relationship between output volatility and inflation volatility varies among countries This result matches with findings of the