Chính sách tiền tệ lạm phát mục tiêu và khả năng áp dụng ở việt nam tt tiếng anh

The central bank has the right to choose monetary policy instruments, but an important condition for the central bank to succeed in applying the inflation targeting mechanism is that the

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MINISTRY OF TRAINING AND EDUCATION THE STATE BANK OF VIETNAM

BANKING UNIVERSITY OF HO CHI MINH CITY

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NGUYEN THI MY HANH

INFLATION TARGETING STRATEGY

AND ITS APPLICABILITY IN VIETNAM

SUMMARY OF DOCTORAL THESIS MAJOR: FINANCE – BANKING

CODE: 9.34.02.01 SUPERVISOR: ASSOC.PROF.DR LE THI MAN

HO CHI MINH CITY – 2019

SUMMARY

For a long time, the State Bank of Vietnam has chosen inflation targeting as its main monetary policy framework However, so far, the transition to the inflation targeting mechanism is still a big challenge for the central bank of Vietnam In this thesis, the author will provide empirical evidences to show that the bottleneck in conducting inflation targeting monetary policy in Vietnam is ineffectiveness of using interest rate tool

The central bank has the right to choose monetary policy instruments, but an important condition for the central bank to succeed in applying the inflation targeting mechanism is that there must exist a relationship between monetary policy instruments and inflation In this thesis, the author will examine the relationship between the interest rate tool (the main monetary policy tool often used when the central bank applies target inflation policy) and inflation In addition, the thesis will determine whether the State bank of Vietnam use interest rate instruments towards stabilizing inflation or exchange rate

The author has set up a vector regression model of 5 variables: inflation, interest rate, exchange rate, domestic aggregate demand and foreign aggregate demand The model is essentially a reflection of the monetary policy transmission mechanism of the interest rate tool There are many different types of interest rates, however, the interest rate that represents the central bank's interest rate tool is policy rates In Vietnam, there are two types of policy interest rates: refinancing rate and interest rate Research results from the thesis show that operating the interest rate instruments including refinancing rate and discount rate to control inflation in Vietnam is not really effective because the relationship between inflation and interest rate instruments is very weak In addition, the research results show that the policy interest rate tool

in Vietnam has a great impact on exchange rates This suggests that it is possible that in the past, Vietnam has used interest rate tools to protect the exchange rate rather than to stabilize prices This also means that Vietnam has not yet satisfied the two basic conditions to be met before applying the inflation targeting monetary policy set by the International Monetary Fund

CHAPTER 1 INTRODUCTION 1.1.The necessity of the thesis

In a survey of the IMF's International Monetary Fund for 88 non-industrial countries, more than half of these countries expressed their desire to move to inflation targeting framework and Vietnam is also included in the group of potential countries that can apply inflation targeting (Batini and Laxton, 2006) The State Bank of Vietnam’s intention of moving

to inflation targeting is clearly reflected in the development plan of Vietnam's banking industry

to 2010 and development orientation to 2020 in Decision No 112/2006 / QD-TTg dated 24/5/2006 of the Prime Minister: “Implementing monetary policy based on the regulation of money amount; at the same time, building necessary conditions to gradually move to the implementation of monetary policy on the basis of interest rate regulation To create necessary conditions for after 2010, the State Bank of Vietnam will move to inflation targeting framework” After 2010, nearly three-quarters (3/4) of the countries assessed by the IMF as potential countries to move to inflation targeting mechanism have fulfilled their wishes Meanwhile, the year of 2020 is coming but Vietnam is still on the way towards inflation targeting policy Perhaps there are many difficult issues that the State Bank of Vietnam has not yet solved to move towards the transition to inflation targeting mechanism

According to the IMF research team, there are two basic conditions that a country needs

to satisfy when applying the inflation targeting mechanism (Debelle et al., 2018) The first condition is that the central bank is independent in conducting monetary policy It is not necessary that the central bank is completely independent of the Government in conducting monetary policy The central bank only needs to be independent in selecting tools to run monetary policy towards controlling inflation In addition, the management of monetary policy

of the central bank must be independent of fiscal policy In other words, the central bank must not allow fiscal dominance, which means that the central bank cannot fund the government budget deficit because it can lead to to increase inflation and reduce the effectiveness of monetary policy Moreover, not letting fiscal policy dominate monetary policy means central bank does not print money to generate revenue for the budget To do this, the central bank needs to have revenues independent of the state budget The second condition for the central bank to be satisfied to apply the inflation targeting framework is that the central bank prioritizes focusing on the most important goal of controlling inflation, instead of focusing on many other goals such as exchange rate stability, economic growth, employment rates

The two basic conditions mentioned above seem simple but why so far Vietnam has not been able to apply the inflation targeting policy? Regarding the first condition, there have

been empirical studies proving that Vietnam does not allow the phenomenon of financial repression because the budget deficit in Vietnam is not the cause of inflation (Nguyen & Nguyen, 2010; Hoang, 2014) Therefore, it is likely that the problem that Vietnam is facing is the independence of monetary policy tool to achieve inflation control target Specifically, Debelle (2001) analyzes the common obstacles facing emerging economies when applying inflation targeting mechanisms in these countries, the relationship between monetary policy instruments and inflation is often unclear If central banks have adopted the inflation targeting mechanism, which often uses the indirect tool of interest rates to conduct monetary policy, central banks in many developing countries still use direct tools followed by issuing administrative orders serving monetary policy management such as credit limit, deposit rate ceilings In order to make it clearer about the independence of monetary policy instruments in Vietnam, in this study, the author will focus on analyzing the relationship between interest rate tools in Vietnam and inflation to see whether this tool is really effective in controlling inflation like the countries that apply inflation targeting Besides, the thesis also considers whether Vietnam satisfies the second condition or not? According to the Vietnam 2035 overview report (World Bank, 2016), the State Bank of Vietnam has too many goals in conducting monetary policy, while many central banks in the world are allowed to assign pricing tasks and report implementation results to the government Since 2012, inflation in Vietnam has always been controlled at a single-digit level; however, due to the lack of commitment of the State Bank on price stability in the long term, the expectation of price increases always exist and affect the sustainable development of Vietnam's economy Therefore, the World Bank team has proposed that Vietnam should choose only one main goal of monetary policy: stablize exchange rate or focus on inflation targeting In the Banking Sector Development Strategy from 2025 to 2030, the Prime Minister's Decision No 986 / QD-TTg of August 8, 2018, clearly affirms that the objective of controlling inflation is priority For a developing country like Vietnam, exchange rate stability is still an important issue to consider before Vietnam the inflation targeting framework since scientific research has proven that exchange rate is an important factor affecting inflation in Vietnam (Nguyen & Nguyen, 2010) Will the floating exchange rate regime as managed in Vietnam last time affect the target of inflation control of monetary policy? In this thesis, the author will examine whether exchange rate stablity or price stability

is the priority of Vietnamese monetary policy

There are many studies on adopting inflation targeting monetary policy in Vietnam such as studies by To Kim Ngoc (2012), To Kim Ngoc and Nguyen Khuong Duy (2012), Ly

Ba Hong Son and Nguyen Van Truong (2012), Nguyen Xuan Hung (2008), Nguyen Xuan

Hung (2009), Nguyen Phuc Canh (2013), Nguyen Thanh Nhan (2010), Do Thi Duc Minh (2003), Nguyen Ngoc Thach (2013), To Kim Ngoc and Le Tuan Nghia (2012) However, these studies have not yet analyzed in depth the independence of monetary policy instruments in Vietnam nor assessed the role of exchange rate in transition to inflation mechanism in Vietnam Hence, in order to further clarify Vietnam's satisfaction with the necessary conditions to apply the inflation targeting policy by quantitative method, the author chooses the topic "Inflation targeting strategy and its applicability in Vietnam” Empirical results from this thesis will also

be the scientific evidences to make necessary recommendations for Vietnam so that the country could apply the inflation targeting framework in the future

1.2 Objectives of the study

The first research objective: The central bank has the right to choose monetary policy

instruments but the important condition for the central bank to succeed in applying inflation targeting framework is that the relationship must exist between monetary policy instruments and inflation Therefore, the author will examine the relationship between monetary policy instruments (particularly the interest rate tool - the tool often used when the central bank applies inflation targeting monetary policy) and inflation

The second research objective: The thesis will determine whether the priority goal of

the State Bank of Vietnam in the conduct of monetary policy is to stabilize inflation or stabilize exchange rate

1.3 Research question

The research question is based on two research objectives of the thesis as follows:

The first research question: Is there a relationship between policy rates and inflation

in Vietnam?

The second research question: Is the current setting of interest rate instruments in

Vietnam geared towards controlling inflation or stabilizing exchange rates?

1.3 Research Method

The thesis uses both quantitative and qualitative research methods To answer the two research questions, the author has set up a vector regression model including 5 variables: inflation, interest rate, exchange rate, Vietnam industrial production index and United States industrial production index The model is a reflection of the monetary policy transmission mechanism of the interest rate tool There are many different types of interest rates, however, the interest rate that represents the central bank's interest rate tool is policy interest rates (interest rates that are determined by the central bank and published to provide a basis for various types of interest rates in the market) In the context of Vietnam, the central bank decides

and announces two types of policy interest rates: refinancing rate and discount rate Because there are 2 types of interest rates acting as policy interest rates, the author built 2 models to test the role of these interest rates Because the data series in the study all stopped at the first difference, the author applied the vector error correction model (VECM) in data analysis The analysis results from variance component analysis will show whether the interest rate instrument in Vietnam has a real impact on inflation or on exchange rate All data is processed

by using STATA 14 Software In combination with qualitative analysis, the author will assess the consistency of quantitative research results with the current situation in Vietnam

1.4 Object and scope of the study

The main research object of this thesis is monetary policy framework and policy interest rates in Vietnam

The dissertation's research period starts from January 2011 This is the time to start applying the State Bank Law 2010 The data in the thesis is collected monthly from January

2011 to June 2018

1.5 The structure of the thesis

The thesis is designed with 5 chapters as follows:

Chapter 1 Introduction

Chapter 2 Literature review

Chapter 3 Model and research method

Chapter 4 Empirical results

Chapter 5 Conclusions and recommendations

1.7 New findings of the thesis

There are many research projects on inflation targeting in Vietnam Compared to previous studies, this thesis found 3 new findings:

- The thesis provides empirical evidence that using interest rate tools towards controlling inflation in Vietnam is not really effective when the relationship between interest rate and inflation is very weak

- The research results also show that policy rates in Vietnam have a great impact on exchange rates and the impact of interest rates on exchange rates is much larger than its impact

on inflation It could be that Vietnam has used interest rate tools to protect the exchange rate

in recent years, or in other words, Vietnam has violated the main conditions of applying inflation targeting monetary policy

- This result shows that the level of transmission of the exchange rate into inflation is very small In other words, the explanation of the exchange rate on the change of inflation in this study is very small Therefore, Vietnam can continue with the current regime of floating exchange rate management, and at the same time, expand the fluctuation range of the exchange rate so that the country could apply the inflation targeting framework in the future

CHAPTER 2 LITERATURE REVIEW 2.1 Monetary policy

2.1.1 Concept

Scientists offer different perspectives on monetary policy Mishkin (2011) argues that monetary policy is the process of managing money supply of the central bank towards an interest rate level to achieve the goals of monetary policy such as inflation control, exchange rate stabilization, full employment or economic growth In Vietnam, Nguyen Van Tien (2009) defines monetary policy as macroeconomic policy, through its tools, the central bank actively changes the supply of money or interest rates (inter-bank interest rates) to achieve its set socio-economic goals

According to Vietnam's State Bank Law 2010, the definition of monetary policy (monetary policy) is as follows: “National monetary policy is monetary decisions at the national level of competent state agencies, including the determination of the target of stabilizing the value of money expressed by the inflation target, the decision to use tools and measures to realize the set objectives ”

2.1.2 Monetary policy target system

2.1.2.1 The final goal

Each country can set many goals for the economy such as high economic growth, full employment of inflation, low inflation, export growth Depending on the economic characteristics, each country will have its own monetary policy However, according to Mishkin and Eakins (2006), the ultimate goal of monetary policy is usually directed to the main goals: price stability, increase in employment, and economic growth In addition, monetary policy also aims to stabilize interest rates, stabilize exchange rates and stabilize financial markets

2.1.2.2 Intermediate target

The impact of monetary policy on final goals usually takes a certain amount of time Policy latency can range from 6 months to 2 years Because of such a delay, the central bank needs to identify intermediate targets before reaching the final goal If you wait until the economy shows signs and then react, it will be too slow

The criterion for choosing an intermediate target is observable and measurable, controllable, and is closely linked to the final goal According to that criterion, the targets often used as intermediate targets are total money supply (M1 or M2 or M3) or interest rates However, the central bank cannot choose both indicators as intermediate targets This means that the central bank can only choose one of the two criteria If the central bank chooses the

money supply target, the target of interest rate removal must be removed or if the central bank chooses the interest rate target, the money supply control target must be removed

2.1.2.3 Operation target

Intermediate targets may have a direct impact on the ultimate goals of monetary policy but cannot respond immediately when the central bank adjusts monetary policy instruments The operational objective is the variable that is directly affected by monetary policy instruments and signals the view of monetary policy (tightening or easing) The criteria for selecting the operational objectives are the same as the criteria for selecting the intermediate targets Only the criteria selected will be related to the intermediate target Therefore, the choice

of activity target will also depend on whether the central bank chooses money supply or interest rates as an intermediate target With these criteria, the variables selected by the central bank as operational targets include two types: (1) reserves including base or intermediate banks, (2) interest rates such as interbank interest rates, treasury bill rates and open market interest rates

The quick response of these indicators helps the central bank to check the soundness of daily monetary policy decisions Therefore, the ability to influence the final goal (mainly inflation) is also the key factor for the effectiveness of any criteria selected as the operating target The relationship between inflation and interest rates is clearer than the relationship between inflation and reserves, so most central banks in the world have used the short-term interest rate target as their operational goal of monetary policy This is an important theoretical basis for building a research model in chapter 3

2.2 Monetary policy inflation targets

2.2.1 The introduction of inflation targeting framework

In order to effectively operate monetary policy, the central bank needs to choose a nominal ‘anchor’ for monetary policy, such as exchange rates, money supply or inflation This nominal anchorage will 'tightly tie' expectations of inflation, preventing prices from rising or falling too quickly, thereby stabilizing the value of the local currency

In the 1980s, the total amount of money as a nominal anchor for central bank monetary policy failed as inflation continued to rise Developed countries must apply tight monetary policy, causing nominal interest rates to rise, leading to a suspension in economic activities More and more people are distrusting the central bank's monetary policy, even though the central bank is committed to trying to keep inflation at a low level This makes inflation expectations higher and higher Therefore, countries need to find a new anchor for monetary policy In 1989, New Zealand became the first country to target inflation as an anchor for

monetary policy After that, many countries around the world such as Australia, Canada, Finland, and Spain have applied the inflation targeting monetary policy framework

2.2.2 Monetary policy concept of inflation targeting

According to Mishkin (2001), this policy relates to five main components:

(1) Transparent of medium-term goals;

(2) Monetary authorities should have a commitment to price stability as a key term goal of monetary policy implementation;

(3) Information strategy including many variables (not only total money supply or exchange rates) used for establishing policy instruments;

(4) Transparent information about monetary policy through communication with the public and the market about plans and targets set by policy makers;

(5) Strengthen the accountability of the central bank in trying to achieve the set goals

Firstly, Milton Friedman and Edmund Phelps have demonstrated that high inflation does not go hand in hand with high growth rates and high employment rates By accepting this view, policy makers no longer view monetary policy as a management tool in the short term, but instead focus on the medium-term goal of price stabilization, which is also considered central target of inflation targeting policy

Secondly, scientists as well as policymakers realize that the positive side of keeping inflation low; and that positive side is more beneficial than accepting high inflation to keep high economic growth Therefore, price stabilization has become the main goal of central banks

Thirdly, there are many scientific studies on monetary policy that have emphasized the importance of inflation expectations Monetary policy decisions will influence decisions of economic factors If the inflation rate is not fixed, people, businesses will expect the future inflation to continue higher Therefore, the target inflation policy is considered as an effective measure to anchor inflation expectations, thereby, keeping inflation at a low and stable level

2.3.2 Conditions given at the time of application of inflation targeting framework

According to Freedman and Laxton (2009), not all countries must have sufficient prerequisites to apply inflation targeting mechanism The reality of countries that have applied inflation targering shows that many countries only meet some conditions but can still apply the inflation targeting monetary policy framework successfully

2.4 Review of related studies

2.4.1 International research

• Impact of applying inflation targeting monetary policy to the economy:

There are many empirical studies that have demonstrated that the national macroeconomic situation is improved after the application of inflation targeting monetary policy (Bernake et al., 1999; Corbo et al., 2001; Neumann and Von Hagen, 2002) The most evidence is that after applying the inflation targeting policies, these countries have low and stable inflation rates However, there are differences between countries that apply inflation targeting and countries that do not apply inflation targeting in two groups: the group of countries belonging to the Organization for Economic Co-operation and Development (OECD) and Emerging economies Specifically, according to the studies of Ball and Sheridan (2005), Lin and Ye (2007), Angeriz and Arestis (2008), Mishkin and Schmidt-Hebbel (2007), for countries under the Organization for Cooperation and Development, there is no significant difference in the economy (OECD), the difference in inflation and the level of fluctuations in inflation are insignificant between the country applying the target inflation and the country applying the target inflation Meanwhile, in the emerging economies group, the countries that applied the inflation targeting policy had significantly lower inflation rates than those that did not apply inflation targeting policy This has been demonstrated in the studies of Batini and Laxton (2007), Gonϛalves and Salles (2008), and Lin and Ye (2009)

The impact of the global financial crisis of 2008-2009 is a great shock to many economies However, with countries applying the inflation targeting policy, the ability to cope with the crisis is better than the countries that do not apply the inflation targeting monetary policy Although, according to the research of Ball and Sheridan (2005), there is no difference

in inflation and the growth rate between the countries applying the target inflation and those not applying the target inflation in the group OECD countries, however, during the global crisis, countries that apply target inflation have a stable (less fluctuating) inflation rate than countries that do not apply target inflation (Fouejieu, 2013) In a larger study, öztṻrk et al (2014) demonstrated that developed countries and developing countries applying the inflation targeting monetary policy have the ability to overcome the 2008-2009 global financial crisis

compared with non-applicable countries The study also suggests that central banks should consider applying inflation targeting to overcome economic crisis

It is worth noting that there are no studies showing that the application of inflation targeting will be detrimental to growth, output, and employment in developed countries and developing countries No country has given up on inflation targeting after it has been applied

• Conditions for applying inflation targeting monetary policy:

According to International Monetary Fund (2005), the prerequisite conditions for applying inflation targeting monetary policy are institutional independence of the central bank; technical infrastructure development in terms of forecasting, building models and databases; deregulated prices; not too sensitive to prices of basic commodities and exchange rates; low dollarization rate; healthy financial system (especially healthy banks) and developed financial markets

To assess the role of prerequisite conditions before the application of inflation targeting monetary policy, Batini and Laxton (2007) conducted a survey with 21 central banks that applied inflation targeting policy and 10 central banks have not yet applied the inflation targeting policy in emerging economies The survey is sent to the central banks of countries where inflation targeting is focused, with following questions: how has the target inflation policy been developed and implemented? How does the central bank develop a communication policy with the public? How the central bank has changed before and after the application of inflation targeting policy? The survey results show that no country applying inflation targeting monetary policy fully meets the prerequisite conditions when applying this policy In addition, the research results also show that emerging economies do not necessarily meet the institutional, technical, and economic prerequisites before applying inflation targeting Instead, the success of targeting inflation targeting monetary policy depends on the commitment of the governing body and the ability to plan for institutional changes after it has been declared to appply inflation targeting

Another study by De Mello (2008) on the actual situation of applying inflation targeting monetary policy of Brazil, Chile, Czech Republic, Indonesia, South Africa and Turkey has concluded that: When countries applies inflation targeting, there are many prerequisites that these countries cannot achieve However, the author pointed out that failing to meet the monetary conditions before applying inflation targeting does not affect the application of inflation targeting monetary policy of these countries if they always make efforts to improve those conditions

In another study by Freedman and Otker Robe (2009) on the experience of countries that have applied inflation targeting, the study has shown that these countries do not support the view that it is necessary to apply a long list of prerequisite conditions to the application of inflation targeting monetary policy However, in their experiences, there are a number of important factors to implement the inflation targeting mechanism in a feasible manner as follows: (1) price stabilization is the most important goal of all other monetary policy objectives, (2) no fiscal dominance (fiscal dominance), (3) monetary policy instrument independence, (4) high domestic consensus on inflation (5) a clear understanding of the monetary policy transmission mechanism and the ability to affect short-term interest rates, (6)

a healthy market and financial system These are considered factors leading to success in applying inflation targeting policy

In terms of prerequisite conditions for emerging economies, it is argued that these countries do not have the institutional and technical conditions to adopt inflation targeting policies According to the research of Eichengreen, Masson, Savastano and Sharma (1999), they believe that these countries lack the technical conditions and the independence of central banks The results of this study also gained agreement from some other studies such as: Agenor (2000); Carare, Schaechter, Stone and Zelmer (2002); Masson, Savastano and Sharma (1997) Therefore, the researchers recommend that countries should keep the old monetary policy framework when the inflation targeting policy is not fully met However, the central banks of these countries should strive to achieve the conditions to apply inflation targeting Research on the experience of applying inflation targeting to emerging economies also includes studies of Truman (2003), Jonas and Mishkin (2003), Debelle (2001), and Amato and Gerlach (2002)

2.4.2 Domestic research

Among the studies on the application of inflation targeting monetary policy in Vietnam,

To Anh Duong et al (2012) is the most notable one This study begins by reiterating the overall goals of monetary policy Next, the empirical research on the application of inflation targeting policies of developed countries as well as developing countries to draw lessons for Vietnam Through an overview of monetary policy management in Vietnam in the period of 2000-2010, the research team made a comment on the application of inflation monetary policy Although, Vietnam is not eligible to pursue inflation targeting policies, but based on the experience of the previous countries, it is not necessary to converge all the conditions of applying inflation targeting Emerging economies can still successfully apply inflation targeting policy On that basis, the research team proposed the necessary conditions and roadmap for Vietnam to apply inflation targeting monetary policy

In addition, some articles mentioned the framework of inflation targeting policy, the experience of applying inflation targeting monetary policy of countries around the world, the conditions for applying the regulatory mechanism to implement inflation targeting monetary policy in Vietnam such as studies by To Kim Ngoc (2012), To Kim Ngoc and Nguyen Khuong Duy (2012), Ly Ba Hong Son and Nguyen Van Truong (2012), Nguyen Xuan Hung ( 2008), Nguyen Xuan Hung (2009), Nguyen Phuc Canh (2013), Nguyen Thanh Nhan (2010), Do Thi Duc Minh (2003), Nguyen Ngoc Thach (2013), To Kim Ngoc and Le Tuan Nghia (2012)

CHAPTER 3 MODEL AND RESEARCH METHOD 3.1 Research model

In a closed economy, monetary policy decisions affect inflation through interest rates Increasing interest rates will make households and businesses consume and invest less Rising interest rates also cause banks to tighten credit, making individuals and businesses spend less When the economy spends less, the demand for production is less and there is less pressure on prices (due to falling demand)

In an open economy, exchange rates is another channel through which monetary policy decisions affect inflation and inflation expectations While other factors remain constant, the central bank decides to tighten monetary policy through an increase in policy rates, this may increase the value of the local currency Specifically, the increase in interest rates makes attracting more inflows of investment capital from other markets into the domestic market Foreign investors transfer capital to the domestic market, so there will be more demand for local currency The increase in demand for the local currency made the local currency appreciate Assuming all other factors remain constant, the domestic currency will appreciate until the difference between domestic and foreign interest rates is equal to the appreciation of the local currency The relationship between interest rates and exchange rates in this case is expressed by the theory of interest rate parity as follows:

rt - rft = et - E(et + 1) or rt = rft + et - E(et + 1)

Inside:

rt is the domestic interest rate

rf

t is the foreign interest rate

et is the present value of 1 unit of local currency in foreign currency

E(et + 1) is the expectation that the value of 1 unit of local currency is calculated in foreign currency

Any change related to appreciation or depreciation of the local currency not only has a significant impact on the import price of finished goods, but also changes in the price of the first imported goods to serve domestic production activities, indirectly increasing the cost of domestic production and business activities When the local currency is devalued, it will cause higher import prices, moreover, it will also increase marginal costs and lead to an increase in the price of domestically produced goods This is called the direct effect of exchange rates on prices In addition, when the domestic currency depreciates, the price of exported goods will

be cheaper than the foreign market and more expensive than domestic goods Therefore, the increasing demand (for foreign markets) and production (for the domestic market) increase the

production pressure on this item, causing the price of labor and the related domestic materials

to produce this item increased This is the indirect effect of exchange rates on domestic prices

Central banks that conduct inflation targeting monetary policy usually choose the interest rate tool as the main instrument (as analyzed in chapter 2) The operation of interest rate tools will be difficult if the central bank wants to stabilize exchange rates and control inflation Without pressure of exchange rate stabilization, the management of interest rate tools towards stabilizing inflation will be more effective If inflation is at a high risk, the central bank will raise interest rates From the formula of the theory of interest rate parity, the value of the domestic currency will decrease or the exchange rate will increase If the central bank wants to keep the exchange rate stable, that is, do not allow the exchange rate to rise, then raising interest rates will not help the central bank to achieve this goal Therefore, the central bank can only choose one of two goals: stabilize the exchange rate or stabilize inflation

Figure 3.1 Transmission mechanism of interest rate tool

Based on the above analysis, in order to evaluate the effectiveness of the interest rate instrument in operating towards controlling interest rates, and at the same time answering the two research questions in chapter 1, the author uses the vector regression model that includes the following variables: interest rate, exchange rate, aggregate demand and inflation In addition, due to the indirect effect of exchange rates on inflation through domestic and foreign aggregate demand, the model separates the effects of domestic and foreign aggregate demand

on inflation Therefore, the research model can assess the level of transmission of the exchange rate pass-through The lower the level of transmission of the exchange rate into inflation, the easier it is for the central bank to conduct policy towards controlling inflation (Choudhri, Faruqee & Hakura, 2005)