The impacts of monetary policy on output growth and inflation in vietnam, a var approach

This thesis examines the impact of monetary policy on real outputgrowth and inflation of the urban area, rural area and all over of Vietnam by usingthe vector auto-regression VAR focusin

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

THE NETHERLANDSVIETNAM

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACTS OF MONETARY POLICY ON OUTPUT GROWTH AND INFLATION

IN VIETNAM: A VAR APPROACH

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

VO PHUOC THUAN

First of all, I would like to convey sincere thanks to my supervisors Assoc Prof Dr.Nguyen Trong Hoai for his guidance, support and patience ensuring a successfulcompletion of the thesis I wish to thank my co-supervisor Dr Pham Khanh Nam forhis encouragement and willingly supports during the thesis writing process with thevaluable comments and suggestions

I wish to thank all staffs and my fellow classmates at the Vietnam-NetherlandsProgramme for M.A in Development Economics for the devoted support and positiveinteraction throughout the years

I also wish to show my thankfulness to Mr Hoang Quang Hung for his devoted helpand support in the process of the thesis

I also wish to show my thankfulness to the Vietnam-Netherlands Programme forM.A in Development Economics along with all professors at there which haveprovided me the knowledge and opportunity to access the best conditions for mystudy What I have learned from their lectures not only help me get knowledge fordoing the thesis but also provide me more profound understanding on economicsparticularly and life generally

To my family, no word can express all my love to them They have always been mybiggest encouragement I could not have finished this course without them Thankyou, mom and my wife, who always encourage and try their best to give me the bestcondition so that I can complete the thesis

I declare that the Thesis, which I hereby submit for the degree of Master of Arts inDevelopment Economics at the Vietnam -Netherlands Programme For M.A InDevelopment Economics - University of Economics Ho Chi Minh City - Vietnam, isthe result of my own work with the guidance of the supervisors, except whereotherwise stated Other sources are acknowledged by explicit references

I certify that the material contained in this thesis has not been submitted in support of

an application for another degree or qualification in this or any university

VO PHUOC THUAN Date: January 21, 2013

through different channels and the time it needs to take effect are both important,which are "visible hand" that could help the country to get over the challenges toachieve the target This thesis examines the impact of monetary policy on real outputgrowth and inflation of the urban area, rural area and all over of Vietnam by usingthe vector auto-regression (VAR) focusing on the reduced-form relationshipsbetween money supply, real output growth, price level (of the urban area, rural areaand all over of Vietnam), interest rate (lending rate), credit and exchange rate

The result suggests that money supply have impact on real output growth andinflation in the urban area, the rural area and all over of Vietnam but the impacts are

at low percentage The fact that the thesis cannot find out any channel having theimpact on the real output growth, this suggest that monetary policy may take impact

on real output growth through other channels which are not mentioned in this thesis.Among the three mentioned channels there is only credit channel has the impact onthe inflation An increase in domestic credit has the positive effects on inflation Thissuggests the need of a system of policies that manage the credit channel in the rightway to control inflation rates efficiently

Interest rate channel has been found to be a very important channel of monetarytransmission mechanism in other countries but it is not significant in Vietnam Thismeans that interest rate policy has not been implemented in an effective way

There is also destitute evidence of the response of real output growth and inflations

to changes in exchange rate This means that exchange rate does not seem to be animportant channel of monetary policy as well

TABLE OF CONTENT

CHAPTER 1: INTRODUCTION !

1.1 Problem Statement 1

1.2 Significant of the study 2

1.3 Research objectives 3

1.4 Research questions 4

1.5 Thesis Structure 4

CHAPTER II: LITERATURE REVIEW 5

2.1 Theoretical literature review 6

2.1.1 Mechanism of the impact of aggregate demand to output and price level 6

2.1.2 Traditional Keynesian IS/LM model 7

2.1.3 The Mundell-Fleming model 8

2.1.4 Tobin q 's theory 8

2.1.5 Monetary transmission mechanism 9 + The interest rate channel 9

+ The credit channel 10

+ The exchange rate channel 13

2.1.6 Conceptual framework for the study 15

2.2 Previous empirical studies related 16

2.3 Chapter remarks 23 CHAPTER III: ECONOMY PERFORMANCE, FINANCIAL SYSTEM

3.4 Chapter remarks 33

CHAPTER IV: RESEARCH METHODOLOGY 34

4.1 Model specification 34

4.2 Data availability and description 35

4.2.1 Data availability 35 4.2.2 Data description 36

4.2.3 Descriptive analysis of data 40

4.3 Test for stationary property" 40

4.4 Model estimation and regression result .41

4.4.1 Model estimation 41

4.4.2 Regression result 43

a) Basic model 43

b) Extended model with lending rate 47

c) Extended model with domestic credit 49

d) Extended model with exchange rate 51

4.4.3 Chapter remarks 51

CHAPTER V: CONCLUSION, POLICY IMPLICATION, LIMITATION, AND SUGGESTION FOR FURTHER RESEARCHES 53

5.1 Conclusion 53

5.2 Policy implication 55

5.3 Limitation of the study 56

5.4 Suggestion for further researches 56

References 58

LIST OF ACRONYMS AND ABBREVIATIONS

DF test: Dicky Fuller test

E or ER: Exchange rate

ECB: European Central Bank

Gross Domestic Product

General Statistic Office

Interest rate

Investment

Incremental Capital-Output Ratio

Direction of Trade Statistics

International Finance Statistics

International Monetary Fund

Organisationfor Economic Co-operation and Development StatExtracts

Aggregate Demand-Aggregate Supply model

Investment-Saving I Liquidity preference-Money supply model.Money supply

State Bank of Vietnam.

The United States of America.Vector Auto-Regression

Output

likelihood ratio test

Final prediction error

Akaike information criterion

Schwarz information criterion.Hannan-Quinn information criterion

LIST OF FIGURE

Figure 2.1: Keynesian AS-AD model

Figure 2.2: A tight monetary policy of traditional Keynesian ISILM model.Figure 3.1: Economic growth- Source: IMF (2012)

Figure 3.2: Inflation and real GDP growth rate- Source: IMF (2012)

Figure 3.3: Interest rate in Vietnam - Source: State Bank of Vietnam and World

Bank website (2012, accessed on November 10, 2012)

Figure 4.1: Response of real output growth to money supply

Figure 4.2: Response of inflation of the urban area, the rural area and all over of

Vietnam to money supply

LIST OF TABLE

growth, Price level of all over Vietnam, Money supply variables

Table 4.5: Granger causality Wald tests for the basic model with variables of Real

output growth, Price level of the urban area of Vietnam, Money supply.Table 4.6: Granger causality Wald tests for the basic model with variables of Real

output growth, Price level of the rural area of Vietnam, Money supply.Table 4.7: Variance Decomposition for the basic model with variables of Real

output growth, Price level of all over Vietnam, Money supply

Table 4.8: Variance Decomposition for the basic model with variables of Real

output growth, Price level of the urban area of Vietnam, Money supply.Table 4.9: Variance Decomposition for the basic model with variables of Real

output growth, Price level of the rural area of Vietnam, Money supply.Table 4.10: Granger-causality tests for the extended model with variables of Real

output growth, Price level of all over Vietnam, Money supply, andLending rate

Table 4.11: Variance Decomposition for the extended model with variables of Real

output growth, Price level of all over Vietnam, Money supply, andLending rate

Table 4.12: Granger-causality tests for the extended model with variables of Real

output growth, Price level of all over Vietnam, Money supply, andDomestic credit

'

Table 4.13: Variance Decomposition for the extended model with Real output

growth, Price level of all over Vietnam, Money supply, and Domesticcredit variables

Table 4.14: Granger-causality tests for the extended with Real output growth, Price

level of all over Vietnam, Money supply, and Exchange rate variables

Summary statistics of the variables.

Appendix 4: Unit root tests by Augmented Dickey-Fuller (ADF) tests

Appendix 5:

Appendix 6:

Lag length selection of the basic and extended models

Granger causality test

Appendix 7: Impulse response functions

Appendix 8: Variance decomposition

CHAPTER I: INTRODUCTION

1.1 Problem Statement

The world economic crisis beginning in 2008 so far have not seen strong recoverytrend when adverse shocks occur in almost all countries and continents, while therisk of the European debt crisis still implicit throughout 20 11 and extending untilnow

In Vietnam, an important point in 2011 is Resolution 11/NQ-CP of the Governmentwith the aim of curbing inflation and macro-economic stability, according to thetightening monetary and fiscal policies are considered carefully and closelythroughout the year; in which the monetary policy tools have special importance forthe characteristics of Vietnam's economy in influencing the growth andmacroeconomic stability Indeed, current and probably the next few years, the mainsource of capital for the economy has been mobilized and distributed through thebanking system and intermediate credit institutions that these institutions areoperating under the regulation of the monetary policy Therefore, the monetarypolicy is crucial for the movement of investment capital flows and even businessstrategy of the business or business sectors In fact, monetary policy plays a majorrole, not only in supporting the business of working capital, but also creatingconditions for enterprises that have a good business strategy can be utilized toperform long-term development strategy, through investment In addition, Monetarypolicy remains the main tool to price stability, implement foreign trade policythrough exchange rate policy and ensure liquidity in the international payment

affected by the Asian crisis in 1997 much as it is being influenced by the globalfinancial crisis from 2008 to now Being more sensitive to global economy, it ismore crucial to build an effective monetary policy tools system to adjust theeconomy, especially during the recession.

Economic theories and empirical studies shows that shocks in monetary policy couldhave influence in output and inflation through different channels; however, thedetailed impact of those channels on recent Vietnamese economy has not beenstudied quantitatively such as impact of monetary policy on inflation of the urbanarea, the rural area and all over of Vietnam instead of in inflation in general Thiscreates difficulty for policy makers to manipulate the suitable policies to achieve themain objective on each area Therefore, an empirical study of the relationshipbetween monetary policy channels and the macroeconomics variables such as realoutput growth of Vietnam and inflation of the urban area, the rural area and all over

•

of Vietnam with the latest update data from 2005M5 to 20 12M6 is timely andnecessary

1.2 Significant of the study

The relationship between the monetary policy and the outcome of the economysuch as real output growth and inflation raises a lot of concern both theoretical andempirical However, there are still many controversial opinions about the directionthat macroeconomics variables are affected by the monetary policy for differentcountries

Thus far, there have been some studies about monetary policy in Vietnam such as

a study by Hoang (20 10) on the effect and time to take place of a change in moneysupply on real output and inflation through different channels He found consistentevidence that monetary policy has significant effect on real output and price level,but at low percentage; or Camen (2006) on the both external factors and policyfactor on the fluctuation in inflation There are also some other researches focusedparticularly on changes in output caused by the exchange rate ratio However, allthose papers do not point out clearly and directly the direction in which real output

-2-growth in Vietnam changed due to monetary policy shocks and do not mention theimpact of monetary policy on inflation in the urban and rural area; or the most recentstudy of Bui (20 11) focus on the effects of money growth on inflation in Vietnamand study of Nguyen (2012) identify the role of credit in monetary mechanism inVietnam in which relationship between output, inflation and monetary policychannels has been mentioned and clarified However, these studies also do notmention the impact of monetary policy on inflation in the urban and rural area ofVietnam Furthermore, most of the studies (with data updated to the end of2010) areobsolete data and therefore do not take into account the recent inflation as well as thecurrent world financial crisis has led to a series of changes in the environment andmacroeconomic policy; so the result seems to be not up-to-date.

This study, therefore, is timely and relevant to the current circumstance of Vietnam

as it helps policy makers to manipulate the monetary policy in order to achieve the

further researches on monetary policy as well as other policies in each rural area,urban area and all over of Vietnam, contributing a more understanding about theevolution of the Vietnam money market Furthermore, this study, somehow, adds tothe wide knowledge of monetary transmission mechanism of the urban area, the ruralarea and all over of Vietnam and in different countries in reality

1.3 Research objectives

The main objectives of this thesis is:

output growth and inflation) of Vietnam

1.4 Research questions

•

This thesis aims at answering the following research questions:

rural area and all over of Vietnam affected by monetary policy?

the urban area, the rural area and all over of Vietnam changes when there are changes inmonetary policy from the State Bank of Vietnam and how significant are those changes?

real output growth of Vietnam and inflation rate of the urban area, the rural area and all over ofVietnam?

used by the State Bank of Vietnam?

1.5 Thesis structure

statement, the significance of the study as well as the research objectives andresearch questions The second chapter summaries the related literature reviews Inthe third chapter, an overview of Vietnam economy performance, financial systemand monetary policy tools in Vietnam are introduced Chapter four will point out themethodology used in the regression model of the study gives the estimated result anddiscuss its policy implications for Vietnam The final chapter summaries the study,its policy implication as well as its limitation and suggest areas for further researches

•

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4-CHAPTER II: LITERATURE REVIEW

Monetary policy is considered to be an important policy of almost every country,which is one of the two main tools of Governmental intervention to the economy as

economic growth, price stability and low rate of unemployment and even though

what would be done, though less quickly and commodiously, without it", but it is an

extremely efficient machine with special features Monetary policy can helppreventing the economic disturbance from money itself and other sources as well asproviding a stable economic background According to Friedman, exchange rates,the price level and the amount of aggregate money (currency and adjusted demanddeposits) are among the most important tools for policy makers (Friedman

(1968))

An examination of the theoretical and the empirical analysis leads to theconsideration of various potential monetary policy tools that is necessary for thestudies of the effects of monetary policy to two macroeconomic variables: realoutput growth and inflation

Therefore, this chapter is divided into two main parts: Theoretical literature reviewand previous empirical studies related The theoretical literature review part refers tothe related theories of monetary policy such as Keynesian AS-AD model on themechanism of the impact of aggregate demand to output and price level, thetraditional Keynesian IS/LM model, the Mundell-Fleming model, Tobin q's theory,

2.1 Theoretical literature review

2.1.1 Mechanism of the impact ofaggregate demand to output and price level

As you have seen that both monetarists and Keynesians agree that the aggregatedemand curve is downward-sloping and shifts in response to changes in the moneysupply However, monetarists see only one important source of movements in theaggregate demand curve- changes in the money supply- while Keynesians suggestthat other factors - fiscal policy, net exports, and "animal spirits" - are equallyimportant sources of shifts in the aggregate demand curve Therefore, althoughMishkin (1995, 1996, 2001) did not mention about a change in output and price level(or inflation), we can easily infer this change based on AD-AS model In AD-AS

6

-2.1.2 Traditional Keynesian IS/LM model

The relationship between interest rate and output has been discovered and explainedvery early in the traditional Keynesian IS-LM model Suppose that the Central bank

is following a tight monetary policy by reduce money supply, the real money

balance MIP will then decrease (P is unchanged in short run) and the LM curve will

shift to the left (from LMl to LM2 in figure 2.2) implies that the demand for money

is higher than the supply one, therefore people will sell bonds to receive cash whichthen makes an increase in interest rate This in tum raises the capital cost forproduction, hence results in a reduction in investment spending and net export Thenew equilibrium in the IS-LM model will move along the IS curve showing a decline

in output This progress can be summarized by a schematic

connection from Mishkin (1995) "Ms! + i j + 1!, NX! +

11

Further studies confirm that beside businesses' investment spending, a fall ininvestment could also be understood as a postponement in consumers' residentialhousing and consumer durable expenditure.

2.1.3 The Mundell-Fleming Model

By adding the effects of international trade and finance to the traditional IS/LMmodel, the Mundell- Fleming Model extends the explanation of response of output tomonetary policy shocks for an open economy with imperfect capital mobility.Suppose that an expansion in money supply is implied by the central bank Then, thereal money balances will increase, shifting the LM curve to the right Interest rate, as

a result, will fall below the world interest rate r* making a flow of capital out of theeconomy Furthermore, an increase in the amount of investment to other countriesraises the demand for foreign currency so, causing the domestic currency todepreciate in value This depreciation, then, make domestic goods become relativelycheaper than foreign goods so spur net export and increase output

2.1.4 Tobin q's theory

A famous Tobin'q theory of investment gives another systematic formal account ofthe link between stock prices and business investment and then on output In his

holding a share increase, which make shares become relatively less attractive thanbond Consequently, financial investors will sell off their shares of the firm to buy

leads to a decline in qt which also equal to the fact that the marginal benefit frominvestment (i.e the gain qt in the value of shares resulting from the installation of anextra unit of capital) will also reduce At the optimal level of investment, themarginal dividend forgone is just compensated by the extra capital gain on shares.Clearly, the lower the market valuation qt of an extra unit of capital, the lowerchance the firm can push its level of investment before the marginal installationcost reaches the threshold where the shareholder's

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8-additional capital gam is offset by the extra dividend forgone Therefore, firms maynot purchase new investment goods when the value of qt is low so that investmentwill decrease causing output to fall This relationship between value of q andinvestment is then mentioned by Mishkin ( 1996) as the following equity channel of

2.1.5 Monetary transmission mechanism

policy is translated into changes in output, employment, prices and inflation"

(Samuelson and Nordhaus (2010), p 211) In Vietnam, monetary policy caninfluence the economy through three main channels: interest rate channel, creditchannel and exchange rate channel Since Vietnam stock market is at very low stage

of development thus VNINDEX subjects to speculation and housing index is notavailable in the economy, therefore the thesis do not introduce and explore Equityprice channel and Real estate channel

In this part, three main channels mentioned above will be presented in greater detail

as following:

~ The interest rate channel

In his research on monetary transmission mechanism, Taylor (1995) emphasizes thatinterest rate is a key component of how monetary policy affects the economy He pointsout that there is a circle relationship between the movements in real GDP and inflationand the short-term interest rate As his explanation, a change in the short-term interestwill affect both the long-term interest rate2 and the exchange rate although it is not the

constituents of GDP, hence leads to a change in real GDP In long run, real variablesreturn to their normal value when wages and goods prices are not rigid In tum, thechange in real GDP and inflation will also have effect on the short rate In the case ofzero nominal interest rate, a decrease in real interest rate still can stimulate theeconomy by the expected price level and expected inflation An expansion in thebroad money makes the expected price level and thereby the expected inflation goes

up As the result, the real interest rate decrease and investment, net export and hence

rate as a strong monetary channel that affects output

According to Mishkin (2006), expansionary monetary policy (increasing money

capital is lowered The fall in real interest rate induces businesses to increasespending on investments spending and consumers to increase their housing anddurable expenditures, which are also considered investment This increase in

output (Y) This process is illustrated in the following schematic:

> The credit channel

Mishkin (1996) demonstrated in his paper three reasons explaining the importance ofcredit channels to the economy Firstly, the effect of credit market imperfection tothe firms' decision on input and output such as the number of workers and machines

is widely accepted Secondly, there is empirical evidence that small companies whoface credit constrained are more affected by monetary policy than large firms.Finally, he pointed out that asymmetric information in the imperfect credit marketalso helps to clarify some economic phenomena

3

Notation are same as previous one, Pe, 1te are expectation of price level and expectation of inflation,

respectively.

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10-Inearlier research by Bemanke and Gertler (1995), the monetary policy transmission

is compared with a "black box" and due to the dissatisfaction with lack of empiricalproof of interest rate channel effects, they suggested that credit channel has its ownrole in explaining the impact of monetary policy to the economy and using thecomplementary movement in the external finance premium along with interest ratemay help to bring a better explanation This credit channel accounts for the agencyproblems of asymmetric information and costly enforcement of contracts arise in thefinancial market and is divided into two specific channels: the bank lending channeland the balance sheet channel

The bank lending channel explains the effects of monetary policy through the

change in the supply of intermediated credit or bank loans In the credit market,banks play an important role in solving the asymmetric information problem as itseems that bank loans cannot be substitute perfectly with other sources of funds.Hence, despite the fact that large firms may directly access the stock and bondmarkets to get the credit without going through banks, small and medium-sized firmswill still depend mostly on borrowing from banks for their investment Consequently,

a decrease in bank reserves and bank deposit due to a contraction of monetary policywill reduce the volume of bank loans and in tum will cause investment to decline.This is result from the fact that that when the bank loans decrease, firms need to findnew lenders and establish a new credit relationship which are costly to firms and arelikely to reduce firms' performance in reality, which means that investment declines.Output will then go down as a result The effect is described in the schematic

easier for the banks to deal with the deposits reduction difficulty during a monetarycontraction This fact along with the drop of the traditional bank lending business allover the world make the role of the banks as well as the availability of bank lendingchannel less important (Edwards and Mishkin (1995).

The balance-sheet channel (or the net worth channel) explains the effects of monetarypolicy to the economy base on the change in borrowers' balance sheets and incomestatements The former one is affected in different ways

A decline in money supply induced by a monetary contraction may account for alower equity prices (P e) This lower net worth raises the problems of adverseselection and moral hazard The former happens because a drop in net worth willlower value of collateral for lenders' loans and they suffer from higher looses Moralhazard problem happens due to the fact that when the equity value of firms reduces,they may have more incentive to invest in riskier portfolios and loans are more likely

to be defaulted So that, a fall in a firm's net worth might result in a decline inlending and thereby, in investment Thus, the output or aggregate demand willdecrease as well This process can be described as follows: "Ms! -+ Pe! -+adverse selectionj, moral hazardj -+ lending! -+ I! -+ Y !"(Mishkin, 1995)

Cash flow channel

Furthermore, a tightening of monetary policy may also push up interest rate whichleads to a deterioration of firm's balance sheets because of a lower cash flow, ahigher interest rate and hence a rise in the chance of adverse selection and moralhazard problem Stiglitz and Weiss (1981) called this phenomenon "credit rationing"where firms who are willing to pay the highest interest rate are those who have theriskiest investment This change builds up a "financial pressure" that account for thedrop in investment and hence the fall in output

"Ms! -+ ij -+ cash flow! -+ adverse selectionj, moral hazardj -+ lending! -+ I! -+ Y !" (Mishkin, 1995)

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12-Unanticipated price level channel

A third way that to describe the link between output and change in the monetarypolicy is through the price level A money supply reduction may cause anunanticipated fall in the price level because of nominal price rigidity in contracts Aresult of this is a decline in the real net worth which then increases the problem ofadverse selection and moral hazard The continued effects are as previous case an can

be summarized as "Ms t unanticipated P t adverse selection j, moral hazardj

Household liquidity effects

The theory of credit channel on business asset is similarly applied to consumerspending by Bemanke and Gertler (1995) A tightening monetary policy may leads

to a lower equity prices as explanation above, hence, consumers might meet a higherpossibility of financial distress (i.e their financial assets such as stock and bondprice is lower) and it is likely that they may prefer the more liquid asset rather thanthe illiquid one This results in a decline in the consumption of durable goods andhousing and in tum a fall in output Mishkin (1995) summaries this process asfollows:

"Ms t - Pet - financial assetst - likelihood of financial distressj - consumer durableand housing expendituret- Y t"

~ The exchange rate channel

To an open economy, net export is impacted by the exchange rate so that onechannel that monetary policy can influence the economy is through the exchange rate

domestic currency which makes domestic goods become relatively more expensivethan foreign goods so that import is stimulated while export reduces Consequently,net export will decline causing a fall in output This relationship can be seen in the

~ ij ~ Et ~ NX! ~ Y!4".

A research from IMF ( 1996) on 145 countries during 30 years considering the effect

of different exchange rate regime to macroeconomic performance gives theconclusion that countries with fixed exchange rate regime can achieve lower inflation

pegged exchange rate regime, therefore, is considered to be an anti-inflationary toolbut equally, output growth and employment are at risk of higher volatility FromRadzyner and Riesinger (1997)'s point of view, a pegged or fluctuation with narrowbands exchange rate reduce the possibility of using exchange rate as an effectivemonetary policy tool They also suggested that Central bank should be allowed tocreate monetary policy autonomously independent with the Government

When it comes to macroeconomics view, it seems to be a trade-off between lowinflation rate and high output growth as evidences show that countries with fixedexchange rate are likely to achieve lower economic growth than countries that allowexchange rate to fluctuate with less control This is due to the effect of exchange rate

on investment and productivity On one hand, a country that follows a fixedexchange rate regime was able to have higher investment by reducing theuncertainties in policy making process and bringing lower interest rate On the otherhand, it might achieve a lower rate of productivity growth due to the misallocation ofresources, in case the exchange rate fixed is the wrong one In other way, countriesthat allow the exchange rate to fluctuate will catch up better with the true price in theexchange rate market, which help to reduce price distortion and

4 The notation M5, i, E, NX, Y stands for Money supply, interest rate, Exchange rate (domestic currency to foreign currency), Net export and Output, respectively.

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14-make a better resources allocation In

brief, drawn that growing pace is often

higher regime IMF (1996)

considering both effects, a conclusion

is in country with floating exchange rate

2.1.6 Conceptual framework for the study

CENTRAL BANK OBJECTIVES

POLICY

MONEY SUPPLY

CREDIT

-15-2.2 Previous empirical studies related

Along with a wide variety supporting theories, there are many researches on therelationship between monetary policy tools and macroeconomics indicators Manystudies focus on the monetary transmission mechanism in different period such asthe studies of Bemanke and Blinder (1992) and Bemanke and Gertler (1995) for theUnited State The study also applied for many different countries such as Disyatatand Vongsinsirikul (2003) build a VAR model for Thailand; Morsink and Bayoumi(1999) examines the case of Japan and Hsing (2004) works through the data ofVenezuela

In many VAR-based researches, short-term interest rates have been used as apreferred indicator of monetary policy stance An example of this is the conclusion

of Bemanke and Blinder (1992) about the particular role of Federal Funds Rate as themain monetary policy tool implemented by Fed over 30 years However, the theory

of interest rate transmission mechanism is highly controversial as there is mildevidence of the quantitative effect of interest rate through the neoclassical cost ofcapital variable Dimitriu et al (2009) in Romania showed in their VAR innovationresponse analysis, inflation had significant responses to shocks from interest ratesand industrial production reacted significantly to the interest rates variation.Conversely, the studies of Boivin and Giannoni (2002) point out the decreasingresponse of real output to the interest channel since 1980s in U.S Empirical research

on the "Tobin's q" formulation has no more success Due to this observation, manyother researchers, for example Bemanke and Gertler (1995) suggest that othermechanism rather than interest rate may also be the transmission of monetary policy

the conclusion that devaluations have negative impact on output for the short period

of one year and after that, with other variables kept constant, real devaluationsaffects output in a positive way and in long run, the effect is neutral Likewise, theresults from the study by Dumitriu et al (2009) in Romania also showed that inflationand industrial production have significant responses to shocks from exchange rate.Another research by Al-Mashat and Billmeier (2007) in Egypt through evaluated themonetary channels in a VAR model showed that the exchange rate channel play animportant role in the transmission of the monetary stance Most other channels arequite weak

There are several researches on response of output growth and inflation to monetary

money supply, inflation and output growth point out that the rate of changes in ERshas altered significantly the Granger-causality between output growth, inflation, andmoney growth The changes in nominal ERs (in the cases of OERs and SERs)served, albeit inconsistently, as a leading indicator for output growth, but thiscausality was not stable Current inflation and (real industrial) output growth havebeen mostly explained by their past movements Real depreciation rates have had apositive and rather significant impact on output growth, though the magnitude wasvery unstable Le and Wade (2008) also build a VAR model on the reduced-formrelationships between money, real output, price level, real interest rate, real exchangerate and credit They found evidence that monetary policy can affect real output andprice level and that the effect of monetary policy on output was strongest after fourquarters but it took longer for monetary policy to have effects on the price level,specifically from the third to the ninth quarter However, the significance of eachchannel was weak, and the credit and exchange rate channels appeared to be the mostsignificant channels or the thesis of Hoang (20 10) is also analyzing the monetarytransmission mechanism in Vietnam by using the VAR approach and focusing on thereduced-form relationships between money, output, output's components, price level,interest rate, real exchange rate and credit He found

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17-consistent evidence that monetary policy has significant effect on real output andprice level, but at low percentage Credit affects output at a significant level whileinterest rate and exchange rate do not Interest rate, exchange rate and credit do notaffect price level at any significant level while monetary policy do affect The factimplies that monetary affects price level through another channel The most recentstudies on monetary transmission in Vietnam are thesis of Bui (20 11) on the effects

of money growth on inflation in Vietnam from 2004 to 2010 She found out asignificantly positive impact of money growth on inflation in long-run and short-run.Credit channel plays an important role in monetary transmission in Vietnam case andinterest rate have bi-directional causality to inflation and money supply, but thecorrelation between lending channel and monetary policy is quite weak; and thesis ofNguyen (2012) on the role of credit and monetary transmission in VietNam, theempirical results support that all the independent variables do not Granger causalitywith money supply in classical market Money supply can help to predict most ofdependent variable in market without credit, excepting the lending rate and viceversa In augmented market, domestic credit is significant to predict money supply.Besides, price level and lending rate are also help to predict money supply but theycannot predict money supply in classical market; and the lagged value of moneysupply can not forecast credit, output and lending rate She also found that in classicalmarket (in case of tightening monetary policy), the output and refinancing rateresponse to money policy shock after one lag The output responses quite sensitive tomoney shock whereas lending channel responses to money shock are short andsometimes abnormal For market with credit, credit channel played as importantchannel in monetary policy mechanism in Vietnam case

Authors Time Observ Endogenous Exogenous Research Key Findings

Period ations Variables Variables Method

effect on output.

monetary policy innovations

circumstantial evidence that this channel is operative, even though loans do not Granger-cause

unem_ployment.

bank lending channels have played important roles in the housii!K market.

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19-Vo, et a/ Jan1991 101 Exchange rate, Official Time series data The rate of changes in ERs (2001) - Jun Monetary exchange UseVAR has altered significantly the

1999 aggregates rate (OER), models, Co- Granger-causality between

(currency in Selling integration output growth, inflation, and circulation CU, interbank techniques, Error money growth.

M1, and M2), Real exchange Correction The changes in nominal ERs industrial output, rate (SER), Model (ECM) (in the cases of OERs and Consumer Price parallel and simple SERs) served, albeit Index selling Lucas-type inconsistently, as a leading

exchange production indicator for output growth, rate in Ho function but this causality was not Chi Minh stable Current inflation and

parallel explained by their past

exchange depreciation rates have had a

Hanoi significant impact on output

magnitude was very unstable.

Boivin 1960 42 Output, inflation, Time series data The change in the and 2001 and interest rates Use VAR model propagation mechanism has

VARs a large extent This change

has been associated further with a diminished effect of monetary policy shocks on output and inflation.

Disyatat 1993Q1- 36 Real GDP, Baht/US Time series data The stylized facts about and 2001Q4 Consumer Price exchange Use VAR model the response of the Vongsinsi Index (PRICE), rate to analyze economy to a tightening of

(2003) repurchase rate decompositions, + The aggregate price

(RP14), private and impulse level initially responds consumption, response very little, but starts to investment, functions decline after about a year

imports, bank + Output follows a

rate (REER), asset quarters and dissipating prices, interest rate after approximately 11

quarters.

+ Investment appears to be

the most sensitive component of GDP to monetary policy shocks Hsing 1961 40 Real GDP, real M2, World Time series data Real GDP responds (2004) 2001 real government output, Use V AR model positively to a shock to real

deficit, real world to analyze M2, government deficit exchange rate, crude oil variance spending, real exchange rate inflation rate price decompositions, depreciation, and the lagged

and impulse real output had a significant response negatively response to a functions shock to the inflation rate

-20-during some of the time periods Except for lagged output, government deficit spending and inflation rate are the most influential variable in first year, and real M2 and the real exchange rate are more influential and longer-term impacts the first year.

Al-Mashat Jan1996 114 Real (distributed) Crude oil Time series data The exchange rate channel and Jun GDP, Wholesale price and Use VAR model plays an important role in Billmeier 2005 Price Index, u.s. in reduced form the transmission of (2007) Monetary Policy Federal to analyze the monetary stance Most other

Stance Index and Funds Rate Granger channels are quite weak Nominal Effective causality tests,

Exchange Rate, variance Interest rate (three- decompositions,

rate), Domestic response credit, Asset Price, functions Reserve Money.

Le and 1996Q2- 39 Real Industrial World Oil Time series data Monetary policy can affect Wade 2005Q4 Output, Consumer Price, Use VAR model real output; the connection (2008) Price Index, Broad World Rice in reduced form between money

Money, Real Price and to analyze the inflation is less clear in the Lending Rate, Federal Granger Vietnam case; the credit and Index of the Real Funds Rate causality tests, exchange rate channels are Effective Exchange variance more important than Rate and Domestic decompositions, interest rate channel.

response functions Dimitriu Jan2000 84 Consumer Price Time series data Inflation and industrial

et a! - Dec Index, Exchange Use VAR model production have significant (2009) 2006 Rate (ROL/EUR), to analyze the responses to shocks

Industrial variance exchange rate, interest rates Production, Money decompositions and money supply.

supply (M2), Government Credit, Three month offered interest rate from Romanian

Non-Interbank Offered Rate

•

21

-Hoang 1999Q1 - 45 Real GDP and its 3 World Oil Time series data Monetary policy

Consumer Price World Rice in reduced form output and price level, but at

components, and monetary policy do affect inflation

Co integration inflation and money supply, test to investigate but the correlation between

influence of monetary policy is quite

on inflation; and use Vector Error Correction model (VECM), Granger causality tests, variance decompositions, and impulse response functions to exemmine the short-run impact

of money on inflation

decompositions, with credit, credit and impulse played as important channel

output strong responses credit shock after one lag.

Source: Author's summarization

•

-22-2.3 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

To clarify this relationship, the Keynesian AD-AS model is used Under KeynesianAS-AD model, an increase in money supply will shift aggregate demand curverightward in the short term As a result, the economy moved to a new equilibriumwith higher output and price level To study Aggregate Demand, the theories ofTraditional Keynesian ISILM model, the Mundell-Fleming Model and Tobin q'stheory are studied and used in the thesis Experimentally, through the researchstudies in the world and Vietnam, the topic of the impact of monetary policy on theeconomy mainly used the VAR model, focusing on three main channels such asinterest rate channel, credit channel and exchange rate channel Therefore, the thesiswill also use the VAR model with three mentioned above channels to study theimpacts of monetary policy on Vietnam economy for the period from 2005M5-2012M6

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