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 output growth and inflation of the urban area, rural area and all over of Vietnam by using the vector auto-regression VAR focus

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACTS OF MONETARY POLICY ON OUTPUT GROWTH AND INFLATION

IN VIETNAM: A V AR APPROACH

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

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

VO PHUOC THUAN

Academic Supervisor:

Assoc Prof Dr NGUYEN TRONG HOAI and Dr PHAM KHANH NAM

HO CHI MINH CITY, JANUARY 2013

ACKNOWLEDGEMENT

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 successful completion of the thesis I wish to thank my co-supervisor Dr Pham Khanh Nam for his encouragement and willingly supports during the thesis writing process with the valuable comments and suggestions

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

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

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

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

CERTIFICATION

I declare that the Thesis, which I hereby submit for the degree of Master of Arts in Development Economics at the Vietnam -Netherlands Programme For M.A In Development Economics - University of Economics Ho Chi Minh City - Vietnam, is the result of my own work with the guidance of the supervisors, except where otherwise 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

ABSTRACT

Understanding of monetary policy and the way it is transmitted to the economy 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 to achieve the target This thesis examines the impact of monetary policy on real output growth and inflation of the urban area, rural area and all over of Vietnam by using the vector auto-regression (VAR) focusing on the reduced-form relationships between money supply, real output growth, price level (of the urban area, rural area and all over of Vietnam), interest rate (lending rate), credit and exchange rate

The result suggests that money supply have impact on real output growth and inflation 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 the impact 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 on the inflation An increase in domestic credit has the positive effects on inflation This suggests the need of a system of policies that manage the credit channel in the right way to control inflation rates efficiently

Interest rate channel has been found to be a very important channel of monetary transmission mechanism in other countries but it is not significant in Vietnam This means 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 an important 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 1 0 + 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 AND MONETARY POLICY TOOLS IN VIETNAM 24

3.1 Economy performance 24

3 1.1 Economic growth 24

3 1.2 Inflation and output growth 25

3.2 Finacial system and the role of Central Bank in Vietnam 26

3.3 Monetary policy 29

3.3.1 Legal framework 29

3.3.2 Monetary policy tools 30

•

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

Dicky Fuller test

Gross Domestic Product

General Statistic Office

Interest rate

Investment

Incremental Capital-Output Ratio

Direction of Trade Statistics

International Finance Statistics

International Monetary Fund

Organisation for Economic Co-operation and Development StatExtracts

Aggregate Demand-Aggregate Supply model

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

Broad money or high-powered money

Nominal Effective Exchange Rate

Real Effective Exchange Rate

Net export

Orthogonalized Impulse Response Function

Consumer Price Index

Expected Price Level

Equity price

•

1te : Expected inflation

SBV: State Bank of Vietnam

VAR: Vector Auto-Regression

LR: likelihood ratio test

FPE: Final prediction error

AIC: Akaike information criterion

SC: Schwarz information criterion HQ: Hannan-Quinn information criterion

Keynesian AS-AD model

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

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

Interest rate in Vietnam - Source: State Bank of Vietnam and World Bank website (2012, accessed on November 10, 2012)

Response of real output growth to money supply

Response of inflation of the urban area, the rural area and all over of Vietnam to money supply

Response of real output growth to money supply, and price level to money supply

Response of domestic credit to money supply, price level to money supply, and price level to domestic credit

'

LIST OF TABLE

Table 4.1: Summary of data

Table 4.2: Stationary tests for variables in level

Table 4.3: Stationary tests for variables in percentage change

Table 4.4: Granger causality Wald tests for the basic model with Real output

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, and Lending rate

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

output growth, Price level of all over Vietnam, Money supply, and Lending 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, and Domestic credit

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

growth, Price level of all over Vietnam, Money supply, and Domestic credit 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

•·

LIST OF APPENDIX

Appendix 1: Vietnam's export and import revenues with 25 biggest trading

partners from 2005Month5- 2012Month6

Appendix 2: Dataset

Appendix 3: Summary statistics of the variables

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

Appendix 5: Lag length selection of the basic and extended models

Appendix 6: 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 recovery trend when adverse shocks occur in almost all countries and continents, while the risk of the European debt crisis still implicit throughout 20 11 and extending until now

In Vietnam, an important point in 2011 is Resolution 11/NQ-CP of the Government with the aim of curbing inflation and macro-economic stability, according to the tightening monetary and fiscal policies are considered carefully and closely throughout the year; in which the monetary policy tools have special importance for the characteristics of Vietnam's economy in influencing the growth and macroeconomic stability Indeed, current and probably the next few years, the main source of capital for the economy has been mobilized and distributed through the banking system and intermediate credit institutions that these institutions are operating under the regulation of the monetary policy Therefore, the monetary policy is crucial for the movement of investment capital flows and even business strategy of the business or business sectors In fact, monetary policy plays a major role, not only in supporting the business of working capital, but also creating conditions for enterprises that have a good business strategy can be utilized to perform long-term development strategy, through investment In addition, Monetary policy remains the main tool to price stability, implement foreign trade policy through exchange rate policy and ensure liquidity in the international payment Because of the above reasons, the understanding of monetary policy and their effect

on the macro-economic stability is becoming significantly important to Vietnamese authorities

Furthermore, it is often said that the more open and developed Vietnam is, the easier the economy to be affected by international circumstance as Vietnam was not

•

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

Economic theories and empirical studies shows that shocks in monetary policy could have influence in output and inflation through different channels; however, the detailed impact of those channels on recent Vietnamese economy has not been studied quantitatively such as impact of monetary policy on inflation of the urban area, the rural area and all over of Vietnam instead of in inflation in general This creates difficulty for policy makers to manipulate the suitable policies to achieve the main objective on each area Therefore, an empirical study of the relationship between monetary policy channels and the macroeconomics variables such as real output 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 and necessary

1.2 Significant of the study

The relationship between the monetary policy and the outcome of the economy such as real output growth and inflation raises a lot of concern both theoretical and empirical However, there are still many controversial opinions about the direction that macroeconomics variables are affected by the monetary policy for different countries

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

a study by Hoang (20 1 0) on the effect and time to take place of a change in money supply on real output and inflation through different channels He found consistent evidence 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 policy factor on the fluctuation in inflation There are also some other researches focused particularly on changes in output caused by the exchange rate ratio However, all those papers do not point out clearly and directly the direction in which real output

growth in Vietnam changed due to monetary policy shocks and do not mention the impact of monetary policy on inflation in the urban and rural area; or the most recent study of Bui (20 11) focus on the effects of money growth on inflation in Vietnam and study of Nguyen (2012) identify the role of credit in monetary mechanism in Vietnam in which relationship between output, inflation and monetary policy channels has been mentioned and clarified However, these studies also do not mention the impact of monetary policy on inflation in the urban and rural area of Vietnam Furthermore, most of the studies (with data updated to the end of2010) are obsolete data and therefore do not take into account the recent inflation as well as the current world financial crisis has led to a series of changes in the environment and macroeconomic 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 main target in real output growth and inflation control It can also be a suggestion for 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 the evolution of the Vietnam money market Furthermore, this study, somehow, adds to the wide knowledge of monetary transmission mechanism of the urban area, the rural area and all over of Vietnam and in different countries in reality

1.3 Research objectives

The main objectives of this thesis is:

• to clarify the relationship between monetary policy and real economy (real output growth and inflation) of Vietnam

• to clarify the difference of impact of monetary policy on inflation of the urban and the rural area ofVietnam separately

• to clarify the impact of each channel in the three main monetary channels (interest rate channel, credit channel and exchange rate channel) on real

•

•

1.4 Research questions

This thesis aims at answering the following research questions:

• Do real output growth of Vietnam and inflation rate of the urban area, the rural area and all over of Vietnam affected by monetary policy?

• If yes, what direction does real output growth of Vietnam and inflation rate of the urban area, the rural area and all over of Vietnam changes when there are changes in monetary policy from the State Bank of Vietnam and how significant are those changes?

• How long does it take the changes in the monetary policy to the changes in the real output growth of Vietnam and inflation rate of the urban area, the rural area and all over of Vietnam?

• On the basis of research results, what is the most useful channel that is being used by the State Bank of Vietnam?

1.5 Thesis structure

The thesis is organized into six chapters The first chapter shows the problem statement, the significance of the study as well as the research objectives and research questions The second chapter summaries the related literature reviews In the third chapter, an overview of Vietnam economy performance, financial system and monetary policy tools in Vietnam are introduced Chapter four will point out the methodology used in the regression model of the study gives the estimated result and discuss 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

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 the "visible hand" It is widely accepted that monetary policy's main goals are economic growth, price stability and low rate of unemployment and even though

sometimes it is considered as the machine ''for doing quickly and commodiously,

extremely efficient machine with special features Monetary policy can help preventing the economic disturbance from money itself and other sources as well as providing a stable economic background According to Friedman, exchange rates, the price level and the amount of aggregate money (currency and adjusted demand deposits) are among the most important tools for policy makers (Friedman (1968))

An examination of the theoretical and the empirical analysis leads to the consideration of various potential monetary policy tools that is necessary for the studies of the effects of monetary policy to two macroeconomic variables: real output growth and inflation

Therefore, this chapter is divided into two main parts: Theoretical literature review and previous empirical studies related The theoretical literature review part refers to the related theories of monetary policy such as Keynesian AS-AD model on the mechanism of the impact of aggregate demand to output and price level, the traditional Keynesian IS/LM model, the Mundell-Fleming model, Tobin q's theory, monetary transmission mechanism and conceptual framework for the study to serve the study of the thesis The previous empirical studies related part reviews the similar empirical studies in the world and Vietnam to learn for my study Details of each part are introduced in detail in the following items:

2.1 Theoretical literature review

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

As you have seen that both monetarists and Keynesians agree that the aggregate demand curve is downward-sloping and shifts in response to changes in the money supply However, monetarists see only one important source of movements in the aggregate demand curve- changes in the money supply- while Keynesians suggest that other factors - fiscal policy, net exports, and "animal spirits" - are equally important sources of shifts in the aggregate demand curve Therefore, although Mishkin (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 model, a rise in money supply shifts the aggregate demand curve from AD! to AD2

moves the economy from point E I to point E2 which leads to an increase in output from YI to Y2 and price level from PI to P2 (Mishkin (1995))

Figure 2.1: Keynesian AS-AD model

2.1.2 Traditional Keynesian IS/LM model

The relationship between interest rate and output has been discovered and explained very 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 which then makes an increase in interest rate This in tum raises the capital cost for production, hence results in a reduction in investment spending and net export The new 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! + Y !"1

11

Figure 2.2: A tight monetary policy

8

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

2.1.3 The Mundell-Fleming Model

By adding the effects of international trade and finance to the traditional IS/LM model, the Mundell- Fleming Model extends the explanation of response of output to monetary policy shocks for an open economy with imperfect capital mobility Suppose that an expansion in money supply is implied by the central bank Then, the real 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 the economy Furthermore, an increase in the amount of investment to other countries raises the demand for foreign currency so, causing the domestic currency to depreciate in value This depreciation, then, make domestic goods become relatively cheaper 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

of the link between stock prices and business investment and then on output In his paper, Tobin (1969) denote "q" as the ratio of market value of shares (V1) per unit of capital (K1) as q1=V1/K1• When the interest rate r increase, the opportunity cost of holding a share increase, which make shares become relatively less attractive than bond Consequently, financial investors will sell off their shares of the firm to buy bonds, and the market value of shares V1 will drop The decrease

in the share price leads to a decline in qt which also equal to the fact that the marginal benefit from investment (i.e the gain qt in the value of shares resulting from the installation of an extra unit of capital) will also reduce At the optimal level of investment, the marginal 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 lower chance the firm can push its level of investment before the marginal installation cost reaches the threshold where the shareholder's

additional capital gam is offset by the extra dividend forgone Therefore, firms may not purchase new investment goods when the value of qt is low so that investment will decrease causing output to fall This relationship between value of

q and investment is then mentioned by Mishkin ( 1996) as the following equity channel of the monetary transmission mechanism "Ms t ~Pet~ qt ~It~ Y f'

2.1.5 Monetary transmission mechanism

Monetary transmission mechanism is defined as "the route by which monetary

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

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

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

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

as following:

In his research on monetary transmission mechanism, Taylor (1995) emphasizes that interest rate is a key component of how monetary policy affects the economy He points out that there is a circle relationship between the movements in real GDP and inflation and the short-term interest rate As his explanation, a change in the short-term interest will affect both the long-term interest rate2 and the exchange rate although it is not the only factor that has impact on those variables over time Due to the rigidities in the economy (e.g price stickiness) this change in the nominal interest rates (both long rate and short rate) and nominal exchange rate will then result in movements in real interest rates and real exchange rates Those real rates change in turn affect real investment, real consumption and real net export, which are all

constituents of GDP, hence leads to a change in real GDP In long run, real variables return to their normal value when wages and goods prices are not rigid

In tum, the change in real GDP and inflation will also have effect on the short rate

In the case of zero nominal interest rate, a decrease in real interest rate still can stimulate the economy by the expected price level and expected inflation An expansion in the broad 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 output all increase It is described as the following notation: Msj ~ Pej ~ nej ~ ir-1 ~ Ij, NXj ~ Yj3• He comes to the conclusion that there is strong evidence of interest rate as a strong monetary channel that affects output

According to Mishkin (2006), expansionary monetary policy (increasing money supply - M5) causes the real interest rate Cir) to fall, which means that the cost of capital is lowered The fall in real interest rate induces businesses to increase spending on investments spending and consumers to increase their housing and durable expenditures, which are also considered investment This increase in investment spending (I) leads in tum to an increase in aggregate demand and a rise in output (Y) This process is illustrated in the following schematic:

Mishkin (1996) demonstrated in his paper three reasons explaining the importance

of credit channels to the economy Firstly, the effect of credit market imperfection

to the 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 who face credit constrained are more affected by monetary policy than large firms Finally, he pointed out that asymmetric information in the imperfect credit market also 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

In earlier research by Bemanke and Gertler (1995), the monetary policy transmission is compared with a "black box" and due to the dissatisfaction with lack of empirical proof of interest rate channel effects, they suggested that credit channel has its own role in explaining the impact of monetary policy to the economy and using the complementary movement in the external finance premium along with interest rate may help to bring a better explanation This credit channel accounts for the agency problems of asymmetric information and costly enforcement of contracts arise in the financial market and is divided into two specific channels: the bank lending channel and 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 it seems 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 bond markets to get the credit without going through banks, small and medium-sized firms will 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 policy will 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 find new lenders and establish a new credit relationship which are costly to firms and are likely 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 summary by (Mishkin, 1995) "Ms t - bank depositt- bank loanst- I t - Y f'

However, the existence of the bank lending channel is still controversial Some researchers, such as Romer and Romer (1989) are suspicious of the ability that bank loans can be affected significantly by the monetary policy due to financial deregulation and innovation base on the case of the United State in the mid-1980s

easier for the banks to deal with the deposits reduction difficulty during a monetary contraction This fact along with the drop of the traditional bank lending business all over the world make the role of the banks as well as the availability of bank lending channel less important (Edwards and Mishkin (1995)

The balance-sheet channel (or the net worth channel) explains the effects of

monetary policy to the economy base on the change in borrowers' balance sheets and income statements The former one is affected in different ways

A decline in money supply induced by a monetary contraction may account for a lower equity prices (P e) This lower net worth raises the problems of adverse selection and moral hazard The former happens because a drop in net worth will lower value of collateral for lenders' loans and they suffer from higher looses Moral hazard 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

in lending and thereby, in investment Thus, the output or aggregate demand will decrease as well This process can be described as follows: "Ms! -+ P e! -+ adverse selectionj, moral hazardj -+ lending! -+ I! -+ Y !"(Mishkin, 1995)

Cash flow channel

Furthermore, a tightening of monetary policy may also push up interest rate which leads to a deterioration of firm's balance sheets because of a lower cash flow, a higher interest rate and hence a rise in the chance of adverse selection and moral hazard 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 the riskiest investment This change builds up a "financial pressure" that account for the drop in investment and hence the fall in output

"Ms! -+ ij -+ cash flow! -+ adverse selectionj, moral hazardj -+ lending! -+ I! -+

Y !" (Mishkin, 1995)

Unanticipated price level channel

A third way that to describe the link between output and change in the monetary policy is through the price level A money supply reduction may cause an unanticipated fall in the price level because of nominal price rigidity in contracts A result of this is a decline in the real net worth which then increases the problem of adverse 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 - lendingt - It - Y t" (Mishkin, 1995)

Household liquidity effects

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

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

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

To an open economy, net export is impacted by the exchange rate so that one channel that monetary policy can influence the economy is through the exchange rate channel In his research paper, Taylor (1995) confirmed that this is a crucial channel in monetary transition mechanism When the authorities follow a contractionary monetary policy results in a raise in interest rate as explained by the ISLM model above the relative price of the domestic currency to foreign currency will change as result from the fact that deposit in the domestic currency become more attractive than deposit in other currency This is the appreciation of the

domestic currency which makes domestic goods become relatively more expensive than 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 work of Mishkin ( 1996) and it is summarized as below: "M8!

~ 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 the conclusion that countries with fixed exchange rate regime can achieve lower inflation rate by increasing the currency's confidence and bringing higher policy discipline A pegged exchange rate regime, therefore, is considered to be an anti-inflationary tool but equally, output growth and employment are at risk of higher volatility From Radzyner and Riesinger (1997)'s point of view, a pegged or fluctuation with narrow bands exchange rate reduce the possibility of using exchange rate as an effective monetary policy tool They also suggested that Central bank should be allowed to create monetary policy autonomously independent with the Government

When it comes to macroeconomics view, it seems to be a trade-off between low inflation rate and high output growth as evidences show that countries with fixed exchange rate are likely to achieve lower economic growth than countries that allow exchange 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 fixed exchange rate regime was able to have higher investment by reducing the uncertainties in policy making process and bringing lower interest rate On the other hand, it might achieve a lower rate of productivity growth due to the misallocation

of resources, in case the exchange rate fixed is the wrong one In other way, countries that allow the exchange rate to fluctuate will catch up better with the true price in the exchange 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

make a better resources allocation In brief, considering both effects, a conclusion is drawn that growing pace is often higher in country with floating exchange rate regime IMF (1996)

2.1.6 Conceptual framework for the study

MONETARY

POLICY

CENTRAL BANK OBJECTIVES

MONETARY POLICY TOOLS

MONEY SUPPLY

CREDIT

OUTPUT, INFLATION

• -•

2.2 Previous empirical studies related

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

In many VAR-based researches, short-term interest rates have been used as a preferred 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 the main monetary policy tool implemented by Fed over 30 years However, the theory of interest rate transmission mechanism is highly controversial as there is mild evidence of the quantitative effect of interest rate through the neoclassical cost of capital variable Dimitriu et al (2009) in Romania showed in their V AR innovation response analysis, inflation had significant responses to shocks from interest rates and industrial production reacted significantly to the interest rates variation Conversely, the studies of Boivin and Giannoni (2002) point out the decreasing response 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, many other researchers, for example Bemanke and Gertler (1995) suggest that other mechanism rather than interest rate may also be the transmission

of monetary policy and they consider the credit channel among others to be an important monetary transmission mechanism

The research on response of output to exchange rate also receives different results Edwards (1986) examined the group of twelve developing countries for 16 years since 1965 by building a model of real output on money growth surprises, fiscal deficit, relative price of exports to imports and real exchange rate He then came to

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 devaluations affects output in a positive way and in long run, the effect is neutral Likewise, the results from the study by Dumitriu et al (2009) in Romania also showed that inflation and industrial production have significant responses to shocks from exchange rate Another research by Al-Mashat and Billmeier (2007) in Egypt through evaluated the monetary channels in a V AR model showed that the exchange rate channel play an important role in the transmission of the monetary stance Most other channels are quite weak

There are several researches on response of output growth and inflation to monetary policy tools in Vietnam The study by Vo, et al (2001) on the relationship between money supply, inflation and output growth point out that the rate of changes in ERs has altered significantly the Granger-causality between output growth, inflation, and money growth The changes in nominal ERs (in the cases of OERs and SERs) served, albeit inconsistently, as a leading indicator for output growth, but this causality was not stable Current inflation and (real industrial) output growth have been mostly explained by their past movements Real depreciation rates have had a positive and rather significant impact on output growth, though the magnitude was very unstable

Le and Wade (2008) also build a V AR model on the reduced-form relationships between money, real output, price level, real interest rate, real exchange rate and credit They found evidence that monetary policy can affect real output and price level and that the effect of monetary policy on output was strongest after four quarters 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 each channel was weak, and the credit and exchange rate channels appeared to be the most significant channels or the thesis of Hoang (20 1 0) is also analyzing the monetary transmission mechanism in Vietnam by using the V AR approach and focusing on the reduced-form relationships between money, output, output's components, price level, interest rate, real exchange rate and credit He found

consistent evidence that monetary policy has significant effect on real output and price level, but at low percentage Credit affects output at a significant level while interest rate and exchange rate do not Interest rate, exchange rate and credit do not affect price level at any significant level while monetary policy do affect The fact implies that monetary affects price level through another channel The most recent studies 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 a significantly 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 and interest rate have bi-directional causality to inflation and money supply, but the correlation between lending channel and monetary policy is quite weak; and thesis of Nguyen (2012) on the role of credit and monetary transmission in VietNam, the empirical results support that all the independent variables do not Granger causality with money supply in classical market Money supply can help to predict most of dependent variable in market without credit, excepting the lending rate and vice versa 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 they cannot predict money supply in classical market; and the lagged value of money supply can not forecast credit, output and lending rate She also found that in classical market (in case of tightening monetary policy), the output and refinancing rate response to money policy shock after one lag The output responses quite sensitive to money shock whereas lending channel responses to money shock are short and sometimes abnormal For market with credit, credit channel played as important channel in monetary policy mechanism in Vietnam case

Industrial production, Capacity utilization, Employment, Unemployment rate, Housing starts, Retail sales, Consumption, Durable-goods orders

Real GDP, GDP deflator, index of commodity prices, Federal funds rate, Final demand, Inventory

investment

Real Private Demand and its 4 components, Consumer Price Index, Overnight call rate and Broad Money, Loan and

security

Exogenous Variables

Research Method Time series data

Use VAR model

in reduced form

Time series data

Use Structural VAR model to analyze the Granger

causality tests, variance

decompositions, and impulse response

functions

Time series data

Use V AR model

Time series data

Use VAR model

in reduced form

impulse response functions

Key Findings

The short-run a devaluation will generate a decline in aggregate output After one year a devaluation will have

an expansionary effect on output In the long-run devaluations will have no effect on output

The funds rate is a good indicator of monetary policy Nominal interest rates are good forecasters of real variables should be refined to note that the Federal funds rate is a particularly informative variable Monetary policy works in part by affecting the composition of bank assets Tighter monetary policy results in a short-run sell-off of banks' security holdings, with little effect

on loans The fact that the timing of the responses of loans and unemployment to monetary policy innovations are so similar is circumstantial evidence that this channel is operative, even though loans do not Granger-cause

unem_ployment

Monetary policy has a strong impact on durable goods spending The large and rapid response of housing investment to change in monetary policy Both the balance sheet and bank lending channels have played important roles in the housii!K market

Monetary policy and banks' balance sheets are important sources of shock, banks play

a crucial role in transmitting monetary shocks to economic activity, business investment is especially sensitive to monetary shocks

aggregates (currency in circulation CU, M1, and M2), Real industrial output, Consumer Price Index

Output, inflation, and interest rates

Consumer Price Index (PRICE),

repurchase rate (RP14), private consumption, investment,

imports, bank credit, real effective exchange rate (REER), asset prices, interest rate

Real GDP, real M2, real government deficit, real exchange rate, inflation rate

Official exchange rate (OER), Selling interbank exchange rate (SER), parallel selling exchange rate in Ho Chi Minh City (SSER), parallel selling exchange rate in Hanoi (HSER)

Baht/US exchange rate

Time series data

UseVAR models, Co- integration techniques, Error Correction Model (ECM) and simple Lucas-type production function

Time series data

Use VAR model

in reduced form and Structural VARs

Time series data

Use VAR model

variance decompositions, and impulse response

oil variance decompositions, and impulse response

functions

The rate of changes in ERs has altered significantly the Granger-causality between output growth, inflation, and money growth

The changes in nominal ERs (in the cases of OERs and SERs) served, albeit inconsistently, as a leading indicator for output growth, but this causality was not stable Current inflation and (real industrial) output growth have been mostly explained by their past

depreciation rates have had a positive and rather significant impact on output growth, though the magnitude was very unstable

The change in the propagation mechanism has lowered the variability of macroeconomic variables to

a large extent This change has been associated further with a diminished effect of monetary policy shocks on output and inflation

The stylized facts about the response of the economy to a tightening of monetary policy:

+ The aggregate price level initially responds very little, but starts to decline after about a year and quite persistently so

+ Output follows a shaped response, bottoming out after around 4-5 quarters and dissipating after approximately 11 quarters

U-+ Investment appears to be the most sensitive component of GDP to monetary policy shocks

positively to a shock to real M2, government deficit spending, real exchange rate depreciation, and the lagged real output had a significant negatively response to a shock to the inflation rate

2005

2005Q4

Real Industrial Output, Consumer Price Index, Broad

Lending Rate, Index of the Real Effective Exchange Rate and Domestic Credit

Consumer Price Index, Exchange Rate (ROL/EUR), Industrial

Production, Money supply (M2), Non- Government Credit, Three month offered interest rate from Romanian

Interbank Offered Rate

Crude oil price and

u.s

Federal Funds Rate

World Oil Price, World Rice Price and Federal Funds Rate

Time series data

Use VAR model

in reduced form

to analyze the Granger

causality tests, variance

decompositions, and impulse response

functions

Time series data

Use VAR model

in reduced form

to analyze the Granger

causality tests, variance

decompositions, and impulse response

functions Time series data

Use VAR model

to analyze the variance

decompositions

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

The exchange rate channel plays an important role in the transmission of the monetary stance Most other channels are quite weak

Monetary policy can affect real output; the connection

inflation is less clear in the Vietnam case; the credit and exchange rate channels are more important than the interest rate channel

Inflation and industrial production have significant responses to shocks from exchange rate, interest rates and money supply

-Dec2003 June2010

2010Q3

Lending Rate, Index of the Real Effective Exchange Rate and Domestic Credit

Consumer Price Index, Broad Money, Real Industrial Output, Domestic Credit, Nominal Exchange Rate VND/USD, Nominal Lending Rate

Real Industrial Output, Consumer Price Index, Broad

Domestic Credit, Refinancing Rate, Lending Rate

World Oil Price, World Rice Price and Federal Funds Rate

Time series data

Use VAR model

in reduced form

to analyze the Granger

causality tests, variance

decompositions, and impulse response

functions components, and inflation

Time series data

Use Granger

Engle-Co integration Test, Error Correction mechanism (ECM) and Johansen

Co integration test to investigate the long-run influence of money growth

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 Time series data

Use V AR model

in reduced form

to analyze the Granger

causality tests, variance

decompositions, and impulse response

functions

Monetary policy has significant effect on real output and price level, but at low percentage Credit affects output at a significant level while interest rate and exchange rate do not Interest rate, exchange rate and credit do not affect price level at any significant level while monetary policy do affect

A significantly 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 and interest rate have bi-directional causality to inflation and money supply, but the correlation between lending channel and monetary policy is quite weak

In classical market (in case

of tightening monetary policy), the output responses

to money policy shock after one lag The output responses quite sensitive to money shock For market with credit, credit channel played as important channel

in monetary policy mechanism in Vietnam case, output strong responses to credit shock after one lag Source: Author's summarization

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 Keynesian AS-AD model, an increase in money supply will shift aggregate demand curve rightward in the short term As a result, the economy moved to a new equilibrium with higher output and price level To study Aggregate Demand, the theories of Traditional Keynesian ISILM model, the Mundell-Fleming Model and Tobin q's theory are studied and used in the thesis Experimentally, through the research studies in the world and Vietnam, the topic of the impact of monetary policy on the economy mainly used the V AR model, focusing on three main channels such as interest rate channel, credit channel and exchange rate channel Therefore, the thesis will also use the V AR model with three mentioned above channels to study the impacts of monetary policy on Vietnam economy for the period from 2005M5-2012M6

•

CHAPTER III: ECONOMY PERFORMANCE, FINANCIAL SYSTEM

AND MONETARY POLICY TOOLS IN VIETNAM

For an overv1ew of the economy, financial system as well as monetary policy implementation in Vietnam, as a basis for policy implications and solutions from the empirical results, this chapter briefly introduce about the economic growth of Vietnam in recent years; then introduce Vietnam's financial system, the role of Central Bank in Vietnam and its differences with developed countries; finally, introduce about monetary policy framework and monetary tools in Vietnam

,._Economic Growth (Real GOP growth)

Figure 3.1: Economic growth

Source: IMF (2012)

Since the reform in 1986, Vietnam has seen a very strong performance in the economic development Annual growth rate was 7.5% per year for the 1990s decade and the rate reached the top of nearly 10% per year in 1995 and 1996 This number for the period 2000-2007 was 7.6% and was one of the highest growth rates in East Asia In this period the economy achieved high growth rate and continuity; according to Central Intelligent Agency (CIA) Real GDP growth rate of Vietnam in this time often ranked in top 30 of the world

The period 2008 - 2010, the growth rate decreased significantly by an average of 6.1%, especially in 2009 GDP growth rate forecast at 5.3%, the lowest rate in the past 10 years due to the global financial crisis and recession has serious impact on the economy of Vietnam, especially exports, investment and tourism

From 2011 until now, the situation is even more tragic, the growth rate continues to decrease, in 2011 the growth rate was only 5.9% and 2012 growth even worse, only 5.03% due to not only the impact of the global financial crisis and recession, but also the weaknesses in organizational and macroeconomic management, especially the weaknesses in the administration of monetary policy and banking, has caused uncertainty regarding the risks derived from the banking system and the state-owned enterprises in recent times In a recent report of Moody's said that the average real GDP growth rate of Vietnam in the next two years will be only around 5% per year

3.1.2 Inflation and output growth

Vietnam experienced hyperinflation in the second half of the 1980s and early 1990s

In the years 1987 to 1991, the annual inflation rate was above 40% It was then followed by a reduction of the inflation rate to 32% in 1992 and closed to 10% in

1996 During this period, Vietnam made great effort to follow restrictive monetary policy and fiscal policy to control the inflation

Figure 3.2: Inflation and real GDP growth rate

3.2 Finacial system and the role of Central Bank in Vietnam

Since 1988, after a comprehensive financial sector reform, Vietnam saw a dramatically transition from the mono-bank system to a two-tier bank system containing 2 parts: The first one is the State Bank of Vietnam (SBV) which belongs

to the Government It is governed by the Law on the State Bank of Vietnam and its governor is a member of the Government The State Bank of Vietnam takes the highest responsibility in controlling the financial market and supervising the

activities of commercial banks using monetary tools It has a monopoly on printing currency, which is loaned to the Government as a legal tender And the second part

is a system of Specialized Commercial Banks and other financial organizations which do the main banking functions such as borrowing and lending money from people and companies

Since then, the banking sector in general and the State Bank of Vietnam in particular have long strides on the path of development However, in the context of the world economy as well as in the country with more unpredictable, the drawbacks of the banking sector in general and the central bank in particular is unavoidable Recognizing the importance of the reform of the central bank, the Vietnam Communist Party and Government have clearly defined: "Reorganization of the State Bank of Vietnam to the structure and nature acts as a modern central bank, operating under the socialist-oriented market mechanism, in line with international practices, contributing to macroeconomic stability, control inflation, increasing the purchasing power of the currency Vietnam, serving the country's economic development." SBV (2009) However, there is a major problem arises: What is a modern central bank? Seemingly simple question is so far still no satisfactory answer

In most developed countries such as USA, Canada, Europe, Switzerland, New Zealand, and Japan organizational model is independent from the government In Vietnam, the model is directly under the government

According to a study by the International Monetary Fund (IMF) announced on December 2004, basically, the central banks on the world are divided into 4 levels of independence include: Independence in setting operational objectives; independence

in setting performance targets; independence in the selection of operating instruments; and limited independence, as follows:

+ The first level is independence in setting operational objectives: With this model, the central bank is responsible for decisions on monetary policy, exchange rate

operational objectives among the objectives prescribed by law This is the highest level of independence that a central bank can achieve; a typical example is the U.S Federal Reserve System (FED)

+The second level is independence in setting performance targets: At this level, the central bank is also given the responsibility to decide on monetary policy and exchange rate regime, but different from the first level is that a major operational objective of the central bank is specified in the Law, for example as a leading operational objective of the European Central Bank (ECB) is to "maintaining price stability"

+ The third level is independence in the selection of operating instruments: With this model, the Government or the National Assembly decided the targets of monetary policy after discussion and agreement with the Central Bank When the decision is approved, the central bank is responsible for the completion of the approved targets

on the basis of given full necessary authority to choose the most appropriate monetary tool Typical for this level is the Reserve Bank of New Zealand and the Bank of Canada

+ The fourth level is limited independence: As the lowest level of independence, according to which Government is a decision-making body of the policy (both operational objectives and performance targets) as well as intervention in the process

of implementing monetary policy This is one of the reasons that limit the performance of the central bank, especially in the implementation of the target on maintaining the stability of the value of money This is the case of the State Bank of Vietnam at present and in fact, this level of independence began to reveal limitations and shortcomings

In the last time, when discussing the issue of the central bank reform, there are some suggestions that Vietnam should choose the model of independent central bank with the basic reason given is that the more independent of central bank from the government, the more easier in implement the target of maintenance low inflation rate, and this is also completely true in theory