External shock, monetary policy and the domestic economy: A structural VAR approach for Bangladesh

Abstract

Economies around the world are interdependent with one another in the present era of globalization. While some global shocks may affect the countries of the world together, domestic policies of a country sometimes can hardly work independent of external factors. Keeping these in view, a large body of literature has developed to address the impact of external shock on domestic economy as well as examining effectiveness of domestic policy in the context of an open economy. While effectiveness of monetary policy has been well studied in the context of both developed world as well as in the developing countries, only a few studies have been conducted in this field in Bangladesh and all these studies are made in a closed economy framework. Moreover, there is no study to formally examine the impact of external shock in Bangladesh. On this backdrop, the present paper makes an attempt to simultaneously assess the impact of external shock and that of monetary policy on the economy of Bangladesh. It builds up a structural vector autoregression (SVAR) model of Bangladesh in an open economy set up. Contemporaneous restrictions are set based on the spirit of the existing literature and the specific condition of Bangladesh economy. The SVAR model is estimated with quarterly data ranging from the year 1989 to 2013. Impulse response function and the variance decomposition analysis are used in exploring the importance of monetary policy and external shocks in explaining variation in domestic price level and output. Estimated Impulse response functions show that innovation in reserve money has a positive impact on price and output, although impact on price level is less significant. On the other hand external shocks seem to have more prominent impact on the domestic economy. Innovation in OECD GDP also has significant positive impact on domestic output of Bangladesh. Shocks in foreign price have an immediate positive impact on domestic prices. Variance decomposition exercise shows that external shocks weight more in explaining variation in domestic price and output compared to the monetary policy. Furthermore, effectiveness of monetary policy in the open economy model of Bangladesh economy seems to be lower compared to that in a closed economy version of the economy, implying that exposure to the rest of the world dilutes the effectiveness of domestic policy of Bangladesh. The findings have important implications. First, as monetary expansion has positive impact on price level, monetary tightening would be the right policy in controlling inflation. However, this may not always bring high success if the external factors are not favorable as the study finds importance of external factor affecting both price level and GDP. On the other hand, as innovation in OECD GDP has positive impact on GDP of Bangladesh, global recovery may have a positive stimulus to GDP growth of the country.