Interest Rate Channel Research Articles

Monetary Transmission Mechanism in India: A Quarterly Model

This paper examines monetary transmission mechanism for India in the context of a small macro model using quarterly data. Given the volatility emanating from the agricultural sector, the paper models both overall growth and overall inflation as well as non-agricultural growth and non-food manufactured products inflation, i.e., components stripped of the influence from the agricultural sector and which are more amenable to monetary actions. Model simulations for a one-quarter 100 bps increase in the nominal effective policy rate show that the peak effect on non-agricultural growth is almost 40 bps with a lag of 2 quarters and that on non-food manufactured products inflation is 25 bps with a lag of 5 quarters. Therefore, the interest rate channel is effective in the Indian context and the magnitude of the impact on growth and inflation is comparable to that in major advanced and emerging economies; however, the evidence for both India and other countries suggest that the impact of monetary policy actions on inflation is modest and subject to lags. The results are sensitive to alternative measures of real interest rate. Despite the monetary tightening by Reserve Bank of India during 2010 and 2011, inflation remained high and this could be attributed to the structural component of food inflation as well as the surge in international commodity prices beginning the second half of 2010 and continuing into the first half of 2011.

Measuring monetary conditions in a small open economy: the case of Malaysia

Purpose – The purpose of the paper is to gauge the usefulness of the Monetary Condition Index (MCI) and Financial Condition Index (FCI) for the conduct of monetary policy in Malaysia.Design/methodology/approach – The MCI is constructed as the weighted sum of changes in the exchange rate and interest rate from their levels in a chosen base year. The weights are obtained by summing up the coefficients on the lags variables from estimating the determinants of backward‐looking aggregate demand.Findings – The paper finds that the movement inflation induces the movement in either interest rate or exchange rate. The result also indicates that the interest rate channel is found to be more powerful than the exchange rate channel. The method in determining the weights for each policy component of the index however indicates some degree of instability due to some external shock affected the exchange rate or the domestic short‐term interest rate.Originality/value – In a small open economy with deregulated markets, it...

Interest rate pass-through in South East Europe: An empirical analysis

This paper investigates the effectiveness of the interest rate channel in three small open economies with rigid exchange rate regimes in South East Europe – Bulgaria, Croatia and Macedonia – during the period 2000–2010. Specifically, we examine the size and speed of adjustment of bank lending rates to the changes in money market rates by employing various cointegration methods. In addition, we assess the stability of interest rate passthrough during the transition period, including the recent economic crisis. The results reveal the existence of a cointegrating relationship among some of the interest rates. We find that the long-run pass-through is far from complete with the exception of Macedonia. The shortrun adjustment of lending rates is also low and sluggish, implying that the domestic monetary policy may have a limited impact on the interest rate channel. Finally, the econometric investigation provides mixed evidence on the stability of the interest rate pass-through. Therefore, the overall findings of the paper support the view that in small open economies with rigid exchange rates the effectiveness of domestic monetary policy through the interest rate channel is quite limited.

A VECM evaluation of monetary transmission in Uzbekistan

This paper presents a VAR/VECM analysis of the monetary transmission process in Uzbekistan for the available data from 2000 to 2009. The general findings obtained support the hypothesis that the interest rate channel in Uzbekistan is relatively weak. Monetary transmission via the exchange rate channel seems to be stronger, even if the form of the channel remains quite ambiguous or rather chaotic. Partially this chaos can be blamed on the contradiction between existing restrictions on capital mobility and the dual objectives of a development of the financial sector and provision of macroeconomic stability. On an analytical level this paper suggests the use of a specific methodology for the future evaluation of monetary policy in Uzbekistan. This is especially important, because in future improved and/or more extensive data might alter some of the results obtained so far.

The effectiveness of monetary policy in steering money market rates during the financial crisis

The financial crisis has deeply affected money markets and thus, potentially, the proper functioning of the interest rate channel of monetary policy transmission. Therefore, we analyze the effectiveness of monetary policy in steering euro area money market rates by looking at (i) the predictability of money market rates on the basis of monetary policy expectations and (ii) the impact of extraordinary central bank measures on money market rates. We find that during the crisis money market rates up to 12 months still respond to revisions in the expected path of future rates, even though to a lesser extent than before August 2007. We attribute part of the loss in monetary policy effectiveness to money market rates being driven by higher liquidity premia and increased uncertainty about future interest rates. Our results also indicate that the ECB’s non-standard monetary policy measures as of October 2008 were effective in addressing the disruptions in the euro area money market. In fact, our estimates suggest that non-standard monetary policy measures helped to lower Euribor rates by more than 80 basis points. These findings show that central banks have effective tools at hand to conduct monetary policy in times of crises.

Assessing independent monetary policy in small, open and euroized countries: evidence from Western Balkan

This article approaches to the optimum currency area from the empirical side by investigating the costs of adoption of a single currency for small, open and euroized Western Balkan countries (WBC). Using several econometric techniques, this study attempts to answer three questions relevant for monetary integration of the WBC and similar transition countries: What are the constraints on an independent monetary policy? What is the need for operating an independent monetary policy? and What is the ability to conduct an independent monetary policy? The constraints on independent monetary policy in most of the WBC at this stage are relatively serious because of high levels of openness and euroization. They limit the ability of the central bank, which is oriented to price stability, to use the nominal exchange rate for achieving other goals (for example, output stabilization). Regarding the second question, the results from structural VAR framework suggest a low synchronization for supply and demand shocks between the WBC and the euro area, indicating potentially high costs of losing independent monetary policy. Furthermore, the results from Kalman filter technique inform that the shock convergence process is slow or absent in the WBC vis-a-vis the euro area. Regarding the last question, the results from cointegration and VAR analysis suggest that the ability to conduct an independent monetary policy, assessed by analyzing the interest rate channel as the most prominent transmission channel in the euro area, is relatively weak in the WBC.

Policy rate pass-through and the adjustment of retail interest rates: Empirical evidence from Malaysian financial institutions

The paper examines the interest rate pass-through from money market rates to various retail rates in Malaysia within the framework of an error-correction model. We estimate the short- and long-run interest rate pass-through and analyse the asymmetric behaviour of financial institutions under different monetary regimes. The results show that both deposit and lending rate pass-throughs are incomplete. However, pass-through and speed of adjustment vary across financial institutions and retail rates. This analysis also shows that interest rate adjustments are asymmetric, with more significant adjustments taking place under monetary easing than under monetary tightening. These results provide support for the existence of the interest rate channel of monetary policy in Malaysia. There is thus a need to conduct effective monetary operations to support efficient monetary transmission in Malaysia.

An Estimated Stochastic General Equilibrium Model with Partial Dollarization: A Bayesian Approach

In this paper, we develop and estimate a dynamic stochastic, general-equilibrium New Keynesian model with partial dollarization. Bayesian techniques and Peruvian data are used to evaluate two forms of dollarization: currency substitution (CS) and price dollarization (PD). The empirical results are as follow: first, it is noted that the two forms of partial dollarization are important in explaining the significance of the Peruvian data. Second, models with both forms of dollarization dominate models without dollarization. Third, a counterfactual exercise shows that by eliminating both forms of partial dollarization, the response of both output and consumption to a monetary policy shock doubles, making the interest rate channel of monetary policy more effective. Fourth, based on the variance decomposition of the preferred model (with CS and PD), it is found that demand type shocks explain almost all the fluctuation in CPI inflation, the monetary shock being the most important (39%). Remarkably, foreign disturbances account for 34% of the output fluctuations.

From Taylor Rule to Money - Traditional and Unconventional Monetary Policies in the First Years of the Financial Crisis: Evidence from the United Kingdom, the USA and Europe

This work examines the role of the Federal Reserve, the Bank of England and the European Central Bank in managing traditional and unconventional tools of monetary policy especially during the first years of the financial crisis. For the traditional approach we estimate a Taylor-type reaction function, while we concentrate on the transmission mechanism by estimating a VAR system for the period January 1999 – September 2009. After describing the initial unconventional policies adopted, we concentrate on the impact on interest rates in two ways: we estimate a Nelson-Siegel (1987) term structure of interest rates and then we test for the link between Central Banks’ statements and ten-year Government bond yields. For the traditional measures, results confirm the respect of the Taylor principle, while the long-run analysis demonstrates a weakening of the interest rate channel. During financial crisis, the impact on interest rates suggests an increase in the uncertainty related to the medium-term representative curvature factor. Moreover if we look at longer term interest rates, we can see that sharp reductions are associated with specific statements’ date. Even if these statements produced desirable effects in the reduction of longer term interest rates, these ones are only temporary, as demonstrated by quasi-immediate upswings in the subsequent days.

Interest Rate Pass-Through in a Small Open Economy with a Fixed Exchange Rate - The Case of Macedonia

This paper examines the effectiveness and stability of interest rate pass-through in a small open economy with fixed exchange rate focusing on Macedonia during the period of transition, including the recent economic recession. Specifically, we examine the size and speed of adjustment of money market rate and banks’ lending rate to changes in the ‘cost of funds’ rate and their stability by employing two cointegration methods: Dynamic Ordinary Least Squares and Autoregressive Distributed Lag Model. The results reveal the existence of a cointegrating relationship among the interest rate series with an almost complete long-run adjustment. However, the size and speed of short-run adjustment of lending rate is quite low and sluggish, implying that in the short-run, the domestic monetary policy may have a limited impact on the interest rate channel. Regarding the stability of the interest rate pass-through, the empirical evidence is mixed.

Channels of Monetary Transmission in the CIS

Twenty years have passed since the breakdown of the Soviet Union, and it is time to draw a concluding line for monetary policy efficiency in the Commonwealth of Independent States (CIS). We propose a comprehensive treatment of the subject for nine members of the CIS for the period of 2000-2009. Four transmission channels are investigated: interest rate channel, exchange rate channel, bank lending channel, and monetary channel. First, we design a VAR framework for each CIS member-state and investigate the short-run dynamics of the impact of each of the four transmission channels on domestic output and inflation. Second, we construct Auto Regressive Distributed Lag Models (ARDL) in order to study the country-wise efficiency of transmission channels in the long run. Finally, we employ a panel data fixed effects method to show how the CIS behaves as a region. Our short-run individual country analysis yields highly heterogeneous results. In the long run, however, it’s apparent that broad monetary base (M2) is the most influential determinant of aggregate output. Inflation is affected the most by the refinancing rate and the flow of remittances. For both output and inflation, exchange rate plays a role of a supporting channel.

Cross-Border Effects of Fiscal Consolidations: Estimates Based on Narrative Records

We estimate cross-border spillover effects of fiscal consolidation episodes on output, bilateral trade flows, interest rate, and the exchange rate, employing the new IMF action-based fiscal consolidation data. Results indicate a negative effect of foreign fiscal consolidation policies on domestic output. Regarding the transmission mechanism, our results suggest that fiscal consolidations in foreign economies work their way into the domestic economy by negatively affecting exports. We do not find evidence for an interest rate channel. Trade effects are particularly pronounced for some European countries and are insignificant for others, such as the US and Canada. This is not due to the common currency or to differential specialization in trade.

Bank Lending Channel in Slovenia: Panel Data Analysis

Channels through which monetary policy affects aggregate demand can be divided into three groups: traditional interest rate channel, other asset price channels and credit channel composed of balance sheet channel (named also broad credit channel), only recently separated bank capital channel and bank lending channel. Banks face troubles in keeping their present or acquiring new financial sources, when central bank tightens its monetary policy. Banks characterized by differences in size, capitalization, liquidity and ownership face different levels of informational asymmetry and are therefore differently affected by changes in monetary policy. If larger, better capitalized, more liquid, state owned and/or domestically owned banks respond weaker to changes in monetary policy it is possible to argue that bank lending channel is effective. This hypothesis is tested on a panel of annual data for individual Slovenian banks in the period between 1993 and 2007 using general method of moments. Results largely confirm the existence of the bank lending channel in Slovenia.

The Effectiveness of Monetary Policy in Steering Money Market Rates During the Financial Crisis

The financial crisis has deeply affected money markets and thus, potentially, the proper functioning of the interest rate channel of monetary policy transmission. Therefore, we analyze the effectiveness of monetary policy in steering euro area money market rates looking at, first, the predictability of money market rates on the basis of monetary policy expectations, and second the impact of extraordinary central bank measures on money market rates. We find that during the crisis money market rates up to 12 months still respond to revisions in the expected path of future rates, even though to a lesser extent than before August 2007. We attribute part of the loss in monetary policy effectiveness to money market rates being driven by higher liquidity premia and increased uncertainty about future interest rates. Our results also indicate that the ECB's non-standard monetary policy measures as of October 2008 were effective in addressing the disruptions in the euro area money market. In fact, our estimates suggest that non-standard monetary policy measures helped to lower Euribor rates by more than 80 basis points. These findings show that central banks have effective tools at hand to conduct monetary policy in times of crises.

Global Food Price Inflation and Policy Responses in Central Asia

This paper examines the implications of elevated global food prices for inflation in select Central Asian economies - Kazakhstan, the Kyrgyz Republic, Tajikistan, and Uzbekistan. The findings suggest that global food inflation has significant short-run effects that build over time. Inflation outcomes simulated under alternative global wheat price assumptions underscore these vulnerabilities, and suggest that sustained administrative measures are unlikely to prove effective. In line with structural economic features, the interest rate channel of monetary policy is found to be limited, arguing for a broad policy strategy to control more expansive inflationary pressures. Looking ahead, measures to enhance supply responses, deepen domestic financial markets, develop adequate social safety nets, and increase central bank independence are warranted.

Internationalisation of the Chinese Currency

Money is a fundamental attribute of power. Its international use depends on whether and how it is supported by a strong econ- omy, which determines a substantial part of the resources of power (the other being the military). Given the resources, the operating power of money is closely linked to the strategic objectives of govern- ments in international politics. The dynamic interaction amongst countries between resource changes (hard power) on the one hand, and policy doc- trines on international governance (soft power) on the other hand, shapes the international monetary system.China's ascent is disturbing in international relations, not only because it is catching up fast in hard power, but also because Chinese ideas of human authority in soft power, stressing international norm-binding in the pursuit of global harmony, is at odds with Western theories of interna- tional relations based upon the stabilising power of a single hegemon. (1) The strategic move to internationalise the renminbi (RMB) is best under- stood within this alternative view. It is not being done to replace the dollar with the RMB as a new key currency, but rather to build up a large consen- sus to abolish hegemony altogether.The balance of forces between domestic constraints and foreign opportunities: Creation of the Hong Kong RMB marketIn October 2008, the apex of the first round of the financial crisis en- tailed a traumatic shock for so open a country as China. The wholesale dol- lar money market seized up entirely, leading to the collapse of interna- tional trade. The Chinese leadership was convinced that China should no longer trust in the robustness of international banks. Furthermore, having studied the lingering Japanese crisis, Chinese leaders correctly diagnosed that the financial crisis was the symptom of a much more serious phe- nomenon: the end of the credit-induced consumer spree that had boosted Western capitalism since the heyday of financial deregulation. The debt deflation process in Western economies will last for years. Therefore the export-led growth regime of the post-WTO decade will no longer support China's development. Foreign trade had to be redeployed partly to devel- oping countries, China had to become the fulcrum of Asian integration, and trade relations had to be based on long-term contracts. On the financial side, long-term loans and a system of payments no longer based on the vagaries of the dollar should back the new phase of globalisation.However, full RMB convertibility is far from being at hand. It must be pre- ceded by the liberalisation of financial services and therefore of the whole structure of interest rates. Such a dramatic change cannot be accom- plished overnight, all the more given that local governments (especially counties and municipalities) are overwhelmed with debt. Interest rates cannot become market-determined before those debts are cleared and the solvency of local governments has been firmly consolidated. Meanwhile, monetary authorities have recourse to regulating bank lending rates and subjecting bonds to bank rates, so that the cost of public finance is min- imised. Of course, this inefficient financial regulation is costly for the na- tion. Too low a cost of capital distorts investment patterns and fosters overcapacities in heavy industries. Regulated interest rates channel all fi- nancing into a handful of state-owned banks, which enjoy secure profit margins because household saving is poorly rewarded. They have no incen- tive for efficient risk management, without which the shock of capital lib- eralisation would be hazardous and might entail devastating losses, as happened in Japan and several European countries in the early 1990s.The main reason for this dismal state of affairs is fiscal. Because China has no political consensus for agreed-upon rules to transfer fiscal revenues amongst regional and local governments, the latter suffer huge discrepancies between their fiscal resources and their commitments to provide basic pub- lic services. …

Studying on the monetary transmission mechanism in China in the presence of structural changes

PurposeThis paper aims to study the monetary transmission mechanism of China from January 1996 to December 2009 under endogenous structural breaks.Design/methodology/approachThe study constructs a benchmark VAR model and then adds the proxy variables for four channels of monetary policy transmission as endogenous or exogenous variables in the model to study the transmission mechanism in China. Considering a number of reforms carried out in the economic and financial field in the past two decades and the possibility of structural changes in the monetary transmission mechanism, the methodology proposed by Qu and Perron is employed to allow for endogenous structural changes in the model.FindingsBy conducting a comparative analysis, conclusions can be drawn from this paper that bank lending is always the dominating channel for monetary policy to influence economy in China and the roles of the interest rate channel and the exchange rate channel have been improved in recent years. However, the role of the asset price channel in monetary policy transmission has weakened since late 2001.Originality/valueThis paper combines the quasi‐maximum likelihood procedure proposed by Qu and Perron in 2007 with a benchmark VAR model, thus providing a new approach to study monetary transmission mechanism and the conclusions can be more sensible.

Monetary Policy and Inflation in India: A Structural VAR Analysis

This paper provides a Vector Auto-Regression (VAR) analysis of inflation and monetary policy. It identifies monetary policy shocks in a benchmark recursive structure of VARs with two alternative inflation measures, viz., headline WPI and core inflation measure. Unlike the results in case of WPI, the response of core prices declined swiftly, following a positive call money interest rate shock. Thus, the interest rate channel is stronger for core prices. It is pertinent as RBI currently operates its monetary management through interest rate channel. The study checks robustness of results of the benchmark recursive model against alternative ordering and non-recursive identification schemes. Finally, a core price targeting scenario is generated in the benchmark VAR model with non-recursive identification scheme.

Consolidation in banking and the lending channel of monetary transmission: Evidence from Asia and Latin America

This paper examines the relationship between increased consolidation in banking and monetary policy transmission in eighteen Asian and Latin American economies, using bank-level data from 1996 to 2006. Our results provide consistent evidence that as concentration in banking increases, the bank lending channel is weakened, leading the monetary policy transmission mechanism to be less effective. We also investigate how this relationship between concentration and the strength of the lending channel depends on bank-specific characteristics. Using bank-level balance sheet and income statement data allows us, first, to better identify the effects of banking consolidation on the supply-side bank lending channel from those of the demand-side interest rate channel, and second, to test for any systematic differences in the impact of consolidation on monetary policy transmission across banks of different size and financial strength. We also discuss potential explanations for and policy implications of the main findings of this paper.

The Regional Impact of Monetary Policy in Indonesia

This paper employs Vector Autoregression (VAR) models to measure the impact of monetary policy shocks on regional output in Indonesia. Having incorporated a possible structural break following the aftermath of the 1997-98 Asian Crisis, the impulse response functions derived from the estimated models reveal substantial cross-region variations in policy responses in terms of their magnitude and timing. Our work complements the existing literature by providing insights from a developing country. The results support previous findings that the differential regional effects of monetary policy are significantly related to sectoral composition (especially the share of manufacturing), providing evidence for the relevance of the interest rate channel of monetary policy. We also find that firm-size contributes to the differences, providing evidence for the relevance of the credit channel.