Interest Rate Shocks Research Articles

From a Quantity to an Interest Rate‐Based Framework: Multiple Monetary Policy Instruments and Their Effects in China

AbstractThis paper investigates the effects of various monetary policy instruments in China with the structural vector autoregression model. Empirical results are as follows. The effects of benchmark lending rate and short‐term interest rate shocks are larger than those of reserve requirement ratio shocks. Nonpolicy shocks exert substantial effects on intermediate targets under a quantity‐based policy framework. The size and effects of short‐term interest rate shocks in recent years are large. Short‐term interest rate shocks have strong effects on property prices. These results suggest that the new interest rate‐based policy framework is more effective than the previous quantity‐based policy framework.

Comparisons of housing price risks between first-time buyer and former owner-occupier markets in England

This study employs housing data from the nine main regions of England and from overall England to compare the volatility risks of housing prices for the first-time buyer (FTB) and former owner-occupier (FOO) markets. This study collects data from February 2012 to March 2020 to assess the volatility characteristics of housing prices in these two markets in each region of England. Additionally, the effect of interest rate shocks and the wealth effect of the stock market on these two markets are observed. The results reveal that for most regions, the FTB market has higher housing price volatility risks compared with the FOO market. Additionally, the FTB market is more easily affected by interest rate shocks and the wealth effect. In contrast to FOOs, FTBs are generally younger and less wealthy. If FTBs are facing a market with higher housing price risk, especially when the overall economy is affected by a shock (such as the European Debt Crisis or the COVID-19 pandemic), the response of the FTB housing market is greater; then the government must pay special attention when implementing policies that interfere with the market since these policies would particularly affect the welfare of FTBs.

Interest Rate Pass-Through and Consumption Response: The Deposit Channel

Abstract This study assesses a new mechanism, the deposit channel, in the transmission of interest rate shock to household consumption using an administrative panel data set of financial transactions for Turkey. Our empirical strategy exploits variation in consumers' adherence to the Islamic laws that forbid earning interest and employs a standard difference-in-difference design. Following an unanticipated announcement of interest rate hike, rate-sensitive consumers significantly reduce their overall spending, and the response persists throughout the post-announcement period. The response of debt payment, disparate exposure to inflation, exchange rate, and the demographic difference can hardly fully account for the documented consumption response heterogeneity.

Revisiting the Link between House Prices and Monetary Policy

Abstract This paper revisits the link between house prices and monetary policy using a data set on house prices provided by the Bank for International Settlements. It is found that a loose monetary policy unambiguously results in a rise in real house prices, and such an increase is statistically significant for 19 of the 20 countries studied here. Empirical results also show that for some countries (Belgium, Canada, Switzerland, Denmark, the Netherlands, Sweden, and South Africa), the interest rate shock can explain a large percentage of real house price movements. The response of house prices to monetary policy shocks varies between countries, and the strength of the relationship between house prices and monetary policy can be associated with financial liberalization. On the other hand, evidence shows that interest rate shock plays an important role in explaining recent house price hikes for Australia, Spain, Ireland, the Netherlands, the US, and South Africa. In particular, during 2002–2006, on average 24% of the house price hikes in the US can be attributed to monetary policy shocks. Finally, we also find evidence that central banks react to the housing market, particularly in those countries adopting a policy of inflation targeting.

Policy errors and business cycle fluctuations: Evidence from an emerging economy

In the immediate aftermath of the global financial crisis, the monetary policy in India became accommodative as in other major economies, but the policy subsequently turned highly contractionary despite falling inflation, which we characterize as policy errors. Government expenditure also had similar pattern. This paper therefore estimates a medium scale New Keynesian model (with earnings and assets based collateral constraint) to explore the impact of such policy errors on Indian business cycles, capturing the prevailing narrative on both monetary and fiscal policies along with the actual inflation scenario. Our smoothed estimates of mark-up, productivity, interest rate and government expenditure shocks mimic the actual transition of the economy, with both policy shocks moving together in a similar pattern in the post crisis period. We find that the interest rate policy was highly contractionary during 2013-2016 which led to significantly lower output. We rationalize that if supply side shocks (adverse productivity or mark-up) dominate, such policy errors tend to occur, suggesting that policy makers need to pay attention to the sources of inflation in a developing economy while setting demand-management policies. Given the current pandemic as more of a adverse supply shock, similar policy errors are likely to occur if interest rate responds to this type of inflationary shocks.

Unemployment dynamics and informality in small open economies

Despite the typically more pronounced aggregate fluctuations in emerging market economies (EMEs), this paper documents that EMEs exhibit lower relative volatility and countercyclicality of the unemployment rate than small open advanced economies. We link these differences to the larger informal economy in EMEs. We build a small open economy model that combines a formal sector featuring labor search frictions with a frictionless informal sector. A larger informal sector amplifies the impact of productivity and interest rate shocks on formal output, consumption, and employment, while dampening their impact on unemployment. Varying the degree of informality explains a significant fraction of differences in unemployment dynamics across small open economies.

Measuring the effects of monetary and fiscal policy shocks on domestic investment in China

This paper investigates the dynamic effects of monetary and fiscal policy shocks on Chinese aggregate investment and three of its components. Our findings are as follows: First, we find that government spending shocks have no significant impact on aggregate investment or its components. Second, we compare the effectiveness of two kinds of monetary policy and show that shocks to the benchmark lending rate have a non-significant effect on aggregate investment, while shocks to the money supply have a positive and significant effect on aggregate investment only during periods of expansion. Third, a positive interest rate shock has a significant negative effect on state-owned investment, while it has an insignificant impact on private investment and foreign investment. Overall, our results show that both government spending policy and monetary policy have rather limited impacts on boosting domestic investment in China. Thus, it is not necessary for the Chinese government to implement a large-scale economic stimulus package to boost domestic investment and output growth.

News, noise, and Indian business cycle

AbstractNew Keynesian dynamic stochastic general equilibrium models with various specifications of technology, markup, and interest rate shocks are estimated with Indian data using Kalman filter based pure and Bayesian likelihood estimation. Preference and interest rate shocks are found to be important for output determination, whereas markup and interest rate shocks are important for inflation. News, as contained in stock market variables and arising from anticipated interest rates, affects growth of gross domestic product. Interest rate shock is anticipated at horizon of one quarter and out of total variance explained by interest rate shock, one third is due to the anticipated shock. Anticipated interest rate shock diminishes the share of preference shock in output determination. Although markup shock has a large share, its persistence is low. There is evidence that permanent component of technology is not well anticipated. Once we incorporate this, technology shocks affect output more, although they still remain much below US levels. Implications for policy include forward guidance on interest rates, less reaction to short‐term supply shocks, and allowing technology shocks to play out.

Endogenous inattention and risk-specific price underreaction in corporate bonds

Corporate bond prices are slow to respond to default risk and interest rate shocks, as proxied by firm-level stock returns and Treasury returns, respectively. Furthermore, the underreaction is risk-specific: bonds with better credit quality underreact more to default risk, while those with worse quality underreact more to interest rates. The underreactions imply substantial out-of-sample return predictability, and investors appear to be leaving too much money on the table. The results are consistent with behavioral inattention models in which investors endogenously allocate more attention to payoff-relevant (or salient) risks, and they are not explained by traditional trading friction mechanisms.

The impact of the Federal Reserve System’s interest rate channel on the components of aggregate demand

Motivation: Monetary policy decisions, through the process of transmission mechanism, affect the term structure of nominal interest rates as well as other asset prices, and thus influences aggregate demand (e.g. consumer spending and business investments) and price levels through these effects. The aspect of monetary transmission to various components of aggregate demand has been relatively little studied in the literature of the subject.
 Aim: The main aim of the study is to empirically investigate the effect of the Fed’s monetary policy on major components of aggregate demand over the past 35 years. To this aim, the scale and timing of the interest rate pass-through to economic activity have been examined.
 Results: The empirical findings showed that that between 1984 and 2019, the sensitivity of consumption and investment expenditures to interest rate impulses were different. Firstly, fixed investment spending accounted for a significant part that was responsible for the response of real GDP following an interest rate shock. Secondly, in the case of personal consumption expenditures, expenses for durable goods were more sensitive to changes in the Fed’s interest rate than spending on services and nondurable goods. In this way, the study expands the existing literature by reporting the effects of the Fed’s monetary policy on major components of aggregate demand over the past 35 years

Nexus Between Interest Rate Risk and Economic Value of Equity of Banks

This analytical study looks to provide recommendations to the banking sector on different policies and regulations by examining certain aspects of the Basel III accord, which was designed to manage specific operational, capital and market risks of banks. A review of extant literature reveals that only a few papers have been written on simulation-based approaches, using basis and re-pricing risks. We look to connect this as a source while attempting to define and measure the impact of interest rate risk (IRR) on the economic value of equity (EVE) of banks. We propose to use the driver—driven method, wherein interest rate shocks are derived through prime lending rate (PLR) for the period of 2016–2019 in the context of India. Monte Carlo Simulation and OLS regression was performed to predict the IRR; Granger causality was used to examine the cause and effect relationship; the impulse response function (IRF) was used for sensitivity analysis; and the vector error correction model (VECM) technique was used for co-integrating relationships. Notably, the EVE movement caused due to shocks in interest rates had to be traced as it envisages probable EVE losses. Importantly, our study is among the first few to show the relationship between IRR and EVE of banks, especially after the deregulation of Indian banking sector.

A nonlinear ARDL model of inflation dynamics in the Philippine economy

This study investigated whether global oil price changes, exchange rate, interest rate, and economic output exert symmetric or asymmetric pass-through effects on inflation in the Philippines. A Nonlinear Autoregressive Distributed Lag (NARDL) model was fitted to the observable data using quarterly observations from 1998 to 2019. Knowledge of these relationships is important in monetary policy setting in achieving targeted inflation; the Philippines adopted inflation targeting in 2002. The finding shows that world oil price shocks are still prominent and the most important determinants of inflation variations in the country. There is prima facie evidence on the short-run asymmetry of oil price changes to inflation. Exchange rate pass-through to inflation was very minimal in the short-run, and there is no long-run effect. Evidence that interest rate and demand shocks have a long-run asymmetric effect on inflation was found. These findings imply that monetary policy setting should account for the asymmetric effects of inflation determinants. Study results provide a deeper understanding of how positive and negative changes of inflation determinants affect actual inflation, which aids policymakers in achieving targeted inflation.

Comparative effect of short-term credit granted to agriculture on agricultural added value in the West African countries

PurposeThe paper analyzes the response of agricultural value added to credit and real interest rate shocks in the West African Economic and Monetary Union (WAEMU) and make a short-term comparative effect analysis of credit granted to the agricultural sector on agricultural value added among member countries.Design/methodology/approachFirst, in order to estimate impulse response functions (IRFs) and study shocks, a panel VAR model is used. Second the paper uses an autoregressive distributed lag (ARDL) model with the associated error correction model to make a comparative analysis of the effect of agricultural credit on agricultural value added in the WAEMU.FindingsResults shows that: (1) credit stimulates agricultural value added only in the medium and long term; (2) in the case of WAEMU, credit only becomes a means of lifting the constraint of capital underutilization after three years; (3) short-term credit granted to agriculture in WAEMU has a weak and differentiated effect on agricultural value added from one country to another.Practical implicationsIt is imperative to implement a policy of lowering real short-term interest rates. Moreover, a monetary policy that favors direct financing of agriculture to the detriment of that oriented toward market financing is to be prioritized.Originality/valueThe originality of this paper is that it makes the link between macroeconomics and agriculture. It shows how the monetary instrument can be manipulated to improve the performance of agriculture. Actually, in WAEMU, the financing of agriculture is provided by the market. This paper proposes a new approach which is direct financing. The paper offers possibilities for the coordination of agricultural policies in the WAEMU.

Analysis of External Debt Sustainability in Mongolia: an Estimated DSGE Approach

In this study, we assess the effects of the structural shocks on the external debt sustainability in Mongolia, based on an estimated small open economy (SOE) dynamic stochastic general equilibrium (DSGE) model with the traded, the non-traded, and the mining sectors. The impulse response results show that the traded sector’s productivity shock, the commodity price shock, the mining output shock, and the foreign interest-rate shock have a decreasing effect on external debt accumulation in Mongolia, whereas the non-traded sector’s productivity shock, the household preference shock, and the government spending shock have an increasing effect on the same. Furthermore, we assess Mongolia’s external debt sustainability under the COVID−19 pandemic shock. Under our assumed pandemic scenario, Mongolia’s external debt will increase by 30% from its steady state over the next 10–28 quarters. Our recommended solution in this study is to develop the traded sector, instead of the mining sector, to maintain sustainability of the external debt and to decrease vulnerability of the economy.

A worst-case approach for interest rate stresses and stock crashes

Abstract In the current low interest rate environment even sovereign bonds cannot be considered as risk-free investments. To care for this aspect we introduce a worst-case continuous-time portfolio problem with combined stresses, that is, both stocks and the money market account can experience shocks in the form of unpredictable downward jumps in their values. We characterize the worst-case optimal portfolio strategy as an indifference strategy that is the solution of a constrained optimization problem. Our results generalize existing results in a multi-asset setting. Numerical examples demonstrate new effects in the presence of interest rate shocks. These insights can be used for risk management in the presence of crash risks.

External debt management as macroprudential policy in a small open economy

This paper examines the role of macroprudential policy and foreign exchange rate intervention in stabilizing the economy facing foreign shocks. To this end, we build a small open economy dynamic stochastic general equilibrium (DSGE) model with a banking sector. We add foreign loans by entrepreneurs regulated by a macroprudential policy via a foreign to domestic loan ratio requirement. The exchange rate intervention is undertaken via a modified Taylor rule. From the analysis, two important results emerge. First, the responses of aggregate output, consumption, investment, and inflation vary widely for different types of foreign shock and policy combinations. Second, the stabilization gain seems to depend on the type of foreign shock hitting the economy. When the economy is hit by a foreign interest rate shock, tightening the macroprudential measure reduces the volatility of output, consumption, and investment-more than if the stabilization effort is carried out through an exchange rate intervention. However, under a risk premium shock, this gain diminishes substantially.

Investigating Exchange Rate Pass-through to Consumer Prices in Nigeria

Abstract Research background: There have been several studies on the degree of exchange rate pass-through (ERPT) to consumer prices, as well as macroeconomic environment with yet no clear direction. Purpose: This research work investigates exchange rate pass-through effects into consumer prices in Nigeria from 1960 to 2018. Research methodology: The methodology employed by the study for estimation is the Johansen cointegration and Vector Error Correction Model (VECM) procedures. Results: The empirical results indicate an incomplete pass-through of exchange rate into consumer prices in Nigeria. The pass-through is found to be 1.6 for the model under consideration. The impulse response function results indicate that the response of the consumer prices to the exchange rate shock decreases immediately to a negative shock in the short run, and continues along the horizon to a positive shock in the long run. Also, the response of consumer prices to interest rate shock decreases immediately and continues to fluctuate to a negative shock in both the short run long run horizon. Novelty: The results support the view that exchange rate policy should be complimented with coordinated macroeconomic policy approaches in order to control inflationary level in the economy. The study therefore recommends that the Federal Government should adopt a tightening of the monetary policy as it will help reduce the impact of exchange rate depreciation on consumer prices.

Monetary policy, customer capital, and market power

In U.S. firm-level data, large firms increase their spending on customer capital significantly more than small firms following an interest rate decline. We interpret this evidence in a model with product market frictions where heterogeneous firms strategically advertise to build a customer base. When a firm advertises, it shifts customers’ demand away from competitors. This externality is especially severe when firms have a sizable existing customer base, discouraging smaller competitors and making them less responsive to interest rate shocks. The model provides a rationale for the rise in market concentration and market power in recent decades, while interest rates fell.

Heterogeneity in the Relationship Between NPLs and Real Economy: Evidence from the Mongolian Banking System

Abstract The paper analyses the relationship between the banks’ credit risk and macroeconomic conditions by addressing the following questions; (i) How are macroeconomic shocks transmitted to lending risk depending on the ban-specific features? (ii) Are the effects of macroeconomic shocks different across the loan portfolios in various economic sectors? Unlike the common assumption in the literature, the empirical analysis considers banks’ heterogeneity and diversification across borrowers. It employs heterogeneous panel SVARs and standard SVAR models on a dataset from 2002. Q1 to 2019.Q1. The results suggest that the deterioration in credit quality is affected by both macroeconomic and bank-specific factors, with substantial heterogeneity in the magnitudes and timing in terms of the type of loans in various business sectors and bank characteristics. In particular, we find strong evidence of cyclical sensitivity of loan quality, and about 1/4 of banks’ NPLs increases stronger in response to the shocks to growth, exchange rate, interest rate, and profitability. The highly profitable banks tend to less engage in excessive risk-taking, resulting in lower NPLs, whereas the relation of asset size to NPLs is not significant for the sample. A growth shock plays a prominent role in explaining the variation of NPLs for the trade and mining sectors. Similarly, the loan supply shock is the main determinant for the construction sector’s NPLs, while the exchange rate shock is the most responsible for the manufacturing sector. The interest rate shock and exchange rate shock are the most effective factors on NPLs of consumer loans. Finally, the feedback effect of NPLs shows that deterioration of credit quality slows down economic growth.

Построение оптимальных инструментальных правил ДКП для экономики с высокой зависимостью от экспорта ресурсов в условиях наличия ZLB (Optimal simple monetary policy rules for a resource-rich economy and the Zero Lower Bound)

In this article, we study the optimal simple monetary policy rules under the Zero Lower Bound using DSGE model. The model economy is open and highly dependent on the terms of trade. Economic dynamics is the result of a terms of trade shock and an external interest rate shock. Using the impulse response functions, we show that the presence of ZLB reduces the impact of positive external shocks. This means greater growth in real interest rates and less growth in consumption and production. Monetary authority minimizes the volatility of key macroeconomic indicators. The optimal parameters of the rule turn out to be such that the regulator de facto reduces the probability of being at the ZLB. Under the ZLB the regulator is less responsive to inflation changes, and the interest rate is more persistent. In the case of Russia, we have got low probability estimate of hitting the ZLB under the current monetary policy and a long-term value of the interest rate of 6%. The gap reaction parameter and interest rate persistence parameter for the current monetary policy are in the range of values for optimal monetary policy rules. The current CPI reaction parameter is much less than the optimal one. This implies a higher probability of hitting the ZLB in the optimum than under the current monetary policy. The results obtained can be used by the regulator to assess the limits of the application of monetary policy and adjust the monetary policy by taking into account the possibility of reaching the ZLB. [In Russian] В работе с помощью динамической стохастической модели общего равновесия исследуются правила денежно-кредитной политики при условии наличия нижней нулевой границы ставок. Модельная экономика является открытой и сильно зависящей от условий торговли. Экономическая динамика является результатом действия шока условий торговли и шока внешней процентной ставки. На уровне функций импульсного отклика показано, что наличие нижней границы ставок приводит к уменьшению влияния позитивных внешних шоков: к большему росту реальных процентных ставок и к меньшему росту потребления и выпуска. Были найдены оптимальные правила ДКП, реализующие стремление органа ДКП минимизировать волатильность ключевых макроэкономических показателей. В оптимуме параметры правила оказываются такими, что регулятор де-факто уменьшает вероятность пребывания на нижней границе ставок. При наличии ограничения нижней границы ставок регулятору выгоднее в меньшей степени реагировать на изменение инфляции и в большей мере сглаживать во времени динамику процентной ставки. Для России вероятность попадания на нулевую границу ставок при текущей денежно-кредитной политике и долгосрочном значении процентной ставки 6% в результате действия внешних шоков была оценена как низкая. Действующее правило ДКП в отношении реакция процентной ставки на разрыв выпуска и сглаживания во времени динамики процентной ставки попадает в диапазон значений из оптимальных правил, тогда как текущая степень реакции на инфляцию оказывается значительно ниже оптимальных параметров, что подразумевает более высокую вероятность попадания на границу ставок в оптимуме. Результаты работы могут быть использованы регулятором для оценки границ применения ДКП и корректировки ДКП с учётом возможности попадания на нижнюю границу процентных ставок.