The impacts of monetary policy on output growth and inflation in vietnam a var approach (luận văn thạc sĩ)

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

VIETNAM- NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACTS OF MONETARY POLICY ON
OUTPUT GROWTH AND INFLATION
IN VIETNAM: A VAR APPROACH
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

VO PHUOC THUAN

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 ............................................................. 10

+ The exchange rate channel ................................................ 13
2.1.6. Conceptual framework for the study ...................................... 15
2.2. Previous empirical studies related .................................................. 16
2.3. Chapter remarks ..................................................................... 23
CHAPTER III: ECONOMY PERFORMANCE, FINANCIAL SYSTEM
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

DF test:

Dicky Fuller test.

E or ER:

Exchange rate.

ECB:

European Central Bank.

VD:

Variance Decomposition.

FED:

The Federal Reserve System is the central bank of the United
States.

GDP:

Gross Domestic Product.

GSO:

General Statistic Office.

1:

Interest rate.

1:

Investment.

ICOR:

Incremental Capital-Output Ratio.

DOT:

Direction of Trade Statistics.

IFS:

International Finance Statistics.

IMF:

International Monetary Fund.

OECD.Stat:

Organisation for Economic Co-operation and Development
StatExtracts.

AD-AS model:

Aggregate Demand-Aggregate Supply model.

ISILM model:

Investment-Saving I Liquidity preference-Money supply model.

Ms orMS:

Money supply.

M2:

Broad money or high-powered money.

NEER:

Nominal Effective Exchange Rate.

REER:

Real Effective Exchange Rate.

NX:

Net export.

OIRF or IRF:

Orthogonalized Impulse Response Function.

P or CPI:

Consumer Price Index.

pe:

Expected Price Level.

Pe:

Equity price.


•

1te :

Expected inflation.

SBV:

State Bank of Vietnam.

u.s.

The United States of America.

VAR:

Vector Auto-Regression.

Y:

Output.

LR:

likelihood ratio test.

FPE:

Final prediction error.

AIC:

Akaike information criterion.

SC:

Schwarz information criterion.

HQ:

Hannan-Quinn information criterion.


LIST OF FIGURE

Figure 2.1:

Keynesian AS-AD model.

Figure 2.2:

A tight monetary policy of traditional Keynesian ISILM model.

Figure 3.1:

Economic growth- Source: IMF (2012).

Figure 3.2:

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

Figure 3.3:

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

Figure 4.1:

Response of real output growth to money supply.

Figure 4.2:

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

Figure 4.3:

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

Figure 4.4:

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

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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 10) 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
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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
economy (real output growth and inflation) of Vietnam.

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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 .

•

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

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:

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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 E 2 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

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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!

----+

ij

----+

1!, NX!

----+

Y !" 1.

11

Figure 2.2: A tight monetary policy

1

8

The notation M , i, I, NX, Y stands for Money supply, interest rate, Investment, Net export and Output,
respectively.

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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
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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:
~

The interest rate channel

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 shortterm interest will affect both the long-term interest rate 2 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
2

The long-term interest rate is approximately an average of expected short-term interest rates.

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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 ~ Yj 3• 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:

>

The credit channel

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,
respectively.

1te

are expectation of price level and expectation of inflation,

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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- It- 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.
From that time onwards, the existence of certificates of deposit (CDs) makes it

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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! ---+ Pe! ---+ adverse
selectionj, moral hazardj---+ lending!---+ I!---+ Y!"(Mishkin, 1995).

Cash flow channel
Furthermore, a tightening of monetary policy may also push up interest rate 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).

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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 hazardj - lendingt -

unanticipated P t -

adverse selection j, moral

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".
~

The exchange rate channel

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

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