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 1.2 Significant of the study 1.3 Research objectives 1.4 Research questions 1.5 Thesis Structure CHAPTER II: LITERATURE REVIEW 2.1 Theoretical literature review 2.1.1 Mechanism of the impact of aggregate demand to output and price level 2.1.2 Traditional Keynesian IS/LM model 2.1.3 The Mundell-Fleming model 2.1.4 Tobin q 's theory 2.1.5 Monetary transmission mechanism + The interest rate channel + 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 1.1 Economic growth 24 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: ISILM model: Aggregate Demand-Aggregate Supply model Ms orMS: Investment-Saving I Liquidity preference-Money supply model M2: Money supply NEER: REER: NX: Broad money or high-powered money Nominal Effective Exchange Rate Real Effective Exchange Rate OIRF or IRF: Net export P or CPI: Orthogonalized Impulse Response Function pe: Consumer Price Index Pe: Expected Price Level 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- Figure 3.3: Interest rate in Vietnam - Source: State Bank of Vietnam and World Source: IMF (2012) 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 ' - 83- BASIC MODEL WITH GROWTH, DL_CPI_UB, DL_M2 Response to Cholesky One S.D movations :1: S E ~T 15 10 W -5 I• -10- ··T - : ;'f\\/\. ·· ·· - :: ·1+-r, -,rr-r-r"T-rrr-r-r-rT.-r-r-1 BASIC MODEL WITH GROWTH, DL_CPI_RR, DL_M2 Response to Cholesky One S.D hnovations :1:2 S.E Response of GROWTH to GROWTH 20 - r 15 10 s ~/ ,, v ·10-J rr-r -r-r-T""t-r, ,rr-rr-r:-r-1 8-, -, -.4 +,., , , ,., rr-T"T., -, r-r-l R ·1 t -84- APPENDIXS VARIANCE DECOMPOSITION BASIC MODEL WITH GROWTH, DL_CPI, DL_M2 Variance Decomposition of GROWTH: Period 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_CPI: Period 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_M2: Period - 85- 10 18 11 12 13 14 15 16 17 2.038553 12.38599 13.35720 74.25681 Cholesky 2.027724 2.032486 2.033356 2.034428 2.036043 2.037181 2.037904 2.038320 2.038467 2.038519 Ordering: GROWTH DL_CPI DL_M2 EXTENDED MODEL WITH GROWTH, DL_CPI, DL_M2, DL_LR Variance Decomposition of GROWTH: Period 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_CPI: Period 10 11 12 13 14 15 16 17 18 - 86- Variance Decomposition of DL_M2: Period 1.631784 1.728950 1.972896 2.004071 2.032408 2.064452 2.082150 2.085929 2.091002 2.091737 2.095375 2.098649 2.102571 2.104540 2.106053 2.106476 2.106692 2.106784 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_LR: Period 10 11 18 12 13 14 15 16 17 7.662977 1.716445 24.55751 5.928325 67.79772 Cholesky 6.110893 6.315207 6.817444 7.023820 7.246553 7.281706 7.317356 7.371191 7.447174 7.529235 7.590753 7.619558 7.635232 Ordering: GROWTH DL_CPI DL_M2 DL_LR EXTENDED MODEL WITH GROWTH, DL_CPI, DL_M2, DL_CREDIT Variance Decomposition of GROWTH: Period S.E 14.73710 16.18840 16.78885 17.67211 17.75228 17.85011 17.88608 17.89820 17.92948 - 87- 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_CPI: Period 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_M2: Period 2.004183 11 12 13 14 15 16 17 18 2.055707 2.069238 2.081491 2.088580 2.090670 2.094395 2.096733 2.098877 2.100492 2.101663 2.102331 2.102791 2.103039 1.815525 1.892713 10 Variance Decomposition of DL_CREDIT: Period 1.989666 2.081869 2.190139 2.234093 2.266031 - 88- 10 11 12 13 14 15 16 17 18 2.288125 2.300837 2.308552 2.312898 2.316931 2.318811 2.320279 2.321192 2.321950 2.322423 2.322700 9.743702 13.85145 42.99321 33.41163 Cholesky Ordering: GROWTH DL_CPI DL_M2 DL_CREDIT EXTENDED MODEL WITH GROWTH, DL_CPI, DL_M2, DL_E Variance Decomposition of GROWTH: Period S.E 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_CPI: Period 15.12705 16.27134 16.89634 17.92684 18.03116 18.07515 18.08392 18.09904 18.11517 18.13285 18.13974 18.14371 18.14693 18.14787 18.14922 18.14984 18.15015 18.15032 S.E 10 11 12 13 14 15 16 17 18 0.537802 0.641792 0.794502 0.877570 0.901878 0.923831 0.934207 0.939243 0.947411 0.957578 0.964159 0.968095 0.969734 0.970063 0.970620 0.971471 0.972499 0.973454 - 89- Variance Decomposition of DL_M2: Period S.E 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_E: Period S.E 10 11 18 2.086016 2.090300 2.093512 2.094836 2.098055 2.101647 2.104143 2.105590 2.106138 2.106270 2.106475 2.106750 12 13 14 15 16 17 1.845236 8.109685 10.64364 5.948609 75.29806 Cholesky 1.480161 1.564857 1.685018 1.697239 1.764020 1.797734 1.818691 1.828461 1.835951 1.837213 1.839416 1.841684 1.843137 1.844271 1.844704 1.845069 1.845204 Ordering: GROWTH DL_CPI DL_M2 DL_E BASIC MODEL WITH GROWTH, DL_CPI_UB, DL_M2 Variance Decomposition of GROWTH: Period S.E -90- 14.84195 15.95194 16.55048 17.38286 17.46052 17.53415 17.54384 17.55881 17.57714 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_CPI_UB: Period 10 11 12 13 14 15 16 17 18 Variance Decomposition of DL_M2: Period 18 2.041487 13.29583 14.84863 71.85554 Cholesky Ordering: GROWTH DL_CPI_UB DL_M2 ~· BASIC MODEL WITH GROWTH, DL_CP -91- ' 14.77800 15.88186 16.45851 10 11 12 13 14 15 16 17 18 17.51895 17.53615 17.56173 17.58443 17.59258 17.59669 17.59754 17.59841 17.59893 17.59947 17.59991 17.60016 Variance Decomposition of DL_CPI_RR: Period 10 11 12 13 14 15 16 17 18 0.709076 0.857863 0.937981 0.975350 1.007758 1.018219 1.019539 1.023227 1.025606 1.028824 1.031492 1.033302 1.034401 1.034861 1.035033 1.035099 1.035146 Variance Decomposition of DL_M2: Period S.E 10 11 12 13 14 1.774125 1.841272 1.944544 1.986760 2.004191 2.024122 2.038181 2.045572 2.045732 2.046411 2.046788 2.047340 2.047828 15 16 17 18 2.048126 2.048323 2.048406 2.048432 11.50091 16.36383 72.13526 Cholesky Ordering: GROWTH DL_CPI_RR DL_M2 - 92- ... 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. .. 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... 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