Assignment 1 (Monetary Economics)

Has the transition to the EU changed the transmission of monetary policy shocks in EU accession countries?

Anton Izvolenskiy Andres Fernando Garcia Parrado

Dimitrios Bermperoglou

1

1. 1. 1. 1. A short theoretical background of short run effects of moneA short theoretical background of short run effects of moneA short theoretical background of short run effects of moneA short theoretical background of short run effects of money and y and y and y and interest rate on economyinterest rate on economyinterest rate on economyinterest rate on economy

Instruments Instruments Instruments Instruments : variables directly controlled by the central bank (e.g. an interest rate charged on reserves borrowed by the central bank) Intermediate target variablesIntermediate target variablesIntermediate target variablesIntermediate target variables: lie in the sequence of links that run from policy instruments to real economic activity. For example, faster than expected money growth may signal that real output is expanding more rapidly than was previously thought. The central bank might change its operating target (in this case, raise the interbank interest rate) to keep the money growth rate on a path believed to be consistent with achieving its policy goals. In this case, money growth is serving as an intermediate target variable. We are going to use both money supply and money market interest rate as the policy variables.

How the central bank can increase money supply?How the central bank can increase money supply?How the central bank can increase money supply?How the central bank can increase money supply? Open-market operations by the CB are the principal tool of monetary policy: the CB can increase or reduce the monetary base by buying government debt from banks or selling government debt to banks.

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Monetary policy and its shortMonetary policy and its shortMonetary policy and its shortMonetary policy and its short----run effectsrun effectsrun effectsrun effects

Expansionary Monetary PolicyExpansionary Monetary PolicyExpansionary Monetary PolicyExpansionary Monetary Policy

If the ECBECBECBECB pursues expansionaryexpansionaryexpansionaryexpansionary monetarymonetarymonetarymonetary policypolicypolicypolicy by increasing the supplysupplysupplysupply ofofofof moneymoneymoneymoney then the nominal interest ratenominal interest ratenominal interest ratenominal interest rate will fall, investmentinvestmentinvestmentinvestment will rise, consumptionconsumptionconsumptionconsumption will rise. Finally, outputoutputoutputoutput may also rise (see IS-LM model).

o interest sensitive purchases are less expensive o people save less and consume more o because the supply of money rises, people buy more goods and services.

As the business cycle expansion gets underway, wealth rises and people buy more financial assets as well.

In long-run, prices increaseprices increaseprices increaseprices increase and restore equilibrium. Money does not affect real economy.

3

Contractionary Monetary PolicyContractionary Monetary PolicyContractionary Monetary PolicyContractionary Monetary Policy

As the money supply is contracted, interest rates riseinterest rates riseinterest rates riseinterest rates rise, investmentinvestmentinvestmentinvestment will fall, consumptionconsumptionconsumptionconsumption will fall.

In turn…In turn…In turn…In turn…rising intrising intrising intrising interest rateserest rateserest rateserest rates

People make a portfolio choiceportfolio choiceportfolio choiceportfolio choice : money and bonds.

People will choose to hold more bonds than they did before because the return on a bond has risen (iiii has gone up).

So, if the EEEECB CB CB CB pursues contractionarycontractionarycontractionarycontractionary monetarymonetarymonetarymonetary policypolicypolicypolicy by decreasing the suppsuppsuppsupplylylyly ofofofof moneymoneymoneymoney, the nominal interest ratenominal interest ratenominal interest ratenominal interest rate will rise, investmentinvestmentinvestmentinvestment will fall, and consumptionconsumptionconsumptionconsumption will fall and so outputoutputoutputoutput.

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2. Research2. Research2. Research2. Research

Sims (1992)Sims (1992)Sims (1992)Sims (1992)

� VAR evidence on money and output � Results: Monetary shocks lead to a hump-shaped output response. Increase in

money growth leads to increase in output over its steady-state.

Eichenbaum (1992)Eichenbaum (1992)Eichenbaum (1992)Eichenbaum (1992)

� Positive money supply shock interest rate rises (puzzling)

Output falls (output puzzle)

� Positive funds-rate shock output falls (no puzzle!)

Prices rise (price puzzle!)

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3333. Econometric project. Econometric project. Econometric project. Econometric project

Data sourcesData sourcesData sourcesData sources � International Monetary Fund � 3 countries: Estonia, Latvia, Lithuania � Quarterly data from 1998 – 2009 � Two samples a) before EU accession 1998:1 – 2004:2 b) after EU 2004:3 – 2009:4 � Variables: Money supply M1 (Currency in circulation + overnight deposits) Annual rate of change of HCPI Money market interest rate Per capita GDP in current prices 2005

Note:Note:Note:Note: The Eastern-european countries do not have sufficient data available since their economic record (history) is too short till now. For this reason, the results we obtain are not very robust. However, we do make some comments on them, just to emphasize how empirical work (impulse responses here) can be linked and directly compared with theoretical facts.

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Evidence for the causality between money growth and outputEvidence for the causality between money growth and outputEvidence for the causality between money growth and outputEvidence for the causality between money growth and output

� Money supply seems to lead outputMoney supply seems to lead outputMoney supply seems to lead outputMoney supply seems to lead output.

-.20

-.15

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-.05

.00

.05

.10

.15

.20

98 99 00 01 02 03 04 05 06 07 08 09

LM GDP

� Strong correlation evidenceStrong correlation evidenceStrong correlation evidenceStrong correlation evidence between money supply and output:

Estimated correlation coefficient Estimated correlation coefficient Estimated correlation coefficient Estimated correlation coefficient ≈≈≈≈ 0.99 0.99 0.99 0.99

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Methodology The VAR system can be written in this vector form:

tttttt uYYYYtY +⋅Π+⋅Π+⋅Π+⋅Π++= −−−− 44332211δµ

Where

iY - vector of variables

t

t

t

y

m

π

iΠ - matrix of coefficients, 3x3

µ - constant vector, 3x1 δ - trend vector, 3x1

tu - vector of VAR shocks.

• First we have to decide the optimal lag length of the VAR model. Doing it through E-views, we obtain the following table. As we see, the most information criteria suggest using 4 lags. VAR Lag Order Selection Criteria Endogenous variables: LM_ES INFLATION_ES LGDP_ES Exogenous variables: C @TREND Sample: 1998Q1 2004Q2 Included observations: 22

Lag LogL LR FPE AIC SC HQ 0 150.2510 NA 4.06e-10 -13.11373 -12.81617 -13.04363 1 166.9778 25.85051 2.06e-10 -13.81616 -13.07227 -13.64093 2 172.3288 6.810377 3.10e-10 -13.48444 -12.29421 -13.20406 3 185.5962 13.26738 2.55e-10 -13.87238 -12.23582 -13.48686 4 230.0949 32.36271* 1.51e-11* -17.09954* -15.01664* -16.60887* * indicates lag order selected by the criterion

LR: sequential modified LR test statistic (each test at 5% level) FPE: Final prediction error AIC: Akaike information criterion SC: Schwarz information criterion HQ: Hannan-Quinn information criterion

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• Next, we estimate the VAR(4) model and the coefficients estimates are summarized in a more convenient VAR representation as follows:

+

⋅

−

−−

−

+

⋅

−−

−−

−

+

+

⋅

−−

−−+

⋅

−

−+⋅

−+

−

=

−

−

−

−

−

−

−

−

−

−

−

−

yt

t

mt

t

t

t

t

t

t

t

t

t

t

t

t

t

t

t

u

u

u

y

m

y

m

y

m

y

m

tE

y

m

πππ

πππ

4

4

4

3

3

3

2

2

2

1

1

1

42.006.038.0

08.083.002.0

56.003.211.0

14.017.022.0

01.089.003.0

05.093.122.0

48.063.037.0

03.025.013.0

009.005.014.0

24.056.139.0

07.051.011.0

06.013.036.0

13.0

055

05.0

06.0

32.0

39.0

Where u are the VAR disturbances/ shocks with var-cov matrix:

=2

2

2

yymy

ym

mymm

uV

σσσσσσσσσ

π

πππ

π

• Remember that VAR presented above can be reduced to a vector notation form as:

tttttt uYYYYtY +⋅Π+⋅Π+⋅Π+⋅Π++= −−−− 44332211δµ

We define a lag operator L such that: 1−= tt xLx

Hence, the above matrix equation becomes:

( )ttt

ttt

tttttt

uYLtY

uYLLLtY

uYLYLYLYtY

+⋅Π++=⇔

+⋅Π+Π+Π+Π++=⇔

+⋅Π+⋅Π+⋅Π+⋅Π++=

−

−

−−−−

1

13

42

321

13

412

31211

)(δµ

δµ

δµ

• However, in order to compute impulse responses, we need to estimate the coefficients of the

SMA(∞) representation. Structural moving average (SMA) representation is derived through the

SVAR(p) representation. And SVAR(p), in turn, can be derived from the VAR(p).

A SVAR representation can be derived from the reduced VAR by multiplying the VAR model

with a Q matrix .

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tt

ttt

eYLQт

uQYLQtQQYQ

+⋅Π⋅++=

⋅+⋅Π⋅+⋅+⋅=⋅

−

−

1

1

)(

)(

κ

δµ

Where e are the structural shocks with var-cov matrix:

=2

2

2

~00

0~0

00~

y

m

eV

σσ

σ

π

As we see, the structural VAR captures not only a lagged but also contemporaneous

relationships among all the variables of the model. The contemporaneous effects are

summarized in the matrix Q. Also the VAR shocks are related to the structural shocks with the

formula:

eQu =

Obviously, Q is a 3x3 matrix since there are 3 variables in the model.

Now, we have to make some identification assumptions on matrix Q, in order to exactly

identify the SVAR parameters using the estimated VAR parameters. For this reason, we proceed

to the following manipulations:

eeQueQu ⋅Θ==⇔= −1

Identification AssumptionIdentification AssumptionIdentification AssumptionIdentification Assumption: Monetary Monetary Monetary Monetary policy is exogenous to contemporaneous output policy is exogenous to contemporaneous output policy is exogenous to contemporaneous output policy is exogenous to contemporaneous output and inflation shocks.and inflation shocks.and inflation shocks.and inflation shocks. Θ is lower triangular

++=

+=

=

⇒

⋅

=

ymy

m

mm

y

m

y

m

u

u

u

u

u

u

εθεθεθεθεθ

εθ

εεε

θθθθθ

θ

π

ππππ

333231

2221

11

333231

2221

11

0

00

10

According to our assumption of the exogeneity of the policy shock, we need to make Θ (thus Q)

lower triangular. In practice, that means setting 3 elements of the matrix equal to zero.

However, E-views uses a slightly different notation of presenting the relation between the VAR

and the SVAR shocks. It assumes that:

eBuA ⋅=⋅ So nothing changes in essence. What was previously as matrix Q now can be decomposed as:

ABQ 1−= So in order to identify matrices A and B, we need to impose 3 restrictions on matrix Q. In the

following table, in the first part, exactly we impose these restrictions by making A a lower

triangular matrix with 1 as diagonal elements and making B a diagonal matrix. E-views will

estimate the remaining elements of these matrices. The estimates are given in the second part of

the table.

Structural VAR Estimates Sample (adjusted): 1999Q1 2004Q2 Included observations: 22 after adjustments Estimation method: method of scoring (analytic derivatives) Convergence achieved after 9 iterations Structural VAR is just-identified

Model: Au = Be where E[ee’]=I

Restriction Type: short-run pattern matrix A =

1 0 0 C(1) 1 0 C(2) C(3) 1

B = C(4) 0 0

0 C(5) 0 0 0 C(6)

Estimated A matrix: 1.000000 0.000000 0.000000 0.197561 1.000000 0.000000 -1.404929 -1.994283 1.000000

Estimated B matrix: 0.017921 0.000000 0.000000 0.000000 0.009269 0.000000 0.000000 0.000000 0.014260

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Note that with the help of matrices A and B (thus Q) the VAR can be written as

tt

ttt

eQYLt

uYLtY1

1

1

)(

)(−

−

−

+⋅Π++=

=+⋅Π++=

δµ

δµ

Now everything is done! We have already estimated the coefficients of the VAR model, i.e.

elements of Π matrices, and previously we estimated matrices A and B (which yields Q). The

final step is to plug equations of this system one into the other, then iterating backward in time

and finally obtaining the SMA(∞) representation:

........22110 +Φ+Φ+Φ+= −− tttt eeeY γ

Where Φ are 3x3 matrices, whose elements captures the impulse responses. More precisely, the analytical expression of the system above is:

........

1

1

1

133

132

131

123

122

121

113

112

111

033

032

031

023

022

021

013

012

011

+

+

+

=

−

−

−

yt

t

mt

yt

t

mt

y

m

t

t

t

e

e

e

e

e

e

y

m

πππ

φφφφφφφφφ

φφφφφφφφφ

γγγ

π

After specifying matrices A and B, E-views can compute automatically the impulse responses

and yields the following graphs. We concentrate on impulse responses of all variables to a

money shock only.

The impulse response function plots the percentage deviation of a variable from its steady state

against periods of time after the shock. So, for example, a money shock causes money in the first

period after the shock (t=1) to increase almost to 0.017% over its steady state, as we see in the

next graph.

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ESTONIA

Effects of a monetary policy shock on Money

* Shock 1 represents a money supply shock, while shock 2 represents an interest rate shock.

-.06

-.04

-.02

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1 2 3 4 5 6 7 8 9 10

Response of LM_ES to StructuralOne S.D. Shock1

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

1 2 3 4 5 6 7 8 9 10


-.08

-.04

.00

.04

.08

1 2 3 4 5 6 7 8 9 10


-.15

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-.05

.00

.05

.10

.15

1 2 3 4 5 6 7 8 9 10


-.02

-.01

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.01

.02

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1 2 3 4 5 6 7 8 9 10


-.04

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10


13

Effects of a monetary policy shock on Inflation

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-.04

-.02

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.02

.04

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1 2 3 4 5 6 7 8 9 10

Response of INFLATION_ES to StructuralOne S.D. Shock1

-.4

-.3

-.2

-.1

.0

.1

.2

1 2 3 4 5 6 7 8 9 10


-.06

-.04

-.02

.00

.02

.04

.06

1 2 3 4 5 6 7 8 9 10


-.08

-.06

-.04

-.02

.00

.02

.04

.06

1 2 3 4 5 6 7 8 9 10


-.012

-.008

-.004

.000

.004

.008

.012

1 2 3 4 5 6 7 8 9 10


-.03

-.02

-.01

.00

.01

.02

1 2 3 4 5 6 7 8 9 10


14

Effects of a monetary policy shock on GDP

-.12

-.08

-.04

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.08

.12

1 2 3 4 5 6 7 8 9 10

Response of LGDP_ES to StructuralOne S.D. Shock1

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

1 2 3 4 5 6 7 8 9 10


-.12

-.08

-.04

.00

.04

.08

.12

1 2 3 4 5 6 7 8 9 10


-.15

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-.05

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-.04

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-.01

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-.05

-.04

-.03

-.02

-.01

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1 2 3 4 5 6 7 8 9 10


15

Effects of a monetary policy shock on Interest Rate

-.04

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10

Response of IR_ES to StructuralOne S.D. Shock1

-.012

-.008

-.004

.000

.004

.008

.012

1 2 3 4 5 6 7 8 9 10


-.008

-.004

.000

.004

.008

.012

1 2 3 4 5 6 7 8 9 10


-.005

-.004

-.003

-.002

-.001

.000

.001

.002

.003

.004

1 2 3 4 5 6 7 8 9 10


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Comments of the impulse responses for ESTONIA

� The impulse response of money and inflation due to a money supply shock is statistically

significant, but is almost zero.

� The impulse response of output due to a money supply shock is not statistically

significant, almost zero.

� The impulse responses of money, inflation and output, using the interest rate for policy

shocks, are not statistically significant, almost zero.

However, what we could say if the results were significant (in fact we have to include more

observations in our sample to make results robust) :

� Before EU accession, an expansionary policy (using money supply shocks) made

inflation to fall. Also a contractionary policy (using interest rate) made inflation to rise.

These results deviate from the standard theory (price puzzle). After the EU accession,

however, the results are expected according to the theory if we consider a money supply

shock. However, the price puzzle remains and it is statistically significant (very small

though) in the case of interest rate policy shock. Hence, the “liquidity effect” does not

hold in the case of interest rate policy.

� Before EU accession, an expansionary policy (using money supply shocks) made output

to fall. Also a contractionary policy (using interest rate) made output to rise. These results

deviate again with the standard theory (output puzzle). After the EU accession, however,

the results are the expected ones if we consider a money supply shock. However, the

output puzzle remains in the case of interest rate policy shock. Hence, the “liquidity

effect” does not hold in the case of interest rate policy.

The results for the other countries, Latvia and Lithuania , are similar. Furthermore, the

impulse responses in all cases are either not statistically significant or almost zero. Hence, the

effects of monetary policy shocks are very weak. (Again the problem is the lack of sufficient

number of observations that would enable us to derive more robust results).

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Latvia


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1 2 3 4 5 6 7 8 9 10

Response of LM_LAT to StructuralOne S.D. Shock1

-.4

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-.1

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.1

.2

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1 2 3 4 5 6 7 8 9 10


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-1.0

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0.0

0.2

0.4

1 2 3 4 5 6 7 8 9 10


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1 2 3 4 5 6 7 8 9 10


18


-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10

Response of INFLATION_LAT to StructuralOne S.D. Shock1

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

1 2 3 4 5 6 7 8 9 10


-.015

-.010

-.005

.000

.005

.010

.015

1 2 3 4 5 6 7 8 9 10


-.06

-.04

-.02

.00

.02

.04

.06

.08

.10

1 2 3 4 5 6 7 8 9 10


-.010

-.005

.000

.005

.010

1 2 3 4 5 6 7 8 9 10


-.03

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10


19


-.3

-.2

-.1

.0

.1

.2

.3

1 2 3 4 5 6 7 8 9 10

Response of LGDP_LAT to StructuralOne S.D. Shock1

-.15

-.10

-.05

.00

.05

.10

.15

.20

1 2 3 4 5 6 7 8 9 10


-.15

-.10

-.05

.00

.05

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1 2 3 4 5 6 7 8 9 10


-.5

-.4

-.3

-.2

-.1

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.1

.2

.3

.4

1 2 3 4 5 6 7 8 9 10


-.08

-.06

-.04

-.02

.00

.02

.04

.06

1 2 3 4 5 6 7 8 9 10


-.03

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-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10


20


-.010

-.005

.000

.005

.010

1 2 3 4 5 6 7 8 9 10

Response of IR_LAT to StructuralOne S.D. Shock1

-.12

-.08

-.04

.00

.04

.08

1 2 3 4 5 6 7 8 9 10


-.006

-.004

-.002

.000

.002

.004

.006

1 2 3 4 5 6 7 8 9 10


-.04

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10


21

Lithuania


-.12

-.08

-.04

.00

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.08

.12

.16

1 2 3 4 5 6 7 8 9 10

Response of LM_LIT to StructuralOne S.D. Shock1

-.08

-.06

-.04

-.02

.00

.02

.04

.06

1 2 3 4 5 6 7 8 9 10


-.3

-.2

-.1

.0

.1

.2

.3

1 2 3 4 5 6 7 8 9 10


-.5

-.4

-.3

-.2

-.1

.0

.1

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1 2 3 4 5 6 7 8 9 10


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-.1

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.1

.2

1 2 3 4 5 6 7 8 9 10


-.3

-.2

-.1

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.1

.2

.3

1 2 3 4 5 6 7 8 9 10


22


-.020

-.015

-.010

-.005

.000

.005

.010

.015

.020

1 2 3 4 5 6 7 8 9 10

Response of INFLATION_LIT to StructuralOne S.D. Shock1

-.04

-.03

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10


-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10


-.04

-.03

-.02

-.01

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.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10


-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10


-.08

-.04

.00

.04

.08

.12

1 2 3 4 5 6 7 8 9 10


23


-.15

-.10

-.05

.00

.05

.10

.15

1 2 3 4 5 6 7 8 9 10

Response of LGDP_LIT to StructuralOne S.D. Shock1

-.10

-.08

-.06

-.04

-.02

.00

.02

.04

.06

1 2 3 4 5 6 7 8 9 10


-.3

-.2

-.1

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.1

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.3

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1 2 3 4 5 6 7 8 9 10


-.25

-.20

-.15

-.10

-.05

.00

.05

.10

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-.16

-.12

-.08

-.04

.00

.04

.08

.12

.16

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-.20

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-.10

-.05

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1 2 3 4 5 6 7 8 9 10


24


-.06

-.04

-.02

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.02

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1 2 3 4 5 6 7 8 9 10

Response of IR_LIT to StructuralOne S.D. Shock1

-.03

-.02

-.01

.00

.01

1 2 3 4 5 6 7 8 9 10


-.03

-.02

-.01

.00

.01

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-.04

-.03

-.02

-.01

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.01

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.03

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Documents

Assignment 1 (Monetary Economics)