MSc. Student: RAMONA STANSupervisor: Professor MOISA ALTAR
ACADEMY OF ECONOMIC STUDIES BUCHARESTACADEMY OF ECONOMIC STUDIES BUCHARESTDOCTORAL SCHOOL OF FINANCE AND BANKING (DOFIN)DOCTORAL SCHOOL OF FINANCE AND BANKING (DOFIN)
MONETARY CONDITIONS INDEX (MCI) AS A SUMMATIVE INFORMATION TOOL FOR
CHARACTERIZING THE MONETARY POLICY STANCE IN ROMANIA
(1997 –2005)
BUCHAREST, JULY 2006
Dissertation paper
1. Objectives
2. What is the Monetary Conditions Index?
3. Theoretic approach
4. Econometric estimation
5. Results
6. Conclusions
Bibliography
CCONTENTSONTENTS
MCI = relevant information tool for characterizing the monetary policy stance in Romania between 1997-2005
Would be worthwhile use a MCI for a better representation of monetary policy stance?
Do indeed short-term interest rate and exchange rate directly influence both
stability of the prices and aggregate demand?
Controlled floating of the exchange rate
To which extent tight control exercised by the National Bank of Romania (NBR) over the national currency depreciation rate influenced stability of the prices and real economic growth?
Assessment of credibility and increased independency of NBR
Is inflation rate’s slow yet continuous decrease to be credited only to NBR’s quantitative approach with exchange rate constraints?
What is the real place of the short-term interest rate within the monetary policy choices, considering it has been used only on short periods as operational target?
1. OBJECTIVESOBJECTIVES 1. OBJECTIVESOBJECTIVES
1997 2005
If MCI = relevant indicator significant indication on the success of the monetary policy better measurement of credibility and independency of the National Bank = essential presumptions on which direct inflation targeting is based upon
Intuitively higher relative influence of the exchange rate both over the prices and aggregate demand if proved clearly better representation in the future of the monetary policy stance by means of MCI
Short-term interest rate inflation rate “paradox” Monetary policy choices throughout the analysis period Maastricht convergence criterion to be achieved Less powerful instrument? to be accounted for in the future
monetary base targeting
direct inflation targeting
Why this historical recourse on monetary policy choices?
1. OBJECTIVESOBJECTIVES 1. OBJECTIVESOBJECTIVES
2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)? 2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)?
MCI = weighted sum of modifications in the short-term interest rate and exchange
rate relative to some arbitrary date.
][][ 01
20 ee
w
wRRMCI ttt
Basic assumption: Monetary policy directly influences inflation through short-term interest rate and exchange rate.
Influence over aggregate demand
Controlling for exogenous shocks
“Appealing operational target for monetary policy”
(Ericsson et al., 1997)
Bank of Canada – the “pioneer” in constructing and using MCI as operational target.
MCI used either as operational target (New Zeeland) or summative information tool (Norway, Sweden) by Central Banks.
MCI – constructed for international comparisons (IMF, Goldman Sachs, JP Morgan).
..
MCI can be used as: Summative information tool Operational target Monetary policy rule
Relevance = directly depending on the choose of underlying model from which the weights are estimated
Nominal versus Real MCI Secondary objective
Base period = closely to the long-run equilibrium relationship
Econometric estimation Underlying model Choice of the variables Cointegration Stability of the coefficients Weak exogeneity “White noise” residuals
2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)? 2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)?
MCI as a summative information tool
Disadvantages/Limitations Relative stance of the monetary policy as compared to an arbitrarily chosen base period
Voluntarily generalizing approach regarding transmission mechanism into the real economy
Not a fundamental measure of monetary conditions, if nothing else, because neither MCI nor short-term interest are nominal anchors of the system
Controlling for validity of hypothesis in econometric estimations ?
Aggregation problem other variables = insignificant in characterizing monetary policy stance
particular exchange rate out of many others
foreign currencies basket weights estimated from bilateral trade statistics
particular short-term interest rate not accounting for the long-term interest rate contribution to monetary policy choices
2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)? 2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)?
3. THEORETIC APPROACH 3. THEORETIC APPROACH
UNDERLYING MODEL
Aggregate demand equation: Δy = F(ΔR, Δe, …)Aggregate Phillips equation: Δp = F(y-y*, Δe, …)
where: Δy = real growth rate of GDPy-y* = output gapΔp = inflation rateΔR = change in real interest rateΔe = change real exchange rate
and lower cases express logarithm.
The suspension points replace the variables that are not representative for monetary policy, thus through which the influence of taxation and fiscal policy is transmitted.
The interest rate influences inflation via the real GDP and thus linking the two equations determines an extremely simplified model, the so-called “reduced-form” model Bank of Canada’s inspiration for the construction of MCI
Where: is the real output gap
y and e – logarithm
rtf - external interest rate (exogenous)
*yyy tgt (1)
(2)
(3)
02* ttE Inflation target
(2): )( 1112 tttgtttttt eeEyEEE
Conditional expectations at t+1:
)(0 111 tttgtttt eeEyEE (5)
And, by substitution of in (3)1tteE
11)( gtttttft yEErr (6)
gtttgt yerEy 1
)( 11 ttgtttt eeyE (8)
(7)
tgtttgt yery 111
tttgttt eey )( 2111
tttftt eeErr 1
tt erMCI )1( Let (0)
)(
)1(
)()1( 1
ftgttt
tt
ryeerMCI
Substituting in (6) and identifying coefficients
3. THEORETIC APPROACH 3. THEORETIC APPROACH
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
Underlying model
In practice, most Central Banks which constructed and used MCI have estimated the coefficients only from the aggregate demand equation and only in a less formal approach, mostly for benchmarking purposes, from the prices equation.
• aggregate demand equation
! prices equation “first paradox” =short-term interest rate actual place inthe monetary policy choices
MCI relevant ?
Estimation period: 1997-2005
Base period: 2002 (“neutral level”)
tttt ewRwwy 210
Choice of variables
• short-term interest rate = BUBOR3M (3 months-active interest rate)
• high volatility of the overnight market
• non-governmental credit high increase (owed also to facilities)
• similar trend of deposit-taking and deposit-placing interest rates
• exchange rate = composite index including Euro and US Dollar
• reference foreign currency USD (until 2001) EUR
• compromise determined by short data series
• following the footsteps of NBR and IMF bilateral trade data
• BASKET = 60% EUR + 40% USD (1997-2003)
= 75% EUR + 25% USD (2004-2005)
• prices index = Consumer Prices Index (CPI) vs. Producer Prices Index (PPI)
• intimate relationship between exchange rate and PPI inflation rate
• final consumption ~ 63% of GDP
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
Notations:
bb3m_n annualized nominal interest rate BUBOR 3M
bb3m_r annualized real interest rate BUBOR3M (Fisher formula)
cpi consumer prices index, fixed base (first quarter 1997)
infl_rate inflation rate, fixed base (first quarter 1997)
infl_rate_an annualized inflation rate, fixed base (first quarter 1997)
basket_n/basket_r nominal/real exchange rate RON/BASKET
gdp_n_sa nominal GDP (de-seasonalized series)
gdp_r_sa real GDP (de-seasonalized series)
defl GDP deflator, fixed base (first quarter 1997)
All variables expressed in logarithm have been denoted as l_variable name (with the first difference d_l_variable name).
Tools: Excel (basic calculations), Eviews 4.1.
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
TESTING FOR INTEGRATION ORDER
• all nominal variables integrated of I(1)
• real GDP I(1)
• real exchange rate I(1)
• real interest rate I(0)
Nominal MCI VEC model
Real MCI alternative VAR model
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
Nominal MCI VEC model
EC(E,1) 2 2 4 4 L_GDP_N_SA BB3M_N L_BASKET_N
cointegration test (5): intercept and trend in CE – deterministic trend in VAR
adjustment speed -0.837
stability of the coefficients roots of characteristic polynomial < 0.8795
weak exogeneity A(2,1)=0, A(3,1)=0, accumulated probability 0.1211
residual tests:
no serial correlation (12 lags tested)
normality (p-value 0.1093 to Jarque-Bera)
homoschedasticity (0.2373 to Chi-sq)
-.06
-.04
-.02
.00
.02
.04
.06
.08
97 98 99 00 01 02 03 04 05
Cointegrating relation 1
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
Estimation of the weights
-.02
-.01
.00
.01
.02
.03
1 2 3 4
Accumulated Response of L_GDP_N_SA to L_GDP_N_SA
-.02
-.01
.00
.01
.02
.03
1 2 3 4
Accumulated Response of L_GDP_N_SA to BB3M_N
-.02
-.01
.00
.01
.02
.03
1 2 3 4
Accumulated Response of L_GDP_N_SA to L_BASKET_N
Accumulated Response to Generalized One S.D. Innovations
Accumulated response over a year• accounts for weak exogeneity• NBR’s projections do not go further that one year time horizon
Period L_GDP_N_SA BB3M_N L_BASKET_N
1 0.015094 -0.006521 -0.003309
2 0.020505 -0.013666 0.001235
3 0.022820 -0.014561 0.012770
4 0.023901 -0.016247 0.025115
Generalized Impulse
)]0(__)(__[016247.0
025115.0)]0(_3)(_3[)(min nbasketltnbasketlnmbbtnmbbtMCI alno
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
Real MCI VAR model
LS 1 2 D_L_GDP_R_SA BB3M_R D_L_BASKET_R @ C
acceptable compromise, provided VAR is stable and the other hypothesis are tested.
quasi-elasticity of GDP to the changes of the exchange rate
how GDP changes if short-term interest rate changes by one percentage point?
Controlling for relevancy of the model:
cointegration test (performed for the levels of the data) (1) / (5)
stability of the coefficients roots of characteristic polynomial < 0.8762
weak exogeneity hypothesis rejected for the long-run equilibrium relationship
residual tests:
no serial correlation (12 lags tested)
normality (p-value 0.1983 to Jarque-Bera)
homoschedasticity (p-value 0.0368 to Chi-sq)
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
-.02
-.01
.00
.01
.02
.03
1 2 3 4
Response of D_L_GDP_R_SA to D_L_GDP_R_SA
-.02
-.01
.00
.01
.02
.03
1 2 3 4
Response of D_L_GDP_R_SA to BB3M_R
-.02
-.01
.00
.01
.02
.03
1 2 3 4
Response of D_L_GDP_R_SA to D_L_BASKET_R
Response to Generalized One S.D. Innovations ± 2 S.E.
Estimation of the weights
Period D_L_GDP_R_SA BB3M_R D_L_BASKET_R
1 0.021869 0.001525 0.002641
(0.00269) (0.00380) (0.00379)
2 0.014706 -0.001073 0.002787
(0.00435) (0.00458) (0.00466)
3 0.017028 -0.007088 0.009022
(0.00478) (0.00531) (0.00587)
4 0.017572 -0.006921 0.010883 (0.00529) (0.00677) (0.00693)
Generalized Impulse
Standard Errors: Analytic
)]0(__)(__[00693.0
010883.0)]0(_3)(_3[)( rbasketltrbasketlrmbbtrmbbtMCI real
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
Controlled floating direct influence over the aggregate demand?
LS 1 2 4 4 L_GDP_N_SA D_L_BASKET_N BB3M_N @ C
Controlling for relevancy of the model: cointegration test stability of the coefficients one root of characteristic polynomial > 0.97 ?! weak exogeneity hypothesis rejected residual tests:
no serial correlation (12 lags tested) at lag 4 (p-value: 0.0597) normality (p-value 0.0781 to Jarque-Bera) homoschedasticity (p-value 0.5726 to Chi-sq)
-.06
-.04
-.02
.00
.02
.04
.06
.08
1 2 3 4
Accumulated Response of L_GDP_N_SA to L_GDP_N_SA
-.06
-.04
-.02
.00
.02
.04
.06
.08
1 2 3 4
Accumulated Response of L_GDP_N_SA to D_L_BASKET_N
-.06
-.04
-.02
.00
.02
.04
.06
.08
1 2 3 4
Accumulated Response of L_GDP_N_SA to BB3M_N
Accumulated Response to Generalized One S.D. Innovations ± 2 S.E.
)]0(___)(___[023635.0
001967.0)]0(_3)(_3[)(_min nbasketldtnbasketldnmbbtnmbbtMCI ctrlalno
4. ECONOMETRIC ESTIMATION4. ECONOMETRIC ESTIMATION
5. RESULTS 5. RESULTS
Notations:MCI_2002_RFREE_BB3M Real MCIMCI_2002_NFREE_BB3M Nominal MCIMCI_2002_GDP2002_N_BB3M Nominal MCI (controlled floating)
-5
-4
-3
-2
-1
0
1
2
3
97 98 99 00 01 02 03 04 05
MCI_2002_RFREE_BB3MMCI_2002_NFREE_BB3MMCI2_GDP2002_N_BB3M
-5
-4
-3
-2
-1
0
1
2
3
97 98 99 00 01 02 03 04 05
MCI_2002_RFREE_BB3MMCI_2002_NFREE_BB3MMCI2_GDP2002_N_BB3M
• Nominal MCI ease of monetary conditions
• Real MCI tightening of monetary conditions
• high inflation rate throughout the period
• controlled floating appreciation in real terms of the national currency
1997-1999
“difficult times” for Romania
three years of real negative growth of GDP
peaks of foreign debt service
almost financial crisis in 1999
2004-2005
preparation for direct inflation targeting
ease of control exercised over the exchange rate
appreciation both in real and nominal terms
Tighter than intended monetary conditions !
5. RESULTS 5. RESULTS
-6
-4
-2
0
2
4
6
97 98 99 00 01 02 03 04 05
MCI_2002_RFREE_BB3M L_INFL
• fairly accurate representation of monetary policy success in controlling stability of the prices after 2002
• high minimum mandatory reserves allowed for decrease of the interest rate
• other external shocks to the inflation
Positive signal regarding NBR credibility and independency
5. RESULTS 5. RESULTS
6. CONCLUSIONS6. CONCLUSIONS
• the relative influence of the exchange rate and short-term interest rate
1.55:1 (1.57:1 in real terms)
SUCCESS OF DIRECT INFLATION TARGETING MCI’s LESSONS
• lower power of the short-term interest rate to induce changes of aggregate demand
= matter of concern for future monetary policy choices
• proven importance of the exchange rate (stability of the prices, economic growth)
= better measurement of monetary conditions with MCI
• need to pay attention still for the monetary base growth rate
• motivation of quantitative approach (taking also into account real facts)
LIMITATIONS OF MCI
• interest rate – inflation “paradox” MCI might not be a relevant indicator of the monetary policy stance
• need to construct an alternative MCI including all monetary variables of importance in achieving final inflation target
• relevancy of coefficients
• short time series (Bank of Canada calculations on MCI cover 1980-2006!!)
• relative importance of the shocks induced to aggregate demand (based on the impulse-response functions) are acceptable to the limit
• aggregation problem the way the “basket” was constructed
6. CONCLUSIONS6. CONCLUSIONS
BIBLIOGRAPHY BIBLIOGRAPHY
Balázs Égert, László Halpern (2005), “Equilibrium Exchange Rates in Central and Eastern Europe: A Meta-Regression Analysis”, William Davidson Institute Working Paper no. 769
Batini, Nicoletta. Turnbull, Kenny (2000) “Monetary Conditions Indices for the UK: A Survey.”, External MPC Unit Discussion Paper No. 1 – Bank of England
Benoit, Anne (2000), “Indicators of Monetary policy orientation: Monetary conditions (MCI) and the Taylor rule”, Erste Bank.
Botel, Cezar (2002), “Determinants of inflation in Romania. June 1997 – August 2001. Analysis based on Structural VAR”, National Bank of Romania (Studies Series, no. 11. June 2002)
Coetzee, C.E. (2001), “Monetary Conditions and stock returns: a South African case study”
De Wet, W. (2002), “Coping with the Inflation and Exchange Rate Shocks in the South African Economy”, The South African Journal of Economics, 70(1):78-94
Eika, K.H., N.R. Erricsson si R. Nymoen (1996), “Hazards in Implementing a Monetary Conditions Index”, Federal Reserve System IFD Paper No. 568.
Ericsson, Neil R., Jansen, Eilev S., Kerbeshian, Neva A., Nymoen, Ragnar. (1997), “Understanding a Monetary Conditions Index”, Federal Reserve System.
Freedman, Charles (1994), “The Use of indicators and of Monetary Conditions Index in Canada”, Policy Issues and Country Experience, 458-476, IMF, Washington , D.C.
Freedman, Charles (1995), “The Role of monetary conditions and the monetary conditions index in the conduct of policy.”, Excerpts from remarks made to the Conference on International Developments and Economic Outlook for Canada.
Guender Alfred V. & Troy D. Matheson. (1997), “Design Flaws in the Construction of Monetary Conditions Indices – A cautionary note.”, Department of Economics; University of Canterbury New Zeeland.
Kesrizeli, M., Kokcaker, I. (1999), “Monetary Conditions Index: A monetary Policy Indicator for Turkey”, Discussion Paper No. 9908, The Central Bank Of The Republic of Turkey.
*** “NBR Policy & Regulations and Investments in Romania”, presentation made by the Deputy Governor of NBR at the British-Romanian Chamber of Commerce Business Breakfast (Bucharest, April 2005), www.bnro.ro
*** “Medium term objectives of the monetary policy and exchange rate”, presentation made by the Governor of NBR, Pre-Ascension Economic Program, Ed.2005, www.bnro.ro
*** International Monetary Fund (FMI). Romania, Selected Issues. www.imf.ofg
*** Romanian National Institute of Statistics (INSS), data series, press releases. www.insse.ro