Monetary Transmission Monetary Transmission Mechanisms in Armenia: A Mechanisms in Armenia: A

Preliminary EvaluationPreliminary Evaluation

Era Dabla-NorrisEra Dabla-NorrisInternational Monetary FundInternational Monetary Fund

Outline of TalkOutline of Talk Recent monetary framework and decision to move Recent monetary framework and decision to move

to inflation targetingto inflation targeting

Monetary transmission mechanismMonetary transmission mechanism– Why important to study?Why important to study?– Overview for Armenia and key weaknesses Overview for Armenia and key weaknesses

Evidence from VAR analysisEvidence from VAR analysis– Usefulness in transition contextUsefulness in transition context– Recent literature (Starr (2005), Ganev et al (2002), Recent literature (Starr (2005), Ganev et al (2002),

Hericourt (2005)Hericourt (2005)

Armenia: Money Multiplier (1998-2005)

1

1.25

1.5

1.75

2

2.25

2.5

6.0

6.5

7.0

7.5

8.0

Mar-02

Jun-02

Sep-02

Dec-02

Mar-03

Jun-03

Sep-03

Dec-03

Mar-04

Jun-04

Sep-04

Dec-04

Mar-05

Jun-05

10

11

12

13

14

15

16

Velocity(M2X, left scale)

Velocity (M2, right scale)

Armenia: Velocity of M2X and M2 (1998-2005)

Unstable Money Multiplier and Velocity ...

Monetary Aggregates and Inflation(In percent, 12-month rate)

-30

-20

-10

0

10

20

30

40

50

60

70

Dec-1999

Jun-2000

Dec-2000

Jun-2001

Dec-2001

Jun-2002

Dec-2002

Jun-2003

Dec-2003

Jun-2004

Dec-2004

Jun-2005

Dec-2005

-30

-20

-10

0

10

20

30

40

50

60

70

Reserve money

Broad money

Inflation

Rapid growth of Monetary Aggregates against backdrop of low inflation

Armenia: Key Interest Rates (1998-2005)

0

10

20

30

40

50

60

70

Repo rate

Money market rate

T-bill rate

From 2006, repo rate to be used to signal stance of Monetary Policy...

Identifying the channels through which monetary policy decisions affect Identifying the channels through which monetary policy decisions affect

aggregate demand and supply, and hence output and inflation: (1) from a aggregate demand and supply, and hence output and inflation: (1) from a

change in official interest rates to financial and asset market; (2) from change in official interest rates to financial and asset market; (2) from

financial and asset markets to spending behavior of firms and householdsfinancial and asset markets to spending behavior of firms and households

– Channels: (i) interest channel; (ii) exchange rate; (iii) credit; (iv) asset price; (v) Channels: (i) interest channel; (ii) exchange rate; (iii) credit; (iv) asset price; (v)

expectationsexpectations

Understanding the transmission process is important for the appropriate Understanding the transmission process is important for the appropriate

design and implementation of monetary policy:design and implementation of monetary policy:

– Monitoring the response of key variables and marketsMonitoring the response of key variables and markets

– Monitoring the dynamics and identifying the lags to MPMonitoring the dynamics and identifying the lags to MP

– Gauging quantitative response to MP decisions.Gauging quantitative response to MP decisions.

Particularly important in case of Particularly important in case of inflation targetinginflation targeting

Monetary transmission mechanismsMonetary transmission mechanisms

Key Features of Transmission Key Features of Transmission Mechanism in ArmeniaMechanism in Armenia

Declining but high levels of dollarizationDeclining but high levels of dollarization

Low levels of monetization and financial Low levels of monetization and financial intermediationintermediation

Shallow financial markets; low elasticity of bank Shallow financial markets; low elasticity of bank credit to interest ratescredit to interest rates– Excess liquidity in banking systemExcess liquidity in banking system– High spreadsHigh spreads

Significance of remittances Significance of remittances

Armenia: Dollarization Ratios (1998-2005)(in percent)

0

10

20

30

40

50

60

70

80

90

FCD/Total deposits

FCD/M2X

FCC/Total credit

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

Armenia Albania Kazakhstan Ukraine Turkey Peru Colombia Mexico Romania CzechRepublic

Broad Money in percent of GDP Banking system credit to the private sector (in percent of GDP)

Potential IT countries Pre-adoption IT countries

Comparison of Monetization and Financial Intermediation with other countries

Interest Rate Spread (average lending-deposit rate), 1998-2005

0

5

10

15

20

25

30

35

40

Real Interest Rates

Short-term Interest Rates

Market Interest Rates (Deposit and Lending

Rates)

Nominal Exchange Rate

Fiscal Policy

Aggregate Demand

CPI Inflation

Imported Inflation

Wages

Foreign Demand

Foreign Interest Rates

Transfers from Abroad

Real Exchange Rate

Mon

etar

y P

olic

y A

ctio

ns

Infl

atio

n/ E

xcha

nge

Rat

e E

xpec

tati

ons

Description of Monetary Policy Transmission Mechanism in Armenia

Evidence from VAR analysisEvidence from VAR analysis Estimate a reduced-form VAR and identify monetary-policy Estimate a reduced-form VAR and identify monetary-policy

shocks through assumptions about variable ordering.shocks through assumptions about variable ordering.

Two basic models: Two basic models: – Baseline: [Real GDP, Prices (CPI index) , Interest rate (repo rate), Baseline: [Real GDP, Prices (CPI index) , Interest rate (repo rate),

exchange rate (nominal effective exchange rate]exchange rate (nominal effective exchange rate]– Extended: [[Real GDP, Prices, monetary aggregate (M1, domestic Extended: [[Real GDP, Prices, monetary aggregate (M1, domestic

currency), Interest rate, exchange rate]currency), Interest rate, exchange rate]– World oil price index as proxy for exogenous factorsWorld oil price index as proxy for exogenous factors

Monthly data for 2000:05 – 2005:10 (Source: IFS); one lagMonthly data for 2000:05 – 2005:10 (Source: IFS); one lag

Robustness tests: alternative variables and ordering schemeRobustness tests: alternative variables and ordering scheme

Table 1. Multivariate and Bivariate block Granger Causality Tests

p -values

Effect on output Block (p, i, e , M1) 0.00*** Interest rate (i ) 0.16 Exchange rate (e ) 0.64 Money supply (M1) 0.00***

Effect on prices Block (p, i, e , M1) 0.06** Interest rate (i ) 0.05** Exchange rate (e ) 0.05** Money supply (M1) 0.21

Note: The block Granger non-causality statistic is calculatedthrough a LR test, and has a 2 distribution. *, **, and *** denoterejection of the null at the 10%, 5%, and 1% levels, respectively.

-.03

-.02

-.01

.00

.01

.02

2 4 6 8 10 12 14 16 18 20 22 24

Response of Y to i

-.03

-.02

-.01

.00

.01

.02

2 4 6 8 10 12 14 16 18 20 22 24

Response of Y to e

-.010

-.008

-.006

-.004

-.002

.000

.002

.004

2 4 6 8 10 12 14 16 18 20 22 24

Response of P to i

-.010

-.008

-.006

-.004

-.002

.000

.002

.004

2 4 6 8 10 12 14 16 18 20 22 24

Response of P to e

-0.5

0.0

0.5

1.0

1.5

2 4 6 8 10 12 14 16 18 20 22 24

Response of i to e

-.010

-.005

.000

.005

.010

.015

.020

2 4 6 8 10 12 14 16 18 20 22 24

Response of e to i

Response to Cholesky One S.D. Innovations ± 2 S.E.

Impulse responses: Baseline Model

Model 2: Response to a shock to the monetary aggregate (M1)

-.004

.000

.004

.008

.012

.016

.020

2 4 6 8 10 12 14 16 18 20 22 24

Response of output

-.001

.000

.001

.002

.003

.004

.005

.006

.007

2 4 6 8 10 12 14 16 18 20 22 24

Response of Prices

-.8

-.7

-.6

-.5

-.4

-.3

-.2

-.1

.0

.1

2 4 6 8 10 12 14 16 18 20 22 24

Response of interest rate

-.012

-.008

-.004

.000

.004

.008

2 4 6 8 10 12 14 16 18 20 22 24

Response of exchange rate

Response to Cholesky One S.D. Innovations ± 2 S.E.

-.012

-.008

-.004

.000

.004

.008

.012

2 4 6 8 10 12 14 16 18 20 22 24

Response of ouput

-.008

-.006

-.004

-.002

.000

.002

.004

2 4 6 8 10 12 14 16 18 20 22 24

Response of prices

-.02

-.01

.00

.01

.02

2 4 6 8 10 12 14 16 18 20 22 24

Response of monetary aggregate

-.012

-.008

-.004

.000

.004

.008

.012

2 4 6 8 10 12 14 16 18 20 22 24

Response of exchange rate

Response to Cholesky One S.D. Innovations ± 2 S.E.

Model 2: Response to a shock to the interest rate

-.008

-.004

.000

.004

.008

.012

.016

2 4 6 8 10 12 14 16 18 20 22 24

Response of output

-.008

-.006

-.004

-.002

.000

.002

.004

.006

2 4 6 8 10 12 14 16 18 20 22 24

Response of prices

-.01

.00

.01

.02

.03

.04

2 4 6 8 10 12 14 16 18 20 22 24

Response of monetary aggregate

-.8

-.6

-.4

-.2

.0

.2

.4

.6

2 4 6 8 10 12 14 16 18 20 22 24

Response of interest rate

Response to Cholesky One S.D. Innovations ± 2 S.E.

Model 2: Response to a shock to the exchange rate

Period (quarter) GDP prices monetary interest exchangeaggregate rate rate

monetary aggregate1 10.12 0.50 82.70 5.46 4.614 36.11 12.85 72.09 15.94 10.406 39.91 21.98 65.12 24.00 11.618 40.84 27.91 59.79 30.07 11.40

interest rate1 0.34 1.38 0.06 85.53 4.054 1.30 13.97 0.08 59.82 5.776 1.24 14.79 0.12 50.17 5.018 1.18 13.53 0.12 43.59 5.56

exchange rate1 0.21 0.35 0.35 0.04 87.524 0.57 15.42 8.99 0.08 50.856 1.58 14.18 15.17 0.08 43.518 3.37 12.23 17.68 0.30 43.43

Variance Decomposition

Summary of ResultsSummary of Results

Some evidence of effect of interest rates on Some evidence of effect of interest rates on prices but not outputprices but not output

Exchange rate important channel for Exchange rate important channel for monetary policy transmission to pricesmonetary policy transmission to prices

Monetary aggregates have real and nominal Monetary aggregates have real and nominal effects – can play role in transition to effects – can play role in transition to inflation targetinginflation targeting

Next StepsNext Steps

Better understanding of links from:Better understanding of links from:– policy instrument to other financial variables (term policy instrument to other financial variables (term

structure of market interest rates; loan and deposit structure of market interest rates; loan and deposit rates)rates)

– financial variables to aggregate demand and output gapfinancial variables to aggregate demand and output gap– output gap, exchange rate, and inflation expectations to output gap, exchange rate, and inflation expectations to

inflationinflation

Small structural macroeconomic model of the Small structural macroeconomic model of the economyeconomy