Bucharest University of Economics Doctoral School of Finance and Banking DOFIN Policy Mechanism Transmission Channels in Romania Supervisor: Professor Dr. Moisă Altăr MSc Student: Ion Săvulescu Bucharest July 2008

Contents The objectives of the dissertation paper The actual stage of research in the field of substantiating the monetary policy using VAR econometric models The theoretical substantiation of the transmission channels for the monetary policy and the justification of the methodology and techniques. Utilised Data and processing methodology The results I obtained Conclusions

1. The objectives of the dissertation paper The identification of the monetary transmission mechanism main features in Romania, using econometric models (VAR methodology) Using the estimated VAR models (including structural VAR) I pursued the identification of the monetary policy transmission channels and also of a way of modeling the money demand

2. The actual stage of research in the field of substantiating the monetary policy using VAR econometric models During the evolution of the economic science the formulation of the first transmission mechanism for the monetary policy belongs to J. M. Keynes Specification of a structural model of the effect of monetary policy over the economic activity On the other side, the monetarists backed the second approach, by specifying a model with reduced form and the analysis of the relation between the levels of the money supply and that of the economic activity, the estimation correlation coefficient between the two variables ( Milton Friedman – the promoter)

3. The theoretical substantiation of the transmission channels for the monetary policy and the justification of the methodology and techniques Monetary policy leads to strong, rapid and generalized effects over some variables like prices and production, these actually being the main objectives of this type of actions Change in the monetary policy instrument Interest rates Exchange rates Alterations of the financial assets prices Alterations of the economic agents’ and households’ behavior Deviations from the equilibrium values of production and unemployment Wages and prices adjustment to a new equilibrium

Many economists agree with the claim according to which the effects of monetary policy over the production begin to appear after some time and are effects on a relatively short term, production receding on long term to its natural level. The main monetary transmission channels are: –The interest rate channel –The exchange rate channel –The assets’ prices channel –The credit channel –The expectations channel

4. Utilised Data and processing methodology SymbolDescription (monthly) BZRezerv Money, in mil. Lei BZRReal BZ, CPI deflated, base 10:1990 CRNGTotal credit to Non-Governments, in mil. Lei CRNGRReal CRNG, CPI deflated, base 10:1990 CSExchange rate (lei/euro) CSRReal exchange rate, CPI deflated, base 01:1990 DALanding rate for non-bank customers DARReal landing rate for non-bank customers DPMMLMonetary Policy Interest Rate

DPMMLRReal Monetary Policy Interest Rate DPDeposit rate to non-bank customers DPRReal DP, CPI deflated, base 10:1990 IPCLInflation CPI IPCXInflation, CPI, chain, base 10:1990 IPCXLOG Inflation, CPI, chain, in logs IPPIXPPI, base 10:1990 IPPILPPI chain, base 10:1990 IPPXLOG PPI in logs M1 M1RReal M1, CPI deflated, base 10:1990 M2 M2RReal M2, CPI deflated, base 10:1990 SCNBR’s Reference Rate

SCRReal NBR’s Reference Rate SMNBNominal gross average monthly wage SMRBReal gross average monthly wage VPIXIndustrial output variation rate, base 02:1990 VPILIndustrial output variation chain

The used methodology I studied the seasonality using U.S. Census Bureau X-12 monthly seasonal adjustment method I also studied the stationarity of the series Granger-causality test Regression equation of the industrial production’s variation (VIP) on the main variables in the analyzed group “Limited” model of unrestricted VAR, with three endogenous variables (VPIX, CRNGR and M1R) and four exogenous (BZR, DP, IPCX and SMRB), with a number of 6 lags. 14 unrestricted VAR models with 7 variables and six lags 1 SVAR model Cointegration test

5. The results I obtained 5.1 Granger causality tests I applied Granger causality tests in two steps. In the first stage I applied the test on the entire set presented in section 4. Using the results from this step, I selected a group of 12 variables on which I applied the Granger causality test again. By processing the results from the second step (the elimination of the pairs with the probability of the hypothesis over the threshold of 5%, the grouping of the remaining variables in “cause” variables), I was able to make the following observations regarding the causality relations between the studied variables:

There are causality relations between the majority of the variables in the study (BZR, M1R, M2R) and the non- governmental credit, which seems to indicate the presence of the credit channel in the monetary policy mechanism; The exchange rate has an influence well showed by the test’s results both on the monetary variables (BZR, M1R, SC) and on the inflation (IPCX) and over the interest rates in use at the commercial banks (DAR, DPR); this seems to indicate the channel of the exchange rate is working; The inflation (IPCX) influences all the monetary variables (except for the NBR’s Reference rate) and also the variables of the economy’s real sector (VPIX, SMBR, IPPX), the commercial banks’ interest rates (DAR and DPR) and exchange rate (CSR). I believe that this observation can be considered a modest argument for the appositeness of choosing the inflation targeting as an objective of the monetary policy.

5.2 Regression equation of the industrial production’s variation (VIP) on the main variables in the analyzed group

I resumed the regression, eliminating the variables that had an insignificant influence

From these regressions I was able to make the following observations: -There is an important influence of the industrial production’s previous value, of the real governmental credit and of the monetary supply in a restricted sense and a smaller influence of the real monetary base I - In the case of the credit and in that of the monetary supply, the contemporaneous has an inverted direction in comparison to that of the previous period.

5.3 Unrestricted VAR model On the ground of previous results I computed an unrestricted VAR on three endogenous variables (VPIX – Industrial output variation rate, CRNGR – Total real credit to Governments and M1R – Real M1) and four exogenous variables (BZR – Real Reserve Money, DP – Real deposit rate to non-bank customers, IPCX – Inflation, CPI, chain and SMRB – Real gross average monthly wage) and with a number of six lags. I have, thereby, obtained the graphs representing the endogenous variables’ responses to to the shocks of a standard error of each of these.

From these graphs we ca observe: The positive reaction of the industrial production’s variation in response to an impulse on the non- governmental credit as well as the fact that the production’s stabilization is being done at a higher level An impulse on the monetary supply leads, in the first part, to a negative reaction of the industrial production followed by waving movement where the positive components are dominated and the amplitude is declining. The shock is desorbed after 6 – 7 periods (months) the industrial production reversing to the previous level.

14 unrestricted VAR models Upon the estimation and analysis of a long series of VAR models I kept 14 of those whose structure is presented below. From among those I selected three models that I presented in the thesis both as structure and as the result of the usage of the functions impulse- response and of the decomposition of that option/variation.

Following, I will present one of the models I used: The variables:

The graphs for all variables’ responses in the model to the impulses coming from each of these are:

From the Analysis of these graphs it can be inferred that The positive variation of the non-governmental credit to the shocks on the monetary policy variables (monetary base and monetary supply in a restricted sense). The stabilization of the credit following a shock on the monetary supply is being achieved at a higher level of the credit; An ample response of all the model’s variables to the shock on the consumer price index (inflation); The shock on inflation has a negative effect on the variation of the industrial production and its stabilization is being achieved at a lower level; The consumer price index is quite sensible to the shocks on the majority of the analyzed variables; A persistent waving movement (more than 20 periods), with dominant positive components, is caused by the exchange rate on the inflation index (IPC).

The responses of the consumer price index to one standard deviation shocks on the variables in model 1 are portrayed in the following graph.

The varince decomposition of the consumer price index is:

The response of the model’s variables to a standard deviation shock on the consumer price index

5.4 Structural VAR (SVAR) The main purpose in the estimation of the SVAR models is to obtain an un-recursive orthogonalization of the error terms for the impulse-response analysis. This alternative to the recursive Colesky orthogonalization requires the user to impose sufficient restriction in order to identify the orthogonal components of the error terms In this paper I made an SVAR model, only with short term restrictions, using the following VAR model:

I identified and introduced 70 restrictions by fixing 70 elements of the matrixes that needed to be estimated (the structural form matrixes of the autoregressive vector). Using the procedure “Estimate Structural Factorization” in EViews, I estimated the SVAR model. Analyzing the impulse-response function from the estimated model, one can notice an ample effect on the system’s variables determined by the shock on the exchange rate.

5.5 Cointegration tests The purpose of these tests is to determine whether a group of non- stationary variables are cointegrated. If for a group of time series, of which one or more are not stationary, a stationary linear combination is identified, one can say the series of the group are cointegrated. The stationary linear combination is called cointegration equation and can be viewed as a long-term equilibrium relation between the variables. The presence of the cointegration relation is the basis for the Vector Error Correction (VEC) models. I applied the cointegration test for the unrestricted VAR model presented in section 5.4.

The results of the test show the following: According to the “trace” test: –For a 5% significance level there are 4 cointegration equations; –For a 1% significance level there are 3 cointegration equations; According to the “max eigenvalue” test, there are 3 cointegration equations at both the 1% and the 5% levels

A synthesis for the results of the cointegration test is showed below.

6. Conclusions Bank credits affect the actual activity in the economy (represented in the study herein by the industrial production and the average gross salary). On its part, the credit is affected on a short term by the monetary policy variables. I consider these elements to be a proof of the existence and functioning of the bank credit channel as one of the main mechanism for the monetary policy diffusion in Romania. Consumer price index (the inflation) is a variable very sensitive to the shocks and influences of the monetary variables, but also, of the macroeconomic variables. I consider this modest emphasize on the inflation manifestation on the current Romanian economy, accomplished by the study carried out in this paper, to be a justification for the appropriateness of aiming to choose target inflation as goal of the monetary policy in Romania.

The exchange rate is another channel through which the monetary policy has been diffused in the Romanian economy during the analyzed period. Exchange rate variation is also highly influenced by the domestic innovations and the monetary shocks. Considering the domestic innovations as main indicator of the forecasts, we notice that these represent the main determinant, on a short term, of the exchange rate evolution. The test performed on the patterns developed and presented in the paper confirm the assessment of many Economists, according to whom, the monetary policy effect on production occurs after a long period of time and are effects on a relatively short term, the production retrieving its natural level on a long term

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