1. Monetary Transmission Mechanisms in Armenia: A Preliminary Evaluation Era Dabla-Norris International Monetary Fund

2. Outline of Talk Recent monetary framework and decision to move to inflation targeting Recent monetary framework and decision to move to inflation targeting Monetary transmission mechanism Monetary transmission mechanism –Why important to study? –Overview for Armenia and key weaknesses Evidence from VAR analysis Evidence from VAR analysis –Usefulness in transition context –Recent literature (Starr (2005), Ganev et al (2002), Hericourt (2005)

3. Unstable Money Multiplier and Velocity...

4. Rapid growth of Monetary Aggregates against backdrop of low inflation

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

6. Identifying the channels through which monetary policy decisions affect aggregate demand and supply, and hence output and inflation: (1) from a change in official interest rates to financial and asset market; (2) from financial and asset markets to spending behavior of firms and households Identifying the channels through which monetary policy decisions affect aggregate demand and supply, and hence output and inflation: (1) from a change in official interest rates to financial and asset market; (2) from financial and asset markets to spending behavior of firms and households –Channels: (i) interest channel; (ii) exchange rate; (iii) credit; (iv) asset price; (v) expectations Understanding the transmission process is important for the appropriate design and implementation of monetary policy: Understanding the transmission process is important for the appropriate design and implementation of monetary policy: –Monitoring the response of key variables and markets –Monitoring the dynamics and identifying the lags to MP –Gauging quantitative response to MP decisions. Particularly important in case of inflation targeting Particularly important in case of inflation targeting Monetary transmission mechanisms

7. Key Features of Transmission Mechanism in Armenia Declining but high levels of dollarization Declining but high levels of dollarization Low levels of monetization and financial intermediation Low levels of monetization and financial intermediation Shallow financial markets; low elasticity of bank credit to interest rates Shallow financial markets; low elasticity of bank credit to interest rates –Excess liquidity in banking system –High spreads Significance of remittances Significance of remittances

9. Comparison of Monetization and Financial Intermediation with other countries

11. Description of Monetary Policy Transmission Mechanism in Armenia

12. Evidence from VAR analysis Estimate a reduced-form VAR and identify monetary-policy shocks through assumptions about variable ordering. Estimate a reduced-form VAR and identify monetary-policy shocks through assumptions about variable ordering. Two basic models: Two basic models: –Baseline: [Real GDP, Prices (CPI index), Interest rate (repo rate), exchange rate (nominal effective exchange rate] –Extended: [[Real GDP, Prices, monetary aggregate (M1, domestic currency), Interest rate, exchange rate] –World oil price index as proxy for exogenous factors Monthly data for 2000:05 – 2005:10 (Source: IFS); one lag Monthly data for 2000:05 – 2005:10 (Source: IFS); one lag Robustness tests: alternative variables and ordering scheme Robustness tests: alternative variables and ordering scheme

14. Impulse responses: Baseline Model

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

16. Model 2: Response to a shock to the interest rate

17. Model 2: Response to a shock to the exchange rate

19. Summary of Results Some evidence of effect of interest rates on prices but not output Some evidence of effect of interest rates on prices but not output Exchange rate important channel for monetary policy transmission to prices Exchange rate important channel for monetary policy transmission to prices Monetary aggregates have real and nominal effects – can play role in transition to inflation targeting Monetary aggregates have real and nominal effects – can play role in transition to inflation targeting

20. Next Steps Better understanding of links from: Better understanding of links from: –policy instrument to other financial variables (term structure of market interest rates; loan and deposit rates) –financial variables to aggregate demand and output gap –output gap, exchange rate, and inflation expectations to inflation Small structural macroeconomic model of the economy Small structural macroeconomic model of the economy