unlicensed monetary policy effect in an economy with heavily managed exchange rate

Monetary Policy Effect in an Economy with Heavily Managed Exchange Rate BUI THANH TRUNG University of Economics HCMC - trungbt@ueh.edu.vn Abstract This paper investigates the effect of monetary policy on macroeconomic variables in Vietnam, a small open economy with heavily managed exchange rate The monetary policy shock is identified by the sign restriction methodology Unlike previous studies, a monetary policy contraction is associated with an increase in interest rate, a decrease in central bank credit, a drop in the stock of foreign exchange reserves, and a fall in broad money The empirical results show several interesting findings First and foremost, output and price, which are represented by industrial production index and consumer price index, show a reduction following a positive shock to monetary policy, which is consistent with the prediction of standard economic theories Moreover, trade balance exhibits a temporary increase before declining in the mid-term A noteworthy finding is that exchange rates show overshooting response, appreciating on impact and peaking after eight to nine months, following a contraction in monetary policy, which is in line with the overshooting hypothesis Furthermore, foreign exchange policy has insignificant impacts on exchange rate movement while exercising positive and significant influences on price and money Finally, our identification resolves certain puzzles in the literature such as price puzzle and exchange rate puzzle The findings suggest two important implications: (1) monetary policy should account for the evolution of foreign exchange intervention policy to effectively control output and price; and (2) developing financial markets is a necessity to alleviate inflationary pressure caused by foreign exchange policy Keywords: sign restriction; monetary policy; exchange rate; fixed exchange rate Introduction An enormous number of empirical studies emphasize the importance of exchange rate channel in the conduct of monetary policy in the context of developed countries with flexible exchange rate regime In those studies, monetary policy is widely defined as unexpected changes or shocks to either interest rate or money However, for a small and open country, it is suggested that monetary policy should be defined in different ways such as spread between interbank interest rate and the exchange rate depreciation ratio for Turkey (Berument, 2007) or the combination of positive shocks to interbank interest rate and negative shocks to the stock of foreign reserves for Taiwan The phenomenon also emerges in Vietnam, of which the economy is much smaller than that of Turkey and the exchange rates are heavily managed just like Taiwan Compared to Taiwan, the money market is underdeveloped in Vietnam and monetary policymakers have less control over the shortterm interest rate Instead, they manipulate policy rates in order to increase or decrease the market interest rates as well as provide credit to certain banks directly through the purchase of short-term securities and even long-term securities in emergent situations Furthermore, exporting is an important stimulus for domestic economic activities and central bankers frequently intervene the foreign exchange market to keep the exchange rates fixed, which is essential for maintaining the stability of revenues and costs incurred in exporting enterprises Regard to this, the setting of monetary policy includes the manipulation in four variables such as policy rate, central bank credit, the stock of foreign reserve, and broad money With respect to empirical estimation, the literature suggests several approaches to examine the effect of monetary policy First and foremost, the recursive VARs were used in a considerable number of studies See, for instance, Sims (1992) and Berument (2007) However, this method provides plausible results when analyzing a relatively close and large economy such as United State (Ho & Yeh, 2010; Kim & Roubini, 2000) In case of small and open economy, the analysis should employ the non-zero contemporaneity methodology because it allows instantaneous reactions of monetary policy instrument to macroeconomic shocks (Kim & Roubini, 2000) Ho and Yeh (2010), on the other hand, adopted sign restriction methodology to investigate the monetary policy transmission in a fixed-exchange rate economy like Taiwan In this paper, we also employ the sign restriction for the identification of monetary policy in Vietnam, which is also a small open economy with heavily managed exchange rate Unlike Ho and Yeh (2010) scheme, this paper associates a monetary policy contraction with a rise in policy rate and a fall in broad money, central bank credit as well as foreign exchange reserves In the language of sign restriction, a monetary policy contraction does not cause a decrease in policy rate and does not lead to an increase in broad money, central bank credit, and foreign exchange reserves Other business variables such as output, price, trade balance, and exchange rate are unrestricted because the main focus of this paper is to analyze whether and how these variables react to unexpected changes in monetary policy instruments Furthermore, unlike other central bankers, monetary authorities in Vietnam emphasize the objective of fostering economic growth as directed by the government and have neither explicit nor implicit target for price stability Therefore, it is important to answer the question as to whether monetary policy contraction is effective in controlling output and inflation in case of Vietnam Literature review 2.1 Exchange rate channel and macroeconomic variables Since the world is more integrated and the number of countries adopting flexible exchange rate regime is increasing, Mishkin (2013) argues that economists should place a greater emphasis on exchange rate channel in monetary policy transmission This channel works mainly through the interest effect, implying that a rise in real domestic interest rate increases the relative attraction of assets denominated in domestic currency to those denominated in foreign currency, which then causes an appreciation of domestic currency As a result, domestic goods become more expensive than foreign goods, which reduces net export (export minus import) and thus economic activities are contracted Another theoretical framework, which is increasingly cited in the literature, is the overshooting hypothesis proposed by Dornbusch (1976) Based on the hypothesis of sticky price, following an increase in domestic interest rate the nominal exchange rate will appreciate instantaneously and then depreciate consistent with the theory of uncovered interest parity The mechanism could be explained as follows As central bankers tighten monetary policy by either increasing interest rates or reducing money supply, the conditions of general economy become more difficult with a rise in funding costs, transaction costs, and information costs However, enterprises cannot immediately modify the quoted prices for goods and services and price level shows a sluggish change On the contrary, currency markets are more liquid, and prices change easily and frequently Hence, a monetary policy contraction immediately causes a rise in real interest rate, increasing the relative attraction of domestic assets and resulting in an impact appreciation of domestic currency Once domestic currency is overvalued, market expectations change, and a depreciation is likely to occur In summary, a monetary policy contraction leads to an impact appreciation and then a gradual depreciation for a prolonged period However, some puzzles have been revealed when empirically analyzing the impulse response function of macroeconomic variables to monetary policy shocks The first puzzle refers to a situation where exchange rates shows a response of depreciation (rather than appreciation) after a contraction shock to monetary policy, which has been termed as exchange rate puzzle (Grilli & Roubini, 1995, 1996; Sims, 1992) The second puzzle appears when exchange rates appreciate persistently for a prolonged period up to year following a monetary policy contraction (Clarida & Gali, 1994; Grilli & Roubini, 1995, 1996; Kim, 2001, 2005) Therefore, exchange rates have a hump-shaped curve on impact of monetary contraction, which violates the theory of uncovered interest parity The economists have widely termed the phenomenon as delayed overshooting puzzle 2.2 Solving the puzzling response of exchange rate on the impact of monetary policy shocks There are three choices of VAR models to analyze monetary policy transmission, including recursive, structural (zero restriction), and sign restricted The first one, recursive VAR, was employed in many studies but its estimations are contrasting with conventional theory Applying recursive ordering for five large industrial countries, Sims (1992) found that exchange rate puzzle could be eradicated by properly choosing the indicator of monetary policy shock in the presence of demand shocks such as short-term interest rate Although the empirical results seem reasonable, several puzzles emerged following a monetary contraction: persistent appreciation of domestic currency for France and Japan or persistent depreciation of home currency for Germany Similar to Sims (1992), Grilli and Roubini (1995) also employed recursive VAR model to analyze the dynamic interaction between exchange rate and monetary policy for non U.S G7 countries and documented puzzling response of exchange rate, showing a persistent (rather than impact) appreciation before exhibiting a gradual depreciation following positive shock to the differential between domestic and foreign interest rates for most countries in G7 group Following studies showed intensive evidences of exchange rate puzzle or delayed overshooting (Eichenbaum & Evans, 1993) As suggested by Sims (1992), many studies add more shocks into VAR model to capture the great pool of information monitored by the central bankers in monetary policy setting For instance, commodity price or oil price are used to account for the fact that policymakers reflect the inflationary pressures in deciding the monetary policy stance A few studies make a further effort by adding factors which represent general concepts like “economic activities” The approach extends the scale of VAR model to capture the enormous pool of information monitored by central bankers when formulating monetary policy stance Although the large-scale VAR shows advantages in solving puzzles in the analysis of monetary policy transmission, it seems to be feasible for the analysis of developed countries where fundamental statistics are adequate and well managed In case of developing country, the restriction of data availability forces studies on this field to rely on smallscale VAR Another explanation for the inefficiency of recursive VAR in solving puzzling outcomes of monetary policy shock is that the simultaneous interaction between exchange rate and interest rate is more likely to happen in small and open countries In fact, G7 economies are opener and smaller than that of the United States In such cases, the non-recursive contemporaneous restriction demonstrates the merit of eliminating puzzles in the monetary policy transmission Cushman and Zha (1997) employed this approach when studying Canada, which is considered as relative small economy to the United States They found no puzzling interaction between money supply, interest rate, and exchange rate based on the assumption that the central bank quickly responds to concurrent shocks in financial variables like exchange rates Kim and Roubini (2000) further developed the identification strategy of Cushman and Zha (1997) to account for the openness of a small economy Kim and Roubini (2000) argued that short-term interest rates quickly respond to innovations in macroeconomic variables such as money stock, world oil price, and exchange rate while exchange rates are affected by shocks to other variables Therefore, they did not impose zero restrictions on the interaction between contemporaneously interacted variables in structural VAR model Sign restriction is another approach used to solve exchange rate anomalies in a small and open country Uhlig (2005) adopted the sign restriction methodology and identified a monetary policy contraction as an increase in federal funds rate associated with a reduction in non-borrowed reserves and a decline in price level The sign restriction is imposed on inflation level due to the objective of price stability pursed by Federal Reserves The study found a monetary policy contraction leads to a fall in output in the short run For Russia, Granville and Mallick (2010) emphasized the importance of exchange rate intervention in an economy with managed floating regime and investigated whether frequent intervention in foreign exchange market influences the performance of economic activities and price stability They imposed sign restriction on selected variables to define exchange shock as well as inflation targeting shock and found that exchange rate targeting exercised relatively strong impact on inflation Rafiq and Mallick (2008) preferred to study the effect of monetary policy on output in three strong economies in European area like German, Italy, and France The study used four shocks to define the stance of monetary policy, including narrow money, exchange rate, interest rate, and inflation The former two characterizes the openness degree of these economies while the latter two capture the objective of price stability in formulating monetary policy by European monetary policymakers In fact, a contraction in monetary policy is associated with an increase in interest rate, a decline in money, an appreciation of domestic currency, and a decrease in price They found that monetary policy shocks are not a dominant driver of output in three EMU countries, suggesting that accounting for national information about inflation and output gap is essential to improve the quality of monetary policy conduct in selected EMU economies The sign methodology of Uhlig (2005) shows appealing features in identifying monetary policy innovation as well as eradicating puzzling response of macroeconomic variables to monetary policy shock not only for studies in countries where exchange rate are floating but also for small-open economies with managed exchange rate regime Ho and Yeh (2010) imposed sign restriction on both interest rate and foreign reserves (rather than exchange rate or exchange rate depreciation as in previous studies) to investigate monetary policy shock in Taiwan because they pointed that monetary authorities in this country usually intervenes the exchange market to stabilize the fluctuation of exchange rate As a result, monetary policy can operate through both interest rate and the stock of foreign reserve Consequently, they associate a monetary policy contraction with a rise in interest rate and a fall in the stock of foreign reserves The findings provide impulse response without any puzzles whereas other schemes like those of Cushman and Zha (1997) and Berument (2007) suffer puzzles This study also employs the new method of VAR, sign restriction, for investigating the effect of monetary policy on macroeconomic variables in Vietnam Unlike most of previous studies, it focuses the case of Vietnam where exchange rates are heavily managed and central bankers regularly intervene the exchange rate market to stabilize the value of domestic currency against foreign currencies Therefore, two policies including monetary policy and exchange rate intervention policy are interacted with each other Unlike the identification of Uhlig (2005) and Ho and Yeh (2010), monetary policy shocks are identified through unexpected changes in policy rate, broad money, and state bank credit since these instruments are easily influenced by the State Bank of Vietnam The stock of foreign exchange reserves is also included in the identification scheme because it reflects the intended objective of remaining the stability of exchange rate pursued by the central bank in Vietnam Methodology There are several strategies to estimate model (1) in most of the literature One is to identify structural shocks using recursive scheme with a Cholesky decomposition and the other is using zerorestriction on either short- or long-run coefficients (Sims, 1980) However, most of the cases these restriction leads to results inconsistent with economic theory (Canova & Pina, 2000) such as exchange rate puzzle (Grilli & Roubini, 1995, 1996; Sims, 1992) and delayed overshooting puzzle (Clarida & Gali, 1994; Grilli & Roubini, 1995, 1996; Kim, 2001, 2005) Instead, we can analyze the monetary policy effect on output, price, and other macroeconomic variables by assigning a prior assumption on the sign of selected shocks in VAR model based on the fundamental understanding of conventional economic theories (Uhlig, 2005) Unlike the strategy of Uhlig (2005) and those of previous studies, the identification strategy used in this paper accounts for the interaction of dubious policy, including monetary policy and exchange intervention policy in the context of a small open country of which the exchange rates are heavily managed 3.1 VAR with sign restriction The VAR has following specification: Yt B1Yt 1 B2Yt 2  BpYtp ut  (1) where Yt is an n x vector of macroeconomic variables and policy variables, Bi are n x n matrices of coefficient, and ut is the error matrix with variance – covariance matrix  According to economic theory, matrix ut can be defined in term of some structural shocks (see equation (2)) ut Avt (2) where A is a n x n matrix of structural parameters and vt are the structural shocks that has zero mean and a variance of unit Therefore, the variance and covariance can be written as:  E(u u' ) AE(v v' ) A' AA' (3) The matrix A requires a least n(n-1)/2 restrictions to be exactly identified Most of the literature imposes restrictions on model coefficients to recover structural shocks, either using a Cholesky decomposition or applying zero restriction on short- or long-run coefficients The sign restriction, on the other hand, imposes a prior belief that selected variables not increase or decrease for a certain period following a specific shock In order to recover the vector of structural shocks, it is essential to obtain an impulse vector of size n, a , as follows: AA'   (4) a A  where is a n x vector of unit length and AA'  is a Cholesky decomposition of  Next, the response vector derived from OLS estimation of unrestricted VAR with a Cholesky decomposition is multiplied by the vector a defined above The impulse response functions are checked to ensure the imposed signs are matched Uhlig (2005) suggested two approaches to find the sign-matched impulse response functions The first one is the rejection method which bases on the acceptance and rejection of a sub-draw for vector , which implies that all impulse response functions satisfying sign restriction are treated equally In this paper, we prefer the second one, termed as the penalty functions, since it minimizes the criterion function of sign restriction violation This approach makes an attempt to obtain an impulse response function that matches the sign restrictions as much as possible 3.2 Identification of important policy shocks based on sign restriction methodology Table indicates the identification of monetary policy shock and foreign exchange intervention shock As observed, a monetary policy contraction does not cause a fall in policy rate and a rise in central bank credit, foreign exchange reserves, and broad money Shocks to foreign exchange intervention involve any unexpected changes in the stock of foreign exchange reserves The identification of monetary policy shock is distinguished with that of Berument (2007) where central bankers can decrease the liquidity by either increasing interest rates at a given depreciation level or buying domestic currency while keeping interest rate unchanged This strategy is less valid in an economy of which exchange rates are heavily managed (Ho & Yeh, 2010) In Vietnam, central bankers tend to keep exchange rate fixed at certain levels while adjusting monetary policy instruments like interest rate, broad money, or central bank credit Therefore, innovation in the stock of foreign exchange reserve is an important signal for policymakers to make decisions about monetary policy instruments In a similar fashion to Like Ho and Yeh (2010), we believe that a monetary policy contraction is also associated with a fall in foreign exchange reserves In the language of sign restriction, a monetary policy contraction does not cause to an increase in foreign exchange rate reserves This prior assumption is essential for capturing the actual contraction in monetary policy As a small and open economy, development policy depends on exporting of goods and services overseas Moreover, the underdevelopment of financial markets as well as financial intermediation cause difficulties for a country to channeling capital inflows to productive local uses, resulting in an excessive supply of foreign exchange If central bankers take no actions, the nominal exchange rates would appreciate and lead to a reduction in export and the general economic activities For this reason, central bankers frequently accumulate the stock of foreign reserves, implying that aggregate money has a tendency to increase and the economy may face high inflation in the long run However, our identification is different with that of Ho and Yeh (2010) since policy rates rather than short-term interest rates are used to access the stance of monetary policy One reason is that policy rates are completely controlled by the State Bank of Vietnam Compared with Taiwan, Vietnam has underdeveloped financial markets that prevent central bankers from quickly influencing the setting of interest rates in the market Moreover, different with most of previous studies, shocks to credit that banks receive from the State Bank of Vietnam is also included to define the contraction shock to monetary policy in Vietnam Since monetary authorities have weak control over the movement of short-term interest rates, they can increase liquidity for the economy by directly providing loans to certain banks during emergent situations This type of credit then can be allocated to specific economic sectors directed by the government such as farming Therefore, the inclusion of central bank loans is better reflect the stance of monetary policy in Vietnam Table Identification of monetary policy shock and exchange rate policy shock Monetary policy shock Exchange rate intervention shock Industrial production index Consumer price index Trade balance Exchange rate Policy rate Central bank credit Foreign exchange reserves Money ? ? ? ? + - - - ? ? ? ? ? ? + ? There are several reasons for leaving the impulse response of output and price (represented by industrial production index and consumer price index respectively) determined by the data First and foremost, we want to examine the effect of monetary policy on its ultimate goal of increasing output in the economy Furthermore, Vietnamese central bank has neither explicit or implicit commitment to the objective of price stability, which is total different with central banks in developed countries such as the United States and European Union members Therefore, there is no sign restriction imposed on the proxies for output and price in the analysis We also leave the impulse response of trade balance and exchange rate unrestricted since it is necessary to examine whether the identification used in this paper can resolve puzzles in the interaction between exchange rate and monetary policy in the literature Since Vietnam adopts a fixed exchange rate regime, the stock of foreign exchange is frequently changed to stabilize the supply of and demand for foreign exchange and keep exchange rates stable Therefore, innovations to monetary policy instruments are not important information for the setting of foreign exchange intervention policy As shown in Table 1, there is no sign restriction put on policy rate, state bank credit, and money In addition to this, the responses of output, price, trade balance, and exchange rate are left unrestricted This identification scheme provides evidence about the effect of foreign exchange intervention on output and price as well as the response of monetary instruments like policy rate, state bank credit, and money 3.3 Data The VAR model in this paper consists of eight endogenous variables of which four variables including policy rate, foreign exchange reserves, state bank credit, and broad money are used to access the monetary policy setting Exchange rates are included because it is an important shock in the transmission mechanism of monetary policy in a small open country where economic growth is significantly contributed by exporting goods and services to foreign countries Industrial production index and consumer price index are business cycle variables that are intensively used to represent output and price in the literature All variables with the exception of policy rate are presented in the natural logarithm form The series of industrial production index is derived from two sources The first part of the series which spans over the period January 2001 - June 2013 is retrieved from the website Asia Regional Integration Center The remaining of the series until July 2016 is derived from General Statistics Office of Viet Nam Both are modified so that they are calculated on the same base year of 2010 Other series of the dataset are collected from the International Monetary Funds (IMF) and also span from January 2001 to July 2016 Empirical results 4.1 Empirical evidence from impulse response analysis Figure plots the response of macroeconomic variables following a monetary policy contraction, which is estimated by the penalty method of Uhlig (2005) As observed, there are three lines for each impulse response plot The median response is the middle line while the upper and lower line are 16th and 84th percentile from a sample of 10000 draws retrieved from posterior distribution respectively The figure shows that when central bankers tighten monetary policy, policy rates show an impact increase, lasting for about months before reducing while foreign exchange reserves exhibit persistent decreases for a prolonged period of about 30 months On the other hand, credit that banks borrow from the State Bank of Vietnam reduces significantly on impact but the negativity fades out quickly after months The negative response of state bank credit is persistent in the long run Money exhibits a permanent decrease following a contraction in monetary policy It is noteworthy that the response of these four variables is restricted by construction for identifying monetary policy shocks The emphasis here is on the impulse response function of unrestricted variables such as output, price, exchange rate, and trade balance Following a positive shock to monetary policy, price shows a persistent decrease, reaching the lowest level after about one and a half year Thereafter, the response shows a persistent increase until 60th month The initial increase in price provides evidence of price stickiness in Vietnam It implies that firms does not adjust price at higher frequency when the macroeconomic environment changes One attribute is that competition in the market is relatively low; firms are not under pressure to reduce prices to compete with other firms The finding about the impulse response function of price to great extent is contrast with those of previous studies where monetary policy represented by either money supply or short-term interest rate exercises insignificant or temporary effects on the development of inflation in Vietnam (Bhattacharya, 2014; Hung & Pfau, 2009) In fact, the negativity of price reaction to a monetary policy contraction is consistent with the prediction of standard economic theories as well as the empirical findings of Phan (2014) On the contrary, output, which is represented by industrial production index, shows a noisy pattern of movement in the first few months after a monetary policy contraction In fact, output shows an impact decrease, rising in the next few months, and then showing a permanent and significant decrease The negative effects of a positive shock to monetary policy on both output and price level are protracted for a lengthy period up to 60 months The negativity in the response of output to a monetary contraction is plausible and well-supported by previous studies on monetary policy transmission in Vietnam, such as Bhattacharya (2014), Hung and Pfau (2009), and Thu Thuy Vinh (2015) A noteworthy finding is that in a few months following a contraction in monetary policy, price and output exhibit positive response, which suggests unexpected changes in the expectation of agents The phenomenon provides evidence of the adverse effects of monetary policy in emerging country, which was mentioned in the study of Maćkowiak (2007) In an economy where the problems of information asymmetry is severe and private sector has an assumption that central bankers may have unavailable information about output and price, the stance of monetary policy operates as an informative signal about the performance of the economy in the future Therefore, in the short run following a contraction monetary policy, the partially irrational agents may quickly update their expectation and behaviors, which counteracts the effects of intended policy In the long run, private sector is certain about the stance of monetary policy, they reverse their behaviors and the restrictive monetary policy shows its intended effects, leading a decline in both output and price Overall, the response of monetary variables such as output and price is consistent with the prediction of standard economic theories As central bankers tighten monetary policy, price and output showing a persistent declining trend both in short- and long-run Our findings indicates that monetary is effective in controlling inflation and economic performance in the long run, which suggests that the transparency (rather than independence) of central bank operation is essential in monetary policy setting in Vietnam Furthermore, the identification indicated in Table has an ability to resolve some puzzles in the VAR literature of monetary policy analysis There is no evidence of price puzzle where a positive monetary policy shock leads to an increase (rather than a decrease) in price (Sims, 1992) The response of exchange rate shows neither exchange rate puzzle, where exchange rates exhibit an immediate depreciation nor delayed overshooting, where exchange rates appreciate for a lengthy period up to three years after a monetary policy contraction Following a positive shock in monetary policy, exchange rates show an impact appreciation, peaking after eight to nine months, and thereafter decay exponentially The finding is in agreement with the overshooting hypothesis proposed by Dornbusch (1976) Figure Response of macroeconomic variables to positive monetary policy shock Figure shows the impact of foreign exchange intervention on various macroeconomic variables A positive shock to foreign exchange reserves indicates that central bankers buy foreign currency, which results in an increase in the liquidity and a depreciation of domestic currency Accordingly, an increase in the stock of foreign exchange reserves indicates that exchange rate will increase, implying a depreciation of domestic currency However, the impulse response function shows that exchange rates have no statistically significant reaction following positive shocks to foreign exchange intervention, which is inconsistent with the prediction of standard economic theory A plausible explanation for this anomaly is that exchange rates are heavily managed in Vietnam In fact, the accumulation of foreign exchange reserves aims at reducing the adverse effect of capital inflows and keeping nominal exchange rate unchanged, which is an important policy to stimulate exporting of domestic goods and services Moreover, the response of policy rate and state bank credit suggests that central bankers make a great effort to sterilize the effect of positive shock to the stock of foreign reserve on exchange rate as well as an increase in money supply From the first and second plot in the right column of Figure 2, policy rates are likely to increase immediately after an unexpected increase in foreign exchange reserves The positive reaction of policy rate lasts for a short period of five months and then become insignificant In addition to a rise in policy rate, central bankers further reduce liquidity injected by exchange rate intervention by slightly reducing the supply of loans for the banking system State bank credit shows a declining trend for a few months before exhibiting an increase in the mid-term These actions cause an appreciation of domestic currency, leading to the allocation of wealth into assets denominated in foreign currency The effect of both policy, monetary and exchange rate, are counteracted and exchange rates remained stable Price, on the other hand, shows an initial and significant increase in the first few months, becoming insignificant from fifth month to twenty-ninth month In the long run, price level shows a considerable and significant increase It is a result of underdeveloped financial markets which cannot afford an enormous amount of capital inflows caused by either the policy of attracting foreign direct investment or remittances from overseas Vietnamese To prevent nominal appreciation of exchange rates, it is more likely that central bank has to buy the excessive supply of foreign exchange in the market, which leads to an increase in money supply and an expectation of high inflation in the future Trade balance increases significantly following a positive innovation in foreign exchange reserves, implying the inflationary pressure embodied in an expansion in the stock foreign exchange reserves In fact, money supply shows a permanent and significant increase as central bankers buy excessive foreign currency supply in the market Output exhibits an impact increase, followed by a temporary drop in the second month before showing a positive shock In the mid-term, the positive response of industrial output becomes persistent and statistically significant Figure Response of macroeconomic variables to positive shock in exchange rate policy 4.2 Empirical evidence from the analysis of forecast error variances decomposition Table depicts the forecast error variances decompositions from the first to 30 month-ahead in a variety of variables included in the model, reporting how monetary policy shocks contribute to the variation of various economic variables As can be seen, the volatility of broad money and foreign exchange reserves is significantly explained by shocks to monetary policy About a quarter of the variation in these variables is contributed by monetary policy shock in the first three months, accounting for roughly 22 percent of variation in both variables The explanatory power of shocks to monetary policy on broad money and foreign exchange rate reserves is quite comparable until 30th month, reducing to approximately 14 percent In the first quarter ahead, monetary policy shocks explained more than 11% of policy rate’s fluctuation, reducing to roughly 10% and then rising to about 10.5% from fifteenth month It is worth noting that the variation of such variables as consumer price index, trade balance, and exchange rate is insignificantly explained by monetary policy shocks Over time horizon of 30 months, innovation in monetary policy accounts for a considerable percentage of industrial production fluctuation, stabilizing in the range from 10 to 10.6 percent Table The variation of each variable to monetary policy shock Horizon Industrial production Consumer price Trade balance Exchange rate Policy Rate State bank credit Foreign exchange reserve Broad money 10.49 5.65 3.15 3.54 11.46 11.93 22.10 22.97 10.66 6.66 7.43 5.40 9.92 11.45 19.64 20.55 10.44 8.49 8.27 7.36 9.50 11.77 18.08 18.03 12 10.23 9.81 8.54 8.25 9.97 11.96 17.40 16.55 15 10.06 10.97 8.77 8.82 10.42 12.07 16.75 15.64 20 9.99 11.77 9.03 9.25 10.72 11.99 15.67 14.92 30 10.04 12.47 9.41 9.78 10.67 11.71 14.17 14.25 Table shows how the variance of model variables is explained by innovations in foreign exchange intervention, which is measured by the unexpected changes in the stock of foreign exchange reserves in this paper As observed, much of the variation in foreign exchange reserve is attributed by innovations to itself It is quite understandable since Vietnam follows a peg regime over the sample horizon In the first three month, more than 60 percent of the volatility of foreign exchange reserves is attributed by positive shocks to itself, which reduces a little to about 51 percent in the next quarter, and then gradually decrease to approximately 29 percent by the 30th month Furthermore, positive shocks to foreign exchange intervention explain a relatively small proportion of exchange rate’s volatility, which is totally consistent with the nature of fixed exchange rate regime Table The variation of each variable to foreign exchange intervention Horizon Industrial production Consumer price Trade balance Exchange rate Policy Rate State bank credit Foreign exchange reserve Broad money 3.95 3.10 3.91 1.90 6.89 5.36 63.94 7.47 5.58 3.65 4.57 2.67 6.42 7.86 51.82 8.76 5.76 4.29 5.20 3.03 6.06 9.02 46.50 9.96 12 5.87 4.67 5.60 3.32 5.84 9.35 42.76 11.85 15 5.99 4.77 6.04 3.62 5.87 9.26 40.36 13.14 20 6.23 5.21 6.82 4.13 5.92 9.25 35.64 14.44 30 6.79 6.20 7.64 5.08 6.28 8.99 28.76 15.31 Conclusion This paper investigates monetary policy effect in a small open economy where exchange rates are heavily managed For that purpose, the sign restriction methodology is employed to identify important shocks to monetary policy and foreign exchange intervention policy Unlike previous study, we identify a monetary policy shock as an increase in interest rate associated with a decrease in central bank credit, and a drop in stock of foreign exchange reserves as well as a decline in money Foreign exchange intervention, on the other hand, is defined by shocks to the stock of foreign exchange reserves The paper has several interesting findings First and foremost, the empirical results show that output and price, which are represented by industrial production index and consumer price index respectively, show a reduction following a positive shock in monetary policy, which is in line with standard economic theories Our findings about the efficiency of monetary policy in controlling both output, especially price, are contrast with most of previous studies on this field in Vietnam (Bhattacharya, 2014; Hung & Pfau, 2009; Thu Thuy Vinh, 2015) Moreover, trade balance exhibits a temporary increase in the mid-term before showing a sharp decline and become insignificant in the long-term A noteworthy finding is that the response of exchange rate on the impact of a monetary policy contraction is overshooting, showing an impact appreciation, peaking after eight to nine months However, foreign exchange intervention shows insignificant impact on the movement of exchange rate while exercises a positive and significant effect on price and money There are two explanations for this finding: (1) central bankers frequently accumulate foreign exchange reserves to stabilize exchange rates due to the appreciation pressure caused by capital inflows; and (2) the reserve effect of monetary policy counteracts the effects of a foreign exchange intervention shock The findings suggest several important implication First, for effectively controlling output and price, central bankers should account for the innovations in foreign exchange intervention in formulating the monetary policy setting Second, foreign exchange intervention policy shows positive effect on inflation and money, suggesting that the development of financial market is a necessity in improving the ability to absorb capital inflows References Berument, H (2007) Measuring monetary policy for a small open economy: Turkey Journal of Macroeconomics, 29(2), 411-430 Bhattacharya, R (2014) Inflation dynamics and monetary policy transmission in Vietnam and emerging Asia Journal of Asian Economics, 34, 16-26 Canova, F., & Pina, J P (2000) Monetary policy misspecification in VAR models Economics and Business Working Paper (420) Clarida, R., & Gali, J (1994) Sources of real exchange-rate fluctuations: How important are nominal shocks? 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Results from an agnostic identification procedure Journal of Monetary Economics, 52(2), 381-419  ... stability in formulating monetary policy by European monetary policymakers In fact, a contraction in monetary policy is associated with an increase in interest rate, a decline in money, an appreciation... Granville and Mallick (2010) emphasized the importance of exchange rate intervention in an economy with managed floating regime and investigated whether frequent intervention in foreign exchange market... while keeping interest rate unchanged This strategy is less valid in an economy of which exchange rates are heavily managed (Ho & Yeh, 2010) In Vietnam, central bankers tend to keep exchange rate