Monetary policy transmission and bank lending channel in vietnam

MINISTRY OF EDUCATION AND TRAININGUNIVERSITY OF ECONOMICS HO CHI MINH CITY

NGUYEN PHUC CANH

MONETARY POLICY TRANSMISSION ANDBANK LENDING CHANNEL IN VIETNAM

PHD THESIS

HO CHI MINH CITY, 2016

MINISTRY OF EDUCATION AND TRAININGUNIVERSITY OF ECONOMICS HO CHI MINH CITY

NGUYEN PHUC CANH

MONETARY POLICY TRANSMISSION ANDBANK LENDING CHANNEL IN VIETNAM

Major: Finance and BankingCode: 62.34.02.01

PHD THESIS

ACADEMIC ADVISORS

HO CHI MINH CITY, 2016

I am deeply indebted to my academic advisers Pro.Dr Sử Đình Thành andAssoc.Pro.Dr Võ Xuân Vinh for their fundamental roles Pro.Thành and Pro.Vinh haveprovided me with guidance, assistances, and supports during my study They have givenme autonomy on decision making and researching the topic, while continuing to providevaluable feedbacks, advices, and encouragement In addition to our academiccollaboration, I greatly appreciate the bonding relationships between Thành, Vinh andI Additionally, I am deeply thankful to Dr Trầm Thị Xuân Hương, my lecturer andmy researching partner at School of Banking, who has assisted me in researching thetopic in this thesis She has also advised, encouraged and generously allowed me toapply our shared works in presenting this thesis I gratefully acknowledge lecturersfrom the research methodology course at University of Economics Ho Chi Minh Citywho have provided me with basis methodologies for this study Such methodologieshave helped me understand, find and utilize correct methods.

I would like to thank my dear colleagues at School of Banking and University ofEconomics Ho Chi Minh City for their substantial influence The School of Bankingand University of Economics Ho Chi Minh City provide the best environment forstudying and researching I also give my thanks to colleagues in Internationaldepartment at School of Banking, they always supported and encouraged me in thisstudy and helped me a lot throughout my career I also would like to thank the boardof professors and the independent external reviewers who gave me a lot of usefulcomments and advices on my first presentation, their comments are one of the majorcontributing factors that allowed me to complete this version of my thesis.

I am deeply thankful to my family for their love, support, and sacrifice Withoutthem, this thesis would never have been written.

Ho Chi Minh City, Sep/2016

Nguyen Phuc Canh

ARDL Autoregressive Distributed Lag Model

BRICS BRICS Group (including Brazil, Russia, India, China andSouth Africa)

DSGE Dynamic Stochastic General Equilibrium Model

FAVAR Factor Augmented Vector Autoregression

FDICIA Federal Deposit Insurance Corporation Improvement Act

G7 Canada, France, Germany, Italy, Japan, UK, US

HLEHNXHSXIRCIS-LMIMFIPVNIRFITLERLIBORMPTMM2NEERNPVOECDOLSKMV EDFQE

RDRRFRSBVSMES&P 500SVARVARVECMVIX

Household Liquidity EffectsHanoi Stock Exchange

Ho Chi Minh Stock ExchangeInterest Rate Channel

Investment, Saving–Liquidity Preference, Money SupplyInternational Monetary Fund

Vietnam Industrial ProductionImpulse Response FunctionInflation Targeting PolicyLending Interest Rate

London Interbank Offer Rate

Monetary Policy Transmission Mechanism

Money Supply definition (expanded money supply)Nominal Effective Exchange Rate

Net Present Value

Organization for Economic Co-operation and DevelopmentOrdinary Least Squares

KMV’s Expected Default FrequencyQuantitative Easing program

Rediscounting RateRefinancing RateState Bank of Vietnam

Small and Medium EnterprisesS&P 500 Index

Structured Vector AutoregressionVector Autoregression

Vector Error Correction Models

The implied volatility of S&P 500 index options

Vietnam Dong (Currency of Vietnam)VNindex

Vietnam Interbank Offer RateVietnam composite stock indexThe United Kingdom

Unexpected Price Level ChannelThe United State

US Dollar

Weighted Average Capital CostWorld Trade Organization

1.1 The overview of Vietnamese economy and monetary policy 1

1.1.1 The Vietnamese economy 1

1.1.2 The State Bank of Vietnam 2

1.1.3 The Vietnamese monetary policy 3

1.1.4.1 Market interest rates 4

1.1.4.2 Inflation 4

1.1.4.3 Exchange rate 6

1.1.4.4 Credit 6

1.1.4.5 Stock markets 7

1.2 Research gap identification 8

1.3 Research objectives and questions 10

1.4 The scope of this study 11

1.5 Research methodologies and data 12

1.5.1 Methodologies 12

1.5.2 Research data 13

1.6 Some key concepts 13

1.7 The structure of study 15

CHAPTER 2 17

THEORETIAL FRAMEWORK AND LITERATURE REVIEW 17

2.1 Monetary policy 17

2.1.1.Introduction 17

2.1.2 Central bank 18

2.1.3 Monetary policy targets 18

2.1.4 Monetary policy tools 19

2.1.5 The ineffectiveness of monetary policy 20

2.1.6 Monetary policy and fiscal policy 20

2.1.7 Unconventional monetary policies 21

2.1.7.1 Quantitative easing program 21

2.1.7.2 Inflation targeting policy 22

2.1.8 Summary 23

2.2 Monetary policy transmission 24

2.2.1 Introduction 24

2.2.2 Conceptual framework 24

2.2.3 Monetary policy transmission channels 26

2.2.3.1 Interest rate channel 26

2.2.3.2 Exchange rate channel 28

2.2.3.3 Asset price channel 30

2.2.3.4 Credit channel 31

2.2.3.5 Expectation channel 35

2.2.4 The lag and effectiveness of monetary policy transmission 36

2.2.4.1 The transmission lags of monetary policy 36

2.2.4.2 The effectiveness of monetary policy transmission 37

2.3 Bank lending channel 38

2.3.5.2 The development of financial markets 43

2.3.5.3 Regulations in banking sector 44

2.3.5.4 The competition in banking sector 45

3.1.2 The relationships between monetary policy, output and inflation 61

3.1.3 Estimating effects of monetary policy 62

3.1.4 Database in study of monetary policy transmission 65

3.1.5 Proxy variables for monetary policy 65

3.1.5.1.Policy rates 65

3.1.5.2.Money supply 66

3.1.6.Variables of commercial bank characteristics in bank lending channel

3.2.5 GMM model for panel data 78

3.3 Research methodologies for this study 81

3.3.1 Introduction 81

3.3.2 Research procedures and testing hypothesizes 81

3.3.3 Vietnam monetary policy transmission testing models 84

EMPIRICAL EVIDENCES FROM VIETNAM 97

4.1 Monetary policy transmission 97

4.1.1 Introduction 97

4.1.2 Data 97

4.1.3 VAR model results 99

4.1.4 SVAR model results 106

5.4.1 Choosing monetary policy tools 139

5.4.2 Appling unconventional monetary policies 142

5.4.3 Developing debt and equity markets 144

5.4.4 Capability of commercial banks 145

5.4.5 Risk of commercial banks 147

5.5 Limitations and suggestions for further research 149

6 LIST OF AUTHOR’S PUBLICATION i

7 LIST OF REFERENCES v

8 APPENDIXES xxxvi

LIST OF TABLES

Table 3.1 Restriction matrix in SVAR model of Neri & d'Italia 87

Table 3.2 SVAR restriction matrix 89

Table 3.3 Expected correlations 92

Table 3.4 Formulas and sources of variables in VAR and SVAR models 94

Table 3.5 Formulas and sources of variables in GMM model 95

Table 4.1 Data statistical description 97

Table 4.2 New statistical description 98

Table 4.3 Granger causality test results 98

Table 4.4 The development of Vietnam stock market 104

Table 4.5 Granger causality test for DLVNI 105

Table 4.6 Variance decomposition for CPI from SVAR 108

Table 4.7 Variance decomposition for CPI from SVAR with DRDR 113

Table 4.8 Variance decomposition for CPI from SVAR with DRFR 115

Table 4.9 GMM data description 116

Table 4.10 Bank lending channel with each effect of bank characteristics 117

Table 4.11 Bank lending channel with whole effects of bank characteristics 120

Table 4.12 Bank lending channel with new measure of bank characteristics 121

Table 4.13 Bank lending channel with whole effects by new measure of bankcharacteristics 122

Table 4.14 Bank lending channel with RFR for each effects 123

Table 4.15 Bank lending channel with RFR for whole determinants 124

Table 4.16 Bank lending channel with RDR for each effects 125Table 4.17 Bank lending channel with RDR for whole determinants 125Table 4.18 The impacts of the 2008 global financial crisis on bank lending channel inVietnam 128Table 5.1 Financial market development in Vietnam 144Table 12.1 Remarkable events in 1986-2012 period xxxviTable 2.1 The laws in banking 1990-2012 period xlTable 2.2 M2 growth rate: plan and results in 2004-2012 period xlTable 2.3 Inflation: plan and results in 2004-2012 period xlTable 2.4 Credit growth: plan and results in 2004-2012 period xlTable 2.5 Altman’s Z – score for Vietnam commercial bank xliTable 12.1 The monetary policy transmission mechanism lxviiTable 14.1 Research methods and Processes lxxxivTable 14.2 Commercial banks in this study lxxxvTable 15.1 VAR unit root test results lxxxviiiTable 15.2 VAR data processing and new code lxxxviiiTable 15.3 VAR(5) model for IRC in Vietnam lxxxixTable 15.4 AR root test result for VAR(5) of IRC xcTable 15.5 Lags criteria results for VAR(5) of IRC xciTable 15.6 LM test results for VAR(5) of IRC xciTable 15.7 VAR(5) results for ERC xciiTable 15.8 AR root test results for VAR(5) of ERC xciiiTable 15.9 Lag criteria results for VAR(5) of ERC xciv

Table 15.10 LM test results for VAR(5) of ERC xcivTable 15.11 VAR(5) results for APC xcvTable 15.12 AR root test results for VAR(5) of APC xcviTable 15.13 Lag criteria results for VAR(5) of APC xcviiTable 15.14 LM test results for VAR(5) of APC xcviiTable 16.1 SVAR results xcviiiTable 16.2 AR root test results for SVAR xcviiiTable 16.3 Lag criteria test results of SVAR xcixTable 16.4 LM test results of SVAR cTable 17.1 Granger causality test results ciTable 17.2 VAR(3) with DLM2 for IRC ciTable 17.3 AR root test result for VAR(3) with DLM2 of IRC ciiTable 17.4 Lags criteria results for VAR(3) with of IRC ciiiTable 17.5 LM test results for VAR(3) with DLM2 of IRC ciiiTable 17.6 VAR(4) results for ERC with DLM2 civTable 17.7 AR root test results for VAR(4) of ERC with DLM2 cvTable 17.8 Lag criteria results for VAR(4) of ERC with DLM2 cviTable 17.9 LM test results for VAR(4) of ERC with DLM2 cviTable 17.10 VAR(3) results for APC with DLM2 cviiTable 17.11 AR root test results for VAR(3) of APC with DLM2 cviiiTable 17.12 Lag criteria results for VAR(3) of APC with DLM2 cviiiTable 17.13 LM test results for VAR(3) of APC with DLM2 cixTable 18.1 SVAR results with DRDR cx

Table 18.2 AR root test results for SVAR with DRDR cxTable 18.3 Lag criteria test results of SVAR cxiTable 18.4 LM test results of SVAR with DRDR cxiTable 18.5 SVAR results with DRFR cxiiTable 18.6 AR root test results for SVAR with DRFR cxiiTable 18.7 Lag criteria test results of SVAR with DRFR cxiiiTable 18.8 LM test results of SVAR with DRFR cxiii

LIST OF FIGURES

Figure 1.1 Vietnamese macroeconomic factors 1

Figure 4.1 Impulse response function of CPI in IRC 100

Figure 4.2 Impulse response function for ERC 102

Figure 4.3 Impulse response function of VAR(5) for APC 104

Figure 4.4 Impulse response function of SVAR 107

Figure 4.5 Impulse response function of VAR for IRC with DLM2 109

Figure 4.6 Impulse response function of VAR for ERC with DLM2 110

Figure 4.7 Impulse response function of VAR for APC with DLM2 111

Figure 4.8 Impulse response function of SVAR with DRDR 112

Figure 4.9 Impulse response function of SVAR with DRFR 114

Figure 4.10 VIX index 127

Figure 5.1 Moody’s KMV EDF index 147

Figure 1.1 Vietnam nominal GDP in 1994-2012 period xxxvii

Figure 1.2 Vietnam GDP growth rate in 1994-2012 period xxxvii

Figure 1.3 Vietnam trade activities in 1994-2012 period xxxviii

Figure 1.4 Vietnam budget deficit in 1994-2012 period xxxviii

Figure 1.5 Vietnam external debt in 1994-2012 period xxxix

Figure 1.6 The Vietnam bank quantity in 1992-2012 period xxxixFigure 2.1 Vietnam money supply in 1994-2012 period xliiFigure 2.2 Vietnam M2 annual growth in 1994-2012 period xliiFigure 2.3 Vietnam interbank offer rate in 1998 – 2012 period xliiiFigure 2.4 Vietnam refinancing rate and rediscount rate in 1997 – 2012 period xliii

Figure 2.5 Vietnam market interest rates in 1997-2012 period xlivFigure 2.6 Vietnam inflation in 1996-2012 period xlivFigure 2.7 Vietnam unemployment rate in 1998-2012 period xlvFigure 2.8 USD/VND rate in 1994-2012 period xlvFigure 2.9 Vietnam balance of payment in 1994-2012 period xlviFigure 2.10 Vietnam credit growth in 1995 – 2012 period xlviFigure 2.11 Vietnam foreign exchange reserves in 1994-2012 period xlviiFigure 2.12 VNindex in 2000-2012 period xlviiFigure 2.13 HNXindex in 2006-2012 period xlviiiFigure 2.14 Vietnam inflation and stock market index in 2003-2012 period xlviiiFigure 5.1 Monetary policy targets livFigure 10.1 Monetary policy transmission mechanism at European central bank lxFigure 10.2 Monetary policy transmission mechanism in the U.S lxiFigure 10.3 Monetary policy transmission mechanism in the U.K lxiiFigure 10.4 Monetary policy transmission mechanism in South Africa lxiiFigure 10.5 Monetary policy transmission mechanism in Vietnam lxiiiFigure 11.1 The IS curve lxivFigure 11.2 The LM curve lxvFigure 11.3 The monetary policy and the IS – LM equilibrium lxvFigure 13.1 Monetary policy transmission channels through the real estate market lxxxiiFigure 13.2 Expectation channel transmission mechanism lxxxiii

The transmission of monetary policy is the center of economic studies, this fieldwas renewed in light of the 2008 global financial crisis with arguments about theeffectiveness and the determinants of transmission channels especially in emergingmarkets such as Vietnam which may have strong bank lending channel while assetprice channel and exchange rate channel may be weak.

This study tries to investigate the existing of interest rate channel, exchange ratechannel, asset price channel, and bank lending channel in Vietnam which are seen asthe main channels in monetary policy transmission In addition, this study tries toinvestigate the determinants of bank lending channel and the effects of the 2008 globalfinancial crisis on bank lending channel in Vietnam that are important for Vietnamesepolicy makers in conducting monetary policy, stabilizing banking systems, financialmarkets and the economy.

Firstly, this study utilizes the VAR model to examine the existing of interest ratechannel, asset price channel and exchange rate channel, one by one, by using monthlymacroeconomics data from 2003 to 2012 including market interest rates, the stock marketindex and exchange rate to proxy for interest rate channel, asset price channel andexchange rate channel respectively Then this study uses SVAR models to test theexisting of these channels in a system with the same data sample Secondly, this studycollects yearly data from 30 Vietnamese commercial banks such as loans, assets, loan lossprovision, capital from 2003 to 2012 to investigate the existing and the determinants ofbank lending channel through the system GMM models Then, this study uses the S&P500 implied volatility index to investigate the effects of the 2008 global financial crisis onbank lending channel through the same system GMM models.

With the first main objective, this study has found the evidence of cost channel inVietnam that reflects the ineffective of monetary policy in controlling inflation thus itis a big challenge for Vietnamese policy makers in conducting monetary policy But,this study did not find statistical evidences of exchange rate channel and asset pricechannel which may be suggest that they are weak or do not exist in Vietnam.

In the second main objective, this study found the evidences of bank lendingchannel in Vietnam, it was also affected by the commercial bank characteristics suchas bank capital, bank size This study also found that the 2008 global financial crisishad significant effects on bank lending channels which is stronger in crisis.

First of all, this study has contribution to the empirical literature about theexistence of cost channel in a small open economy Secondly, this study contributesempirical evidences of bank lending channel, the determinants and the effects of thecrisis on bank lending channel in an emerging market Thirdly, this study has majorcontributions to Vietnamese policy makers in conducting monetary policy andstabilizing the banking system and financial markets, especially in the case of facingfurther external shocks in the future such as the global crisis With the academiccontributions, this study defined that economists should test all transmission channelsin one model for better controlling the interactions between channels and bettermeasuring the effectiveness of each channel.

With the empirical results, this study has significant practical implications forVietnamese policy makers in developing debt and equity markets, controlling therisky activities of banking systems and applying unconventional monetary policiessuch as inflation targeting.

CHAPTER 1

1.1.The overview of Vietnamese economy and monetary policy

1.1.1 The Vietnamese economy

The ‘Doi Moi” policy since 1980s has been transmitted to the Vietnamese economyfrom plan to market-oriented economy, but it is still limited to phrase "market economyunder the management of the state" The changes in economy led to many changes in theeconomic structure and even in the law system with the birth of the 1992 constitution that

had acknowledged private sectors (see table 1.1 in Appendix 1 for more information

about law system innovations) The Vietnamese economy has gone through high growth

periods from 1994, in which it has had two slow periods due to the 1997 Asian economic

crisis and the 2008 global financial crisis (see figure 1.1 and 1.2 in appendix 1) To cope

with crisis and slowdown in the economy, Vietnamese government implemented astimulus packages worth 143,000 billion VND (equivalent to USD 8 billion at 2009exchange rate) in 2009, then increased to 160,000 billion VND later (equivalent to USD 9billion), it has recovered GDP growth to 6.8% in 2010, but their effects did not last long,Vietnam fell into instability again in in 2011 and 2012.

Vietnamese macroeconomic factors

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012(10.00)

Figure 1.1 Vietnamese macroeconomic factors

Source: ADB (2014).

In the trend of international integration, Vietnam has integrated stronger and deeperinto the world economy by signing the Vietnam – U.S trade agreement in 2001 andofficially joined WTO on 11/Jan/2007, thus trade activities have increased from 10 billion

USD in 1994 to over 80 billion USD in 2006, and over 200 billion USD in 2012 (see

figure 1.3 in Appendix 1), which makes the Vietnamese economy more vulnerable to the

international shocks which became clearer in the 2008 global financial crisis when theVietnamese economy fell into a difficult situation: bad debt in the banking system,inventory rising, recession in the real estate market and securities market, especially thereal estate market which severely degraded in 2011 and 2012.

1.1.2 The State Bank of Vietnam

Roles, duties, and functions of the State bank of Vietnam (SBV) was separated by the

1990 banking ordinance, it was defined as an agency of the council of ministers (now is

government) with the functions of managing monetary policy, credit, and banking system

in order to stabilize currency values, and the role of the exclusive money printingdepartment of Socialist Republic of Vietnam However, the 1990 banking ordinancedidn’t clearly indicate the independence of SBV in monetary policy conducting under the

government management (see table 2.1 in Appendix 2) According to the 1990 banking

ordinance, SBV could use rediscount rate (article 43), reserve requirement (article 44),minimum deposit interest rates and maximum lending interest rates (article 43), clearingorganization (article 45), but it didn’t directly mention how SBV could manage themoney supply and policy rates Then, the 1997 state bank act specified that SBV was agovernment agency with functions of monetary management, banking systemmanagement, and money issuing SBV aimed to stabilize currency value, ensure safety ofbanking system and credit institutions, and promote economic development (clause 1, 2, 3of article 1) Article 2 of the 1997 state bank act also stated that SBV was the monetarypolicy conductor, SBV could use: refinance rates, reserve requirements, interbankpayments, and credit supply management to conduct monetary policy Until 2003, the2003 state bank act amendment was launched to amend some articles of the 1997 versionthat provided more specific details on rediscount rates,

refinance rates, open market operations, base rates, and banking operations, but theroles and functions of SBV did not change.

The operations of SBV were more apparent in the 2007 – 2012 period when theVietnamese economy fell into crisis In 2010, the Vietnamese parliament approved the2010 state bank act with changes in comparison to the 2003 version, in which the mostimportant change was the SBV’s function of monetary policy conducting in article 2.However, the 2010 state bank act still defined that SBV was a government agency; itremains under government control in monetary policy conducting The annual targetof inflation is still defined by Vietnamese parliament thus there is no progression inthe independence of SBV However, there is an important step in determining themain target of monetary policy, the 2010 state bank act defines that price stability issole target of monetary policy that doesn’t include the target of economic growth.Article 10 of the 2010 state bank act defines monetary policy tools as refinance rates,rediscount rates, foreign exchange rates, reserve requirements, open marketoperations, and other tools that are permitted by government.

1.1.3 The Vietnamese monetary policy

SBV had expanded the monetary policy in the 2000 – 2007 period to cope with the1997 Asian crisis and to stimulate economic growth, then they expanded and tightenedmonetary policy on numerous occasions in the 2008 – 2012 period After the 1997 Asiacrisis, Vietnam expanded monetary policy to stimulate investment and consumption to

cope with crisis, thus M2 grew up to 39.2% in 1999 and 56.2% in 2000 (see figure 2.2 in

Appendix 2) After joining the WTO in 2007, high economic growth combined with large

capital inflows made M2 raise up to 46.1% in 2007, and it was still high in the 2008 –

2012 period (see figure 2.2 in Appendix 2) Money supply from under 50,000 billion

VND in 1994 had increased to over 200,000 billion VND in 2000, nearly 1 million billion

VND in 2006, and over 3.6 million billion VND in 2012 (see figure 2.1 in Appendix 2).Besides that, SBV constantly couldn’t keep targets of monetary policy From 2004 to

2006, targets of M2 growth rate were 22%, 22%, and 23-25% per year respectively, butSBV always broke them in implementation, M2 growth rates were

actually higher than targets from 7% to 10% per year, this situation continued in 2007,

2009, 2010 and 2012 and then after (see table 2.2 in Appendix 2).

Vietnam interbank offer rate (VNIBOR) decreased in 1999, 2000 and thenstabilized at 6% to 7% per year in 2001 – 2007 period alongside money supply growth

(see figure 2.3 in Appendix 2) SBV kept a low interest rate to cope with the 1997Asian crisis and kept it for a long time to simulate economic growth in the latter

period In the next period, VNIBOR fluctuated: increasing sharply in 2008, decreasingin 2009, increasing again in 2010 and 2011, and then decreasing in 2012 The changesin VNIBOR reflected unstability in monetary policy, SBV tightened monetary policyto control inflation in 2008, expanded to stimulus economic growth in 2009, tightenedagain to control inflation in 2010 and 2011, and then expanded to stimulate the

economy in 2012 and continuing (see figure 2.3 in Appendix 2) It is easy to realizethat SBV has lost their proactive approach in monetary policy conducting (see figure

2.4 in Appendix 2) The changes in money supply and policy rates all confirmed that

SBV had expanded monetary policy in 2000 – 2007 period, tightened in 2008,expanded in 2009, 2010, tightened in 2011, and expanded again in 2012 and the

following years (see figure 2.4 in Appendix 2) These changes led to several changesin Vietnam’s macroeconomic factors.

1.1.4 The Vietnamese monetary policy and macroeconomics factors

1.1.4.1 Market interest rates

Market deposit rates and lending rates had changed in the same patterns withVNIBOR Average deposit rates fell sharply from 9.23% in 1998 to 3.65% in 2000,meanwhile lending rates fell less and slower then they were stable at a low level in the

2000 – 2007 period (see figure 2.5 in Appendix 2), but they fluctuated with the

changes in monetary policy by increasing in 2008, decreasing in 2009, increasing in2010, 2011, and dropping in 2012.

1.1.4.2 Inflation

Prior to 2000, inflation was low and it even fell sharply to -1.6% in 2000, lowinflation along with low economic growth motivated SBV to expand monetary policy

in the period after 2000, but the expansionary monetary policy in the long term createdinflation risk The overheating economic growth, large and inefficient public investment,a sharp increase of aggregate demand after joining WTO, long lasting budget deficit, highcredit growth, and high money supply growth in combination with the increase in theworld commodity price, and other things had pushed Vietnamese inflation to a high ratein 2008 – 2012 period Inflation rose sharply from 8.33% in 2007 up to 23.08% in 2008,which created a major shock to the Vietnamese economy SBV tightened monetary policyimmediately in 2008 by raising policy rates, reducing money supply, while Vietnamesegovernment tightened fiscal policy, cut spending to cope with inflation which fell sharply

from 23.08% in 2008 to 5.93% in 2009 in just one year (see figure 2.6 in Appendix 2).Both contractionary monetary policy and contractionary fiscal policy helped control

inflation, but this sudden change in inflation was not completely good for the economybecause GDP growth fell to 5.3% in 2009, the lowest rate in comparison with the

previous period (see figure 1.2 in Appendix 1).

The spreading of the 2008 global financial crisis put Vietnam in danger of recessionso the government implemented a stimulus package, while SBV implementedexpansionary monetary policy in 2009 to stimulate economy GDP growth recovered to6.8% in 2010, but expansionary monetary policy and expansionary fiscal policy once

again caused inflation in 2010 and 2011 (see figure 2.6 in Appendix 2) With the

experience of 2008, Vietnamese government immediately issued Resolution no.11 thattightened fiscal and monetary policy to cope with inflation This policy helped inflationdecrease, but it couldn’t completely control inflation, Vietnam’s inflation rose to over

18% in 2011 (see figure 2.6 in Appendix 2) As stated, one of the problems of SBV in

conducting monetary policy was policy disciplines, which was reflected more clearlythrough inflation targets SBV usually didn’t achieve inflation targets, for example it wasset less than 5% but the actual figure was 7.7% in 2004, the same situation happened in

2005, 2008, 2010 and 2011 (see table 2.3 in Appendix 2).

1.1.4.3 Exchange rate

The USD/VND rate increased from 10,966 in 1994 to 15,994 in 2006 and 20,293 in

2012 (see figure 2.8 in Appendix 2) Vietnamese currency remained stable in 1994 and

1995, but the outflow of foreign capital plus the decrease in export put pressures onexchange rates throughout the 1997 Asia crisis USD/VND increased with a low stablestep after 2000, until 2007 it was at 16,105 In fact, the increase in money supply, lowinterest rates, more open economy as well as trade deficit led to depreciation of VND.After 2007, the USD/VND continued to rise in 2008, 2009, 2010, and 2011, and stilled in

2012 (see figure 2.8 in Appendix 2) due to the dual deficits in trade balance and balance

of payments in 2009 and 2010 in combination with the 2008’s global financial crisis, thetrend of capital withdrawal out of Vietnam, the low remittances in 2009, thus SBVdeclared currency devaluation on numerous occasions throughout the 2008 – 2012period1 In addition, high inflation in 2008 has lost people’s faith in VND so peopleturned to hold USD rather than VND despite the high interest rate of VND’s deposits.

1.1.4.4 Credit

Credit was expanded quickly and broadly in 2000 – 2007 period from 50,000 billionVND in 1994 to over 700,000 billion VND in 2006 and over 3,200,000 billion VND in

2012, it particularly increased to 70% in 2000 and 50% in 2007 (see figure 2.10 in

Appendix 2) The expansionary monetary policy with increasing money supply,

decreasing policy rates that decreased lending rates of commercial banks thus simulatingprivate sectors to borrow for investment and consumption The high credit growth wasalso a result of the 1997 state bank act and the 1997 credit institutions act that created alegal background for commercial banks and other financial institutions In addition, thehigh economic growth rate required large capital input, but Vietnamese stock market hadjust launched in 2000, and it was too small to meet the capital needs of the economy.Credit had fluctuated strong in the 2008 – 2012 period but it grew higher and rose fromover 1 trillion VND in 2007 to over 3 trillion VND in 2012, but

1 One of the most depth devaluation was on 11/2/2011, SBV devalued VND up to 9.3%.

credit growth rates usually exceeded the targets of SBV such as in 2004, 2005, 2006,

2007, 2009, and 2010 (see table 2.4 in Appendix 2), this over-controlled growth

caused overheating growth and bad debt risks for the Vietnamese banking system andeconomy However, credit growth rate was much lower than the target of SBV in2012 which shows that Vietnam economy had fallen into low-growth stage with lowneeds of capital Looking at the credit growth pattern, we find that it is quite contraryto policy rates and market rates patterns, when policy and market rates raised, creditgrowth decreased and vice versa.

1.1.4.5 Stock markets

Vietnam developed stock markets in the early 21st century with Ho Chi Minh stockexchange in 2000 (HSX) then Hanoi stock exchange in 2006 (HNX) There were only 5listed companies on HSX in 2000, then companies from various industries were listed,but it remained insignificant in comparing to total enterprises Besides that, almost alllisted companies are large with good financial health, meanwhile Vietnamese companiesare mainly small and medium VNindex (the market composite index of HSX) had twostrong growth phases in 2001 and 2005 – 2007 period, while it was stable in all remainingyears in 2000 – 2007 period, these fluctuations were primarily caused by the investor’spsychology and the foreign portfolio investment Vietnamese economy grew higher andwas more stable in the 2000 – 2007 period, but VNindex increased stronger in 2005 –2007 period when foreign investment went in and the herd behavior of domestic investors

(see figure 2.12 in Appendix 2) Meanwhile, VNindex changed very little even when

economy, credit, investment, money supply grew and interest rates were low in the 2002– 2004 period This shows that money supply during 2002 – 2004 period didn’t go intostock markets, it mainly went into manufacturing or other channels, possibly real estate.But at the end of 2005 and 2006, a large amount of money went into stock markets that

made the VNindex and the HNXindex increase sharply (see figure 2.12 and 2.13 in

Appendix 2) Thus, stock markets may not have responded strictly to monetary policy in

the 2000 – 2006 period After booming in 2007, Vietnam’s stock market declined rapidlyin 2008 and hit rock bottom in early 2009 when inflation was high and the 2008 globalfinancial crisis impacted around the world.

A large amount of money was injected into the economy through economic stimuluspolicies in 2009, while lower interest rates helped the Vietnamese stock markets tomake a slight recovery in 2009, then it continued to lower until 2012 after the stimuluspolicies ended.

1.2 Research gap identification

The analysis of macroeconomic, monetary policy and macroeconomic factors hasshown that Vietnamese economy grew rapidly in the 2000 – 2007 periods The rapideconomic growth was seemly contributed from expansionary monetary policy, bankcredit operations with low inflation and low interest rates, and other elements.Monetary policy was expanded with low policy rates, high money supply growth inthe 2000 – 2007 period, but it reversed and change many times in the 2008 – 2012period However, the overheating economic growth, credit growth, and money supplygrowth had caused the Vietnamese economy to many more problems in 2008 – 2012period The patterns of macroeconomic data suggest that the effects of the Vietnamesemonetary policy on economy may have been transmitted through market interest ratesand bank credit during the 2000 – 2012 periods, meanwhile it may not have been

transmitted through stock markets and exchange rates.

Meanwhile, the theory states that the monetary policy impacts on the economythrough various transmission channels including interest rate channel, exchange ratechannel, asset price channel, credit channel and expectation channel, and bank lendingchannel is an important sub-channel of credit channel in developing countries such asVietnam (Angeloni et al., 2002, Bassett et al., 2014, Apergis and Christou, 2015).Theoretical and experimental studies confirm that monetary policy transmits throughsome main channels: interest rate channel, exchange rate channel, asset price channel,credit channels2 and expectation channel (Mengesha and Holmes, 2013) However, in

developed countries, interest rate channel is the most important transmission channel,

2 Credit channel includes bank lending channel and other sub-channels

while bank lending channel is the enhanced channel for interest rate channel throughcommercial bank credit supply (Altunbas et al., 2002, Altunbas et al., 2009, Altunbas

et al., 2012) In emerging countries, bank lending channel is an important channel

(Mishra and Montiel, 2012), which are affected by macroeconomic factors, industryfactors, and bank characteristics (Altunbas et al., 2002, Altunbas et al., 2009, Altunbaset al., 2012) If the central bank tightens monetary policy, credit supply of commercialbanks plummet and more in small commercial banks, particularly the ones whosefunds mainly come from deposits (Kashyap and Stein, 2000, Stein, 1998) Monetarypolicy also impacts more strongly on commercial banks that have small enterprises(Peek and Rosengren, 1995c, Peek and Rosengren, 1995a, Van den Heuvel, 2002b).

In fact, Vietnam is a small open emerging economy which has transmitted to themarket economy since the 1980’s Vietnam now may share common characteristics ofsmall open emerging countries that have an incomplete institutional framework with ayoung equity market, and an emerging financial market so that interest rate channelmight not be the most important channel While, exchange rate channel might be weakdue to the intervention of government in foreign exchange markets and financialmarkets Furthermore, asset price channel might also be weak due to the low-development stock markets In contrast, Vietnam has the right potential conditions forthe existence of bank lending channel, which may become an important channel suchas Vietnamese economy depends strongly on commercial banks in capital supply;private sectors (including enterprises, households, and individuals) rely heavily onbank loans for investment, consumption and other economic activities; whileVietnamese commercial banks rely heavily on deposits to supply loans, and theyalmost can’t replace this source easily.

There are many potential determinants of bank lending channels includingmacroeconomics and microeconomics elements, in which bank capital, bank scale,bank liquidity and bank risk are important characteristics which must be noticed andstudied (Altunbas et al., 2002, Altunbas et al., 2012) Meanwhile, the 2008 globalfinancial crisis has strongly affected on Vietnamese economy so that monetary policytransmission and bank lending channel may be affected and changed.

From both academic aspects and empirical aspects, we need a comprehensive studyabout monetary policy transmission in an emerging market such as Vietnam that aremotivations for this study in Vietnam The next section presents objectives of this study.

1.3 Research objectives and questions

So, the research topic on monetary policy transmission and especial bank lendingchannel are mentioned as the essential topic in studying monetary policy, especially inemerging markets such as Vietnam.

Firstly, this study attempts to test the existence of interest rate channel, exchange

rate channel, and asset price channel in Vietnam, these results are significantconsiderations for Vietnamese policy makers in conducting the monetary policy Thisfirst objective aims at finding the existences of monetary policy channels and alsodefines which important channel in Vietnam This first study also is done as thebackground for next objective of this study in finding the bank lending channel inVietnam Since the bank lending channel is a sub-channel in credit channel,meanwhile the other channels such as interest rate channel, exchange rate channel, andasset price channel are seen as the main channels in monetary policy transmission, butcredit channel is also found strong in developing countries with low – development offinancial markets and high intervention of government into foreign exchange marketsuch as Vietnam So, this study firstly tests the existence of interest rate channel,exchange rate channel and asset price channel to make sure the sense of credit channelexistence in Vietnam and then go to the second part of this study.

Secondly, this study attempts to investigate the existence of bank lending channels

and then analyze the determinants of bank lending channel including the effects of the2008 global financial crisis which are also good for Vietnamese policy makers inconducting monetary policy but also in stabilizing banking system and financialmarkets Finally, this study attempts to discover some policy implications forVietnamese policy markets in conducting monetary policy, especially in facing shocks

such as the global crisis in the future In order to achieve these research objectives, this study goes to answer these questions

1 Which do channels of interest rate channel, exchange rate channel and asset price channel exist in Vietnam?

2 Does bank lending channel exist in Vietnam? And do bank size, bank capital,bank liquidity, bank risk, and the 2008 global financial crisis effect on bank lendingchannels in Vietnam?

The scope of study is very important which may affect to the reliable of thestudy, so next section presents this scope.

1.4.The scope of this study

This study is going to examine the monetary policy transmission and banklending channel in Vietnam in period from 2003 to 2012.

Firstly, Vietnam as a developing and emerging economy that is also an open small

economy which is suitable for studying monetary policy transmission and bank lending

channel as stated in the purpose of this study Secondly, in order to satisfy the

requirements of statistical models we need an appropriate period of time that why thisstudy is going to study in the period from 2003 to 2012 which is enough time to studymonetary policy transmission This period is also suitable to test the impacts of the 2008global financial crisis on the monetary policy transmission with the point on 2008.

Thirdly, this study is going to examine the existences of interest rate channel, exchange

rate channel and asset price channel which are seen as the main channels of monetarypolicy transmission in both developed and developing countries Meanwhile, due to lackof data about expectations thus this study is not going to examine the expectation channel.

In addition, the credit channel will be tested through the bank lending channel Fourthly,this study is going to test the existence of bank lending channel through the micro-data of

bank characteristics in Vietnam which will present for supply – side of credit channel.Meanwhile, the other determinants such as macroeconomic conditions

are not examined because these factors present for the demand – side of credit channelwhich are the factors in balance sheet channel In order to find the right answers forstudy’s questions, we need appropriate methodologies which will be clarified in nextsection.

1.5 Research methodologies and data

1.5.1 Methodologies

Many previous studies have used the VAR model (vector autoregression model) tostudy the monetary policy transmission (Bernanke and Blinder, 1992, Walsh, 2010),however the VAR model still has some drawbacks such as VAR depends on volumeof data, or economic theory which sometimes can not work even when the conditionsof VAR model are derived from this theory Therefore, researchers suggest usingSVAR (structural vector autoregression model) which is developed from VAR forbetter measurement of monetary policy transmission SVAR requires fewer conditionsthan the standard VAR model, but it still provides two tools to analyze monetarypolicy transmission including impulse response functions and variance decomposition,while the SVAR model is proposed to be used for small open economies becauseSVAR helps detect and measure shocks better (Kim and Roubini, 2000) Meanwhile,the system GMM model is considered as most appropriate to measure panel data dueto the advantages of this model in solving endogeneity, heteroskedasticity,autoregression problems of dynamic panel data in comparison with other models suchas pooled least square, fixed effects model or random effects model (Arellano andBond, 1991a, Arellano and Bover, 1995b, Blundell and Bond, 1998, Blundell andBond, 2000, Bond and Meghir, 1994, Bond et al., 2001).

Thus in the first main body, this study is going to use the VAR models to investigate

the existence of interest rate channel, exchange rate channel, and asset price channel inVietnam through a monthly time series from 2003 to 2012 one by one Then this study isgoing to use the SVAR model as the main model to check the test the evidences of abovechannels These results will answer for the 1st question In the second main body,

this study uses the system GMM model to investigate bank lending channel inVietnam, in which this study also measures the impacts of bank characteristics and the2008 global financial crisis on bank lending channel by yearly panel data in 2003 –2012 period The data of commercial bank characteristics such as size, capital,liquidity and risk are incorporated into GMM model to investigate the determinants ofbank lending channels Then, this study use S&P 500 implied volatility index toinvestigate the effect of the 2008 global financial crisis on bank lending channel.These results will be answered the 2nd question.

1.5.2 Research data

This study will use two kinds of data: Vietnamese macroeconomic data andmicroeconomic data from commercial banks in the 2003-2012 period Monthlymacroeconomic data including exchange rate, VNIndex, policy interest rates, marketinterest rates (lending and deposit interest rates), money supply, and GDP growthfrom 2003 to 2012 that were collected from SBV, General Statistics Office ofVietnam and IMF; while other international variables such as U.S interest rates, U.S.GDP, oil prices and other international data are collected from IMF Yearlymicroeconomic data including total asset, liquidity asset, capital, liquidity and loanloss provision are collected from audited financial statements and annual reports ofVietnamese commercial banks in 2003 – 2012 period In order to be easier inunderstanding this study, the next section presents some key concepts which arerelated to monetary policy, monetary policy transmission and bank lending channel.

1.6.Some key concepts

Monetary policy In general, monetary policy is the macroeconomic policy that is

executed by a central bank in order to influence money supply and/or interest rate withthe ultimate target is inflation stability (Begg et al., 2008).

Central bank Central bank is the monopoly agency in money issuance; it is also the

government's bank, the bank of the banks, the lender of last resort, the payment system

manager, and the banking system supervisor (Smart, 1999, Summers, 1991,Castiglionesi, 2007) Yet, the most important role in a central bank is the monetarypolicy manager (Goodhart, 1988).

Monetary policy targets Monetary policy targets are often expressed in several

aspects such as maintaining economic stability, ensuring optimal unemployment, orstabilizing the financial system, etc (Rogoff, 1985, Clarida et al., 1998a) Yet inreality, a central bank cannot achieve all targets at one time so they have to choose themost important targets in monetary policy conducting, this is price stability (Cecchettiand Krause, 2002).

Monetary policy tools To achieve monetary policy targets, central bank usesdifferent tools including three important tools: open market operations, policy interest

rates, and reserve requirements (Hamilton and Wu, 2012, Kashyap and Stein, 2012,Bean et al., 2010).

Monetary policy transmission Central bank can use open market operations, policy

interest rates, or reserve requirements to influence short-term interest rates on theinterbank market in order to conduct monetary policy They aim at price stability sothat there must be a process to transmit monetary policy changes into real economicvariables, this process may result in multiple transmission channels with differentlevels (Afandi, 2005a, Agha et al., 2005, Aleem, 2010, Andrieş and Stoica, 2014,Angeloni and Ehrmann, 2003, Baglioni, 2007, Barran et al., 1996, Beck et al., 2014).Studies on monetary policy transmission have been implemented in many countriesand areas (Mishra and Montiel, 2012), almost all previous studies confirm thatmonetary policy transmits through interest rate channels, exchange rate channels, assetprice channels, credit channels, and expectation channels (Mukherjee andBhattacharya, 2011, Dabla-Norris and Floerkemeier, 2006, Honda, 2004).

Bank lending channel In contrast to traditional channel of monetary policy

transmission (such as interest rate channels, exchange rate channels, and asset pricechannels), bank lending channels focus on the impact of monetary policy on bankcredit supply (Altunbas et al., 2002, Altunbas et al., 2012).

Monetary policy → fund of commercial banks → credit supply → investment, consumption → aggregate demand → output

Thus, this study is going to investigate the monetary policy transmission and banklending channels in Vietnam that is presented in 5 chapters The next section presentsthe detail of each chapter in this study.

1.7 The structure of study

This study is structured as

Chapter 1: Introduction This chapter firstly collects and then analyses monetary

policy and the effects of monetary policy on macroeconomic variables in Vietnam from2000 to 2012 It finds that Vietnamese monetary policy was expansionary in the 2000– 2007 period, yet it has changed and fluctuated in the 2008 – 2012 period Thefluctuations in Vietnamese monetary policy impacted on other economic variablesstrongly, especially in and after the 2008’s global financial crisis Market interest rates arechanged in line with policy rates, while money supply had increased highly over a longperiod from 2000 to 2007 lead to high inflation in 2008 – 2012 Through analysis, thischapter suggests that Vietnam may have interest rate channel, while exchange ratechannel and asset price channel may be weak, and bank lending channel may be strong.Then it shows the necessary objectives and questions of this study In which, this partpresents more detail on some main concepts in monetary policy, monetary policy tools,monetary policy targets, monetary policy transmission, and bank lending channels.

Chapter 2: Theoretical framework and Literature review This chapter presents a

fully detailed literature review on monetary policy transmission and bank lendingchannel It summarizes that monetary policy transmits through interest rate channel,exchange rate channel, asset price channel, credit channels, and expectation channel.In which, a bank lending channel is an important sub-channel of a credit channel withsome existence conditions: enterprises depend on bank loans, commercial banks can’treplace all funds from deposits, central banks can impact on bank credit supply andsome other conditions.

Chapter 3: Methodologies This chapter presents methodologies that are used for

monetary policy transmission and bank lending channel testing It finds that we canuse policy rates or money supply to proxy for monetary policy, yet policy rate is abetter indicator In studying monetary policy transmission, time series data is the mainkind of data that is used with certain conditions in relationship between economicvariables Econometric models which are suitable with time series data in studies ofmonetary policy transmission are VAR, SVAR, FAVAR, ECM, VECM, ARDL,DSGE, GMM, and some other models In which, VAR and SVAR have the advantageof measuring time series data and GMM has the advantage of measuring panel data.From this basis, this chapter goes to build models for empirical studies: VAR andSVAR are used to test interest rate channel, asset price channel, and exchange ratechannel by monthly time series data, while the system GMM model is used to testbank lending channel by annual panel data.

Chapter 4: Empirical evidences from Vietnam This chapter presents results of

monetary policy transmission testing and bank lending channel by using statisticalmodels from chapter 3 Through VAR and then SVAR, this study finds the evidenceof cost channel in Vietnam, and that this study does not find the evidences ofexchange rate channel and asset price channel Meanwhile, bank lending channel isstrong and affected by characteristics of commercial banks including size, capital, andit is also affected by the 2008 global financial crisis This study goes further to test therobustness of results by recruiting money supply (M2) to replace for VNIBOR inVAR and SVAR models, and rediscount rate and refinance rate for VNIBOR in GMMmodel This study finds that M2 is not a good proxy for Vietnam monetary policy,meanwhile results are not change in models with rediscount rate and refinance rate.

Chapter 5: Conclusions and policy implications This chapter goes to conclusions

and gives some recommendations that are based on experiences in the world, situationin Vietnam, and results of this study This chapter also goes to clarify its limitationsand suggests some new direction studies.

M x V = P x Y

where: M - monetary supply, V - money velocity in circulation, P - average price

level, Y - real output.

If real output doesn’t react to changes in money supply, policy makers shouldn’t try tochange money supply because it will change the price instead of real output (Begg et al.,2008) Money supply is defined as M1, M2, M3, and M4 in England; M1, M2 in US; M1,M2, and M3 in Europe and Japan3, and it depends on monetary base which is supplied bycentral bank and the monetary multiplier which is created by the banking systemactivities, therefore money supply depends on monetary policy and banking

3 See more detail about money supply definition in Appendix 1

system operations Money demand depends on the demand of private sectorsincluding incentives to keep money for transactions, hedging, speculation and publicsectors including demand for expenditure and investment (Friedman, 1956) A changein money supply or money demand will alter nominal market interest rates so that thecentral bank changes money supply or policy rates to influence on nominal marketinterest rates to conduct monetary policy (Friedman, 1981).

2.1.2 Central bank4

Central bank is monopolized for printing and issuing money, it is also thegovernment bank, the bank of commercial banks, the lender of last resort, the managerof payment system, the agency for monetary policy implementation, and thesupervisor of the banking system Central bank acts as the bank of government and thebank of commercial banks in deficit funding, credit activities, and other financialactivities Central bank is also the lender of last resort which helps avoid crashes in thefinancial system (Diamond and Dybvig, 1983) Central bank also manages foreignexchange reserves to ensure the stability of exchange rates and the economic stabilitywith external shocks (Chowdhury et al., 2006) Finally, central bank plans, implementand supervise monetary policy which is called monetary policy conducting (Blinder etal., 2008, Friedman, 1999).

2.1.3 Monetary policy targets

Central bank conducts monetary policy to aim at economic stability, optimalunemployment, financial system stabilizing, but price stability is always the mostimportant target5 (Cecchetti and Krause, 2002, Geraats, 2002, Issing, 2004, Spyromitrosand Tuysuz, 2012, Van der Cruijsen and Demertzis, 2007, Jean Louis and Balli, 2013) Inorder to achieve price stability, full employment, economic growth, central bank has tofocus on intermediate targets such as money supply (M1, M2 or M3), short-term andlong-term interest rates (Rogoff, 1985, Friedman, 1976, Flood and Isard, 1988).

4 See more detail about central bank in Appendix 4

5 See more detail about monetary policy target of some central banks in Appendix 5

However, they have to accept some trade-offs in monetary policy conducting such asthe trade-off between inflation and unemployment (Phillips, 1958, Herring andMarston, 1977, Issing, 2003, Gali and Monacelli, 2005) Central bank conductsmonetary policy to achieve price stability through three main tools: open market

operations, policy interest rates (in short: policy rates) and reserve requirements.

2.1.4 Monetary policy tools

Policy interest rates Central bank uses different policy rates to conduct monetary

policy such as rediscount rate, and interbank offer rate Central bank cuts policy ratesto expand monetary policy and vice versa.

Policy rates → market interest rates → economic activities

Currently, there are different types of policy rates around the world6 In monetarypolicy conducting, the limitation of this tool is that central bank has to wait for aresponse from the market Instead, central bank can use open market operations which

has a direct impact on money supply and market interest rates.

Open market operations Central bank buys or sells short-term securities on the open

market to directly impact on money supply and money demand thereby it has an effecton market interest rates and other economic elements (Thành and Hằng, 2008).

Open market operations → money base → money supply → market interest rates

Central bank uses open market operations quite often nowadays7 Besides openmarket operations, central bank also uses reserve requirements to impact on moneycreation mechanism in the banking system in order to conduct monetary policy.

Reserve requirements Central bank uses mandatory reserve requirements to impact

on money supply since reserve requirements have a direct influence on the monetarycreating multiplier that is created by banking system8.

6 See more detail about policy interest rates in Appendix 67 See more detail about open market operations in Appendix 7

8 See more detail about reserve requirements in Appendix 8

Reserve requirements → cash leakage → money creating multiplier → money supply

Central bank usually uses more than one tool to conduct monetary policy such asraise policy rates combined with selling securities on the open market and increasingreserve requirements to tighten monetary policy However, monetary policy is notalways effective in promoting price stability, economic growth, and job optimizationas expected (Mengesha and Holmes, 2013).

2.1.5 The ineffectiveness of monetary policy

Central bank may ease monetary policy to prevent the economic downturn byreducing policy rates to stimulate investment and consumption then increase aggregatedemand and output (Moss, 2007) Nevertheless, expansionary monetary policysometimes can’t stimulate economic growth due to the liquidity trap (Dieppe andMcAdam, 2006), due to individuals and households may decide to hold cash ratherthan other assets when the interest rate closes to zero, money demand willsimultaneously increases with money supply therefore expansionary monetary policycan’t stimulate investment and consumption anymore Deflation is also anotherproblem in monetary policy conducting In a deflated environment, real interest ratesare higher than nominal interest rates thus real borrowing costs will be higher thannominal costs so that investments will be limited even when interest rates drop to nearnil (Bernanke and James, 1990) Besides monetary policy, fiscal policy is also animportant macroeconomic tool The interactions between monetary policy and fiscalpolicy are important in influencing aggregate demand and the economic activities(Lucas Jr and Stokey, 1983, Mankiw and Taylor, 2011).

2.1.6 Monetary policy and fiscal policy

Through expansionary fiscal policy, government increases spending, decreasestaxes or does both simultaneously to stimulate investment and consumption (Moss,2007) However, the expansion of government spending increases budget deficit andinterest rate then reduce investment and consumption in the private sector, which isknown as “crowding out effects” (Cebula, 1978, Abrams and Schitz, 1978) In fact,

monetary policy and fiscal policy can’t substitute each other because monetary policyimpacts on money supply and interest rates to influence aggregate demand, while fiscalpolicy impacts on aggregate demand through government spending and taxation.

The expansionary fiscal policy in combining with the contractionary monetarypolicy: interest rates will increase, while output may increase or decrease which is

dependent on the total effect of both policies by aggregate demand.

The contractionary fiscal policy in combining with the expansionary monetarypolicy: output can increase, decrease, or not change, while interest rates will decrease.

The expansionary fiscal policy in combining with the expansionary monetarypolicy: both policies will increase output, while interest rates can increase, decrease,

2.1.7 Unconventional monetary policies

2.1.7.1 Quantitative easing program

Quantitative easing program (QE) is an unconventional monetary policy to cope withthe deflation and near nil interest rate situation by the central banks in Japan, U.K., andU.S Central banks enact quantitative easing by purchasing without reference to theinterest rate a set quantity of bonds or other financial assets on financial markets from