A Combination of Monetary Base Targeting and Interest Rate Targeting: Case of Thailand

Phai Phongthiengtham

Chulalongkorn University

Presentation Outline

Conclusion and Suggestion

Empirical Analysis

Theoretical Model

Introduction

Purpose of the study

Purpose of the study

To evaluate and compare the interest rate targeting and monetary base targeting policy.

Illustrate the combination of both interest rate and monetary base targeting.

Introduction

Introduction

John Maynard Keynes (1883-1946) favors interest-rate targeting.

Controversy among

Economists

Milton Friedman (1912-2006) argues for a quantitative policy.

Introduction

Interest RateLM

IS

Output

Introduction According to the IS-LM framework,

Interest Rate Targeting: Adjusting money supply such that the LM curve shifts to keep interest rate constant.

Monetary Aggregate Targeting: Keep money supply at a specific value.

Differences arise according to these factorsShocks in goods market (IS) and shocks in money market

(LM)Slope of IS and LM curves

Introduction

LM1

IS1

Interest Rate

IS2

LM2

Output

Negative shocks in goods market causes output to fall…

…For interest rate targeting policy; however, output falls even more…

…Interest rate targeting policy performs worse.

Introduction

LM1

IS1

Interest Rate

Output

LM2 Negative shocks in money market causes output to fall under monetary targeting regime…

…For interest rate targeting policy; however, output remain the same…

Introduction

Slope of IS and LM curveDifferent values of slope alter the result of monetary policy.

More concrete mathematical model can be derived to corporate all factors simultaneously.

There is no concise conclusion whether interest rate targeting policy is superior than monetary targeting policy.

Introduction

Combination Policy

The policy that lies between pure interest rate and monetary base targeting.

Monetary base is a function of the interest rate prevailed in the market.

For example, M(t) = c0 + c1R(t)» c1 = 0; pure monetary base targeting» c1 approach infinity; pure interest rate

targetingOptimum values of c1 and c0 can be calculated.

Theoretical Model

Theoretical Model

Mathematical model of IS and LM curve

IS Equation:

LM Equation:

M(t) = bo + b1R(t-1) + b2 Y(t-1) + b3M(t-1) + v(t)

Y(t) = ao + a1R(t-1) + a2 Y(t-1) + a3M(t-1) + u(t)

Theoretical Model

Y(t) = ao + a1R(t-1) + a2 Y(t-1) + a3M(t-1) + u(t)

M(t) = bo + b1R(t-1) + b2 Y(t-1) + b3M(t-1) + v(t)

where,Y = Real National Income (Output)M = Real Money stockR = Real Interest rateu = error term in IS equation where E(u) = 0, E(u2) = σu

2

v = error term in LM equation where E(v) = 0, E(v2) = σv2 and

E(uv) = ρu,v

Theoretical Model

Y(t) = ao + a1R(t-1) + a2 Y(t-1) + a3M(t-1) + u(t)

M(t) = bo + b1R(t-1) + b2 Y(t-1) + b3M(t-1) + v(t)

Expected sign of the coefficients are

Theoretical Model

For simplification, many features have been left out. 1) Price Rigidity2) Exchange International Trade and Capital Flow3) Government Sector

The models also assumes that monetary policy goal is to stabilize output of national income.

If price rigidity feature could be incorporated in the model , then we can build the model such that price stability is the goal for monetary policy.

Theoretical Model

More assumptions about the model

Central bank can control money supply completely.

Interest rate structure has been left out.

Diagram

1

Optimal value of the instrument in each policy is calculated.

2Each policy will be evaluated by comparing between their loss function of the deviation.

3

The loss function is

퐿=퐸 [푌−퐸(푌∗) ]2.

The analysis has the following procedure.

Theoretical Model

Interest Rate Policy

First, update IS equation by 1 period

Substitute LM equation into the updated IS equation to eliminate M(t)

Theoretical Model

Loss Function of interest rate targeting policy is

If monetary transmission only works though interest rate, the coefficient a3 would be zero. This reduces the loss function into σu

2 as in the traditional IS-LM model.

E{Y(t+1) - E[Y*(t+1)] }2 = 푎32휎푣2+ 2푎3휌푢,푣+ 휎푢2

Theoretical Model

Monetary Aggregate Policy

Update LM equation by 1 period

Rewrite the updated LM equation

Update IS equation by 1 period

Substitute R(t) is the updated IS equation to eliminate R(t)

Theoretical Model

Loss Function of interest rate targeting policy is

E{Y(t+1) - E[Y*(t+1)] }2 = 휎푢2 − 2(푎1/푏1)휌푢,푣 + (푎1/푏1)2휎푣2

Theoretical Model

Combination Policy

Assume linear function: M(t) = c0 + c1R(t)Rewrite as, R(t) = (M(t) - c0)/c1

Update the IS equation

Substitute R(t) in the updated equation

Substitute LM Equation to eliminate M(t)

Theoretical Model

Lose Function of combination targeting policy is

L = {(a1/c1)+a3}2휎v2 + 2{(a1/c1)+a3}휌u,v + 휎u

2

Minimize loss function by differentiating L with respect to c1

휕 L /휕c1 = - 2휎v2{ (a1/c1)+a3} (a1/c1

2) – 2휌u,v(a1/c12) = 0

vߪ2{ (a1/c1)+a3} (a1/c1

u,v(a1/c1ߩ + (22) = 0

Theoretical Model

Conclusion

Lose Function of interest rate targeting policy isa3

vߪ22 +2a3 uߪ+u,vߩ

2

Lose Function of monetary base targeting policy isuߪ

2 -2(a1/b1)ߩu,v+(a1/b1)2ߪv2

Lose Function of combination targeting policy is

{(a1/c1)+a3}2ߪv2 + 2{(a1/c1)+a3}ߩu,v uߪ +

2

Where c1 can be calculated as vߪ

2{ (a1/c1)+a3} (a1/c1u,v(a1/c1ߩ + (2

2) = 0

Empirical Analysis

Empirical Analysis

Estimate all the parameters using Vector Error Correction Model (VECM)

VECM model ensures that any deviation from equilibrium will be adjusted, as the IS-LM model illustrates

IS equation : Y(t) = ao + a1R(t-1) + a2 Y(t-1) + a3M(t-1) + u(t)LM equation : M(t) = bo + b1R(t-1) + b2 Y(t-1) + b3M(t-1) + v(t)

And also the variance and covariance of disturbances, which are 휎u

2 휎v2 and 휌u,v

Empirical Analysis

Description Source

Y Real GDP (1988 Baht) NESBD

R MLR BOT

Inflation CPI IMF

M M2A BOT

Data Description

1.) Variables R and M are converted in real terms using CPI.2.) The estimation has all variables in logarithmic scale.

Empirical Analysis

Econometrics Procedure

1.)Unit Root Test

2.)Co-integration Test

3.)VECM

Empirical Analysis

Econometrics Procedure

1.)Unit Root Test

2.)Co-integration Test

3.)VECM

Empirical Analysis

Unit Root Test

t-Statistic Prob.*

LMLR -0.90668 0.771

LGDP -1.86655 0.3421

LM2A -1.78337 0.6823

*MacKinnon (1996) one-sided p-values.

Empirical Analysis

Econometrics Procedure

1.)Unit Root Test

2.)Co-integration Test

3.)VECM

Empirical Analysis

Unrestricted Cointegration Rank Test (Trace) Series LM2A LGDP

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.387709 13.58771 12.32090 0.0305**At most 1 0.012621 0.342937 4.129906 0.6208

Trace test indicates 1 cointegrating eqn(s) at the 0.05 level* denotes rejection of the hypothesis at the 0.05 level**MacKinnon-Haug-Michelis (1999) p-values

Empirical Analysis

Econometrics Procedure

1.)Unit Root Test

2.)Co-integration Test

3.)VECM

Empirical Analysis

Vector Error Correction Estimates

t-statistics in [ ]

Cointegrating Eq: CointEq1

LOG(GDP(-1)) 1.000000

LOG(M2AN(-1)) -0.44536

[-26.5829]

C -8.59015

[-23.9381]

Empirical Analysis

Error Correction: D(LOG(GDP)) D(LOG(M2AN))

CointEq1 -0.399071*** 0.194854*

D(LOG(GDP(-1))) 0.303786* 0.384474*

D(LOG(M2AN(-1))) 0.635298*** 0.393956*

LOG(MLR(-1)) -0.101852** 0.061683*

*** = 1% significant / ** = 5% significant /* = 10% significant

Empirical Analysis

The equations can be illustrated as follows,

ΔYt = -0.4[Yt-1 - 0.45Mt-1 - 8.6] + 0.3(ΔYt-1) + 0.64(ΔMt-1) – 0.1Rt-1

ΔMt = 0.2[Yt-1 - 0.45Mt-1 - 8.6] + 0.38(ΔYt-1) + 0.4(ΔMt-1) +0.06Rt-1

After rearranging equations, the estimated values of all parameters could be obtained

Empirical Analysis

a0 = 3.44, a1 = -0.1, a2 = 0.9, a3 = 0.82b0 = -1.72, b1 = 0.06, b2 = 0.58, b3 = 1.31

The estimation also provides residual terms. The variance and covariance of residual terms are as follows.

휎u2 = 0.001

휎v2 = 0.0014

휌u,v = 0.007

Empirical Analysis

Therefore, we can substitute the parameters and variance / covariance in the loss function to compare between interest rate targeting policy and monetary base targeting policy.

Loss function from interest rate targeting policy = a3

2휎v2 +2a3 휌u,v+휎u

2 = 0.00309

Loss function from monetary base targeting policy= 휎u

2 -2(a1/b1)휌u,v+(a1/b1)2휎v2 = 0.00632

Empirical Analysis

Interest rate targeting policy is preferred to monetary base targeting policy

Combination Policy Calculate c1 from vߪ

2{ (a1/c1)+a3} (a1/c1u,v(a1/c1ߩ + (2

2) = 0

Get c1 = 0.12185 Evaluate loss functionL = {(a1/c1)+a3}2휎v

2 + 2{(a1/c1)+a3}휌u,v + 휎u2 = 0.00099

Empirical Analysis

Loss function estimated

Interest rate targeting policy = 0.00309Monetary base targeting policy = 0.00632Optimal combination policy = 0.00099

Interest rate targeting policy seems to be superior to monetary base targeting. However, optimal combination policy performs better than both.

Conclusion and Suggestion

Conclusion and Suggestion

This paper illustrates the theoretical idea regarding a combination of monetary base targeting and interest rate targeting in the context of Thailand.

Empirical evidence suggested that interest rate targeting is superior to monetary base targeting.

Nevertheless, combination policy performs better.

Conclusion and Suggestion

The model could be modified to corporate more realistic features of the economy. Exchange Rate and international trade Government sector, private sector and consumers Price Rigidity

Also, loss function could also be modified. The ARCH model of the disturbance? Dynamic optimization?