ACADEMY OF ECONOMIC STUDIES BUCHAREST DOCTORAL SCHOOL OF FINANCE AND BANKING (DOFIN)

1. ACADEMY OF ECONOMIC STUDIES BUCHARESTDOCTORAL SCHOOL OF FINANCE AND BANKING (DOFIN) Dissertation paper MONETARY CONDITIONS INDEX (MCI) AS A SUMMATIVE INFORMATION TOOL FOR CHARACTERIZING THE MONETARY POLICY STANCE IN ROMANIA (1997 –2005) MSc. Student: RAMONA STAN Supervisor: Professor MOISA ALTAR BUCHAREST, JULY 2006

2. CONTENTS • Objectives • What is the Monetary Conditions Index? • Theoretic approach • Econometric estimation • Results • Conclusions Bibliography

3. 1.OBJECTIVES • MCI = relevant information tool for characterizing the monetary policy stance in Romania between 1997-2005 • Would be worthwhile use a MCI for a better representation of monetary policy stance? • Do indeed short-term interest rate and exchange rate directly influence both stability of the prices and aggregate demand? • Controlled floating of the exchange rate • To which extent tight controlexercised by the National Bank of Romania (NBR) over the national currency depreciation rate influenced stability of the prices and real economic growth? • Assessment of credibility and increased independency of NBR • Is inflation rate’s slow yet continuous decrease to be credited only to NBR’s quantitative approach with exchange rate constraints? • What is the real place of the short-term interest rate within the monetary policy choices, considering it has been used only on short periods as operational target?

4. 1.OBJECTIVES Why this historical recourse on monetary policy choices? 1997 2005 • If MCI = relevant indicator significant indication on the success of the monetary policy  better measurement of credibility and independency of the National Bank = essential presumptions on which direct inflation targeting is based upon • Intuitively higher relative influence of the exchange rate both over the prices and aggregate demand  if proved  clearly better representation in the future of the monetary policy stance by means of MCI • Short-term interest rate inflation rate “paradox” • Monetary policy choices throughout the analysis period • Maastricht convergence criterion to be achieved • Less powerful instrument? to be accounted for in the future monetary base targeting direct inflation targeting

5. 2.WHAT IS THE MONETARY CONDITIONS INDEX (MCI)? MCI = weighted sum of modifications in the short-term interest rate and exchange rate relative to some arbitrary date. Basic assumption: Monetary policy directly influences inflation through short-term interest rate and exchange rate. “Appealing operational target for monetary policy” (Ericsson et al., 1997) Controlling for exogenous shocks Influence over aggregate demand Bank of Canada – the “pioneer” in constructing and using MCI as operational target. MCI used either as operational target (New Zeeland) or summative information tool (Norway, Sweden) by Central Banks. MCI – constructed for international comparisons (IMF, Goldman Sachs, JP Morgan).

6. 2.WHAT IS THE MONETARY CONDITIONS INDEX (MCI)? • MCI can be used as: • Summative information tool • Operational target • Monetary policy rule Relevance = directly depending on the choose of underlying model from which the weights are estimated Nominal versus Real MCI • Secondary objective Base period = closely to the long-run equilibrium relationship Econometric estimation • Underlying model • Choice of the variables • Cointegration • Stability of the coefficients • Weak exogeneity • “White noise” residuals .

7. 2.WHAT IS THE MONETARY CONDITIONS INDEX (MCI)? MCI as a summative information tool Disadvantages/Limitations • Relative stance of the monetary policy as compared to an arbitrarily chosen base period • Voluntarily generalizing approach regarding transmission mechanism into the real economy • Not a fundamental measure of monetary conditions, if nothing else, because neither MCI nor short-term interest are nominal anchors of the system • Controlling for validity of hypothesis in econometric estimations ? • Aggregation problem other variables = insignificant in characterizing monetary policy stance particular exchange rate out of many others foreign currencies basket  weights estimated from bilateral trade statistics particular short-term interest rate  not accounting for the long-term interest rate contribution to monetary policy choices

8. 3. THEORETIC APPROACH UNDERLYING MODEL Aggregate demand equation: Δy = F(ΔR, Δe, …) Aggregate Phillips equation: Δp = F(y-y*, Δe, …) where: Δy = real growth rate of GDP y-y* = output gap Δp = inflation rate ΔR = change in real interest rate Δe = change real exchange rate and lower cases express logarithm. The suspension points replace the variables that are not representative for monetary policy, thus through which the influence of taxation and fiscal policy is transmitted. The interest rate influences inflation via the real GDP and thus linking the two equations determines an extremely simplified model, the so-called “reduced-form” model  Bank of Canada’s inspiration for the construction of MCI

9. (5) Inflation target And, by substitution of in (3) (2): (6) 3. THEORETIC APPROACH (0) Let Where: is the real output gap y and e – logarithm rtf - external interest rate (exogenous) (1) (2) (3) Conditional expectations at t+1: (7) (8) Substituting in (6) and identifying coefficients

10. 4. ECONOMETRIC ESTIMATION • Underlying model • In practice, most Central Banks which constructed and used MCI have estimated the coefficients only from the aggregate demand equation and only in a less formal approach, mostly for benchmarking purposes, from the prices equation. • aggregate demand equation • ! prices equation  “first paradox” =short-term interest rate actual place in • the monetary policy choices • MCI relevant ? • Estimation period: 1997-2005 • Base period: 2002 (“neutral level”)

11. 4. ECONOMETRIC ESTIMATION • Choice of variables • short-term interest rate = BUBOR3M (3 months-active interest rate) • high volatility of the overnight market • non-governmental credit high increase (owed also to facilities) • similar trend of deposit-taking and deposit-placing interest rates • exchange rate = composite index including Euro and US Dollar • reference foreign currency  USD (until 2001)  EUR • compromise determined by short data series • following the footsteps of NBR and IMF  bilateral trade data • BASKET = 60% EUR + 40% USD (1997-2003) • = 75% EUR + 25% USD (2004-2005) • prices index = Consumer Prices Index (CPI) vs. Producer Prices Index (PPI) • intimate relationship between exchange rate and PPI  inflation rate • final consumption  ~ 63% of GDP

12. 4. ECONOMETRIC ESTIMATION Notations: bb3m_n annualized nominal interest rate BUBOR 3M bb3m_r annualized real interest rate BUBOR3M (Fisher formula) cpi consumer prices index, fixed base (first quarter 1997) infl_rate inflation rate, fixed base (first quarter 1997) infl_rate_an annualized inflation rate, fixed base (first quarter 1997) basket_n/basket_r nominal/real exchange rate RON/BASKET gdp_n_sa nominal GDP (de-seasonalized series) gdp_r_sa real GDP (de-seasonalized series) defl GDP deflator, fixed base (first quarter 1997) All variables expressed in logarithm have been denoted as l_variable name (with the first difference d_l_variable name). Tools: Excel (basic calculations), Eviews 4.1.

13. 4. ECONOMETRIC ESTIMATION TESTING FOR INTEGRATION ORDER • all nominal variables integrated of I(1) • real GDP  I(1) • real exchange rate  I(1) • real interest rate  I(0) • Nominal MCI  VEC model • Real MCI  alternative VAR model

14. 4. ECONOMETRIC ESTIMATION • Nominal MCI  VEC model • EC(E,1) 2 2 4 4 L_GDP_N_SA BB3M_N L_BASKET_N • cointegration test  (5): intercept and trend in CE – deterministic trend in VAR • adjustment speed  -0.837 • stability of the coefficients  roots of characteristic polynomial < 0.8795 • weak exogeneity  A(2,1)=0, A(3,1)=0, accumulated probability 0.1211 • residual tests: • no serial correlation (12 lags tested) • normality (p-value 0.1093 to Jarque-Bera) • homoschedasticity (0.2373 to Chi-sq)

15. 4. ECONOMETRIC ESTIMATION Estimation of the weights • Accumulated response over a year • accounts for weak exogeneity • NBR’s projections do not go further that one year time horizon • PeriodL_GDP_N_SA BB3M_N L_BASKET_N • 1 0.015094 -0.006521 -0.003309 • 2 0.020505 -0.013666 0.001235 • 3 0.022820 -0.014561 0.012770 • 4 0.023901-0.016247 0.025115 • Generalized Impulse

16. 4. ECONOMETRIC ESTIMATION • Real MCI  VAR model • LS 1 2 D_L_GDP_R_SA BB3M_R D_L_BASKET_R @ C • acceptable compromise, provided VAR is stable and the other hypothesis are tested. • quasi-elasticity of GDP to the changes of the exchange rate • how GDP changes if short-term interest rate changes by one percentage point? Controlling for relevancy of the model: • cointegration test (performed for the levels of the data)  (1) / (5) • stability of the coefficients  roots of characteristic polynomial < 0.8762 • weak exogeneity  hypothesis rejected for the long-run equilibrium relationship • residual tests: • no serial correlation (12 lags tested) • normality (p-value 0.1983 to Jarque-Bera) • homoschedasticity (p-value 0.0368 to Chi-sq)

17. 4. ECONOMETRIC ESTIMATION Estimation of the weights PeriodD_L_GDP_R_SA BB3M_R D_L_BASKET_R 1 0.0218690.001525 0.002641 (0.00269) (0.00380) (0.00379) 2 0.014706 -0.001073 0.002787 (0.00435) (0.00458) (0.00466) 3 0.017028 -0.007088 0.009022 (0.00478) (0.00531) (0.00587) 4 0.017572 -0.006921 0.010883 (0.00529) (0.00677) (0.00693) Generalized Impulse Standard Errors: Analytic

18. 4. ECONOMETRIC ESTIMATION Controlled floating  direct influence over the aggregate demand? LS 1 2 4 4 L_GDP_N_SA D_L_BASKET_N BB3M_N @ C Controlling for relevancy of the model: • cointegration test • stability of the coefficients  one root of characteristic polynomial > 0.97 ?! • weak exogeneity  hypothesis rejected • residual tests: • no serial correlation (12 lags tested)  at lag 4 (p-value: 0.0597) • normality (p-value 0.0781 to Jarque-Bera) • homoschedasticity (p-value 0.5726 to Chi-sq)

19. 5. RESULTS Notations: MCI_2002_RFREE_BB3M  Real MCI MCI_2002_NFREE_BB3M  Nominal MCI MCI_2002_GDP2002_N_BB3M  Nominal MCI (controlled floating)

20. 5. RESULTS • Nominal MCI  ease of monetary conditions • Real MCI  tightening of monetary conditions ? • high inflation rate throughout the period • controlled floating  appreciation in real terms of the • national currency 2004-2005 preparation for direct inflation targeting ease of control exercised over the exchange rate appreciation both in real and nominal terms Tighter than intended monetary conditions ! 1997-1999 “difficult times” for Romania three years of real negative growth of GDP peaks of foreign debt service almost financial crisis in 1999

21. 5. RESULTS Positive signal regarding NBR credibility and independency • fairly accurate representation of monetary policy success in controlling stability of the prices  after 2002 • high minimum mandatory reserves  allowed for decrease of the interest rate • other external shocks to the inflation

22. 6. CONCLUSIONS • the relative influence of the exchange rate and short-term interest rate • 1.55:1 (1.57:1 in real terms) • SUCCESS OF DIRECT INFLATION TARGETING  MCI’s LESSONS • lower power of the short-term interest rate to induce changes of aggregate demand • = matter of concern for future monetary policy choices • proven importance of the exchange rate (stability of the prices, economic growth) • = better measurement of monetary conditions with MCI • need to pay attention still for the monetary base growth rate • motivation of quantitative approach (taking also into account real facts)

23. 6. CONCLUSIONS • LIMITATIONS OF MCI • interest rate – inflation “paradox”  MCI might not be a relevant indicator of the monetary policy stance • need to construct an alternative MCI including all monetary variables of importance in achieving final inflation target • relevancy of coefficients • short time series (Bank of Canada calculations on MCI cover 1980-2006!!) • relative importance of the shocks induced to aggregate demand (based on the impulse-response functions) are acceptable to the limit • aggregation problem  the way the “basket” was constructed

24. BIBLIOGRAPHY Balázs Égert, László Halpern (2005), “Equilibrium Exchange Rates in Central and Eastern Europe: A Meta-Regression Analysis”, William Davidson Institute Working Paper no. 769 Batini, Nicoletta. Turnbull, Kenny (2000) “Monetary Conditions Indices for the UK: A Survey.”, External MPC Unit Discussion Paper No. 1 – Bank of England Benoit, Anne (2000), “Indicators of Monetary policy orientation: Monetary conditions (MCI) and the Taylor rule”, Erste Bank. Botel, Cezar (2002), “Determinants of inflation in Romania. June 1997 – August 2001. Analysis based on Structural VAR”, National Bank of Romania (Studies Series, no. 11. June 2002) Coetzee, C.E. (2001), “Monetary Conditions and stock returns: a South African case study” De Wet, W. (2002), “Coping with the Inflation and Exchange Rate Shocks in the South African Economy”, The South African Journal of Economics, 70(1):78-94 Eika, K.H., N.R. Erricsson si R. Nymoen (1996), “Hazards in Implementing a Monetary Conditions Index”, Federal Reserve System IFD Paper No. 568. Ericsson, Neil R., Jansen, Eilev S., Kerbeshian, Neva A., Nymoen, Ragnar. (1997), “Understanding a Monetary Conditions Index”, Federal Reserve System. Freedman, Charles (1994), “The Use of indicators and of Monetary Conditions Index in Canada”, Policy Issues and Country Experience, 458-476, IMF, Washington , D.C. Freedman, Charles (1995), “The Role of monetary conditions and the monetary conditions index in the conduct of policy.”, Excerpts from remarks made to the Conference on International Developments and Economic Outlook for Canada. Guender Alfred V. & Troy D. Matheson. (1997), “Design Flaws in the Construction of Monetary Conditions Indices – A cautionary note.”, Department of Economics; University of Canterbury New Zeeland. Kesrizeli, M., Kokcaker, I. (1999), “Monetary Conditions Index: A monetary Policy Indicator for Turkey”, Discussion Paper No. 9908, The Central Bank Of The Republic of Turkey. *** “NBR Policy & Regulations and Investments in Romania”, presentation made by the Deputy Governor of NBR at the British-Romanian Chamber of Commerce Business Breakfast (Bucharest, April 2005), www.bnro.ro *** “Medium term objectives of the monetary policy and exchange rate”, presentation made by the Governor of NBR, Pre-Ascension Economic Program, Ed.2005, www.bnro.ro  *** International Monetary Fund (FMI). Romania, Selected Issues. www.imf.ofg  *** Romanian National Institute of Statistics(INSS), data series, press releases. www.insse.ro