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Monetary policy effect in an economy with heavily managed exchange rate

This paper identifies a monetary contraction by a combination of an increase in interest rates, 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 that output and prices begin to reduce after a restrictive monetary shock in the medium term, suggesting the adverse effect of monetary policy in the short term and the necessity to improve the transparency of monetary setting. | Bui Thanh Trung / Journal of Economic Development 24(2) 31-50 31 Monetary policy effect in an economy with heavily managed exchange rate BUI THANH TRUNG University of Economics HCMC – trungbt@ueh.edu.vn ARTICLE INFO ABSTRACT Article history: The primary objective of this paper is to investigate the effect of monetary policy on macroeconomic variables in Vietnam, which is a small, open, and developing economy with heavily managed exchange rate. Monetary policy shock is identified by the sign restriction methodology. Unlike previous studies, this paper identifies a monetary contraction by a combination of an increase in interest rates, 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 that output and prices begin to reduce after a restrictive monetary shock in the medium term, suggesting the adverse effect of monetary policy in the short term and the necessity to improve the transparency of monetary setting. Meanwhile, exchange rates are unresponsive to a tightening decision, which is not a sign of puzzle but plausible when the nature of a peg regime is taken into account. Furthermore, foreign exchange policy causes inflation to rise since its effect is partially sterilized by changes in monetary policy instruments. Therefore, Vietnamese monetary authorities should consider a shift toward a more floating regime to achieve monetary independence or foster the development of financial markets in order to alleviate inflationary pressure caused by foreign exchange policy. Received: Nov. 15, 2016 Received in revised form: Mar. 13, 2017 Accepted: Mar. 31, 2017 Keywords: Sign restriction Monetary policy Exchange rate Fixed exchange rate 32 Bui Thanh Trung / Journal of Economic Development 24(2) 31-50 1. Introduction An enormous number of empirical studies have emphasized the importance of exchange rate channel in the conduct of monetary policy in developed .