Monetary policy effect in an economy with heavily managed exchange rate

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.