Chapter 1: Introduction

1. Relevance of the thesis

In the past 12 years of economic and financial reform, monetary policy has been considered as an important macroeconomic policy for ensuring low inflation and stability of the financial system, promoting investment, and enhancing economic growth. However, since 1998, after a high economic growth period, the Vietnam’s economy has experienced a slowdown. Aggregate demand has decreased, reflecting the reduction in investment and consumption. Therefore, since 1999 the government has tried to apply these policies, including expanding government expenditure, loosening credit conditions, cutting interest rates and increasing money supply. The Government has also committed to apply strongly these policies in the year 2002 in order to boost the economy growth through its domestic demand. But the effectiveness of these policies in the last three years is unclear and still under debate. The framework and effectiveness of monetary policy can be altered due to three factors: (i) The instability in the demand for real balances, (ii) Changes in the behavior of the public and commercial banks, and (iii) changes in transmission mechanisms of monetary effects (Khan and Sundararajan 1991). Therefore, it is necessary for Vietnam to reassess the usefulness of financial variables such as monetary aggregates, interest rates used in the monetary process and the information they provide.

2. Research questions

The central question is: how important is the monetary policy for Vietnam in economic development and stabilization?

In order to answer the central question, I will explore the following sub questions:

1. What are the impacts of monetary policy? What are the influences of exchange rate (ER) regime on monetary policy?

2. What have been the achievements of Vietnam's economic development and stabilization in the period 1990-2001? What are factors affecting these achievements?

3. What is a model that can be used for evaluating impacts of monetary policy?

4. What recommendations can be drawn for Vietnam in implementing monetary policy?

3. The scope of the thesis

The thesis will focus on a short - run analysis, therefore the approach of the demand-side of the economy will be employed.

Meanwhile inflation is the heart of every stabilization programme[1], and due to the limited scope of the thesis, stabilization is understood as inflation stabilization.

In general, ER is one of economy's external policies but not an instrument of monetary policy. In the study, ER will be considered as a monetary policy instrument because in Vietnam, until 1999, ER was directly intervened by the State Bank of Vietnam (SBVN), and through adjusting the ER, SBVN can change the balance sheets of commercial banks (CBs)

4. Methodology

This thesis employs descriptive, analytical and quantitative methods. An econometric model of simultaneous equations is used to find out the quantitative effects of policy interventions of Vietnam in 1990-2001.

5. Structure of the study

The thesis is divided into 5 chapters:

Chapter 1 is introduction. Chapter 2 is the theoretical framework. Chapter 3 will point out renovation in implementation of monetary policy in Vietnam since 1990 and describe the contributions of monetary policy on Vietnam's economic growth and stabilization. Chapter 4 will build a model for measuring impacts of changes in monetary policy on economic growth and stabilization. After evaluating the model, some policy simulations will be described in this chapter. Chapter 5 summarizes the main findings of the thesis and gives policy recommendations.

Chapter 2: Theoretical framework

I. Major issues of monetary policy

1. Goals of Monetary Policy

The goals of monetary policy are meant its ultimate aims or objectives. Four such goals have been explored in some depth so far: high employment, economic growth, price level stability, and stability in the international exchange value of the national currency.

2. Choosing the targets

The CB's problem is that it wishes to achieve certain goals, such as price stability with high employment, but it does not directly influence the goals. It has a set of tools to employ that can affect the goals indirectly after a period of time. After deciding on its goals for economic growth and the price level (ultimate targets), the CB chooses a set of variables to aim for, called intermediate targets, such as the monetary aggregates (M1, M2, or M3) or interest rates (short or long-term), which have a direct effect on growth and the price level. However, the CB’s policy tools do not directly affect even these intermediate targets. Therefore, it chooses another set of variables to aim for, called operating targets, or alternatively called instruments, such as reserve aggregates (reserves, nonborrowed reserve, monetary base, or nonborrowed base[2]) or interest rates (overnight rate), which are more responsive to its policy tools.Transmission mechanism is:

Instrument --->Operating targets ---> intermediate targets ---> ultimate targets

3. Instruments of monetary policy

- Credit ceilings: Typically, credit ceiling is the limit on the volume of loans each bank can provide. Hence, lowering credit ceilings reduces the credit aggregate, excess bank funds can be used to repay loans from the CB, so increase reserve and reduce the money base and then reduce money supply.

- Required reserve: This is regulation of CB that imposes on banks a minimum reserve-deposit ratio. Changes in reserve requirements affect the demand for reserves: A rise in reserve requirements means that banks must hold more reserves, then money supply reduces. And a reduction means that they are required holding less, and then money supply increases.

- Discount window: Discount loans are loans from the CB to depository institutions and that the discount rate is the interest rate charged on these loans. A higher discount rate raises the cost of borrowing from the CB, so banks will take out fewer discount loans; a lower discount rate makes discount loans more attractive to banks, and loan volume will increase. Thus the CB, through discount window can influence reserves in the banking system and the money supply reserves and therefore money supply.

- Open market operations: They are broadly defined as the CB's purchases or sales of financial instruments in opened market (Mishkin, 1990:207). An open market purchase leads to an expansion of reserves and deposits in the banking system and hence to an expansion of the monetary base and the money supply. In contrast, when a CB conducts an open market sale, the public pays for the bonds by writing a check that cause deposits and reserves in the banking system to fall. Thus an open market sale leads to a contraction of reserves and deposits in the banking system and hence to a decline in the monetary base and the money supply.

- Interest rate controls: The CB can control the interest rate in monetary market by regulating the ceiling of lending rate and ceiling of deposit interest rate. When the credit ceiling increases, the lending or borrowing rate set by commercial banks will increase also, thus reduce the excess reserve of banks and increase money supply, makes credit more expensive and reduce the demand for credit (Jansen and Tankha, 1996).

4. Lags in monetary policy

Monetary policy may affect the economy only after a long and variable time. There are 2 types of lag in the effect of monetary policy on national income, they are:

- The inside lag: is the duration from the need for action emerged to the actual occurrence of that action.

- The outside lag: is the time between when a particular action is taken and when the effects of that action have some substantial impacts on the goals of monetary policy.

II. Transmission mechanism of monetary policy

1. The Interest Rate Channel

Negative monetary shocks limit the banking system’s ability to sell deposits. Demand for bonds increases while demand for money decreases. If prices are not fully adjustable, real money balances will decline, pushing up interest rates, and raising the cost of capital. Investment spending declines, reducing both aggregate demand and output. The monetary transaction mechanism under this view works through the liability side of bank balance sheets. How a monetary tightening transmitted to the real economy can be characterized by

Tight monetary policy ===> interest rate (up) ===> investment (down) ===> output (down)

2. The Credit Channel

The credit channel is a set of factors that amplify and propagate the conventional interest rate effects. As described by the credit channel, an external financial premium, which is a wedge between the cost of funds raised externally (by issuing equity or debt) and the opportunity cost of funds raised internally (by retaining earnings), has an important role in economic activities. The size of an external finance premium reflects imperfections in credit markets that drive a wedge between the expected return received by lenders and the costs faced by potential borrowers. Thus, the direct effects of the monetary policy on interest rate are amplified by changes in the external financial premium. Two mechanisms have been suggested to explains the link between monetary policy actions and the external finance premium: the balance sheet channel and the bank lending channel.

The Balance Sheet Channel: is based on the theoretical prediction that the external finance premium facing a borrower should depend on borrower’s financial position. That is, the greater is the borrower’s net worth, the lower the external finance premium should be. Lower net worth means that lenders in effect have less collateral for their loans, and so losses from adverse selection are higher. Lower net worth of business firms also increases the moral hazard problem because it means that owners have a lower equity stake in their firms, giving them more incentive to engage in risky investment projects. Since taking on riskier investment projects makes it more likely that lenders will not be paid back, a decrease in business firms’ net worth leads to a decrease in lending and hence in investment spending.

The Bank Lending Channel: Monetary policy may affect the external finance premium by shifting the supply of credit, particularly loans by commercial banks. Decreasing the supply of loans is more likely to increase the external finance premium and reduce real economic activity. The monetary policy effect is:

Tight monetary policy ==> bank loans (down) ===> investment (down) ===> output (down)

3. Other Asset Price Effects

With an easier monetary policy stance, equity price may rise, increasing the market price of firms relative to the replacement cost of their capital. Even if bank loan rates react little to the policy easing, monetary policy can still affect the cost of capital and hence investment spending. Policy-induced changes in asset prices may also affect demand by altering the net worth of households and enterprises. Such changes may trigger a revision in income expectation and cause households to adjust consumption. Similarly, policy-induced changes in the value of assets held by firms will alter the amount of resource available to finance investment.

A decline in asset prices may have particularly strong effects on spending when the resultant change in debt-to-asset ratios prevents households and firms from meeting debt repayment obligations; it can have similar effects if it raise fears about the ability to service debts in the future. As households and firms thus become more vulnerable to financial distress, they may attempt to rebuild their balance-sheet positions by cutting spending and borrowing. The impact of monetary policy through other asset prices to the economy can be described by

Tight monetary policy ===> asset price (down) ===> investment and consumption (down) ===> output (down)

4. The Exchange Rate Channel

Under flexible exchange rates, when domestic real interest rate rise, domestic currency deposits become more attractive vis a vis deposits denominated in foreign currencies. This leads to currency appreciation and causes a fall in net exports and aggregate output. However, under a fixed exchange rate system, an expansionary monetary policy initially lowers the domestic interest rate and raises income. This results in capital outflows as well as a current account deficit. The government’s attempt to increase the money supply fails because its acquisitions of domestic bonds are offset by its losses of foreign exchange reserves. This leads to a constraint in conducting monetary policy.

In summary, the international channel allows for the importance of capital flows in response to monetary policy after financial liberalization. The testing of the transmission mechanism of monetary policy under high capital mobility hypothesizes:

Tight monetary policy ===> interest rate differential between domestic money market and international money market (up) ===> capital inflows (up) ===> investment (?) ===> output (?)

Conclusion: Monetary policy is a powerful tool, however it sometimes has unexpected consequences. To be successful in conducting monetary policy, the monetary authorities must have an accurate assessment of the timing and effect of their policies on the economy, thus requiring an understanding of the mechanisms through which monetary policy affects the economy.

Chapter 3: banking reforms and the monetary policy implementation in Vietnam period 1990-2001

I. Reform in banking sector and monetary policy

1. Renovation in institutional framework

Prior to 1990, the Vietnamese banking system followed a centrally-planned economy model. The primary task of the SBVN was to provide all banking services in accordance with the national plan. Only in 1990 did the new banking Ordinances authorize the SBVN to assume traditional CB functions such as the conduct of monetary policy and the supervision of the banking system. The further step in institutional reform was promulgation of the Law on State Bank of Vietnam and the Law on credit institutions on October 1^th, 1998. These Laws have created an adequate legal framework for banking operations under which SBVN conducts the state’s management over monetary and banking activities aimed at the stabilization of the value of the VND, contributing to securing the safety of banking activities and the system of credit institution, facilitating the socio-economic development in a manner consistent with the socialist orientation[3].

2. Improvement in regulating money supply and monetary instruments

Before 1993, the SBVN depended very much on the government in regulating money supply. Money in circulation inflows to banks in term of saving deposit but it outflows from banks in term of government expenditure. The hardening of the soft budget constraint, which was an important part of the 1989 package of stabilization measures, was reversed somewhat in 1990-1991. The relationship between budget deficit financed by SBVN’s credit and inflation was clear in many years. Therefore, the government tried to eliminated SBVN’s credit to budget deficit in 1992.

After that, the method of monetary control has been improved continuously. From 1992, the SBVN has had the authority to control monetary growth through its instruments. Reserve requirements were put into practice in 1990; credit ceilings replaced credit plans; and rules over holding of government securities were put in place in 1991; interbank markets for both domestic funds and foreign exchange were established in 1993 and 1994, respectively; a foreign exchange auction system, allowed for intervention in determining the ER and for payment of instruments such as transfer payment checks, cash transfer check, payment order and payment vouchers. Monetary instruments have been gradually completed towards using indirect instruments of monetary management instead of direct ones develop to be in line with international practice and the development of the economy. In fact, since 1998, SBVN has decided to stop using the credit ceilings. While, required reserve and refinancing have been flexibility adjusted in line with the development of capital supply and demand in the market, giving credit institutions flexibility in using their funds and increasing SBVN's ability in monetary management. Specially, on July 12^th, 2000, the SBVN officially launched the OMOs, making a new step forward in renovating the monitoring of monetary policy. On July 2001, the SBVN also provided the SWAP as a monetary instrument, increasing number of effective indirect instruments used by the SBVN to control money stock. At present, however, the lack of development in the financial structure is a serious institutional factor that limits the effectiveness of the most monetary instruments available to the monetary authority.

II. Impact of monetary policy on inflation and economic growth

1. Impacts of money supply

Money and inflation have exhibited broadly similar trends, at least since the general liberalization of prices and the ER (Figure 1).

Figure 1: Vietnam- Money and inflation, 1992-2001

(Year on year, changes in percent)

An analysis of the IMF on the determinants of inflation in Vietnam from 1990 to 1995 indicated a significant relationship between money and inflation. An increase in liquidity leads to higher inflation with a lag of 1 to 4 months, with a maximum impact involving a two-month lag. This confirms that the early introduction and consistent implementation of tight financial policies was a key element of Vietnam’s success in bringing inflation under control.

The relationship between the inflationary movement and monetary aggregates since 1999 deserves consideration. The inflation rates seem not as sensitive to changes on domestic credit and money supply as in the past. The correlation coefficient calculated between the changes in M2 and inflation rate during the period of 1990-1995 is 0.93, and for the domestic credit, the coefficient is 0.80. This means that there are very close causality relationships between monetary aggregates and inflation during the first half of the 1990s. But in period of 1996-2001, the correlation coefficient between the changes in M2 and inflation rate is only 0.18, when for the domestic credit, the coefficient is 0.12. This reflects in the period 1996-2001, monetary aggregates had weak link with the movements in inflation rate.

In short, the results clearly suggest that the pursuit of tight monetary policy, in the initial period of the transition process to a market economy, has played a decisive role in Vietnam's success in curbing inflation. However, since mid 1990s, there has been a weak link between changes in M2 and inflation movements.

2. Impacts of interest rate

Renovation of monetary policy in Vietnam was recorded in early 1989 when the government decided to effect a radical change in interest rate policy. Interest rate were strongly increased and used as the main instrument to check running inflation. With higher interest rate, people willing to save more, reducing money in circulation. The wealthy effect of increased interest rate is that inflation was suddenly reduced from nearly 400% in 1987 to 34% in 1989.

The interest rate policy was adjusted in 1992 in order to reform further. The adjustment of interest rate policy were in the following direction: To ensure a positive real interest rate, that is to maintain the interest rate of banking credit at all level not lower than the rate apply to saving deposit. With the expected to increase efficiency level in production and mobilize idle capital from people then reduced the inflation rate. In 1993, inflation rate were only at 5.2%.

In 1996, VND deposit interest rate was liberalized, the SBVN applied only VND and foreign currency lending ceiling mechanism and maximum USD deposit rate applied to credit institution’s customers as legal entities.

In August 1998, the SBVN decided to change the interest rate management mechanism from ceiling - managed mechanism to basic rate one for VND lending and to regulated-market rates for foreign currency lending to compliance with SBVN’s Law. The movement showed that basic interest rates determination was based on low risk market interest rates, ensuring the SBVN' ability in interest rate control. This was an important advance in the process of interest rate liberalization [4].

In June 2001, foreign currency lending rates were fully liberalized. Commercial banks were allowed to autonomously determine their own deposit and lending rates based on demand for and supply of foreign currencies in the market.

The renovation in interest rate management mechanism towards liberalization, result in positive opportunity costs of holding VND, encourage people put idle money into the banking system. The domestic saving rate stood at a negative level during 1986-1989. After interest rate reform in 1989, the domestic saving rate started to rise and reached 17.4 percent of GDP in 1993. Thereafter, the saving rate fluctuated around 16.7-18 percent of GDP. Then banks have larger capital resources and more clear incentive to provide credit expansion to investment projects (Table 1).

Table 1 – Growth rate of deposit mobilization and Bank credit, 1993-2001

1993

1994

1995

1996

1997

1998

1999

2000

2001

- Deposit

- Credit to Economy

27.66

52.59

35.36

34.33

55.9

26.85

28.44

20.1

30.5

22.6

33.1

16.4

19.2

43.3

38.1

25.1

21.5

Furthermore, real interest rate also have positive impacts on the efficiency of investment which is proxied by the incremental output- capital ratio. Applying the Fry model (1981) for Vietnam in the period of 1986-1999, Tung (2000) found that more than 46% of fluctuation of IOCR could be explained by the real deposit rate.

In short, the above analysis shows that the interest rate renovation was a significant determinant in bringing down inflation to rather low rate during he first half of 1990s. It also played a remarkable role to increase savings and strengthen credit expansion for investment development, contributing to growth economic.

3. Impacts of Exchange Rate

Figure 2 below shows the relationship between the movement of the official ER (OER) and price levels during the 1990s. During the period 1989-1991, the two exhibited high degree of correlation. It seems that the pegged and stable ER was a significant determinant in bringing down inflation to rather low rates during 1992-1993, after long period of hyperinflation in the 1980s and the early 1990s. It is not easy to demonstrate, however, just how important its effect has been on prices since 1994.

It has also been widely argued that given the stable ER, monetary policy as the positive real interest rate have greatly contributed to the anti-inflation fight as well[5]. Since 1997, depreciation rates have become statistically less significant in explaining the low level of inflation. Moreover, the lack of a comprehensive and flexible approach in dealing with the ER and interest rates for both domestic and foreign currencies has created problems of policy inconsistency.

In addition, the ER regime can influence economic growth. An empirical study carried out by the IMF (1996) asserts that "investment rates were highest under a pegged ER" while "fixing the nominal ER can prevent relative prices from adjusting. This lowers economic efficiency". In the end, however, a portion of this lower productivity growth is offset by increased investment. A pegged ER regime, on the other hand, can result in greater volatility of GDP growth and employment.

Table 2 confirms that, excluding the year 1993, export formed an essential component of aggregate demand, contributing to economic growth. However, net export in fact has had a very small or even negative contribution to economic growth. This may indicate that Vietnamese export come from high value-added manufacturing sectors, which is consistent with the fact that in 1998 the share of manufacturing was only 17.7 of GDP.

Table 2: Vietnam- The contribution of Demand Components to Growth, 1991-2001

(percentage points of GDP growth rate)

	1991	1993	1994	1996	1997	1998	1999	2000	2001
GDP (% increase)	5.96	8.07	8.84	9.34	8.15	5.83	4.8	6.75	6.8
- Final consumption	3.40	3.82	5.43	7.25	4.63	3.21	3.62	4.92	4.84
- Gross capital formation	1.00	8.42	3.43	3.87	2.67	2.24	1.43	2.14	2.09
- Export	6.10	1.23	7.39	10.50	4.88	3.54	1.79	2.56	2.61
- Import	-3.20	-6.53	-9.12	-11.68	-3.74	-3.20	-1.93	-2.72	2.85
- (Net export)	2.90	-5.30	-1.73	-1.18	1.14	0.25	-0.14	-0.16	-0.24
Errors and omissions	1.34	-1.13	-1.70	-0.61	0.28	-0.13	-0.11	-0.15	-0.11

Source: Data from 1991 to 1999 are from Vo (2001). The data after 1999 are estimated based on data provided by GSO

This seems to confirm assertion that following several successful years of stabilizing the nominal ER with help from a surge in foreign investment, Vietnam experienced difficulties financing her external deficits as a result of her weak economy, which was compounded by the regional economic crisis. Moreover, the relative stability of the nominal ER during the period of 1993-1996 was associated with the highest growth rate of exports and the devaluations of the ER in 1998 did not improve the export performance. After a year of positive and significant impact on trade, ER seemed to lose its effectiveness. Export expansion could largely be explained by increasing demand in trading partner-countries; the high export growth is experienced in 1999 mainly followed economic recovery in East Asia and rising demand from the EU. Nevertheless, the ER has remained rather rigid and has not been used effectively as an instrument for restraining imports; instead, these outcomes have largely come from Vietnam’s active administrative measures to control the current account and FE.

In short, the effects described above will change the framework of monetary policy and, as a result, policymakers will need to respond by reassessing the usefulness of financial variables used in the monetary policy process.

Chapter 4: Model for measuring impact of changes in the monetary policy on inflation and output growth

I. Model specification

1. Inflation Function

Model:

PRICE_t= const + αIMPRI + βGM2_t+ δGM2_t-1 + γGGDPCO_t + λEXRG_t + ηR_t + μ (1)

Where PRICE is consumer price index, IMPRI is price index of import; GM2 is growth rate of M2, GGDPCO is growth rate of GDP at constant price, and EXRG is depreciation rate of VND and Ris interest rate

By using OLS running equation (1) I find that GM2_t-1 and interest rate are insignificant in explaining movements of price. Indeed, interest rate policy was used as a core tool to halt high inflation only in the early of 1990s. Years after, when inflation reduced to one-digit levels, interest rate focused on promoting investment rather than controlling inflation. After weeding out these variables, I obtained the estimation results of Co-integration equation as follow:

PRICE= 93.94761 + 0.052296*IMPRI + 2.41E^-05*EXRG + 0.097414*GM2 + 0.033923* GGDPCO +

(14.06643) (0.890688) (1.945162) (1.951392) (1.561349)

2.470218* D1 + [MA(2)= 1.297419] (1^*)

(6.407835) (5.576262)

R² = 0.765

As indicated by the Tet dummy variables (D1), an increase in consumer spending during the months of January and February significantly affects inflation. We also can see that depreciation at least in the short run tend to be inflationary. However impacts of money growth and ER on inflation are quite small. Thus, if one takes into account conclusions from studies of the determinants of inflation in Vietnam during the first half of 1990s, then the impact of the rates of change in nominal ERs and money growth on inflation seems to have become much weaker and insignificant/much less significant during the second half of 1990s and period 2000-2001. In other words, other things being equal, there could be room for Vietnam to manipulate the ER regime with more flexibility without a considerable increase in the inflation rate. At the same time, Vietnam also need reconsider information content of M2 on predicting future movements of inflation.

2. Export and Import Functions

Model:

EXPOR_t = Const. + α EXPOR_t-1 + βQE_t + ηQE_t-1 + γEXRG_t + δEXRG_t-1 +ε (2)

IMPOR_t = Const. + φIMPOR_t-1 + λGDPCO_t + ωEXRG_t + ζEXRG_t-1 + μ (3)

Where EXPOR and IMPOR are export and import at constant price, respectively; QE is foreign demand.

To estimate equations (2) and (3) for the period 1990.1-2001.4, I find that lagged ER and lagged foreign demand are insignificant in explaining fluctuations of export in equation (2), it is the case for lagged ER in equation (3). These can be explained that export and import depend on their past movements, while lages of export and import capture the past developments of ER and foreign demand.

To reject these variables, I obtain results of the OLS estimation of equations:

EXPOR = -19987.07 + 0.8697344*EXPOR_-1 + 0.079358*EXRG + 230.120667*QE + [MA(1)=-0.9322]

(-2.637430) (17.29524) (2.865836) (2.801150) (-13.09735) (2*)

R² = 0.975629

and:

IMPOR = 0.850358*IMPOR_-1 - 0.243282*EXR + 0.103456*GDPCO + 4633.48636*D3+ [AR(1)=-0.90458]

(15.30298) (-1.601474) (2.659039) (4.155707) (-7.314849) (3^*)

R² = 0.960789

From the result in equation (2^*) it can draw out some main conclusions, as follows: (i) the positive relationship between depreciation rate and export is significant, but the impact of depreciation on export is very small. That means ER is limited in stimulating export. This arise because Vietnamese exports require many imported materials as inputs; exports are less responsive to changes in relative prices due to capacity constraints; in addition, it is also due to uncompetitive quality of Vietnamese export, (ii) export depends heavily on the foreign trade partners' demand on Vietnamese good and services. This is highlighted in period 1998-2000 when export growth of Vietnam reduced sharply due to troubles at home of its Asian importers as a result of the Asia crisis; (iii) current export is also remarkably explained by its past movements.

Results in equation (3*) also imply some important ideas: (i) import increased in the third quarter (D3); (ii) higher outputs is associated with higher demands for imports; (iii) the coefficient of ER show that import did not respond actively to movements in ER. It can be explained that like other developing countries, Vietnam is heavily dependent on imports of production inputs, so its price elasticity of demand for imports was likely to be very low. On the other word, ER played an unimportant role in controlling import; (vi) Results also show that import is largely explained by its past movement.

In general, ER has proven to be limited in stimulating export as well as in controlling import. Also, in the context of high trade and current account deficits, perhaps Vietnam needs to move to a more flexible ER mechanism.

3. Investment Function

Model:

LnINVES_t = Const. + δLnINVES_t-1 + θLnSRLR_t + λLnSRLR_t-1 + φLnGDPCO_t + ε (4)

Where INVES is investment at constant price, SRLR is short run lending rate.

Now adding a quarter dummy variable (D4 equals 1 in the fourth quarter) into equation (4) and estimating, I obtain following OLS estimation, where:

Ln(INVES) =10.46251 - 0.432842*Ln(INVES)_-1) - 0.664589*Ln (1/2*(SRLR+ SRLR_-1)) (4^*)

(4.231357) (-3.386419) (-3.272924)

+0.346538*Ln(GDPCO)_-1 + 0.230844 D4 +[MA(1)=0.959597]

(2.161059) (4.505171) (32.16045)

R² = 0.852317

From the results in the equation we can see that: (i) investment increases in the fourth quarter each year (D4); (ii) output have robust and positive impact on investment with a lag of 3 months; (iii) impact of short -run lending interest rate on investment is very robust for the case of Vietnam in the period 1990-2001. These findings once again reinforce the arguments in the Chapter 3 pointed out that interest rates has became effective in affecting investment after the interest rate reforms towards interest rate liberalization.

4. Consumption Function

For the Vietnam case, due to the lack of tax, income is used as a proxy for disposable income. In addition, as mentiond in theory chapter, monetary policy as interest rate affects individual consumption though other asset price. However, capital markets in Vietnam is underdeveloped, debt instruments are very poor. Furthermore Vietnamese income per capita is very low level[6] (WB, 2000) that hindered individuals from holding financial asset. Therefore, consumption in Vietnam seems less responsive to the changes in interest rates. Moreover, it is also difficult to have data on real wealth of private sector. Because of the above charecteristics, we have following econometric results where consumption is only explained by its past movement and real GDP:

Ln(CONSO) = 1.636527 + 0.482492*Ln(CONSO)_-1 + 0.361439*Ln(GDPCO)_-1+0.073953*D4

(3.718782) (3.191487) (2.906673) (3.564433) (5*)

R² = 0.963241

Where CONSO is consumption at constant price. The results in equation (5*) imply that: (i) the current consumption depends heavily on real GDP and consumption in the past quarter; (ii) these results also predict that consumption in the fourth quarter is larger than the other quarters.

5. Money supply function

The determination of M2 depends firstly on ultimate targets and secondly on its instruments. Taking these factors into account, I found the following estimation of money equation:

Ln(M2) = -0.765835 + 0.931666*Ln(M2)_-1 + 0.00695*Ln(EXR)_-1 + 0.177921*LnGDPCO_-1 (6^*)

(-3.191072) (43.73167) (2.246643) (6.712484)

+ 0.051213*D4 + 0.989849* MA(1)

(5.301277) (8.615092)

R² = 0.99858

The results in equation (6^*) point out some conclusions: (i) money supply in the fourth quarter is larger than the other quarters (ii) money supply is largely predicted by its past movement. This was the case of Vietnam where the determination of M2 majorly based on its movement in the past; (iii) the money supply seems to respond actively to past movements in output but their correlation is quite small. This results reflect the less dependent between money supply management and output in Vietnam; (v) depreciation rates contain significant advance information on money supply development but its impact on money supply is very small. In fact, during the period, the SBVN did not effectively sterilize FE interventions[7] (Vo Tri Thanh, 2001). An examination of the relation between the ER and the money supply supports the assertion that Vietnamese monetary authorities, while interested in stabilizing ER and raising international reserve, paid little to the control of money supply, so the above result predicted that ER is ineffective in effecting net foreign assets.

II. Model evaluation

The significance of the single equation is a necessary but not sufficient requirement for the quality of a structural model. Even if all single equations fit the data well and are statistically significant, the model as a whole, when simulated, may not track those data series closely. That ‘s why the simulation properties of the model have to be evaluated carefully.

After the estimation using the OLS method[8], the behavioral equations and identities are merged into the model. Econometric models can be evaluated by calculating the differences between the simulated values of variables and the actual ones. A measure that is often used for this purpose is the so called RMSPE (root-mean-square-percentage-error). The closer the simulated values are to the actual ones, the more reliable are the simulation results and the smaller is the RMSPE. The RMSPE for the most important variables of the model are shown in Table 3.

Table 3 : Model evaluation

VARIABLES

RMSPE (%)

GDPCU

PRICE

INVES

CONSO

EXPOR

IMPOR

1.7

2.6

0.9