Academic journal article Baltic Journal of Economics

Monetary Policy and Financial Stability: Empirical Evidence from Central and Eastern European Countries

Academic journal article Baltic Journal of Economics

Monetary Policy and Financial Stability: Empirical Evidence from Central and Eastern European Countries

Article excerpt

Abstract

The international financial and economic crisis highlights that central banks should go beyond their traditional emphasis on low inflation to adopt an explicit goal of financial stability. Our paper addresses this highly topical issue of macro-prudential framework with the focus on effectiveness of monetary policy in affecting some financial stability indicators, in the experience of several Central and Eastern European countries during 2003M01-2012M06. Using a Structural Vector Autoregressive model and impulse response function, we analyze the impact of short-term interest rates upon industrial production, loan to deposit ratio for the banking system, stock prices and exchange rate (proxy variables for financial stability). We want to test if the interest rate is conducive to financial stability. Our empirical results show that the effectiveness of the short-term interest rate in affecting selected asset prices depends on monetary policy strategy. In the case of the Czech Republic, Hungary, Poland and Romania, the interest rate instrument used for inflation targeting is conducive to financial stability. Among countries with a fixed exchange rate regime, only in Bulgaria does transmission of the foreign interest rate impulse to domestic variables promote financial stability. Additionally, our results show that in Latvia and Lithuania adjustments to the monetary policy of the European Central Bank (ECB) are not in accordance with country-specific conditions. The paper contributes to a policy debate on the design of macro-prudential polices in the aftermath of the boom-bust cycle experienced by the Central and Eastern European countries in the second half of the last decade.

JEL classification codes: E52, C58, G01

Key words: monetary policy, financial stability, Structural Vector Autoregressive model, CEE countries

(ProQuest: ... denotes formulae omitted.)

1. Introduction

It has long been understood that monetary policy can enhance financial stability (IMF, 2012), but the international financial and economic crisis highlights that central banks should go beyond their traditional emphasis on low inflation and adopt an explicit goal of financial stability. Our paper addresses this highly topical issue of macro-prudential framework with the focus on effectiveness of short-term interest rates in affecting selected asset prices.

The purpose of our paper is to investigate the implications of monetary policy on financial stability in the experience of several Central and Eastern European (CEE) countries, during 2003M01-2012M06. Using a Structural Vector Autoregressive model, we analyze the impact of the short term interest rate upon industrial production, loan to deposit ratio for the banking system, stock prices and exchange rate (proxy variables for financial stability). We want to test whether a monetary policy interest rate is conducive to financial stability.

The literature outlines that there is no widely accepted definition of financial stability or a standard measurement framework. As in Granville and Mallick (2009), we define financial stability in terms of changes in share prices, the exchange rate measured as local currency versus the single European currency and the bank loan-deposit ratio. We also examine the effect of monetary policy on the real sector, by including the industrial production index in the empirical model.

The motivation to address these issues is related to a niche revealed by the literature review. Although the monetary policy transmission mechanism in the candidate countries has been written about from the empirical standpoint, the studies are less numerous, and the results often contradictory due to the relatively short time series and the narrow set of variables. Thus, we aim to address this problem by considering different data series, extending the sampling and grouping the countries according to their monetary policy strategy. In addition, from the econometrical standpoint, the period under review represents a real challenge because we are dealing with structural breaks of the time series due to the macroeconomic impact of the crisis since 2007. …

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