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Transmission mechanisms of conventional and unconventional monetary policies in open economies

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Abstract

This paper provides an empirical examination on the transmission mechanisms of conventional and unconventional monetary policies for two non-EMU countries, Switzerland and the United Kingdom, over the period 1990–2017. We investigate the role of stock prices and consumer expectations in the transmission of monetary policy. We propose two distinct structural VAR models. The model for the case of conventional monetary policy covers the pre-2009 period, while the model for the case of unconventional monetary policy covers the post-2009 period. The official bank policy rate and central bank’s reserve assets are used as instruments for conventional and unconventional monetary policy. The analysis reveals that the inclusion of a forward-looking informational variable of near-term development in economic activity and a financial variable such as the stock prices is of key importance for the monetary policy assessment. We provide evidence for the existence of a consumer confidence channel in the transmission of conventional monetary policy. Moreover, the long-term government bond yields, the exchange rate and stock prices have an important role in the transmission of unconventional monetary policy. Our findings indicate that conventional and unconventional monetary policies have short-run expansionary effects in both countries by increasing output, consumption, investment, stock prices and wages, while reducing unemployment.

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Notes

  1. Alternative methods can also be used for the identification of conventional and unconventional monetary policy shocks. For instance, it will be meaningful to identify monetary policy shocks using sign restrictions (e.g., Uhlig 2005). However, since the identification of exogenous structural shocks using the sign-restrictions approach is usually based on theoretical models, we prefer to use the standard recursive identification approach as it only requires assumptions on the contemporaneous responses of the endogenous variables to structural shocks to the other variables of the system.

  2. Since our empirical analysis is carried out on sub-periods and requires estimating a large number of parameters, including an additional variable would considerably lower the number of degrees of freedom. Although the credit channel is usually recognized as a potential channel of monetary policy in the literature (e.g., Bernanke and Gertler 1995; Mishkin 1995), most empirical studies neglect it. In normal times, banking system distress and significant disruptions in the supply of bank loans are relatively rare in developed banking sectors, as in Switzerland and in the United Kingdom. Thus, the bank lending credit channel may be relatively infrequent. For this reason, we do not consider it in the analysis of the transmission mechanisms of conventional monetary policy. However, this assumption is not likely to hold during periods of crisis and may therefore represent a potential limitation for the analysis of the transmission mechanisms of unconventional monetary policy.

  3. Since the European Union is Switzerland’s largest trading partner, the euro area consumer price index can be considered as a reasonable indicator of future inflation rates in the VAR model. Given the size and the specific characteristics of the United Kingdom economy, we follow the existing literature and use the global commodity price index as it contains more information about the evolution of the global level of prices (e.g., Sims 1992).

  4. The model specifications are summarized in Appendix Table 2.

  5. While this assumption is plausible for a small open economy such as Switzerland, we acknowledge that it may be somewhat restrictive in some respects for the United Kingdom. In particular, the United Kingdom stock price index is calculated from the prices of common shares of companies traded on the London Stock Exchange and therefore exhibits a correlation with the euro area stock price index. Nevertheless, considering the euro area stock price index as endogenous would require additional restrictive assumptions on the contemporaneous relations between domestic variables and the euro area stock price index. For simplicity purposes and in order to be consistent with our approach of separating domestic and foreign variables into two different blocks, we consider the euro area stock price index as exogenous.

  6. For Switzerland, gross fixed capital formation of the private sector series is not available at the quarterly frequency. Instead, we use gross fixed capital formation series, which is available at this frequency, to avoid excessive loss of information due to the interpolation of the series.

  7. For the United Kingdom, we use the log of hourly earnings in the manufacturing sector, which is available at the monthly frequency. For Switzerland, the model could not be estimated in Stata 13 using the log of nominal per capita wage because of collinearity issues. Thus, we use the growth rate of the nominal wage, defined as the log difference of wages and salaries.

  8. The data for reserve assets are only available since 2000.

  9. We perform the Zivot and Andrews (1992) unit root test with a single structural break for the official bank policy rate and central bank’s reserve assets in order to motivate the choice to separate the pre-2009 period and the post-2009 period. The results of the test reveal that structural breaks in central bank’s reserve assets occurred in 2009m6 for Switzerland and 2008m10 for the United Kingdom. In addition, structural breaks in the official bank policy rate were identified in 1995q1 and 2008q4, respectively. For Switzerland, although the identified structural break does not coincide with the year 2009, interest rates reached unprecedent low levels at the end of 2008 and have turned negative since the beginning of 2015. Thus, we can reasonably assume that another structural break in the official bank policy rate occurred in 2009.

  10. The impulse responses are symmetrical, so an expansionary or contractionary shock yields the same absolute values.

  11. 68% error bands are commonly used in the VAR literature (e.g., Giordano et al. 2007; Caldara and Kamps 2008; Mountford and Uhlig 2009; Anzuini et al. 2012). Although it is a common practice, there is no formal theoretical justification for this choice. Sims and Zha (1999) pointed out that error bands corresponding to 0.68 probability are often more useful than 0.90 or 0.95 bands since they provide a measure of shape uncertainty and a more precise estimate of the true coverage probability. We use the 68% error bands to follow the existing literature and facilitate the comparison of impulse responses between the various model specifications.

  12. In the analysis, the various specifications generally yield very similar results to those of the baseline model, with only small differences in the magnitude of the impulse responses. As a robustness check, we have estimated a variant of the presented models by including the effective federal funds rate and federal reserve assets, respectively, as exogenous variables to control for spillovers emanating from United States monetary policy innovations. Overall, the results remain similar to those of the paper. In addition, we have found no evidence of the price puzzle when using inflation based on GDP deflator instead of the consumer price index.

  13. Kim (2001) covers the period 1979–1996 and includes foreign variables as endogenous in the VAR model, meaning that the author allows feedback effect of the United Kingdom variables on the world economy.

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Acknowledgments

I would like to express my sincere gratitude to my PhD supervisor Raúl Ramos for his excellent guidance and support at all stages of this paper.

Data availability

Data would be available at Figshare repository.

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Code would be available at Figshare repository.

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Appendix

Appendix

1.1 Data sources and variable definitions

1.1.1 Switzerland

Output: Real Gross domestic product, Code: CLVMNACSAB1GQCH. Source: Federal Reserve Bank of St. Louis.

Industrial production: Production of total industry index, Code: CHEPROINDQISMEI. Source: Federal Reserve Bank of St. Louis.

Private consumption: Private final consumption expenditure, Code: CHEPFCEQDSMEI. Source: Federal Reserve Bank of St. Louis.

Private investment: Gross fixed capital formation (1990–2009), Code: CHEGFCFQDSMEI. Source: Federal Reserve Bank of St. Louis. Gross fixed capital formation: Private sector (2009–2017). Source: Annual macro-economic database of the European Commission.

Nominal wages: Wages and Salaries. Source: Organisation for Economic Co-operation and Development.

Inflation rate: Consumer price (all items) growth rate same period previous year, Code: CPALTT01CHQ659N. Source: Federal Reserve Bank of St. Louis.

Consumer prices: Consumer price (all items) index, Code: CHECPIALLMINMEI. Source: Federal Reserve Bank of St. Louis.

GDP deflator: GDP implicit price deflator, Code: CHEGDPDEFQISMEI. Source: Federal Reserve Bank of St. Louis.

Real effective exchange rate: Real narrow effective exchange rate, Code: RNCHBIS. Source: Federal Reserve Bank of St. Louis.

Official bank policy rate: 3-month Swiss franc London Interbank Offered Rate: LIBOR, Code: CHF3MTD156N. Source: Federal Reserve Bank of St. Louis.

Unemployment rate: Registered unemployment rate, Code: LMUNRRTTCHQ156S. Source: Federal Reserve Bank of St. Louis.

Reserve assets: Official total reserve assets. Source: Swiss National Bank.

Trade balance: Net exports of goods and services as a percentage of GDP, Exports of goods and services (Code: CHEEXPORTQDSMEI) minus imports of goods and services (Code: CHEIMPORTQDSMEI). Source: Federal Reserve Bank of St. Louis.

Population: Total population, Code: POPTOTCHA647NWDB. Source: Federal Reserve Bank of St. Louis.

Stock prices: Total share prices for all shares, Code: SPASTT01CHQ661N. Source: Federal Reserve Bank of St. Louis.

Consumer confidence: Consumer opinion surveys: Confidence indicators (composite indicators): European Commission and National Indicators, Code: CSCICP02CHQ460S. Source: Federal Reserve Bank of St. Louis.

Long-term government bond yields: Long-term government bond yields: 10-year, Code: IRLTLT01CHM156N. Source: Federal Reserve Bank of St. Louis.

Euro area interest rate: German 3-month interbank rates (1990–1993), Code: IR3TIB01DEM156N. 3-month interbank rates for the euro area (1994–2009), Code: IR3TIB01EZQ156N. Source: Federal Reserve Bank of St. Louis.

Euro area stock prices: Total share prices for all shares for the euro area, Code: SPASTT01EZQ661N. Source: Federal Reserve Bank of St. Louis.

Euro area consumer prices: Consumer price (all items) index for the euro area, Code: EA19CPALTT01IXOBQ. Source: Federal Reserve Bank of St. Louis.

Euro area reserve assets: Central bank assets for the euro area, Code: ECBASSETS. Source: Federal Reserve Bank of St. Louis.

Global oil price: Global price of West Texas Intermediate crude, Code: POILWTIUSDM. Source: Federal Reserve Bank of St. Louis.

Global commodity prices: Global price index of all commodities, Code: PALLFNFINDEXQ. Source: Federal Reserve Bank of St. Louis.

United States official bank policy rate: Effective federal funds rate, Code: FEDFUNDS. Source: Federal Reserve Bank of St. Louis.

United States reserve assets: Total assets (less eliminations from consolidation), Code: WALCL. Source: Federal Reserve Bank of St. Louis.

1.1.2 United Kingdom

Output: Gross domestic product, Code: UKNGDP. Source: Federal Reserve Bank of St. Louis.

Industrial production: Production of total industry index, Code: GBRPROINDMISMEI. Source: Federal Reserve Bank of St. Louis.

Private consumption: Private final consumption expenditure, Code: GBRPFCEQDSMEI. Source: Federal Reserve Bank of St. Louis.

Private investment: Gross fixed capital formation: Private sector. Source: Annual macro-economic database of the European Commission.

Nominal wages: Wages and Salaries: Resources (1990–2009), Code: RPCG. Source: Office for National Statistics. Hourly earnings in the manufacturing sector (2009–2017), Code: LCEAMN01GBM661S. Source: Federal Reserve Bank of St. Louis.

Inflation rate: Consumer price (all items) growth rate same period previous year, Code: CPALTT01GBQ659N. Source: Federal Reserve Bank of St. Louis.

Consumer prices: Consumer price (all items) index, Code: GBRCPIALLMINMEI. Source: Federal Reserve Bank of St. Louis.

GDP deflator: GDP implicit price deflator, Code: GBRGDPDEFQISMEI. Source: Federal Reserve Bank of St. Louis.

Real effective exchange rate: Real narrow effective exchange rate, Code: RNGBBIS. Source: Federal Reserve Bank of St. Louis.

Official bank policy rate: Official bank rate, Code: IUQABEDR. Source: Bank of England.

Unemployment rate: Registered unemployment rate, Code: LMUNRRTTGBM156S. Source: Federal Reserve Bank of St. Louis.

Reserve assets: Government stock (gilts), Code: BKPM. Source: Office for National Statistics.

Trade balance: Net exports of goods and services as a percentage of GDP, Exports of goods and services (Code: GBREXPORTQDSMEI) minus imports of goods and services (Code: GBRIMPORTQDSMEI). Source: Federal Reserve Bank of St. Louis.

Population: Resident population: Mid-year estimates (quarterly data interpolated), Code: EBAQ. Source: Office for National Statistics.

Stock prices: Total share prices for all shares, Code: SPASTT01GBQ661N. Source: Federal Reserve Bank of St. Louis.

Consumer confidence: Consumer opinion surveys: Confidence indicators (composite indicators): European Commission and National Indicators, Code: CSCICP02GBM460S. Source: Federal Reserve Bank of St. Louis.

Long-term government bond yields: Long-term government bond yields: 10-year, Code: IRLTLT01GBM156N. Source: Federal Reserve Bank of St. Louis.

Euro area interest rate: German 3-month interbank rates (1990–1993), Code: IR3TIB01DEM156N. 3-month interbank rates for the euro area (1994–2009), Code: IR3TIB01EZQ156N. Source: Federal Reserve Bank of St. Louis.

Euro area stock prices: Total share prices for all shares for the euro area, Code: SPASTT01EZQ661N. Source: Federal Reserve Bank of St. Louis.

Euro area consumer prices: Consumer price (all items) index for the euro area, Code: EA19CPALTT01IXOBQ. Source: Federal Reserve Bank of St. Louis.

Euro area reserve assets: Central bank assets for the euro area, Code: ECBASSETS. Source: Federal Reserve Bank of St. Louis.

Global oil price: Global price of West Texas Intermediate crude, Code: POILWTIUSDM. Source: Federal Reserve Bank of St. Louis.

Global commodity prices: Global price index of all commodities, Code: PALLFNFINDEXQ. Source: Federal Reserve Bank of St. Louis.

United States official bank policy rate: Effective federal funds rate, Code: FEDFUNDS. Source: Federal Reserve Bank of St. Louis.

United States reserve assets: Total assets (less eliminations from consolidation), Code: WALCL. Source: Federal Reserve Bank of St. Louis.

1.2 Model specifications

Table 2

Table 2 Model specifications

Table 3

Table 3 Summary of variables

1.3 Descriptive statistics

Table 4

Table 4 Descriptive statistics (Switzerland)

Table 5

Table 5 Descriptive statistics (United Kingdom)

1.4 VAR model: Lag length selection and specification tests

Table 6

Table 6 Residual autocorrelation test and lag length selection (CMP model specifications)

Table 7

Table 7 Residual autocorrelation test and lag length selection (UCMP model specifications)

1.5 Johansen cointegration maximum eigenvalue test

Table 8

Table 8 Johansen cointegration maximum eigenvalue test (CMP model specifications)

Table 9

Table 9 Johansen cointegration maximum eigenvalue test (UCMP model specifications)
Table 10 Summary of the results (Switzerland)
Table 11 Summary of the results (United Kingdom)

1.6 Summary of the results

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Hajdukovic, I. Transmission mechanisms of conventional and unconventional monetary policies in open economies. Int Econ Econ Policy 19, 491–536 (2022). https://doi.org/10.1007/s10368-021-00527-0

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