A Macro-Model Approach to Monetary Policy Analysis for VN

A Macro-Model Approach to Monetary Policy Analysis and Forecasting for Vietnam 

by Allan Dizioli and Jochen M. Schmittmann 

The paper develops a small New-Keynesian FPAS model for Vietnam. The model closely matches actual data from 2000-2014. We derive an optimal monetary policy rule that minimizes variablity of output, inflation, and the exchange rate. Compared to the baseline model, the optimal rule places a larger weight on output stabilization as the intermediate target to achieve inflation stability, while allowing greater exchange rate flexibility. We analyze the dynamics of key macro variables under various shocks including external and domestic demand shocks and a lift-off of U.S. interest rates. We find that the optimal monetary policy rule delivers greater macroeconomic stability for Vietnam under the shock scenarios.

I. INTRODUCTION 

The Vietnamese authorities have made commendable progress in achieving macroeconomic stability in recent years after episodes of high inflation in 2008 and 2011. The export sector has grown substantially making Vietnam one of the most open economies in the world. The export product mix has evolved from predominantly commodities to manufacturing of electronics and apparel. Integration into the world economy has been very beneficial for Vietnam, but has also increased exposure to external shocks.

Monetary policy in Vietnam is anchored around exchange rate stability as the intermediate target to achieve price stability. Specifically, the authorities maintain the dong closely linked to the U.S. dollar. In recent years, Vietnam’s need for accommodative monetary conditions has coincided with exceptionally easy monetary policy in the U.S. Going forward the balancing act of maintaining a close link to the U.S. dollar and implementing monetary policy appropriate for Vietnam is going to be more difficult. Vietnam is increasingly exposed to asymmetric shocks compared to the U.S. as a result of its evolving trade product and partner mix. The likely start of a monetary tightening cycle in the U.S. in the near-term, associated U.S. dollar appreciation, and currency movements in the rest of Asia could severely test Vietnam’s current monetary policy approach. 

This paper contributes to monetary policy analysis in Vietnam through estimation of a small New Keynesian macroeconomic model, the Forecasting and Policy Analysis System (FPAS model). FPAS models have become popular for monetary policy analysis due to their simplicity while capturing the key aspects of an economy for monetary policy analysis (Laxton et al. 2009). The model provides a tool for analyzing the monetary transmission mechanism and the dynamics of shocks to the economy. It can also be used for forecasting.

 The FPAS model is estimated using Bayesian techniques on Vietnamese data from 2000–14. The baseline parameterization fits the actual data closely and performs well in in-sample forecasts. We find that the inflation process is mostly backward looking, which complicates the conduct of monetary policy and implies that monetary policy has to be more active and maintain a certain stance for longer. In addition to the baseline, we derive an optimal monetary policy rule that jointly minimizes the variability of output, inflation, and the exchange rate. 

The optimal monetary policy rule places a greater weight on the output gap as the intermediate target to achieve inflation stability, while allowing greater exchange rate flexibility. We analyze the dynamics of key macro variables under exogenous shocks for the baseline and optimal model parameterization. Shocks include rising U.S. interest rates, an increase in food prices, a domestic demand shock that can be interpreted as a fiscal expansion, and an external demand shock. The optimal monetary policy rule delivers greater macroeconomic stability for Vietnam under the shock scenarios. A critical factor in achieving more output and inflation stability is the buffer role a flexible exchange rate can play when confronted with external shocks. 

The paper is structured as follows. Chapter II provides a brief overview of monetary policy and recent economic developments in Vietnam. Chapter III introduces the model including its main properties and equations. Chapter IV provides a brief overview of the data used for model estimation. Chapter V discusses estimation of the model, results, and forecasts. Chapter VI develops an alternative optimal monetary policy rule that increases macroeconomic stability in the model. Chapter VII employs the baseline model and the model with the optimal monetary policy rule to analyze the reaction of key variables to a range of shocks. We conclude in chapter VIII. 

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