RDP 9008: Financial Deregulation and the Monetary Transmission Mechanism 4. Results

(a) Granger-Causality

Vector autoregression models are a convenient way to test Granger-causality between variables. Table 1 presents the Granger-causality results of the four equations in our model. The figures are the marginal significance levels for the hypothesis that all 6 lags of the given right hand side variable can be excluded.

Table 1 is read as follows: the dependent variables are listed on the left side of each row. The explanatory variables are listed at the top of each column. A small value indicates a statistically significant variable.

Using the five percent level of significance as a benchmark, the only variables to Granger-cause other variables are the bill rate and employment growth, which both lead inflation. This effect disappears, however, after deregulation. In the post-deregulation period, the bill rate Granger-causes employment. The general message that we take from the Granger-causality tests is that deregulation appears not to have made a great deal of difference to the reduced form relationships between these variables. This result might simply reflect the possibility that these tests lack power, and so we now turn to alternative examinations of the data.

(b) Impulse Response Functions

In this Section, we analyze the effects of an unanticipated shock to a particular variable on all the variables in our model. Impulse response functions trace the effect of a one standard deviation shock to a variable on the time path of all the variables in the system. These are shown in Figures 1–16. The vertical axes refer to monthly growth rates, while the horizontal axes denote elapsed time (in months). For ease of comparison the impulse to a particular variable has been standardised so that the shock is the same size both before and after deregulation.

IMPULSE RESPONSES OF A ONE STANDARD DEVIATION SHOCK TO THE 90- DAY BANK BILL RATE

PRE-DEREGULATION —— POST-DEREGULATION ---

IMPULSE RESPONSES OF A ONE STANDARD DEVIATION SHOCK TO THE EMPLOYMENT GROWTH RATE

PRE-DEREGULATION —— POST-DEREGULATION ---

IMPULSE RESPONSES OF A ONE STANDARD DEVIATION SHOCK TO THE INFLATION RATE

PRE-DEREGULATION —— POST-DEREGULATION ---

IMPULSE RESPONSES OF A ONE STANDARD DEVIATION SHOCK TO THE REAL CREDIT GROWTH RATE

PRE-DEREGULATION —— POST-DEREGULATION ---

(i) The 90-Day Bank Bill Rate

Figures 1–4 show the impulse responses following a shock to the bank bill rate. Figure 1 shows the time path of the bill rate itself. The path of the bill rate decays slowly pre-deregulation and somewhat more quickly in the post-deregulation period. Figure 2 shows that the bill rate shock causes the growth rate of employment to fall by around 0.0005 (or 0.6 per cent in annualised terms) both before and after deregulation, for about two years. The effect on inflation appears to be negligible (Figure 3), while the growth rate of real credit tends to fall, quite substantially, especially in the post-deregulation period.

(ii) The Employment Growth Rate

Figure 5 shows that a positive shock to the employment growth rate leads to a tightening of monetary policy both pre and post-deregulation. This tightening appears to be more sustained in the pre-deregulation period. Figure 6 shows that the effect of the shock to employment growth on itself disappears immediately after the initial impulse. The effect on inflation is almost non-existent, (Figure 7), which is not surprising since the shock lasts for only one period. Some increase is evident in the growth rate of real credit, shown in Figure 8, but this effect is relatively short-lived, no doubt due to the effects of the higher interest rates.

(iii) The Inflation Rate.

A one per cent annualised shock to the inflation rate leads to a modest tightening of monetary policy (an increase in the bill rate, Figure 9) pre-deregulation, but not post-deregulation. The effect on employment (Figure 10) is similar to that following the bill rate shock, suggesting that it is the response of monetary policy, rather than the inflation shock, per se, which is driving the response of employment. The inflation rate itself exhibits a damped cycle (Figure 11) as does the growth rate of real credit, as shown in Figure 12.

(iv) Real Credit Growth.

Figure 13 shows that a shock to the growth rate of credit elicits a sustained tightening of monetary policy in both periods. As a result, the growth rate of employment is lower (Figure 14)especially pre-deregulation. The response of employment growth to the credit shock does not lend support to the view proposed by Bernanke and Blinder (1989) that credit is important in driving the business cycle. If credit matters, it seems to be only through the effects of the monetary policy reaction function.

The effect on inflation is very small, both before and after deregulation, while the growth rate of real credit actually becomes negative after about six months. This effect is again due to the reaction of monetary policy.

The salient features of the impulse responses can be summarized as follows. First, interest rates seem to have about the same effect on the real economy in both the pre-deregulation and post-deregulation periods. Second, any positive effect of a credit shock to the real economy is more than offset by the reaction of monetary policy. Third, the reaction of monetary policy to a shock to the real economy is far greater than to a shock to the inflation rate. Fourth, real credit growth responds positively to a shock to the real economy, at least until the effects of the monetary policy reaction are felt.

(c) Variance Decompositions

Equivalently, these data can be analyzed using variance decompositions. The forecast error variance of each variable, at each time horizon, is decomposed into contributions of innovations of all of the variables in the model. These are shown in Tables 2–5.

(i) The 90-Day Bank Bill Rate (Table 2)

In the pre-deregulation period, very little of the forecast error variance of the bill rate is attributable to other variables in the system. After 36 months, the bill rate still explains over 70.0 per cent of its own forecast variance; the inflation rate and the rate of growth of employment each explain about 7.5 percent. Credit explains 12.0 percent of the variance. Post-deregulation the contribution, after 36 months, of the inflation rate falls to negligible levels while that of employment increases slightly. The influence of credit increases markedly, explaining nearly 30 percent of the variance after 36 months. The predominant influence is still, however, the forecast variance of the bill rate itself.

(ii) The Employment Growth Rate (Table 3)

Deregulation has had very little effect on the determinants of employment's forecast error variance. The largest influence comes from itself, with the bank bill rate contributing about 20 percent, demonstrating that shocks to monetary policy can have significant and long-lasting effects on the real economy.

The effect of inflation is about half that of interest rates, while real credit growth has a relatively small effect explaining about eight percent of the variance pre-deregulation and about 14 percent afterwards.

(iii) The Inflation Rate (Table 4)

Deregulation does not seem to have had much of an affect on the forecast variance of the inflation rate. The bank bill rate contributes a great deal to the variance in the pre-deregulation period (nearly 30 per cent after 36 months) and makes a somewhat smaller but still significant contribution post-deregulation. The effect of employment is unchanged while the contribution of credit is slightly smaller post-deregulation. By far the greatest contribution, in both periods, comes from the inflation rate itself, even after 36 months. This suggests that an inflation shock is difficult to remove, probably due to inertia in the expected inflation rate.

(iv) Real Credit Growth (Table 5)

The variance decomposition of credit also does not change much in the post-deregulation period. The bill rate explains about 20 percent of the forecast error variance, in both periods. Employment growth and inflation have small but not negligible effects.