WP/15/273

A Macro-Model Approach to Monetary Policy Analysis

and Forecasting for Vietnam

by Allan Dizioli and Jochen M. Schmittmann

IMF Working Papers describe research in progress by the author(s) and are published
to elicit comments and to encourage debate. The views expressed in IMF Working Papers
are those of the author(s) and do not necessarily represent the views of the IMF, its
Executive Board, or IMF management.

©International Monetary Fund. Not for Redistribution

© 2015 International Monetary Fund WP/15/273

IMF Working Paper

Asia and Pacific Department

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

Prepared by Allan Dizioli and Jochen Schmittmann1

Authorized for distribution by John Nelmes

December 2015

IMF Working Papers describe research in progress by the author(s) and are published to
elicit comments and to encourage debate. The views expressed in IMF Working Papers are
those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board,
or IMF management.

Abstract

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.

JEL Classification Numbers: E31, E47, E52

Keywords: Inflation Targeting, Monetary Policy, Bayesian Estimation

Authors’ E-Mail Addresses: [email protected]; [email protected]

1
We are grateful to John Nelmes for guidance and many helpful discussions.

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Contents Page

I. Introduction ........................................................................................................................... 4
II. A Brief Overview of Monetary Policy and Macroeconomic Developments ....................... 5
III. The FPAS model ................................................................................................................. 7
IV. Data ..................................................................................................................................... 9
V. Estimation and Results ....................................................................................................... 10
A. Estimation ...................................................................................................................... 10
B. Baseline Results ............................................................................................................. 11
C. In-Sample Forecast Properties ....................................................................................... 11
D. Out-of-sample forecasts with U.S. Federal Reserve lift-off .......................................... 12
VI. Optimal Monetary Policy Response ................................................................................. 14
VII. Shocking the Baseline and Optimal Models ................................................................... 15
A. Monetary transmission in the model .............................................................................. 15
B. Domestic demand shock................................................................................................. 17
C. External demand shock .................................................................................................. 18
D. Tighter U.S. monetary policy ......................................................................................... 19
E. Food Prices Shock .......................................................................................................... 20
VIII. Conclusions .................................................................................................................... 21
References ............................................................................................................................... 24

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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

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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.

II. A BRIEF OVERVIEW OF MONETARY POLICY AND MACROECONOMIC DEVELOPMENTS

Growth averaged over 7 percent in the years before the Global Financial Crisis, led mainly
by increasingly intensive agricultural production, rapidly expanding state-owned enterprise
(SOE) investment, financial services and labor-intensive manufacturing driven by foreign
direct investment. In anticipation of WTO accession in early 2007, Vietnam received large
capital flows and domestic credit growth reached more than 50 percent. Inflation reached
double-digit levels in 2007 and averaged more than 23 percent in 2008. In the wake of the
global financial crisis growth slowed and the dong weakened amid large trade deficits and
dwindling foreign exchange reserves. Weaknesses in the growth model based on high, but
inefficient SOE and state investment were exposed. Confronted with slowing growth, the
authorities implemented a large fiscal stimulus combined with a push to increase credit in
2009 and early 2010. While this succeeded in pushing up growth in the short-term, it led to
another episode of high inflation in 2011 and pressure on the currency. After stabilization of
the economy in 2012, growth fell to around 5 percent in 2012.

In the last three years, growth has slowly recovered to about 6 percent at the end of 2014
supported mainly by a strong FDI-driven export sector. Inflation has been on a downward
trend due to a persistent negative output gap and a disinflationary external environment, and
there are signs of a recovery in domestic demand in 2015. The economy nevertheless
continues to face structural challenges that create a headwind for growth (SOE reform,
banking sector weakness and diminishing fiscal space for bank and SOE restructuring costs
and countercyclical policies).

The Vietnamese dong has been closely tied to the U.S. dollar since 2012 with small
occasional adjustments. In real effective terms, the dong has appreciated by close to 30
percent due to persistent inflation differentials and, more recently, U.S. dollar appreciation
vis-à-vis the Euro, the Yen and many EM currencies.

Monetary policy is conducted by the State Bank of Vietnam (SBV). By law, the SBV
proposes an inflation target to the National Assembly, which then sets the target as national
policy (5 percent for 2015). The SBV is free to use its instruments to achieve that rate of
inflation. The SBV also announces an official dong-US dollar exchange rate with bands, and
it manages the supply of foreign exchange to keep the interbank exchange rate within the
bands.2 The SBV issues central bank bills, conducts repo operations, sets a reference interbank

2
The exchange rate trading band vis-à-vis the U.S. dollar was widened to +/- 3 percent from +/- 1 percent in
August 2015.

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rate, and maintains overnight lending and deposit facilities to manage overall system liquidity.
In addition, there are caps on deposit rates. The SBV also announces a domestic credit growth
objective including credit growth guidance for individual banks and sectors.

Figure 1: CPI Inflation

(In percent)
50
Headline inflation Core inflation
45
Food inflation 3-month interbank rate
40
35
30
25
20
15
10
5
0
2005M1
2005M7
2006M1
2006M7
2007M1
2007M7
2008M1
2008M7
2009M1
2009M7
2010M1
2010M7
2011M1
2011M7
2012M1
2012M7
2013M1
2013M7
2014M1
2014M7
2015M1
2015M7
Figure 2: Exchange Rate
160 25000

140
20000
120

100 15000
80

60 10000
NEER (2010=100)
40
REER (2010=100) 5000
20 Dong per US Dollar (RHS)

0 0
2005M1
2005M7
2006M1
2006M7
2007M1
2007M7
2008M1
2008M7
2009M1
2009M7
2010M1
2010M7
2011M1
2011M7
2012M1
2012M7
2013M1
2013M7
2014M1
2014M7
2015M1
2015M7

Figure 3. GDP Growth

(in percent)
8

0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

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III. THE FPAS MODEL

The analysis employs a small New Keynesian model following Berg and others (2006) with
some extensions to better capture Vietnam specific factors. Small New Keynesian or FPAS
models are increasingly used in central banks and at the IMF for monetary policy analysis
and forecasting. A key advantage of FPAS models is transparency and simplicity, while
allowing for an analysis of the key features of an economy. FPAS models can help frame
policy discussions about forecasts, risks to forecasts, and the appropriate responses to shocks.

FPAS models are dynamic stochastic general equilibrium models. They are structural in the
sense that the model’s equations have an economic interpretation. They are general
equilibrium because the main variables are endogenous and jointly determined. FPAS models
are stochastic as each equation in the system contains a random error term that allows the
quantification of uncertainty in the model’s forecast. They incorporate partly forward-
looking expectations that depend on the forecasts the model produces. To keep the model
tractable and intuitive for monetary policy analysis, it abstracts from issues related to
aggregate supply, fiscal policy, and the levels of real variables but instead expresses variables
in terms of deviation from their long-run trend (in “gap” terms). Long-run trends are assumed
to follow autoregressive processes that map properties of the data.

Four equations constitute the core of the model: (1) an aggregate demand curve that relates
real activity to expected and past real activity, the real interest rate, and the real exchange rate;
(2) two Phillips curves that relate components of inflation to past and expected inflation, the
output gap, and the exchange rate; (3) an uncovered interest parity condition for the exchange
rate;3 and (4) a monetary policy rule, which is a function of the output gap, changes in the
exchange rate, and deviations of expected inflation from the authorities’ inflation target.

(1) Aggregated demand curve

The output gap yGAPt depends on its own lag and projected values, on deviations from the
neutral real interest rate ( RR * ), on deviations from the steady state real exchange rate ( z * ),
and on foreign demand ( ygap RW ) which is approximated by the U.S. output gap:

y GAPt   ld y GAPt 1   lag y GAPt 1   RRGAP * ( RRt 1  RR *t 1 )   zgap * ( z t 1  z * t 1 )

  RWGAP ygap RW t   t
y

The neutral real interest rate is not constant over time, but evolves according to an AR(1)
process:

RR*t  RR*t 1  (1   ) RR   t
RR

3
The forward-looking expectations assumption is relaxed here as some forms of backward-looking expectations
are allowed in determining the exchange rate.

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(2) Phillips curves

Price dynamics are described by two Phillips curves, one for food and fuel inflation and one
for core inflation (Andrle and others 2013). Modeling these categories separately allows us to
capture differences in dynamics between the categories. Food and fuel inflation is likely to be
determined by domestic or international shocks to a large degree with a limited impact from
monetary policy, while core inflation is more sensitive to changes in monetary conditions.
Both Philips curves have the same functional form but different coefficient priors for
estimation (see section III).

The Philips curves are given by:

π α π4 1 α π4 α s s α yGAPt ϵ

so that the year-on-year quarterly consumer price index (CPI), π , depends on the expected
annual change in the CPI (π4 ), the change in the CPI over the previous year (π4 ),
changes in the nominal effective exchange rate (s ), and the output gap ( yGAPt ).

For Vietnam, we expect a relatively small coefficient on expected inflation due to price
frictions and a weak monetary transmission mechanism (IMF 2014). We expect the
coefficient on exchange rate changes (α ) to be relatively large for a very open economy such
as Vietnam.

(3) Uncovered interest parity

The uncovered interest parity is determined as follows:

RR RR ρ∗
z δ z 1 δ z ϵ
4

where z is the real exchange rate (defined so that an increase is a depreciation), RR is the
policy real interest rate, RR is the real U.S. interest rate, and ρ∗ is the equilibrium risk
premium. The interest rate term is divided by 4 because the interest rates and the risk
premium are measured at annual rates. It is assumed that the risk premium ρ∗ is not constant
and evolves depending on the difference between Vietnam’s and the world’s neutral interest
rates. We allow, but do not impose, forward-looking expectations for the exchange rate4, that
is:

z δ z 1 δ z

(4) Monetary policy rule

4
Berg, Karam, and Laxton (2006a/b) discuss how incomplete forward-looking expectations provide for realistic
dynamics.

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We assume that the central bank sets short-term nominal interest rates to achieve a target
level for inflation, π*. The central bank also reacts to deviations of output from its trend and
to changes in the real exchange rate. The rule is given by:
∗ ∗
RS γ RS 1 γ ∗ RR π4 γ π4 π γ ygap
γ z z ϵ

where the nominal policy rate (RS ) depends on its own lag, the equilibrium real rate (RR ∗ ),
the annual inflation rate (π4 ), deviations of expected inflation from the target rate of
inflation (π ∗ ), the output gap (ygap ), and changes in the real exchange rate z .

The monetary policy rule follows standard formulations, and we allow the central bank to
smooth interest rates. In addition, we include a term to account for the monetary authorities’
response to exchange rate fluctuations, which is important in the case of Vietnam.5 Deviating
from standard formulations, we allow the central bank to specify a stochastic process for its
inflation target π*, that is:
∗ ∗
π ρ π 1 ρ π∗ ϵ

This specification seeks to capture time-varying central bank tolerance to different levels of
inflation and has been shown useful in mimicking inflation dynamics in developed and
emerging markets.6

Foreign block
The model includes a similar set of equations as discussed above representing the foreign
sector. We use the U.S. to represent the foreign sector in the model.

IV. DATA

The sample covers the period 2000 to 2014 with most data series at a quarterly frequency.
The real effective exchange rate is obtained from IFS. Headline, core and food and fuel CPI
are provided by the Vietnamese authorities. We use the weekly interbank rate (averaged into
quarters) as the short-term interest rate in the model, as the reference interbank rate has been
almost constant in the last three years and does not capture the policy stance. For the output
gap we use a simple HP filter. Other approaches to output gap estimation yield qualitatively
similar model results.

We estimate the foreign block in the model with U.S. economic data. Our sample is based on
data from the International Finance Statistic and the IMF’s World Economic Outlook, from 2000
to 2014. The federal funds rate was used as the nominal interest rate to the rest of the world.

5
Since our model assumes serially correlated errors in exchange rate expectations (δz < 1), there is a role for
monetary policy to respond directly to exchange rate changes.
6
Berg, Karam, and Laxton (2006a/b) and Smets and Wouters (2003).

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V. ESTIMATION AND RESULTS

A. Estimation

We use a Bayesian approach to estimate the parameters of the model. Bayesian estimation
involves the estimation of the posterior distribution for the model’s parameters, and an
evaluation of data likelihood given the parameters, the model, and parameters’ prior
distributions. The principle is to first approach the data with a set of prior views on the
appropriate values of the parameters of the model, and then to adjust these prior views based
on Vietnam’s data.

The Bayesian methodology has a number of advantages over classical estimation or the
calibration of macro-models. The Bayesian approach formalizes the incorporation of prior
empirical and theoretical understanding about the parameters of interest and delivers more
stable estimation results with short samples. It also allows for measurement error, so that
some of the excess volatility in the data is allocated to measurement error instead of entering
the stochastic simulations. These advantages are particularly relevant in the case of Vietnam
where sample periods are short and measurement error is an issue.

The priors and estimated posterior values on the main parameters in the model are
summarized in Table A1 at the end of the paper. We chose priors’ functional forms based on
the existing literature on FPAS models. The prior means were chosen to reflect views about
structural features of the Vietnamese economy. In the following paragraphs we discuss some
key parameters of the model.

In the aggregate demand curve, the relatively large backward-looking term and small
forward-looking term account for the view that expectations of future developments play a
relatively small role in output dynamics. The priors on the lagged real interest rate and real
exchange rate (  RRGAP and  zgap ) reflect our view that the effect of a 100-basis-points
increase in the real interest rates on the output gap would be equivalent to a 1 percent
appreciation in the real exchange rate. The choice of these parameters result in hump-shaped
dynamics in response to monetary induced interest rate shocks. The large parameter on the
international output gap reflects the high degree of openness of the Vietnamese economy.

For the Phillips curves, we estimate separate single equation Phillips curves for core and for
food/fuel inflation. The estimated parameters from these equations are then used as prior
means in the FPAS model. The single equation estimations confirm a greater responsiveness
of core inflation to changes in the output gap when compared to food/fuel inflation. In turn,
food/fuel inflation is more responsive to exchange rate movements (large αs coefficient). This
result is as expected, since food and fuel are either imported or determined by world market
prices to a larger degree than components of core inflation.

For the monetary policy rule, the relatively high prior on the parameter on the lagged interest
rate (γ implies a high degree of inertia in the policy rate as observed in the data. We
also assume that the central bank adjusts the policy rate incrementally to the desired value
based on deviations of inflation from the official target and output from equilibrium. To

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reflect the State Bank of Vietnam’s focus on stabilizing the exchange rate, we allow a
response of the policy rate to nominal exchange rate movements.

The priors on the foreign block of the model are taken from applications of similar models
estimated for the U.S. economy (Coats, Laxton and Rose (2003); Anand, Ding, and Tulin
(2014); Andrle and others (2013)). The prior means of the autoregressive coefficients of most
exogenous variables, as well as the variances of the shocks are chosen so that the model
delivers plausible interpretations of recent macroeconomics dynamics in Vietnam.

B. Baseline Results

One way to assess how well the overall estimation of the model fits the data is through the
comparison of the moments predicted in the model with the actual Vietnamese data. Table 1
provides means and standard deviations of the actual data and estimated moments in the
model. The baseline model fits actual means and standard deviations very well. The only
significant deviation from the actual data moments occurs for the standard deviation of
nominal interest rates. This can be rationalized by considering that in the model different
tools of monetary policy are subsumed in the interest rate. In reality, monetary policy in
Vietnam does not exclusively rely on interest rates but a number of measures including credit
targets, guidance, and management of the exchange rate. To capture monetary policy in only
one variable, the interest rate has to be more reactive in the model than observed in actual
data.

Table 1. Actual data and baseline model moments

Actual data Baseline model
Mean Std. Dev. Mean Std. Dev.
Output gap 0.0 1.0 0.0 1.4
Inflation 8.9 6.3 8.9 5.3
Core Inflation 7.3 4.5 7.4 7.1
Food Inflation 11.6 10.3 11.3 10.0
Nominal interest rate 7.0 3.4 7.0 9.6
Real exchange rate 11.5 12.4
Nominal exchange rate 2.2 2.3

C. In-Sample Forecast Properties

One-quarter ahead model-based in sample forecasts are created each quarter. The forecasts
use only data until the quarter before the forecast. Figure 4 presents in sample forecasts (red)
along with the actual data (blue) for the output gap and inflation. The in sample forecasting
performance of the model is strong. Forecasts capture the spikes in inflation in 2008 and
2011 and track output gap dynamics well. The forecasting performance confirms that the
model matches Vietnam’s data well.

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Figure 4. In-Sample Forecasts

Output Gap
4
3
2
1
0

07Q1
07Q2
07Q3
07Q4
08Q1
08Q2
08Q3
08Q4
09Q1
09Q2
09Q3
09Q4
10Q1
10Q2
10Q3
10Q4
11Q1
11Q2
11Q3
11Q4
12Q1
12Q2
12Q3
-1
-2
-3
-4
-5 Output GAP

-6 Model simulated output gap

-7

Inflation
40
35 Inflation
30
Model simulated inflation
25
20
15
10
5
0
07Q1
07Q2
07Q3
07Q4
08Q1
08Q2
08Q3
08Q4
09Q1
09Q2
09Q3
09Q4
10Q1
10Q2
10Q3
10Q4
11Q1
11Q2
11Q3
11Q4
12Q1
12Q2
12Q3
-5
-10

D. Out-of-sample forecasts with U.S. Federal Reserve lift-off

FPAS models can be very useful in the process of forecasting. While the model itself does
not make the central forecast, it can serve to frame the discussion about the forecast, risks to
the forecast, appropriate responses to a variety of shocks, and dependencies of the forecast
and policy recommendations on assumptions (Berg, Karam, and Laxton 2006). In this section
we present out-of-sample forecasts for the output gap, inflation and nominal interest rates on
a quarterly basis starting at the end 2014 (Figure 5). The forecasts incorporate a gradual
tightening of U.S. monetary policy with the Fed Funds rate reaching 2 percent after three
years. This is complemented by a discussion of the effect of shocks in section VII.

Consistent with a pick-up in economic growth the model predicts a gradual closing of the
output gap. Accordingly, inflation is forecast to slowly increase toward the 4 percent target
assumed in the model. However, confidence bands (bands are for 95 percent confidence
intervals) leave a wide margin of error, including the possibility of persistently low inflation.
The model forecast for the nominal interest rate projects a very slow increase in interest rates
starting towards the end of 2015. Again, confidence bands are wide and this should be
interpreted as suggesting that monetary policy should closely monitor inflation developments
with a bias to tighten if needed.

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Figure 5. Out-of-Sample Forecasts for the Output Gap, Inflation, and Interest Rates

Output gap projection

(in percent)
2

1.5

0.5

0
1 2 3 4 5 6 7 8 9 10 11 12
-0.5

-1

-1.5

-2

Inflation projection
(in percent)
12

10

0
1 2 3 4 5 6 7 8 9 10 11 12
-2

Interest rate projection

(in percent)
15

10

0
1 2 3 4 5 6 7 8 9 10 11 12

-5

-10

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VI. OPTIMAL MONETARY POLICY RESPONSE

In this section, we derive an ex-post optimal monetary policy rule for Vietnam. A
comparison of the optimal rule with the baseline parameterization provides guidance on how
monetary policy could adjust weights on intermediate targets to achieve greater
macroeconomic stability.

We define optimality as the joint minimization of output, inflation and exchange rate
variability. The derivation of the optimal weights in the monetary policy rule depends on the
chosen loss function. Specifically, the minimization problem is:

min  E ( yt'Wy t )
s.t.
A1 Et yt 1  A2 yt  A3 yt 1  Cet  0

where θ are the parameters in the monetary policy rule to be optimized, yt are the model
endogenous variables, the et are the exogenous shocks, and W is the weighting matrix7. The
constraint summarizes the path to be followed by the variables so that they are a solution to
our model, that is, we are minimizing the variance of the chosen variables subject to them
satisfying the model equations.

Figure 6 presents the relative weights on the output gap, the nominal exchange rate, and
inflation in the monetary policy rule in the baseline model (blue) and in the optimal model
(red) as obtained from the above optimization problem. Table 2 compares the standard
deviations of the output gap, inflation, nominal interest rates, nominal exchange rate in the
baseline and optimal models. The optimal monetary policy rule suggests that the output gap
is a better intermediate target than the exchange rate to stabilize the economy. The central
bank would be able to deliver substantial improvements in inflation stability and less
accentuated business cycles at the cost of a small increase in exchange rate variability (table
2). In other words, a strong focus on nominal exchange rate stability as an intermediate target
to control inflation results in more inflation and output variability. The optimal monetary
policy rule would require a more active monetary policy as implied by the larger variability
of the nominal interest rate in the optimal model.

7
The only positive weights on the weighting matrix are the ones related to output gap, inflation and exchange
rate.

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Figure 6. Relative Weights in the Monetary Policy Rule

4
3.5
Baseline Model
3
Optimal Model
2.5
2
1.5
1
0.5
0
Output gap Nominal exchange Inflation
rate

Table 2. Standard Deviations in Baseline and Optimal Model

Standard Baseline Optimal
deviations: model model
Output gap 1.4 0.9

Inflation 5.3 3.8

Nominal interest 9.6 12.4

rate
Nominal exchange 2.3 2.4
rate

VII. SHOCKING THE BASELINE AND OPTIMAL MODELS

We use the estimated models to analyze the dynamics of shocks to Vietnam’s economy.
Contrasting the effect of shocks under the baseline and optimal monetary policy rule
provides valuable insights into the properties of both policy functions. In the following, we
first provide a measure of the monetary transmission in the model and then discuss results for
four shocks to Vietnam’s economy: a domestic demand shock, a negative external demand
shock, rising U.S. interest rates, and an increase in food prices.

A. Monetary transmission in the model

With the model, we can measure the response of inflation, the output gap and the exchange
rate to a monetary policy intervention (Figure 7).8 An increase in the nominal interest rate
8
Results are presented in deviations, i.e., movements in the variables in relation to their long-run values.

©International Monetary Fund. Not for Redistribution

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suppresses domestic demand directly through the monetary channel and indirectly through an
appreciation of the Vietnamese dong.9 The appreciation of the currency combined with a
contraction in demand leads to a reduction in headline inflation. The model suggests that
100 basis point increase in the nominal interest rate results in a fall in output that reaches a
peak of 0.1 percent after about 4 quarters and a real appreciation of about 0.25 percent. The
monetary tightening also leads to a decline in headline CPI inflation that peaks at
0.15 percent after two years. The results of our model for Vietnam are qualitatively similar to
findings in other empirical studies on the monetary transmission mechanism in developing
and emerging countries.

Properties are similar with the optimal monetary policy rule, but deviations from equilibrium
are much smaller and reversions back to equilibrium are much faster. This is a result of the
greater responsiveness of monetary policy in the optimal model, particularly to output
deviations. In the optimal model, the central bank reacts fast to declining output and falling
inflation by lowering interest rates. This, in combination with a short-term depreciation of the
currency following a brief appreciation in response to the initial rate hike, takes the output
gap and inflation back to their equilibrium values after a few quarters.

Figure 7. Monetary Transmission in the Model

Output gap Inflation

0.1 0.05
Baseline Baseline
0.05 0
Optimal 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Optimal
33 35 37 39
-0.05
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 -0.1
-0.05
-0.15
-0.1
-0.2
-0.15
-0.25

-0.2 -0.3

-0.25 -0.35

Interest rate Nominal exchange rate

2 0.2
Baseline Baseline
1.5 0.1
Optimal Optimal
0
1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.1
0.5
-0.2
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 -0.3
-0.5
-0.4

-1 -0.5

-1.5 -0.6

9
Note that with our definition of the exchange rate, a decline is an appreciation of the dong.

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 17

B. Domestic demand shock

Even though fiscal policy has not been directly incorporated in the formulation of this model,
we can partially assess the impact of fiscal policy by interpreting a fiscal expansion
(contraction) as a positive (negative) shock to domestic demand (Figure 8).

In the baseline model, a fiscal expansion equivalent to a one standard deviation increase in
demand (about 0.66 percent), leads to an increase in headline inflation by about 0.35 percent.
The central bank responds to rising inflation only with a slow and limited increase in interest
rates. Over the medium term, rising inflation leads to a real effective appreciation of the dong
(the nominal exchange rate remains stable). The real appreciation causes a medium-term fall
in output and inflation falling below target.

In the optimal model, the central bank aggressively raises interest rates to control inflation.
The nominal exchange rate is allowed to appreciate which also dampens inflationary
pressures. The output gap returns relatively quickly to a neutral level. Shocks dissipate faster
with the optimal monetary policy rule than under the baseline.

Figure 8. Positive Domestic Demand Shock

Output gap Inflation

7.00E-01 0.4

6.00E-01 Baseline Baseline

0.3
Optimal Optimal
5.00E-01
0.2
4.00E-01
0.1
3.00E-01
0
2.00E-01 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.1
1.00E-01

0.00E+00 -0.2
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-1.00E-01 -0.3

-2.00E-01 -0.4

Interest rate Nominal exchange rate

7.00E+00 1

6.00E+00 Baseline Baseline

0.5 Optimal
5.00E+00 Optimal

4.00E+00
0
3.00E+00 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
2.00E+00 -0.5

1.00E+00
-1
0.00E+00
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-1.00E+00
-1.5
-2.00E+00
-3.00E+00 -2

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 18

C. External demand shock

Vietnam is one of the most open economies in the world and the export-oriented sector has
substantially contributed to growth in recent years.10 Integration in the global economy has
provided many benefits to the Vietnamese economy, but has also increased the exposure to
external demand shocks. Growth slowdowns in trade partners or flagging global growth
affect Vietnamese exports and growth to a substantial degree. External demand shocks can of
course also be positive, including through new trade agreements (bilateral Free Trade
Agreements, the Trans-Pacific Partnership, and the ASEAN Economic Community). We
present the impact of a decrease in external demand in Figure 9, but an increase in external
demand would follow the analog reverse logic.

Under the baseline model, a negative external demand shock causes a reduction in output
which leads to a decline in inflation. In response, the central bank slowly cuts interest rates.
The nominal exchange rate remains broadly stable, while low inflation leads to a real
appreciation.

Figure 9. Negative External Demand Shock

Output gap Inflation

0.1 0.1
Baseline Baseline
0.05 Optimal 0 Optimal
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
0 -0.1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.05 -0.2

-0.1 -0.3

-0.15 -0.4

-0.2 -0.5

Interest rate Nominal exchange rate

0.4 0.4

0.2 Baseline 0.35 Baseline

Optimal 0.3 Optimal
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 0.25
-0.2
0.2
-0.4
0.15
-0.6
0.1
-0.8
0.05
-1 0
-1.2 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.05
-1.4 -0.1

10
The sum of exports and imports is about 160 percent of GDP.

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With the optimal monetary policy rule, the nominal exchange rate is allowed to depreciate
and the central bank promptly cuts interest rates. A depreciated dong and supportive
monetary policy help to dampen the deviation of output from equilibrium and keep inflation
close to target.

D. Tighter U.S. monetary policy

Interest rates have been extraordinarily low in the U.S. for an extended period following the
Global Financial Crisis. Easy monetary conditions in the U.S. have benefitted emerging
markets including Vietnam through low external borrowing costs. As the U.S. economy
strengthens and moves closer to potential, a gradual tightening of monetary conditions in the
U.S. becomes likely. The taper tantrum of 2013 when global bond yields and emerging
market spreads spiked in response to speculation about an end to quantitative easing provides
an example of the possible dislocations associated with a shift in U.S. monetary policy.
Vietnam is exposed to spillovers from U.S. monetary tightening through rising external
borrowing costs and effective appreciation if the close link between the dong and the U.S.
dollar is maintained.

We present model-based impulse responses to a one-standard deviation increase in U.S.

interest rates in Figure 10.11 This shock is in addition to the U.S. monetary policy tightening
in the model generated out-of-sample forecasts in section V.D. Under the baseline model
specification, the authorities let the exchange rate depreciate in response to higher U.S.
interest rates. The dong depreciation supports output, more than offsetting the negative
impact from lower external demand and higher domestic interest rates. As a result of the
positive output gap and depreciation, inflation remains elevated for an extended period.

Under a more flexible exchange rate regime with a higher weight on output stabilization in
the monetary policy rule (the optimal model), the authorities would initially let the exchange
rate depreciate more than under the baseline in response to the negative external shock. The
dong depreciation stabilizes output, but more active monetary policy keeps inflation
relatively stable and output returns faster to equilibrium than under the baseline model. The
model demonstrates that by allowing more exchange rate flexibility in the face of a
tightening in U.S. interest rates, greater macroeconomic stability can be achieved.

11
In the data, a one standard deviation move in U.S. rates is 0.21 percentage points.

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Figure 10. Tighter U.S. Monetary Policy

Output gap Inflation

0.02 0.06
Baseline Baseline
0.015 Optimal 0.04 Optimal

0.01 0.02

0.005 0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
0 -0.02
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.005 -0.04

-0.01 -0.06

Interest rate Nominal exchange rate

0.2 0.08
Baseline 0.07 Baseline
0.15
Optimal Optimal
0.06
0.1
0.05
0.05 0.04

0 0.03
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 0.02
-0.05
0.01
-0.1
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.15 -0.01

E. Food Prices Shock

Figure 11 presents impulse response functions for a one standard deviation shock in food
price inflation under the baseline and optimal monetary policy rules. In the baseline model,
the central bank reacts to inflation by increasing the nominal interest rates by about 100 basis
points initially. However, the rate hike does not fully offset inflation so that real interest rates
decline which leads to an initial nominal depreciation. Rising nominal interest rates lead to a
decline in output in the medium-term.

With the optimal monetary policy rule, the authorities react strongly to the increase in
inflation raising interest rates by 400 basis points. This leads to an increase in real interest
rates and initial nominal appreciation followed by subsequent depreciation. The combined
effect of these policies is an earlier contraction in output, and an earlier and quicker recovery.
Accumulated output losses are lower than in the baseline model and inflation returns to target
more quickly in the optimal model.

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 21

Figure 11. Food Price Shock

Output gap Inflation

0.1 2
Baseline Baseline
0.05 Optimal Optimal
1.5

0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 1
-0.05
0.5
-0.1

0
-0.15
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

-0.2 -0.5

Interest rate Nominal exchange rate

5 0.6
Baseline Baseline
4 0.4
Optimal Optimal
3
0.2
2
0
1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-0.2
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
-1 -0.4

-2 -0.6

VIII. CONCLUSIONS

The Vietnamese authorities place high importance on maintaining macroeconomic stability

with robust sustainable economic growth and low inflation. Monetary and exchange rate
policy is essential to achieve this goal. In recent years, the focus of monetary policy has been
on the exchange rate as the nominal anchor. Maintaining a de facto exchange rate targeting
regime will become increasingly difficult as Vietnam faces asymmetric shocks compared to
the U.S. An exit of U.S. monetary policy from quantitative easing will likely test Vietnamese
monetary policy. The SBV plans to gradually implement a forward-looking monetary policy
framework focused on using inflation as a nominal anchor with greater exchange rate
flexibility.

We estimate a stochastic general equilibrium model for Vietnam to aid the analysis of
different monetary and exchange rate policies through a consistent framework that formally
models and clarifies transmission mechanisms, measures policy stances and allows
forecasting given policy actions. The model provides a good fit for actual Vietnamese data
over the last 15 years and performs well in in-sample forecasting.

The model estimation provides insights into some structural features of the Vietnamese
economy. We find that the inflation process is very persistent, which implies that monetary

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policy has to maintain a tight stance for a prolonged period of time to bring inflation back to
the desired target. This result is not unusual given Vietnam’s level of development. The
development of an inflation target regime, combined with improved central bank credibility
and a better understanding of the monetary transmission mechanism, would over time lower
the necessary adjustments in policy interest rates to contain inflation and inflationary
pressures. The estimation of Phillips curves for core and food/fuel inflation shows the
expected result that monetary policy has little impact on food inflation, and a larger impact
on core inflation. These results imply that the sacrifice ratio in Vietnam, the amount of output
adjustment necessary to steer inflation, is relatively large and stress the importance of a more
active monetary policy that focus on inflation stability.

In addition to the baseline parameterization of the model, we derive an optimal monetary

policy rule that jointly minimizes the variability of output, inflation, and the exchange rate.
The optimal model places a greater weight on the output gap as the intermediate target to
achieve inflation stability, while allowing greater exchange rate flexibility to absorb shocks.
The optimal monetary policy function delivers greater macroeconomic stability (reduced
inflation and output variability) with only a small increase in exchange rate variability. Over
longer periods, the more flexible exchange rate regime does not increase exchange rate
variability by much, as large forced exchange rate changes become less necessary.

Finally, 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 buffering role a flexible exchange rate can
play to facilitate internal and external adjustment.

The model in this paper provides a tool for a rigorous approach to monetary and exchange
rate policy analysis and to support the implementation of a forward-looking monetary policy
framework. To transition to a more inflation-centered monetary policy regime, other practical
issues also need to be addressed (see Laxton and others 2009 for an overview of practical
steps towards an IT targeting regime).

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Table A1: Priors and Estimated Posteriors

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