Effectiveness of monetary policy: Application of modified Peter and Clark (PC) algorithms under Graph-Theoretic Approach
Keywords:monetary policy, inflation, causality, Graph theory
It is common practice that central banks around the world must adopt an inflation targeting framework; based on the assumption that inflation could be reduced by increasing interest rates. On contrary, the theoretical literature and data-based evidences differ remarkably. The arduous attached in finding the true association and causation is the existence of multiple monetary transmission channels. Theoretical literature lists both monetary and non-monetary channels linking interest rate and inflation. However, most of the existing studies are focused on single equation model ignoring other parallel channels. This study is first of its kind where we have developed modified Peter and Clark (PC) algorithm of the Graph-Theoretic approach taking all the monetary and non-monetary channels to determine the causal nexus between monetary policy and inflation. The results show that, causality is running from interest rate towards inflation; suggesting a positive and significant long run relationship of interest rate with inflation in case of Pakistan. Furthermore, monetary policy have cost-side effects on inflation; however, the monetary policy becomes counterproductive whenever high interest rate is used to decrease cost push inflation. Therefore, there is need of serious rethinking about current monetary policy regime.JEL Codes - E4; E5; E42; E52
Angelina, S., and Nugraha, N. M., 2020. Effects of Monetary Policy on Inflation and National Economy Based on Analysis of Bank Indonesia Annual Report. Technium Social Sciences Journal, 10(1), 423-435.
Asari, F. F. A. H., Baharuddin, N. S., Jusoh, N., Mohamad, Z., Shamsudin, N., and Jusoff, K., 2011. A vector error correction model (VECM) approach in explaining the relationship between interest rate and inflation towards exchange rate volatility in Malaysia. World Applied Sciences Journal, 12(3), 49-56.
Asgharpur, H., Kohnehshahri, L. A., and Karami, A., 2007. The relationships between interest rates and inflation changes: An analysis of long-term interest rate dynamics in developing countries. Paper presented at the International Economic Conference on Trade and Industry (IECTI), Bayview Hotel Georgetown, Penang.
Barth, M. J., and Ramey, V. A., 2001. The cost channel of monetary transmission. NBER Macroeconomics Annual, 16, 199-240. http://dx.doi.org/10.1086/654443
Charemza, W. W., and Deadman, D. F., 1997. New directions in econometric practice: Books.
Demiralp, S., and Hoover, K. D., 2003. Searching for the causal structure of a vector autoregression. Oxford Bulletin of Economics and Statistics, 65, 745-767. http://dx.doi.org/10.1046/j.0305-9049.2003.00087.x
Fazal, R., Rehman, A., and Alam, A., 2020. Tracing Causality and Co-Movement Between Pakistani and The Leading Foreign Stock Markets: A Graph Theoretic Approach. International Review of Management and Business Research, 9(4).
Fazal, R., Rehman, S. A. U., Rehman, A. U., Bhatti, M. I., and Hussain, A., 2021. Energy-environment-economy causal nexus in Pakistan: A graph theoretic approach. Energy, 214, 118934. http://dx.doi.org/10.1016/j.energy.2020.118934
Gibson, A. H., 1923. The Future Course of High Class Investment Values. Banker’s Magazine, 115(January), 15-34.
Hernando, I., 1998. The credit channel in the transmission of monetary policy: the case of Spain. Topics in Monetary Policy Modelling, 257-275. https://www.bis.org/publ/confp06j.pdf.
Hoover, K. D., 2005. Automatic inference of the contemporaneous causal order of a system of equations. Econometric Theory, 21(1), 69-77. http://dx.doi.org/10.1017/S026646660505005X
Hoover, K. D., 2020. The Discovery of Long-Run Causal Order: A Preliminary Investigation. Econometrics, 8(3), 31. http://dx.doi.org/10.3390/econometrics8030031
Hu, Q., and Quan, J. J., 2005. Evaluating the impact of IT investments on productivity: A causal analysis at industry level. International Journal of Information Management, 25(1), 39-53. http://dx.doi.org/10.1016/j.ijinfomgt.2004.10.006
Khumalo, L. C., Mutambara, E., and Assensoh-Kodua, A., 2017. Relationship between inflation and interest rates in Swaziland revisited. Banks and Bank Systems, 12(4), 218-226. http://dx.doi.org/10.21511/bbs.12(4-1).2017.10
Kumar, V., Acharya, S., and Ho, L. T., 2020. Does Monetary Policy Influence the Profitability of Banks in New Zealand? International Journal of Financial Studies, 8(2), 35. http://dx.doi.org/10.3390/ijfs8020035
Ma, X., Yang, R., Zou, D., and Liu, R., 2020. Measuring extreme risk of sustainable financial system using GJR-GARCH model trading data-based. International Journal of Information Management, 50, 526-537. http://dx.doi.org/10.1016/j.ijinfomgt.2018.12.013
McCallum, B. T., 1981. Price level determinacy with an interest rate policy rule and rational expectations. Journal of Monetary Economics, 8(3), 319-329.
Mehwish, M. N., U., S., and K., S. U., 2017. Correlation and Causality between Inflation and Selected Macroeconomic Variables: Empirical Evidence from Pakistan. iBusiness, 9, 149-166.
Mishkin, F. S., 1996. The channels of monetary transmission: lessons for monetary policy (Vol. w5464): National Bureau of Economic Research. http://dx.doi.org/10.3386/w5464
Modigliani, F., 1971. Monetary Policy and Consumption: Linkages via Interest Rate and Wealth Effects in the FMP Model, Consumer Spending and Monetary Policy: The Linkages. Consumer spending and monetary policy: the linkages. Proceedings of a Monetary Conference, 9-28.
Onanuga, A., and Onanuga, O., 2014. The Impact of Interest Rate Channel of Monetary Policy on Output and Prices in Nigeria: An Unrestricted VAR Approach. Journal of African Macroeconomic Review, 4(1), 286-294.
Osterholm, P., and Berger, M. H., 2008. Does money growth granger-cause inflation in the euro area? Evidence from out-of-sample forecasts using Bayesian VARs. IMF Working Papers, 2008(53). http://dx.doi.org/10.5089/9781451869156.001
Parker, M., 2014. Exchange rate movements and consumer prices: Some perspectives. Reserve Bank of New Zealand Bulletin, 77(1), 31-41.
Rashid, A., and Husain, F., 2013. Capital inflows, inflation, and the exchange rate volatility: An investigation for linear and nonlinear causal linkages. Pakistan Development Review, 52, 183-206. http://dx.doi.org/10.30541/v52i3pp.183-206
Rehman, A. U., 2015. Revival of legacy of Tooke and Gibson: Implications for monetary policy. Journal of Central Banking Theory and Practice, 4(2), 37-58. http://dx.doi.org/10.1515/jcbtp-2015-0008
Rehman, A. U., and Malik, M. I., 2014. The modified R a robust measure of association for time series. Electronic Journal of Applied Statistical Analysis, 7(1), 1-13.
Saini, K. G., 1982. The monetarist explanation: The experience of six Asian countries. World Development, 10(10), 871-884. http://dx.doi.org/10.1016/0305-750X(82)90062-6
Sims, C. A., 1992. Interpreting the macroeconomic time series facts: The effects of monetary policy. European Economic Review, 36(5), 975-1000. http://dx.doi.org/10.1016/0014-2921(92)90041-T
Swanson, N. R., and Granger, C. W., 1997. Impulse response functions based on a causal approach to residual orthogonalization in vector autoregressions. Journal of the American Statistical Association, 92(437), 357-367. http://dx.doi.org/10.1080/01621459.1997.10473634
Taylor, J. B., 1995. The monetary transmission mechanism: An empirical framework. The Journal of Economic Perspectives, 9(4), 11-26. http://dx.doi.org/10.1257/jep.9.4.11
How to Cite
Copyright (c) 2021 SCIENTIFIC ANNALS OF ECONOMICS AND BUSINESS
This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.
All accepted papers are published on an Open Access basis.
The Open Access License is based on the Creative Commons license.
The non-commercial use of the article will be governed by the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License as currently displayed on https://creativecommons.org/licenses/by-nc-nd/4.0
Under the Creative Commons Attribution-NonCommercial-NoDerivatives license, the author(s) and users are free to share (copy, distribute and transmit the contribution) under the following conditions:
1. they must attribute the contribution in the manner specified by the author or licensor,
2. they may not use this contribution for commercial purposes,
3. they may not alter, transform, or build upon this work.