MONETARY TRANSMISSION MECHANISM IN ESTONIA - EMPIRICAL MODEL Rasmus Pikkani Tallinn 2001 Working Papers of Eesti Pank No 5, 2001

Estonia has conducted effectively monetary policy according to currency board arrangement for nine years already. For this Estonia has traded off its freedom in active monetary policy operations for nominal anchoring economy through exchange rate. In this context Estonian own monetary policy actions could hardly make any difference and Estonian monetary conditions are heavily relying on decisions made by the issuer of anchor currency. At the same time, there are number of factors having influence on the degree of dependence on foreign monetary factors, most important of which is the openness of the economy to all balance of payments flows and the strength of the domestic banking sector. A mix of all possible factors and decision-making rules in the economy specifies directly the speed and the strength of transmission of foreign monetary signal into domestic economy.

The aim of the current paper is to study transmission of ECB monetary policy decisions into Estonian economy. Additionally, absorption of unanticipated foreign and domestic monetary shocks are analysed. For this, rather small macroeconometric model with 11 behavioural equations is specified and estimated. Special emphasis is given on the formation of domestic interest rates and on the intermediation of domestic and foreign funds by domestic banking sector over shock periods. As a result, it is found that the transmission of ECB monetary policy actions over European inter-bank money market into Estonian economy is relatively fast. This is probably mostly due to high openness of the economy and to high price and wage flexibility in Estonia.

Author's e-mail address: Rasmus.Pikkani@mail.ee

The views expressed are those of the authors and do not necessarily represent the official view of Eesti Pank.

CONTENTS

INTRODUCTION TO THE SERIES "MONETARY TRANSMISSION MECHANISM IN ESTONIA"

1. INTRODUCTION

2. THE IDEA OF THE MODEL

2.1. BLOCKS

2.2. CHANNELS, LINKS AND SIGNALS

3. SPECIAL ISSUE

3.1. MEASURING DOMESTIC INTEREST RATES

3.2. FORM OF BANK CREDIT SUPPLY FUNCTION UNDER CBA

4. SPECIFICATION OF THE SYSTEM

4.1. INTEREST RATES

4.2. DEMAND FOR BANK CREDIT AND CREDIT RATIONING

4.3. INFLATION EXPECTATIONS

4.4. DOMESTIC DEMAND AGGREGATES

4.5. TRADE AND SERVICE BALANCE

4.6. FIXED CAPITAL AND PRODUCTION FUNCTION

4.7. PUBLIC SECTOR

4.8. ADDITIONAL IDENTITIES

5. SPECIFICATION AND ESTIMATION OF THE EMPIRICAL MODEL

5.1. CONDITION ON INTERNATIONAL MONEY MARKETS

5.2. DOMESTIC INTEREST RATES

5.3. BANK CREDIT

5.4. PRIVATE CONSUMPTION EXPENDITURE

5.5. PRIVATE FIXED CAPITAL FORMATION

5.6. TRADE AND SERVICE BALANCE

5.7. PUBLIC SECTOR

5.8. INFLATION EXPECTATIONS

5.9. POTENTIAL OUTPUT

5.10. GETTING THE MODEL TOGETHER

5.11. BIGGEST SHORTCOMINGS OF THE CURRENT SPECIFICATION

5.12. ADEQUACY OF THE MODEL

6. SIMULATIONS OF MONETARY IMPULSES THROUGH ESTIMATED TRANSMISSION MODEL

6.1. CHANGES IN THE ECB MAIN REFINANCING RATE

6.2. FOREIGN MONEY MARKET SHOCK

6.3. DOMESTIC INTEREST RATE SHOCK

6.4. NOMINAL EFFECTIVE EXCHANGE RATE SHOCKS

CONCLUSION AND FUTURE PROSPECTIVE

REFERENCES

APPENDIX 1. FIGURES AND FABLES

APPENDIX 2. ESTIMATED MODEL

APPENDIX 3. MODEL'S EX POST FORECAST

APPENDIX 4. RESULTS FORM EX ANTE SHOCKING

APPENDIX 5. RESULTS FROM SIMULATED MONETARY SHOCKS

GLOSSARY

Monetary Transmission Mechanism in Estonia - Empirical Model, Working Papers of Eesti Pank, No 5, 2001 (PDF*)

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