The Channel of Monetary Transmission in Thailand via Inflation Targeting: A Structural VAR Analysis

After the Asian currency crisis, Thailand shifted to a floating exchange rate regime, and has since May 2000 adopted inflation targeting as the cornerstone of its monetary policy. The key monetary policy instrument is the 14-day repurchase rate, and the target is to maintain core inflation in the range of 0–3.5%. Fully fledged inflation targeting is well regarded and there was no deviation from the target range between May 2000 and June 2005. Accordingly, the Bank of Thailand is assumed to have controled the rate of inflation within the target range over the sample period.<br>The aim of this paper is to examine, using a structural vector autoregression (SVAR), the monetary transmission mechanism and the effects of monetary policy shocks on inflation or other variables in Thailand. We analyzed estimated impulse responses and variance decompositions in two SVARs with short-run restrictions. One of the restrictions reflects a normal monetary channel, and the other a credit channel. According to the estimated impulse responses of the former model, we find that a contractionary monetary policy shock does not instantly lead to a fall in base money and it is impossible to explain the movement of output in the monetary transmission mechanism. However, according to the estimated impulse responses of the latter model, the movements of all variables can be explained theoretically. Moreover, the fractions of forecast error variances attributed to monetary policy shocks in the latter model are also found to follow the results of impulse responses.<br>These empirical results indicate that monetary policy shocks finally affect inflation. Regarding the monetary transmission mechanism, however, the operations of Thailand’s monetary policy seem to affect more private credit or commercial bank credit than money supply or monetary base. That is, not only the monetary channel but the credit channel is assumed to be important for explaining the monetary transmission mechanism because the financial sector of Thailand may not yet have matured. Furthermore, the new finding is that the empirical evidence indicates that a contractionary monetary policy shock (a rise in the interest rate) leads a rise in real output.This is paradoxical according to standard macro-economic models. A suitable rise in interest rates may stimulate commercial banks’ incentive for lending to the private sector because a credit squeeze occurred in Thailand following the Asian currency crisis.