Transmission Effects in the Presence of Structural Breaks: Evidence from South-Eastern European Countries

Transmission Effects in the Presence of Structural Breaks: Evidence from South-Eastern European Countries

In this paper, we investigate the monetary transmission mechanism through interest rate and real effective exchange rate channels.

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The integration procedure of the South-Eastern European economies to the European Union (EU) is continuously evolving and becomes intense during the last decade. For instance, some of the South-Eastern European countries are either already members of the European Union (EU) or the Eurozone, or associated with the EU; and some others are set to become EU members. Of course, this implies that the EU affects the above countries in a more systematic way. At the same time, the economic transactions in this region have become more significant and systematic, leading banks, enterprises, trade and individuals to extend their activities in the whole region. Thus, there is a need of systematic and detailed research about the economic policies of the countries in this region, especially in our days when the current financial and debt crisis in the Eurozone is at stake. On the one hand, Greece, which is a Eurozone member since 2001, is in deep recession with high sovereign debt, and having signed the Memoranda I and II with the ECB-EU-IMF, is in fiscal contraction and faces high unemployment. On the other hand, the emerging economies of the South-Eastern Europe are characterised by relatively high current account deficits and are more vulnerable to the deterioration of the international economy, since they have been negatively affected by the reduction of external demand and the increase in the cost of borrowing from abroad.

In the present paper we attempt to investigate the monetary transmission mechanism for five countries of South-Eastern Europe, namely Bulgaria, Croatia, Greece, Romania and Turkey. Especially for the transition economies (Bulgaria, Croatia and Romania) this investigation is quite important, since it will allow us to understand how fast, and to what extent, a change in the central bank’s instruments modifies domestic variables, such as inflation. Note that an increasing number of transition economies are already making use of inflation targeting regime, or are planning to do so. Also, it is important to evaluate whether monetary transmission operates differently in the transition economies. Coricelli, Égert and MacDonald, (2006) analysed monetary policy transmission mechanism in Central and Eastern Europe through four channels: (i) interest rate channel, (ii) exchange rate channel, (iii) asset price channel, and (iv) broad lending channel. In the present analysis we will focus on the interest rate and real effective rate channels.

The literature about monetary policy transmission mechanism is quite large and extending, both in the theoretical and empirical frameworks. Regarding the interest rate channel, there are three approaches. The ‘cost of funds’ approach, which tests how market interest rates are transmitted to retail bank interest rates of comparable maturity (De Bondt, 2002), the ‘monetary policy’ approach, which directly tests the impact on retail rates of changes in the interest rate controlled by monetary policy (Sander and Kleimeier, 2004a), and a unifying approach that includes two stages: the pass-through from the monetary policy rate to market rates and the transmission from market rates to retail rates. Note that the interest rate pass-through is usually investigated using an error correction model (ECM) framework. During the last two decades, several researchers have focused on the transition countries of the Central and Eastern Europe. They have mainly studied the asymmetry of the adjustment process, in relation to the Eurozone countries, and (b) the long-run pass through. Regarding the former their results are mixed (Opiela, 1999; Crespo-Cuaresma, Égert and Reininger, 2004; Horváth, Krekó and Naszódi, 2004; Sander and Kleimeier, 2004b; Égert, Crespo- Cuaresma and Reininger, 2006), while regarding the latter their results indicate that both the contemporaneous and long-run pass-through increase over time, while the mean adjustment lag to full pass-through decreases, as more recent data can be used (Crespo-Cuaresma, Égert and Reininger, 2004; Horváth, Krekó and Naszódi, 2004; Sander and Kleimeier, 2004b). The exchange-rate pass-through in the transition economies has also been studies by several researchers, using mainly vector autoregressive (VAR) and vector error-correction (VECM) models (see, for instance, Darvas, 2001; Mihaljek and Klau, 2001; Coricelli, Jazbec and Masten, 2003; Dabušinskas, 2003; Gueorguiev, 2003; Bitâns, 2004; Kara et al., 2005; Korhonen and Wachtel, 2005).

The novelty of this paper lies on the following issues. Firstly, we use the most recent data from the mid-1990s to 2011, in order to establish a valid long-run relationship for each sample country and to estimate impulse response functions. Secondly, recently developed Lagrange Multiplier (LM) unit root (Lee and Strazicich, 2003) and cointegration tests (Johansen, Mosconi and Nielsen, 2000 and Lütkepohl and Saikkonen, 2000, and their extensions in several recent papers noted below) have been implemented in the analysis. These tests allow for structural breaks in the data. Such breaks are important in this context, since the economic policies implemented in the sample countries are likely to have caused structural shifts in the level and trend of their variable. Additionally, the sample countries are heterogeneous and in different stages of integration with the EU: Bulgaria and Romania joined the EU in 2007 after a long transition period from centrally-planned to free market economies; Croatia will join the EU in 2013 having also followed a long transition period; Greece is a Eurozone member since 2001; and Turkey has settled a customs union with the EU in 1996, is under negotiations for EU membership in the future, and also had a stand-by agreement with the IMF for a number of years. 

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