The long-term interest rate will equal the average of expected future short-term interest rates, meaning that lower short-term real interest rates lead to a fall in long-term real interest rates. These lower real interest rates create an increase in fixed asset investment by businesses, housing investment by households, durable goods spending, and inventory investment, all of which will increase aggregate output.
The fact that the real interest rate rather than the nominal interest rate affects spending provides an important mechanism for how monetary policy can stimulate the economy, even if the nominal interest rate hits a floor of zero during a deflationary period. With a nominal interest rate at zero, an expansion in the money supply (M rising) can raise the expected price level (P e rising), which raises inflation expectations (π e rising), thereby lowering the real interest rate (i r falling), even if the nominal interest rate is fixed at zero. The stimulus to spending through the real interest rate channel is expressed as follows:
M increases P e increases π e increases i r decreases I increases Y increases
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This mechanism thus shows that monetary policy remains effective even when nominal interest rates are zero. Indeed, this mechanism is a central discussion among monetarist economists about why the US economy did not become trapped in a liquidity trap during the Great Depression and why expansionary monetary policy prevented a sharp decline in output during this period.
1.1.2 Pass-through of policy interest rates into retail interest rates
Rousseas (1985) developed a model describing how commercial banks set retail interest rates. This model is based on the theory of 'markup pricing' 6 under imperfectly competitive banking conditions. According to Rousseas, banks are the price setters in the lending market, banks set retail interest rates by adding their profit margin to variable costs as in equation (1.1).
6 Model of setting selling price with profit added. In this model, selling price includes unit cost
and return on sales.
i = k(u) (1.1)
Where i is the loan interest rate; u is the unit variable cost and k is the variable cost margin or markup 7 .
The main variable cost of banks is the change in the input cost component in which the cost of capital mobilization has a large proportion in lending activities, the input cost is considered as the cost of funds of banks. Rousseas (1985) hypothesized that the cost of capital is an exogenous variable. Thus, the cost of capital is related to the policy interest rate because this interest rate is beyond the scope of the bank's decision and is equivalent to the market interest rate. In the capital supply market segment, banks are considered price takers due to the high level of competition among banks to obtain funds. However, Ho and Saunders (1981)
argue that this is not true in the retail market. The model of Ho and Saunders (1981) 8 predicts that both deposit and lending rates are endogenous variables determined by bank managers in an imperfectly competitive market. More precisely, Ho and Saunders (1981) argue that the variation in interest rates
Retail interest rates depend not only on the cost of capital but also on the marginal interest rate. This part is the difference between the lending interest rate and the deposit interest rate, which is a buffer for commercial banks to face risks. For example, when the demand for new loans does not match the demand for new deposits or vice versa, commercial banks have to borrow or lend in the money market, so commercial banks always face interest rate risks. Depending on the interest rate risk in each period, commercial banks will adjust the marginal interest rate (this is an endogenous variable decided by the bank). This implies that lending interest rates, in addition to the cost of capital, also include marginal profits that vary according to the business cycle. In addition, this behavior of commercial banks implies a balanced relationship between retail interest rates and money market interest rates. If we assume that the central bank can control the interbank market (by increasing or decreasing the amount of cash in this market), there will be a relationship
7 Add-ons in the Pricing Model
8 More detailed discussions are presented in section 1.2.4
The relationship between retail pricing of commercial banks and interest rate control tools of banks
central bank. These tools are policy interest rates.
Based on the pricing models proposed by Rousseas (1985), Ho & Sauders (1981), Bondt (2002), the popular empirical model for studying interest rate pass-through is established as follows:
݅ = ߚ ଵ + ߚ ଶ ݑ (1.2)
Where i is the interest rate set by the bank (retail interest rate), ߚ ଵ is the markup coefficient 9 , u is the cost of funds and ߚ ଶ is the retail interest rate pass-through coefficient.
According to Bondt (2002), the approach to determining lending rates based on the cost of funds satisfies many aspects of bank operations. For example, banks often rely on market developments to decide on short-term lending. Therefore, short-term lending rates will be related to market interest rates. As for long-term lending rates, they are related to long-term government bond interest rates, the long-term bond interest rate represents the bank's opportunity cost. Moreover, deposit interest rates are also related to market interest rates because: (1) deposits and money market instruments are considered investment instruments that can be substituted for each other in the investment decisions of individuals and companies; (2) Both deposits and money market instruments are funding sources that banks can substitute for each other.
In the monetary policy perspective approach, Sander & Kleimeier (2004) argue that changes in market interest rates affect deposit rates, short-term and long-term lending rates through changes in the yield curve of short-term and long-term financial instruments in the money market.
Equation (1.2) shows that the change in retail interest rates is determined by the change in the cost of funds, but the degree of pass-through of the cost of funds into retail interest rates depends on the magnitude of the coefficient ߚ ଶ . This implies that ߚ ଶ can be less than 1, equal to 1, or greater than 1 .
9 This factor represents the markup in the pricing model.
If ߚ ଶ is less than 1 it implies incomplete pass-through, if ߚ ଶ is equal to 1 it implies complete pass-through, and if ߚ ଶ is greater than 1 it implies excessive pass-through.
During the economic cycle, when the central bank adjusts monetary policy (such as the discount rate), market interest rates (such as the interbank rate) will be affected. In this case, commercial banks can pass on the increased costs caused by changes in market interest rates to retail interest rates (such as deposit and lending rates). This process is called interest rate pass-through (Wang & Lee, 2009; Wang & Nguyen, 2010). If commercial banks can pass on all costs to their customers, this is called complete pass-through. In practice, due to financial, regulatory, or policy considerations, most commercial banks may only pass on part of the costs immediately instead of the entire costs. This is called incomplete pass-through. On the other hand, if the pass-through ratio is greater than one, it is called complete pass-through. Regardless of whether the transmission is complete or incomplete, there is an equilibrium or long-run relationship between interest rates, and this relationship is an important factor in determining the effectiveness of monetary policy.
Karagiannis et al. (2010) have a similar view. According to the authors, the study of interest rate pass-through is concerned with the extent to which central bank interest rates and interbank market interest rates are passed on to retail interest rates (deposit and lending rates). Ideally, changes in policy rates should be completely passed on from the market to retail interest rates within a certain period. Therefore, the effectiveness of monetary policy depends on the extent and speed of the pass-through from market interest rates to retail interest rates (Bredin et al., 2001).
In this study, the thesis empirically analyzes the retail interest rate transmission in Vietnam limited to the relationship between changes in policy interest rates (refinancing interest rates) and the exchange rate.
10 Cointegration Approach
The interest rate on one-year treasury bills and the three-month interbank market interest rate are passed on to the three-month deposit interest rate and the lending interest rate for less than 12 months of the average of four state-owned commercial banks 11 .
1.1.3 Retail interest rate pass-through reflects the effectiveness of monetary policy
The effectiveness of monetary policy can be examined through the interest rate transmission channel. When the central bank adjusts short-term interest rates, this action affects real interest rates because commercial banks adjust the lending rates they charge their customers. The interest rate transmission channel becomes effective if commercial banks quickly pass on changes in policy rates to their customers. Otherwise, the interest rate transmission channel is ineffective.
Manna et al. (2001) believe that most central banks use short-term market interest rates as a major monetary policy tool. Manna et al. (2001) also argue that during the transmission process, interest rate fluctuations become an important indicator of monetary policy. In addition, Bredin et al. (2001), Bondt (2002) also consider that the success of monetary policy depends on the speed of transmission and the margin of transmission from market interest rates to retail interest rates. The importance of interest rate transmission lies in the fact that deposit and lending rates directly affect the behavior of the supply and demand sides of funds, so retail interest rate transmission determines economic growth, inflation and the success of monetary policy.
Previously, Cechetti (1999) pointed out the influence of the national financial structure on the monetary policy transmission coefficient. Financial structure affects monetary policy transmission because early studies in industrialized countries found the importance of the banking system and the interest rate channel to be stronger than other channels. From the credit channel perspective, changes in monetary policy management affect the source of
11 Banks include Vietnam Development Investment Bank, Vietnam Foreign Trade Bank,
Vietnam Joint Stock Commercial Bank for Industry and Trade and Vietnam Bank for Agriculture and Rural Development
banks' capital and thus their ability to lend. Firms' access to credit depends on the financial assessment methods applied by banks. This reflects the impact of monetary policy on firms. Firms are strongly affected by monetary policy when their financial resources depend on bank loans. In addition, the financial health of some banks also affects the adjustment of bank policies. Banks with good health are more adaptable to changes in monetary policy than banks with poor health.
1.2 Factors affecting the effectiveness of monetary policy transmission
In this part, the thesis focuses on presenting the factors affecting the effectiveness of monetary policy transmission through the interest rate channel. In other words, these are the factors that make the retail interest rate transmission incomplete. These factors include rigid interest rate adjustment behavior, asymmetric retail interest rate adjustment behavior, the issue of monetary policy transparency, the issue of dollarization and factors related to the behavior of setting marginal interest rates. Marginal interest rates are considered as additional endogenous variables in the retail pricing model of commercial banks.
1.2.1 Rigid retail interest rate adjustment behavior
Studies on retail interest rate pass-through are often concerned with the adjustment process to equilibrium when retail interest rates deviate from this position. Many studies have found evidence of interest rate rigidity, such as Hannan & Berger (1991), Neumark & Sharpe (1992), Cottarelli & Kourelis (1994), Egert et al. (2007).
Aziakpono & Wilson (2010) state that if a change in the policy rate produces a smaller change in the market rate, then the market rate is said to be sticky. Studies also distinguish between short-term and long-term adjustments. If the long-term adjustment shows a strong response of the market rate to the change in the policy rate (in some cases, the adjustment has
In the short run, such an adjustment may not occur. In the short run, due to menu costs, banks react slowly to changes in policy rates. Furthermore, because of limited funding and investment options for bank loans and deposits or asymmetric information, customers do not have many options in the short run. As a result, banks may not feel pressure to adjust their interest rates in the short run when there is a change in policy rates (Cottarelli & Kourelis 1994).
Egert et al. (2007) state that due to long-term and close relationships with customers, banks do not want to adjust interest rates immediately for fear of causing instability. Therefore, there will be a period between long-term and short-term adjustments, and the longer the adjustment in the long term can be seen as evidence of interest rate rigidity.
Aziakpono & Wilson (2010) cited many theoretical studies that often focus on short-term interest rates in the money market, especially on bank deposit and lending rates. Normally, the purpose of the central bank's operations is to influence the overall lending policy of commercial banks, the demand for money and credit in the economy through changes in the liquidity of the banking system and interest rates in the money market. Changes in interest rates in the money market may be transmitted to capital market interest rates as the content of the yield curve expectations theory (Mishkin, 2007). However, according to the liquidity preference theory of the yield curve, due to the risk of long-term debt, long-term interest rates will not respond completely to changes in short-term interest rates. Therefore, banks will want to adjust long-term interest rates lower than short-term interest rates in the money market before changes in policy interest rates.
In theory, there are a number of factors that can influence interest rate adjustments, including: a liberal or controlled monetary policy, the structure of financial markets that reflect concentration,
The concentration of power in a few commercial banks is high or low, the level of financial market openness and the problem of information asymmetry.
First, if a monetary policy directly controls interest rates and credit allocation, interest rates themselves will be rigid because interest rate changes occur only at the command of the bank. In contrast, in a free market monetary policy without regulation, interest rates will be determined based on the market so the adjustment will be more flexible (Gidlow, 1998).
The structure of financial markets also affects interest rate adjustment. Financial market structure is related to the degree of competition among commercial banks and financial institutions. The degree of competition in the financial system depends on the regulatory environment (e.g., whether regulations are unfair to small, foreign banks) and the openness of financial markets. In a highly competitive market, profit-maximizing behavior requires banks to adjust their interest rates quickly to changes in market conditions. Conversely, if the market is highly concentrated (low competition), banks will adjust their interest rates more rigidly (Cottarelli & Kourelis, 1994).
The ownership structure of banks (state-owned or private) is also a factor that can affect the speed of interest rate adjustment. The banking system based on state ownership leads to the concentration of power in a few banks, which will cause rigid interest rate adjustment as mentioned above. Moreover, due to political pressure or inefficiency, bank interest rates will change slowly when there is an adjustment in the market (Cottarelli & Kourelis, 1994).
The responsiveness of domestic banks to changes in policy rates also depends on the extent to which banks rely on the conditions under which the central bank provides liquidity to commercial banks. If the financial system is open and commercial banks have easy access to international sources of funding, this may reduce their complete reliance on the central bank (Fourie et al., 1999). As a result, in an open financial system,