LINEAR TAYLOR RULE APPLICATION IN THE STUDY OF VIETNAMESE

OFFICIAL TARGETED INFLATION RATE

Summary
This paper is performed based on the study of Vietnams macroeconomic data ranging
from January 2008 to December 2015. Using OLS and GMM methods, this paper was
performed to examine the suitability of the use of the linear Taylor rule in an attempt
to describe Vietnams monetary policy through the study of the relationship between
inflation rate and related economic factors. This paper also proceeds to calculate the
true targeted inflation rate for Vietnam. Based on our calculations, we will compare
and discuss the possible explanations for such difference, if it may arise. Our
econometric result shows that Vietnams monetary policy must be explained under the
usage of the linear forward looking Taylor rule, in the sense that the explained variable
is the targeted inflation rate, not the past inflation rate. Our result also shows that the
State Bank of Vietnam (SBV) incorporates the linear Taylor rule into its inflation
control regime. The calculated true targeted inflation rate for Vietnam is fairly stable,
oscillating around 4.5%. This paper also presents evidence for the SBVs
consideration of M2 money supply as well as global economic trends, represented by
the use of the USA and Chinas inflation rate. However, we cannot find evidence
supporting the alleged effects of financial conditions on Vietnams targeted inflation
rate policy.
Key words: monetary policy, Taylor rule, targeted inflation rate, output gap, financial
condition index.

1. Overview
Monetary policy plays a substantial role in keeping inflation low, creating jobs and
stimulating economic growth (Milton Friedmann, 1968). Therefore, state banks must
be responsible for creating efficient and suitable monetary policies. There are two
ways that a state bank can choose to run its monetary policy which are following a
strict and rigid set of rules or being flexible between monetary and economic goals. Of

course, being flexible gives a state bank a lot of freedom to continuously switch
among goals, at the cost of economic instability, which basically goes against the
point of a sound monetary policy (Finn E. Kydland and Edward C. Prescott, 1977). In
the long run, this policy uncertainty will take its toll on public trust and expectations.
On the other hand, following a rigid set of rules can help state banks keep inflation
rate low as well as avoiding a high unemployment rate (Finn E. Kydland and Edward
C. Prescott, 1977; Barro and Gordon, 1983). This advantage fuels the trend of
imposing and following strict and rigid rules in monetary policy with the most popular
being the Taylor rule. Although the SBV has never officially declared to follow any
particular rule in its monetary policy practices, examining them under a scope of the
linear Taylor rule may help explain and furthermore, build a better policy.

2. Literature review
The subject of inflation in general and Taylor rule in particular have witnessed a
rigorous attention. The original Taylor rule has also been updated with various
modernization attempts and as a result, render the study of complex monetary
behaviors of state banks possible. Clarida et al (1998 & 2000) proposed a forward
looking Taylor rule under which state banks will use targeted inflation rate and
forecast output gap as variables. This is one of the first attempts to use the Taylor rule
as a tool to conduct monetary policy, a significant leap from the original rule which
was mostly explanatory in nature. Fourcans and Vranceanu (2004); Sauer and Sturm
(2007) also stressed the importance of the Taylore rule in studying ECBs monetary
policies. Various papers also suggest state banks consideration of other economic
factors. Fourcans and Vranceanu (2004) found evidence suggesting that changes in
foreign exchange rates may affect the ECBs monetary behaviours. This is similar to
the conclusion of Chadha et al (2004) for the FED, BOE, BOJ as well as Lubik and
Schorfheide (2007) for the BOC (Bank of Canada) and the BOE. Regarding the
effects of money supply on monetary policy, Fendel and Frenkel (2006); Surico
(2007b) concluded that although they could not find supporting evidence for a direct
relation between them, money supply can be a useful tool to forecast future inflation
rate. The most controversial extension to the original Taylor rule however is the
2

addition of financial conditions into monetary policy consideration. Cecchetti et al

(2000); Borio and Lowe (2002); Goodhart and Hofmann (2002); Sack and Rigobon
(2003); Chadha et al (2004); Rotondi and Vaciago (2005) all were in favor of adding
financial conditions into monetary policy consideration. Bernanke and Gertler (1999,
2001); Bullard and Schaling (2002) however argue against controlling asset prices.
The latter suggests that since asset prices have already been incoporated into inflation
rates, monetary policies should not consider them twice. Instead, they think that state
banks should tackle asset prices only when (1) they can significantly affect targeted
inflation rate and (2) after the fallout of economic recessions. Montagnoli and
Napolitano (2005), one of the strongest advocates for financial condition
consideration found evidence for the necessity for information contained in financial
conditions in applying Taylor rule as a model for monetary policy. Another popular
extension to the original Taylor rule is the undeniable fact that state banks objectives
may not be linear. Various studies have shown that, asymmetries in monetary policies
can be derived from nonlinear macroeconomic models (Dolado et al, 2005) or
nonlinear objectives (Dolado et al, 2000; Nobay and Peel, 2003; Ruge and Murcia,
2003; Surico, 2007a) or both (Surico, 2007b). The last one was able to show a certain
type of loss aversion in monetary policy. Castro (2011) showed that FED, BOE and
ECB all apply the forward looking Taylor rule in their monetary policy construction as
well as conduction. Particularly, the ECB also shows signs of financial condition
consideration. Although the literature background on this subject may be
contradicting, all agree that (1) there exists a trend of imposing and following a rigid
set of rules in monetary conduction in the world and (2) it is generally beneficial for
state banks to do so. Whether the Vietnams SBV uses the linear forward looking
Taylor rule in its monetary policy construction is the primary concern of this paper.
3. Methodology
3.1 Model
To examine whether the SBV uses the linear forward looking Taylor rule in its
monetary policy construction, this paper employs both the original Taylor model and
its extended version.

Model 1: The original Taylor rule

i t =r + + ( t )+ ( y t y t )

Model 2: The forward looking Taylor rule

n

'
i t= 0+ 1 t +k + 2 ~yt + p + x t +q + j i t j+ t
j=1

Next, based on the paper of Castro (2011), we calculate the true targeted inflation rate
for Vietnam based on this function derived from the Taylore rule function:
* =
In which,

and

r
1

are the constant and the estimated coefficient of targeted

inflation gap at every model respectively; r is the long term parity interest rate.
3.2 Variable description.
3.2.1 Independent variables and hypothesis
Inflation
Inflation shows a continuous appreciation of prices or a continuous depreciation of
buying power of money in an economy. Therefore, to calculate Vietnams inflation
rate, we use the percentage of change in CPI index, seasonally adjusted of course.
Inflation =

It
I t 1

100%

In which, It is the current periods CPI, It-1 the previous one. According to Taylor rule,
for a monetary policy to be stable, the inflation gaps coefficient must be greater than
1. Therefore, we expect this coefficient for Vietnam to be greater than 1 and
significant. Furthermore, we also calculated the true targeted inflation rate for
Vietnam using r as an average of the discount rate (D_rate).
Output gap
Output gap is a variable measuring the % difference between real and potential output
of an economy, in which potential output is the highest level of output when all
resources are used. This variable is used to indicate whether an economy is too hot
or cold at any given period. To be more specific:

 If Outputgap > 0: real output exceeds potential output, inflationary pressure rises, state
banks will increase interest rates to stop the economy from becoming too hot.
If Outputgap < 0: real output is lower than potential output, deflationary pressure
rises, state banks will lower interest rates in order to encourage consumption and
investment.
The output gap variable in this paper is calculated as the % difference between the
logarithm of industrial production index and its trend value achieved by running it
through the Hodrick Prescott filter. Based on Taylor rule, the coefficient for this
variable must be greater than 0. Therefore, we expect this coefficient for the Vietnams
output gap variable to be significant and greater than 0.
Money supply growth (M2)
Castro (2011) showed that to achieve monetary goals, one of which is low inflation
rate, state banks rely on two frameworks: economic and monetary analysis. While
economic analysis can show the effects of economic factors, monetary analysis can
show the effects of monetary factors. Therefore, to examine the effects of money
supply growth, we add the M2 growth variable and expect its coefficient to be
significant and negative.
Financial condition Index (FCI)
Some papers have added financial conditions or information as an extension to the
original Taylor rule model to examine the effects of those aforementioned on state
banks behavior. Based on Castro (2011), we will also use a financial condition
variable in our model to help explain the SBVs supposed Taylor rule obeying
behavior. However, financial data needed for the construction of this variable is
limited in the case of Vietnam, so we use only the real effective exchange rate (REER)
as representative for FCI.
Output gaps of China and the USA (China_OG and US_OG)
Aside from the usual variables, we also set out to test if the SBV actually considers
global economic trends in its monetary policy construction. To test this, we use the
output gap of the USA (US_OG) and China (China_OG) to represent current
economic trends since the USA and China are two major drivers of the global
5

economy. In the current global economic context, as Vietnam is trying to take

advantage of economic globalization, changes in global economics will more or less
affect Vietnams economy. This will in turn affect decisions made by the SBV.
Therefore, we expect the coefficient of this variable to be significant and positive.
3.2.2 Dependent variable Discount rate (D_rate)
We use the discount rate as a tool of monetary authorities instead of basic interest rate
since (1) in Vietnam, this discount rate represents the effects of monetary policies on
the economy and (2) the basic interest rate does not have such a strong and direct
effect as the discount rate.
3.3 Data and estimation methods
Using the monthly data set of Vietnam retrieved directly from Thompson Reuterss
Data Stream ranging from January 2008 to December 2015, the estimation is
performed as follows:
Step 1: Stationarity test by using ADF, KPSS test and unit root test NP with
stationarity accepted in at least one out of the three tests.
Step 2: Regression of aforementioned estimating functions by using OLS with original
Taylor rule model and GMM with extended Taylor rule model. Besides, we also
calculate the true targeted inflation rate of the SBV based on the coefficients achieved
from the estimation.
Step 3: Using Sargan/Hansen J-test (1982) to determine the validity of the explaining
variable set used in GMM.

4. Results
4.1 Stationarity test
Table 4.1: Stationarity test results.
Variable

ADF test

KPSS test

NP test

D_rate

-2.2328

0.3428+

-2.3306**

Inflation

-3.8233***

0.5311++

-2.0704**

OutputGap

-12.8937***

0.0970+

-4.7328***

M2

-2.1922*

0.2889+

-2.1054**

L_rate

-2.4070*

0.6292+

-2.2691**

REER_gap

-4.0907*

0.0781+

-1.1390

US_OG

-4.2879***

0.0712+

-0.8490

China_OG

-3.5745***

0.0463++

-2.2401**

Note: ADF = Augmented Dickey-Fuller test. NP = Ng-Perron (2001) tests MZt unit root. (MZa, MSB
and MPT all show similar results). KPSS = Kwiatkowski-Phillips-Schmidt-Shin (1992) tests for
stationarity. Newey West automatic bandwidth selection procedures used in KPSS and in both
situations.
*

Unit root rejected at 10% significance level

**

Unit root rejected at 5% significance level

***

Unit root rejected at 1% significance level

stationarity unrejected at 10% level

++

stationarity unrejected at 5% level

+++

stationarity unrejected at 1% level

Stationarity tests show that all strands are stationary at ***1%, **5%, *10%.
Therefore, Vietnams data set is stationary.

4.2 Estimation results

Table 4.2: Linear Taylor rule estimation for Vietnam

Inflation

1.4328**

1.6546**

(4.5221)
OutputGa
p

-0.1175
(-0.2849)

(7.6501)

4.5068**
*

2.3687**
*

(12.0612)
0.9836**

(350.169
8)

1.2706**

1.8139***

(2.2323)

(4.0978)

-0.1032

0.7493**

1.3541***

(-0.5124)

(2.5181)

(3.9223)

0.9508**

0.9689**

0.9775***

(245.341

(171.159

(264.734)

1.407***

(10.3785
)
0.9149**

D_rate(-1)

(4.3409)
0.936***
(81.5985
)

(-4.0874)

7
16.8927
(3.1897
)
8.1238
(2.6652
)

0.999**
*

L_rate(-1)

(0.0032
)
-0.92***

M2

(12.1958)
3.501***

REER_ga
p

(13.0071)
9.6801**
*

US_OG

(6.1849)
18.4185**

China_O

(8.3108)
2.33%

4.81%

4.75%

0.02%

4%

4.78%

0.11%

18.6434

Hansen

15.2399

15.4515

18.3201

15.2053

15.2331

J-stat

[0.9999]

[0.9999]

[0.9998]

[0.9999]

[0.9999]

0.9387

0.9424

0.965

1.7436

1.8587

1.865

Adj. R2

0.1649

0.9383

0.9499

DW

0.1942

1.7440

2.0586

2.1824

[0.9998
]

Note: Instrumental variable set consists of a constant and lagged values from 1 to 12 of Inflation,
Outputgap, M2, lagged values from 1 to 12 of D_rate; identical lagged values of other variables are
also used when added to the function. Long term average D_rate equals to

= 7.17%. P-value of

Hansen test is shown in square parentheses. DW is results of Durbin-Watson.

1st column. Although the coefficient of Inflation is statistically significant and

complied to Taylor rule, this model does not explain the reactions of the SBV to
changes in output gap since gamma is less than 0 and statistically insignificant.
Implied targeted inflation rate calculated in this instance is 2.33%. However, since
gamma is less than 0, which goes against the basic principles of Taylor rule and at the
same time proves to be statistically insignificant. Therefore, this 2.3% value is
unrealistic. We conclude from this result that the monetary policy of the SBV cannot
be explained by a simple Taylor rule. So we move on to perform estimations with the
extended Taylor rule model. With all the estimations shown from column 2 to 7, we
apply the GMM method with smooth interest rates transition and with a degree of lag
that we deem enough to eliminate any possible autocorrelation. We chose k = 6 and p
= 6, with every other variable lagged one month. The result shown in column 2
improves over the first estimation, with the SBV reacting much more significantly to
changes in the targeted inflation rate. Specifically, a 1% increase in targeted inflation
rate will lead to a 1.65% increase in discount rate. This result nicely corresponds to the
principles set by Taylor rule. Furthermore, a 1% increase in forecast output gap will
lead to a 2.38% increase in discount rate, proving that the SBV also cares about
economic cycles. Implied targeted inflation rate is calculated to be 4.81%. Estimation
result shown in column 3 gives evidence supporting our theory that M2 plays an
important role in the SBVs consideration. The coefficient for this variable is
statistically significant. Besides, M2 is also a very good indicator of future inflation so
we keep M2 as an important instrumental variable. Calculated implied targeted
9

inflation rate now sits at 4.75%. Estimation result in column 4 shows that all but
output gaps coefficient is statistically significant. However, the coefficient of
Inflation is less than 1, violating the Taylor rule, at the same time, implied targeted
inflation rate stands at 0.02%, too low to be realistic. Therefore, our estimation fails to
find a connection between REER and the SBVs reaction. Results in column 5 and 6
show that global economic trends play an important role in the SBVs consideration
since all the coefficients are statistically significant and also obey the principles set by
Taylor rule. Specifically, when the US and Chinas economy becomes too hot, the
SBV reacts by increasing discount rate. Implied targeted inflation rates of these 2
models are 4% and 4.78% respectively. Regression result in column 7 shows that by
replacing discount rate with short and mid-term lending rates, all the independent
variables turn out to be statistically insignificant, therefore using the discount rate is a
suitable choice.
Our estimation results show that the SBV really was acting based on a forward
looking Taylor rule model. However, we fail to find a connection between financial
conditions and the SBVs monetary behavior. In turn, we found evidence supporting
our theory that the SBV takes into account current economic trends, represented by
the output gap of the USA and China. Furthermore, we are also successful in
calculating the implied targeted inflation rate of the SBV according to each model to
be 4.81%, 4.75%, 4% and 4.78%. This has demonstrated a success for the SBV in
keeping in line with a preset Taylor rule and also keeping inflation low. In addition,
we can clearly see that with an implied targeted inflation rate to be below 5%, the
SBV takes the goal of low inflation very seriously. This may be a result of a period of
chronic inflation before 2008 and the collapse of the stock and real estate market of
Vietnam in 2007. However, by comparing the implied targeted inflation rate and the
real inflation rate, we come to the conclusion that the SBV is not effectively
controlling inflation. This may come from the insensitivity of the investment sector to
the discount rate, hence, the inefficiency of the SBVs monetary policy. Therefore, we
expect the SBV to have possible countermeasures to (1) improve the aforementioned
efficiency of the discount rate channel and (2), find other channels to help stabilize
prices and keep inflation low. The economy in Vietnam, which itself has great
10

potential, still has a considerable number of problems such as over inflated business
cycles which come with chronic inflation. This situation has created a lot of
difficulties as well as opportunities for the SBV to practice its monetary policy and
gain more experience dealing with a young and growing economy. Therefore, we hope
this paper can shed a light on the upcoming policies of the SBV.

5. Conclusion
Based on data about inflation, discount rate, Vietnams output gap, the USA and
Chinas output gap, M2 money supply from 2008 to 2015, the goal of this paper is to
examine the relationship between discount rate and targeted inflation rate in Vietnam.
We also set out to find out whether the SBV follows a rigid set of rules in constructing
and conducting monetary policies, which has become a popular trend for state banks
in recent years. Our results show that the SBVs behavior suits a linear forward
looking Taylor rule model. The SBV takes into account all but the information
concealed in financial conditions. One interesting finding of this paper has been the
connection between Chinas output gap and Vietnams discount rate. The coefficient
of the variable representing Chinas output gap is positive and statistically significant,
therefore confirming the theory and suspicion that the Vietnams economy is
dependent on Chinas economy. We also calculated implied targeted inflation rates,
based on the behaviors of the SBV. This implied targeted inflation rate proves to be
fairly consistent throughout models, oscillating around 4.5%, considerably low for a
growing economy like that of Vietnam. This in turn shows a very serious and
conservative attitude towards inflation controlling of the SBV. However, in
comparison with the real inflation rates during the same period, we conclude that the
SBV has failed to channel the effects of monetary policy through controlling discount
rates. Therefore, we urgently expect the SBV to come up with new means to achieve
its monetary goals. However, we have also encountered difficulties in constructing a
reliable financial condition index (FCI) to capture the important information
concealed in the market. In the future, we hope to be able to extend our data set and
more importantly, to build a more complete and reliable financial condition index to
truly study its effects on the SBVs monetary policy.
11

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