VAR Evidence: Spain

F. Alvarez, A. Budai, D. Matveev, P. Wu

IDEA-UAB

April, 2010

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 1 / 15

 Monetary Policy Procedures in Spain

Historic periods
Target in terms of monetary aggregate M3 from 1973 to 1984
Target in terms of monetary aggregate ALP (liquid assets held by the
public) from 1984 to 1995
Increasing importance of short-term interest rate control since 1987
Complete replacement of monetary aggregate target by inflation
target since 1995

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 2 / 15

 Monetary Policy Procedures in Spain

Important dates
Start of the EMS (European Monetary System) in 1979
Agreement to stop frequent realignments within the EMS in 1983
Spain joining EMS in 1989
Spain adopting the very broad bands of the EMS after speculative
attack on the peseta in late 1992

Monetary reforms
Increased reserve requirements in 1987 to drain liquidity and obtain
cheap way of financing government deficits due to the low interest
rates on reserves
Reduction of reserve requirements and commitment of the
government to reduce its borrowings from the Bank of Spain in 1990
Devaluation of Peseta in 1992/1993
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 3 / 15
 VAR Modelling Process

Goal
Aim of VAR models is to distinguish different theoretical models by means
of analyzing responses of macroeconomic variables on monetary policy
shocks, but not to obtain optimal monetary policy.

Specification steps
Variables choice
Sample period and frequency selection
Integration and stationarity issue
Lag length choice

Identification problem
Short run restrictions
Long run restrictions
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 4 / 15
 Setting up Models

Variables
1 Macroeconomic variables
real GDP as a measure of output (seasonally adjusted)
CPI (Consumer prices index) as a measure of inflation
2 Policy variables
Monetary aggregate M3
IR (Short-term interest rate) (3-month)

Period and frequency of data

Quarterly data from 1980 to 1998/2009 in model with M3/IR

Data transformations
Take GDP, M3 and, CPI in logarithms to smooth series, but keep them in
levels in order not to care about cointegration relations. By doing so we
keep consistency, though loose in efficiency.
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 5 / 15
 Setting up Models
M3-model

const GDP trend GDP

       GDP 
GDPt GDPt−1 ut
 CPIt  = A(L)  CPIt−1  + B  const CPI trend CPI  +  utCPI 
M3t M3t−1 const M3 trend M3 utM3

Lag structure
Based on Schwarz information criterion 2 lags are included in the model.

Diagnostic tests
Residuals from all equations repeatedly exceed ±2σ error bands, signaling
potential departures from normality and homoskedasticity. But formal tests
do not reject normality, homoskedasticity and, absence of autocorrelation.

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 6 / 15

 Setting up Models
IR-model

const GDP trend GDP

       GDP 
GDPt GDPt−1 ut
 CPIt  = A(L)  CPIt−1  + B  const CPI trend CPI  + utCPI 

IRt IRt−1 const IR trend IR utIR

Period restriction
To avoid Lucas critique we focus on the period after Spain joined EMS

Lag structure
Based on Schwarz information criterion 2 lags are included in the model.

Diagnostic tests
Residuals from all equations repeatedly exceed ±2σ error bands, signaling
potential departures from normality and homoskedasticity. Formal tests
indeed reject normality, homoskedasticity and, absence of autocorrelation.
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 7 / 15
 Short-run Effects of Monetary Policy Shocks

Identifying monetary policy shock

Common restriction of no contemporaneous effects of monetary policy on
non-policy variables which is plausible for quarterly data. To implement it
we use Cholesky decomposition with policy variable ordered last.

M3-model
Expansionary shock in money supply leads to growth in output and
increasing inflation. Effect on output dies out after 6 quarters, but on
inflation it lasts longer.

IR-model
Contractionary shock, i.e. increasing interest rate, leads to typical
hump-shaped response of output and inflation, when both decline after a
small rise in the beginning, with peak effect after 9 and 14 respectively.

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 8 / 15

 Short-run Effects of Monetary Policy Shocks
Impulse response functions of both models

Response of LOG(GDP) to IR Response of LOG(CPI) to IR

.010 .002
.005 .001
.000 .000
-.005 -.001
-.010 -.002
-.015 -.003
-.020 -.004
5 10 15 5 10 15

Response of LOG(GDP) to LOG(M3) Response of LOG(CPI) to LOG(M3)

.02 .008
.01 .006
.00 .004
-.01 .002
-.02 .000
-.03 -.002
5 10 15 5 10 15

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 9 / 15

 Short-run effects of monetary policy shocks
Output Variance decomposition of both models

Percent LOG(GDP) variance due to LOG(M3) Percent LOG(GDP) variance due to IR

100 100

80 80

60 60

40 40

20 20

0 0
2 4 6 8 10 12 14 16 2 4 6 8 10 12 14 16

Discussion
In M3-model monetary policy shock has highest influence on output
variance right after its occurrence and this influence rapidly decreases.
In IR-model on the contrary fraction of the variance of output due to
monetary policy shock is low in the initial quarters after shock and it
increases with time.
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 10 / 15
 Appendix
Data time series

LOG(M3) IR
13.2 24
13.0 20
12.8
12.6 16
12.4 12
12.2 8
12.0
11.8 4
11.6 0
80 85 90 95 00 05 80 85 90 95 00 05
LOG(GDP) LOG(CPI)
12.8 4.8
12.4 4.4
12.0
4.0
11.6
3.6
11.2
10.8 3.2

10.4 2.8
80 85 90 95 00 05 80 85 90 95 00 05

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 11 / 15

 Appendix
M3-model residuals

LOG(GDP) Residuals LOG(CPI) Residuals

.06 .02
.04
.01
.02
.00 .00
-.02
-.01
-.04
-.06 -.02
85 90 95 85 90 95
LOG(M3) Residuals
.08
.04
.00
-.04
-.08
-.12
85 90 95
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 12 / 15
 Appendix
IR-model residuals

LOG(GDP) Residuals LOG(CPI) Residuals

.04 .02
.02 .01
.00
.00
-.02
-.01
-.04
-.06 -.02
-.08 -.03
90 95 00 05 90 95 00 05
IR Residuals
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
90 95 00 05
F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 13 / 15
 Appendix
M3-model lag order selection and residuals diagnostic tests

Lag length
Lag Schwarz criterion
0 -9.304019
1 -15.87221
2 -15.91020*
3 -15.41627
4 -15.08979
∗ marks optimal value

Diagnostic tests
Jarque-Berra test pvalue=0.38, thus do not reject normality
White test pvalue=0.67, thus do not reject homoskedasticity
LM test does not reject absence of serial correlation

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 14 / 15

 Appendix
IR-model lag order selection and residuals diagnostic tests

Lag length
Lag Schwarz criterion
0 -3.258556
1 -10.16601
2 -10.74633*
3 -10.63794
4 -10.49116
∗ marks optimal value

Diagnostic tests
Jarque-Berra test pvalue=0.00, thus reject normality
White test pvalue=0.01, thus reject homoskedasticity
LM test rejects absence of serial correlation

F. Alvarez, A. Budai, D. Matveev, P. Wu (IDEA-UAB)VAR Evidence: Spain April, 2010 15 / 15