How Automatic Adjustment Mechanism Works in Practice – A VECM Analysis of Monetary Transmission Mechanism in Bosnia and Herzegovina

ABSTRACT

This paper takes stock of the literature on the monetary transmission mechanism in currency boards and analyzes the process of monetary transmission in Bosnia and Herzegovina. The transmission of monetary signals through the economy is based on the automatic adjustment mechanism of the currency board. Three channels of monetary transmission are discussed in this paper: the interest rate channel, the narrow credit channel, and the exchange rate channel. The empirical analysis shows how exogenous monetary shocks are transmitted through different channels and how long it takes for the automatic adjustment mechanism to restore equilibrium in the economy.

KEYWORDS:

• Monetary transmission
• monetary shocks
• currency board
• Bosnia and Herzegovina

JEL CLASSIFICATION:

• C52
• E42
• E52
• F41

Acknowledgments

The author would like to express his gratitude to Cecilia Fernandes, Yuan Gao Rollingson, and Andrew Jewell from the International Monetary Fund for their useful comments and feedback.

Disclosure Statement

No potential conflict of interest was reported by the author.

Notes

1. The Argentinian currency board is an example of this strategy, with a limited backing of monetary liabilities by the reserve currency. The central bank was allowed to hold domestic government securities on top of foreign reserves on the assets side of its balance sheet. However, this arrangement proved problematic, as the Argentinian currency board ended in a crisis in 2001.

2. In accordance with the uncovered interest rate parity (UIP) condition.

3. Often called fundamentals.

4. Large amounts of liquidity held by banks at reserve accounts with the central bank could be partly explained by capital inflows resulting from the large-scale quantitative easing measures of the ECB in the aftermath of the global financial crisis.

5. As the exchange rate of the domestic currency against the euro is fixed and inflation converges to the level in the reserve currency region.

6. Recognizing that innovations to this variable may not be purely identified as innovations to domestic monetary or macroprudential policy, as they may result from changes in banks’ liquidity policy, some shocks affecting the structure of assets of foreign banks in their home markets, etc.

7. This is the banking agencies’ regulation on maturity mismatches in banks’ asset and liabilities composition. According to this regulation, banks needed to have 85% of liabilities maturing within 30 days covered by assets maturing within 30 days. As roughly 65% of domestic savings held with banks belong to this very short-term maturity bucket, this regulation limits banks’ potential for maturity transformation of those funds, i.e., extending longer term credit from these short-term sources. This regulation was relaxed after the COVID-19 pandemic crisis to 65% coverage: in June 2020 by the FBH Banking Agency and in June 2021 by the RS Banking Agency.

8. The value of the current account has been constantly negative, which is a typical characteristic of a small, non-oil exporting open economy like Bosnia and Herzegovina.

9. Note that a change of 0.01 in the log level of a variable is approximately equal to a one percent change in that variable.

10. The original data sample is relatively short and divided into two separate subsamples to have enough observations to get reliable estimates of the model.

11. A nominal anchor is a policy variable that determines the average price level in an economy in the long run.

Additional information

Notes on contributors

Dejan Kovačević

Dejan Kovačević is a central banker, holding PhD in Macroeconomics from the University of Belgrade. He currently works as Head of Monitoring and Analysis Department at the Central Bank of Bosnia and Herzegovina. He was a visiting researcher at the Geneva Graduate Institute for International and Development studies. His professional interests include macroeconomics, monetary economics, monetary policy analysis, financial markets, investment and risk management, and portfolio analysis.