## _wp15273

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---

### I. INTRODUCTION — Macroeconomic context and challenges
- Vietnam achieved macroeconomic stability in recent years after episodes of high inflation in 2008 and 2011.
- The export sector has grown substantially, making Vietnam one of the most open economies in the world.
- Export product mix evolved from predominantly commodities to manufacturing of electronics and apparel.
- Integration into the world economy has increased exposure to external shocks.
- Monetary policy is anchored around exchange rate stability as the intermediate target to achieve price stability, with the authorities maintaining the dong closely linked to the U.S. dollar.
- Recent accommodative monetary conditions in Vietnam coincided with exceptionally easy monetary policy in the U.S.
- The likely start of a monetary tightening cycle in the U.S., associated U.S. dollar appreciation, and currency movements in the rest of Asia could severely test Vietnam’s current monetary policy approach.

### Modeling approach — FPAS model and estimation
- Model type and purpose:
  - A small New Keynesian FPAS model estimated for Vietnam, capturing key aspects of monetary transmission and usable for forecasting.
  - FPAS models are noted for simplicity while capturing essential economy features.
- Estimation:
  - Bayesian estimation using Vietnamese data from 2000–14.
  - Baseline parameterization fits the actual data closely and performs well in in-sample forecasts.
- Core model structure (functional forms preserved from source):
  - Aggregate demand curve with neutral real interest rate RR_t* evolving as an AR(1): RR_t* = ρ_RR RR_{t-1}* + (1-ρ_RR) RR* + ε_RR_t.
  - Two Phillips curves: separate for food and fuel inflation and for core inflation; food/fuel inflation more responsive to exchange rate (large α_s); core inflation more responsive to output gap.
  - Uncovered interest parity (UIP): real exchange rate z depends on lags, policy real interest rate RR, world real interest rate RR*_US, and equilibrium risk premium ρ*; interest rate term divided by 4 to convert annual rates to quarterly.
  - Monetary policy rule: nominal policy rate RS depends on lagged RS, equilibrium real rate RR*, annual inflation π4, deviations of expected inflation from the inflation target π*_t, the output gap, and changes in real exchange rate z; inflation target follows π*_t = ρ_π π*_{t-1} + (1-ρ_π) π* + ε_π,t.
- Foreign block:
  - U.S. economy represents the foreign sector; federal funds rate used as foreign nominal interest rate.

### Data
- Sample period: 2000 to 2014 (mostly quarterly).
- Key data sources and choices:
  - Real effective exchange rate from IFS.
  - Headline, core and food and fuel CPI from Vietnamese authorities.
  - Weekly interbank rate averaged into quarters used as short-term interest rate.
  - Output gap computed using a simple HP filter; other methods yield qualitatively similar results.
  - Foreign block estimated with U.S. data from International Finance Statistics and IMF’s World Economic Outlook, 2000 to 2014.

### Estimation approach and baseline results
- Priors drawn from FPAS literature; posterior values summarized in Table A1 (in source).
- Parameter interpretations:
  - Aggregate demand: relatively large backward-looking term and small forward-looking term.
  - Priors on RRGAP_β and zgap_β reflect view that a 100-basis-points increase in real interest rates has effect equivalent to a 1 percent appreciation in the real exchange rate.
  - Large parameter on international output gap reflecting high openness.
  - Phillips curves: core inflation more responsive to output gap; food/fuel inflation more responsive to exchange rate (large α_s).
  - Monetary policy rule: high prior on lagged interest rate γ_R implies a high degree of inertia; policy responds to nominal exchange rate movements.
- Model fit and moments (Actual data vs Baseline model — preserve numbers exactly):
  - Output gap: Mean 0.0, Std. Dev. 1.0 (Actual data); Mean 0.0, Std. Dev. 1.4 (Baseline model).
  - Inflation: Mean 8.9, Std. Dev. 6.3 (Actual data); Mean 8.9, Std. Dev. 5.3 (Baseline model).
  - Core Inflation: Mean 7.3, Std. Dev. 4.5 (Actual data); Mean 7.4, Std. Dev. 7.1 (Baseline model).
  - Food Inflation: Mean 11.6, Std. Dev. 10.3 (Actual data); Mean 11.3, Std. Dev. 10.0 (Baseline model).
  - Nominal interest rate: Mean 7.0, Std. Dev. 3.4 (Actual data); Mean 7.0, Std. Dev. 9.6 (Baseline model).
  - Real exchange rate: Mean 1.5, Std. Dev. 12.4 (Actual data).
  - Nominal exchange rate: Mean 2.2, Std. Dev. 2.3 (Actual data).
- Forecasting:
  - One-quarter ahead in-sample forecasts capture inflation spikes in 2008 and 2011 and track output gap dynamics.
  - Out-of-sample forecasts (starting end-2014) assume Fed Funds rate reaching 2 percent after three years.
  - Model predicts gradual closing of the output gap and inflation slowly increasing toward the 4 percent target assumed in the model.
  - Confidence bands are 95 percent intervals and include possibility of persistently low inflation.
  - Nominal interest rate projected to increase very slowly starting towards the end of 2015; confidence bands wide suggesting policy should closely monitor inflation with bias to tighten if needed.

### Optimal monetary policy response (Chapter VI key results)
- Objective:
  - Derive an ex-post optimal monetary policy rule for Vietnam that minimizes joint variability of output, inflation and exchange rate.
- Optimization problem (functional form preserved from source):
  - Minimize E_t Σ (y'_t A y_t + e'_t C e_t + ... ) with θ the monetary policy rule parameters and W the weighting matrix; only positive weights in W are for output gap, inflation and exchange rate.
- Main comparative results (baseline vs optimal — preserve numbers exactly from Table 2):
  - Output gap: Baseline 1.4, Optimal 0.9
  - Inflation: Baseline 5.3, Optimal 3.8
  - Nominal interest rate: Baseline 9.6, Optimal 12.4
  - Nominal exchange rate: Baseline 2.3, Optimal 2.4
- Interpretation:
  - The optimal rule places relatively more weight on the output gap and inflation and relatively less weight on the exchange rate compared with the baseline.
  - The optimal rule delivers substantial improvements in inflation stability and less accentuated business cycles at the cost of a small increase in exchange rate variability.
  - Strong focus on nominal exchange rate stability as an intermediate target leads to more inflation and output variability.
  - The optimal rule implies a more active monetary policy (larger nominal interest rate variability).

### Monetary transmission and general shock analysis (Chapter VII overview)
- Monetary transmission measure (model implication):
  - A 100 basis point increase in the nominal interest rate leads to:
    - A fall in output that reaches a peak of 0.1 percent after about 4 quarters.
    - A real appreciation of about 0.25 percent.
    - A decline in headline CPI inflation (magnitude and peak timing described in source).
  - Monetary tightening suppresses domestic demand directly through the interest rate channel and indirectly via currency appreciation.
- General finding:
  - Contrasting baseline and optimal rules shows optimal rule yields lower output gap and inflation volatility but higher nominal interest rate variability and a small increase in nominal exchange rate variability.
  - Under the optimal rule deviations from equilibrium are much smaller and reversions back to equilibrium are much faster than under the baseline; greater responsiveness of monetary policy, particularly to output deviations, drives faster adjustment.
  - Under the optimal model the central bank reacts fast to declining output and falling inflation by lowering interest rates; short-term depreciation following brief appreciation helps return output gap and inflation to equilibrium after a few quarters.
- Numeric reference preserved from source: "0.15 percent after two years."

### Shock-specific findings and policy implications
- Domestic demand shock (fiscal expansion specification):
  - One standard deviation increase in demand is about 0.66 percent.
  - Baseline response:
    - Headline inflation increases by about 0.35 percent.
    - Central bank responds with a slow and limited increase in interest rates.
    - Over the medium term, rising inflation leads to a real effective appreciation of the dong while the nominal exchange rate remains stable.
    - Real appreciation causes a medium-term fall in output and inflation falling below target.
  - Optimal response:
    - Central bank aggressively raises interest rates to control inflation.
    - Nominal exchange rate is allowed to appreciate, dampening inflationary pressures.
    - Output gap returns relatively quickly to a neutral level; shocks dissipate faster than under the baseline.

- External demand shock:
  - Vietnam: sum of exports and imports is about 160 percent of GDP.
  - Baseline response to a negative external demand shock:
    - Output reduces, leading to a decline in inflation.
    - Central bank slowly cuts interest rates.
    - Nominal exchange rate remains broadly stable, while low inflation leads to a real appreciation.
  - Optimal response:
    - Nominal exchange rate allowed to depreciate and the central bank promptly cuts interest rates.
    - Depreciated dong and supportive monetary policy dampen output deviation and keep inflation close to target.

- Tighter U.S. monetary policy:
  - One-standard deviation increase in U.S. interest rates is 0.21 percentage points (in the data).
  - Baseline response:
    - Authorities let the exchange rate depreciate in response to higher U.S. interest rates.
    - Dong depreciation supports output, more than offsetting negative impacts from lower external demand and higher domestic interest rates.
    - Result: positive output gap and depreciation keep inflation elevated for an extended period.
  - Optimal response:
    - Authorities initially allow greater dong depreciation than under the baseline.
    - Dong depreciation stabilizes output; more active monetary policy keeps inflation relatively stable.
    - Output returns faster to equilibrium than under the baseline.
  - Policy insight:
    - Allowing more exchange rate flexibility in the face of tightening in U.S. interest rates can achieve greater macroeconomic stability.

- Food prices shock:
  - Shock: one standard deviation shock in food price inflation.
  - Baseline response:
    - Central bank increases nominal interest rates by about 100 basis points initially.
    - Rate hike does not fully offset inflation; real interest rates decline leading to an initial nominal depreciation.
    - Rising nominal interest rates lead to a decline in output in the medium-term.
  - Optimal response:
    - Authorities react strongly by raising interest rates by 400 basis points.
    - This raises real interest rates and produces initial nominal appreciation followed by subsequent depreciation.
    - Combined effect: earlier contraction in output and an earlier, quicker recovery.
    - Accumulated output losses are lower than in the baseline and inflation returns to target more quickly.

### Conclusions and policy implications
- Policy objectives:
  - Vietnamese authorities prioritize macroeconomic stability with robust sustainable growth and low inflation.
  - Monetary and exchange rate policy are essential to achieve these goals.
- Current practice and transition:
  - Recent focus has been on the exchange rate as the nominal anchor.
  - Maintaining a de facto exchange rate targeting regime will become increasingly difficult as Vietnam faces asymmetric shocks compared to the U.S.
  - The SBV plans to gradually implement a forward-looking monetary policy framework focused on using inflation as a nominal anchor with greater exchange rate flexibility.
- Model utility and structural insights:
  - The stochastic general equilibrium model provides a tool to analyze monetary and exchange rate policies, measure policy stances, and allow forecasting.
  - The model fits Vietnamese data over the last 15 years and performs well in in-sample forecasting.
  - The inflation process is very persistent, implying monetary policy must maintain a tight stance for a prolonged period to bring inflation back to target.
  - Phillips curve estimates show little impact of monetary policy on food inflation and larger impact on core inflation; the sacrifice ratio in Vietnam is relatively large.
- Optimal policy rule implications:
  - The optimal rule jointly minimizes variability of output, inflation, and the exchange rate.
  - It places greater weight on the output gap as intermediate target to achieve inflation stability while allowing greater exchange rate flexibility.
  - The optimal policy delivers greater macroeconomic stability (reduced inflation and output variability) with only a small increase in exchange rate variability.
- Overall recommendation:
  - A flexible exchange rate can play a critical buffering role to facilitate internal and external adjustment.
  - The model provides a tool to support implementation of a forward-looking inflation-centered monetary policy regime; practical implementation steps remain necessary.

*Source: _wp15273 - Excerpt from IMF working paper.*

### References .............................................................................................................

### _wp15273 - References .............................................................................................................

### I. INTRODUCTION — Macroeconomic context and challenges
- Vietnam achieved macroeconomic stability in recent years after episodes of high inflation in 2008 and 2011.
- The export sector has grown substantially, making Vietnam one of the most open economies in the world.
- Export product mix evolved from predominantly commodities to manufacturing of electronics and apparel.
- Integration into the world economy has been very beneficial for Vietnam, but has also increased exposure to external shocks.
- Monetary policy in Vietnam is anchored around exchange rate stability as the intermediate target to achieve price stability, with the authorities maintaining the dong closely linked to the U.S. dollar.
- Recent need for accommodative monetary conditions in Vietnam has coincided with exceptionally easy monetary policy in the U.S.
- The likely start of a monetary tightening cycle in the U.S. in the near-term, associated U.S. dollar appreciation, and currency movements in the rest of Asia could severely test Vietnam’s current monetary policy approach.

### Modeling approach — FPAS model and estimation
- The paper estimates a small New Keynesian macroeconomic model, the Forecasting and Policy Analysis System (FPAS model).
- FPAS models are noted for their simplicity while capturing key aspects of an economy for monetary policy analysis (Laxton et al. 2009).
- The model provides a tool for analyzing the monetary transmission mechanism and the dynamics of shocks to the economy, and can be used for forecasting.
- The FPAS model is estimated using Bayesian techniques on Vietnamese data from 2000–14.
- The baseline parameterization fits the actual data closely and performs well in in-sample forecasts.

### Key empirical findings
- The inflation process is mostly backward looking, which complicates the conduct of monetary policy and implies that monetary policy has to be more active and maintain a certain stance for longer.
- An optimal monetary policy rule is derived that jointly minimizes the variability of output, inflation, and the exchange rate.
- The optimal monetary policy rule places a greater weight on the output gap as the intermediate target to achieve inflation stability, while allowing greater exchange rate flexibility.

### Shock analysis and policy implications
- The paper analyzes dynamics under exogenous shocks for both baseline and optimal parameterizations. Shocks considered include:
  - rising U.S. interest rates,
  - an increase in food prices,
  - a domestic demand shock that can be interpreted as a fiscal expansion,
  - an external demand shock.
- The optimal monetary policy rule delivers greater macroeconomic stability for Vietnam under the shock scenarios.
- A critical factor in achieving more output and inflation stability is the buffer role a flexible exchange rate can play when confronted with external shocks.

### Paper structure (as provided)
- Chapter II: brief overview of monetary policy and recent economic developments in Vietnam.
- Chapter III: introduces the model including its main properties and equations.
- Chapter IV: brief overview of the data used for model estimation.
- Chapter V: discusses estimation of the model, results, and forecasts.

*Source: _wp15273 - References .............................................................................................................*

### Chapter VI develops an alternative optimal monetary policy rule that increases

### _wp15273 - Chapter VI develops an alternative optimal monetary policy rule that increases

### Brief overview of monetary policy and macroeconomic developments
- Growth averaged over 7 percent in the years before the Global Financial Crisis, led mainly by increasingly intensive agricultural production, rapidly expanding state-owned enterprise (SOE) investment, financial services and labor-intensive manufacturing driven by foreign direct investment.
- Domestic credit growth reached more than 50 percent in anticipation of WTO accession in early 2007.
- Inflation reached double-digit levels in 2007 and averaged more than 23 percent in 2008.
- Growth fell to around 5 percent in 2012 after stabilization in 2012; by end-2014 growth recovered to about 6 percent supported mainly by a strong FDI-driven export sector.
- The State Bank of Vietnam (SBV):
  - Proposes an inflation target to the National Assembly, which then sets the target as national policy (5 percent for 2015).
  - Announces an official dong-U.S. dollar exchange rate with bands and manages foreign exchange supply to keep the interbank exchange rate within the bands.
  - Issues central bank bills, conducts repo operations, sets a reference interbank rate, and maintains overnight lending and deposit facilities; caps on deposit rates exist.
  - Announces a domestic credit growth objective including credit growth guidance for individual banks and sectors.
- Exchange rate regime and movements:
  - The exchange rate trading band vis-à-vis the U.S. dollar was widened to +/- 3 percent from +/- 1 percent in August 2015.
  - In real effective terms, the dong has appreciated by close to 30 percent due to persistent inflation differentials and U.S. dollar appreciation vs. Euro, Yen and many emerging market currencies.

### The FPAS model (model structure and key equations)
- Model type and purpose:
  - A small New Keynesian or FPAS model following Berg and others (2006) with Vietnam-specific extensions; dynamic stochastic general equilibrium with partly forward-looking expectations.
  - Expresses variables in “gap” terms (deviations from long-run trend); long-run trends follow autoregressive processes.
- Four core equations:
  1. Aggregate demand curve: output gap depends on its own lag and projections, deviations from the neutral real interest rate (RR*), deviations from the steady state real exchange rate (z*), and foreign demand approximated by U.S. output gap.
     - Neutral real interest rate evolves as an AR(1): RR_t* = ρ_RR RR_{t-1}* + (1-ρ_RR) RR* + ε_RR_t (functional form preserved from source).
  2. Two Phillips curves: separate equations for food and fuel inflation and for core inflation; each relates inflation to expected and past inflation, output gap, and exchange rate changes.
     - Food/fuel inflation more responsive to exchange rate (large α_s); core inflation more responsive to output gap.
  3. Uncovered interest parity (UIP): real exchange rate z depends on lags, policy real interest rate RR, world real interest rate RR*_US, and equilibrium risk premium ρ* which evolves with differences in neutral rates; interest rate term divided by 4 to convert annual rates to quarterly.
     - Forward-looking expectations for the exchange rate are allowed but not imposed.
  4. Monetary policy rule: nominal policy rate RS depends on its lag, equilibrium real rate RR*, annual inflation π4, deviations of expected inflation from the inflation target π*_t, the output gap, and changes in the real exchange rate z.
     - The rule includes interest rate smoothing (lagged RS), a response to exchange rate movements, and allows a stochastic process for the inflation target: π*_t = ρ_π π*_{t-1} + (1-ρ_π) π* + ε_π,t.

- Foreign block: U.S. economy represents the foreign sector; federal funds rate used as foreign nominal interest rate.

### Data
- Sample period: 2000 to 2014, most series quarterly.
- Key data sources and choices:
  - Real effective exchange rate from IFS.
  - Headline, core and food and fuel CPI provided by Vietnamese authorities.
  - Weekly interbank rate averaged into quarters used as short-term interest rate (reference interbank rate almost constant in last three years and does not capture policy stance).
  - Output gap computed using a simple HP filter; other methods yield qualitatively similar results.
  - Foreign block estimated with U.S. data from International Finance Statistics and IMF’s World Economic Outlook, 2000 to 2014.

### Estimation approach and baseline results
- Estimation method: Bayesian estimation with priors drawn from FPAS literature; priors and posterior values summarized in Table A1 (in source).
- Key parameter interpretations:
  - Aggregate demand: relatively large backward-looking term and small forward-looking term.
  - Priors on RRGAP_β and zgap_β reflect view that a 100-basis-points increase in real interest rates has effect equivalent to a 1 percent appreciation in the real exchange rate.
  - Large parameter on international output gap reflecting high openness.
  - Phillips curves: core inflation more responsive to output gap; food/fuel inflation more responsive to exchange rate (large α_s).
  - Monetary policy rule: high prior on lagged interest rate γ_R implies a high degree of inertia; policy responds to nominal exchange rate movements.
  - Foreign block priors taken from U.S. applications; autoregressive coefficients and shock variances chosen to deliver plausible interpretations of recent Vietnamese dynamics.
- Model fit and moments (Table 1: Actual data and baseline model moments — preserve numbers exactly):
  - Output gap: Mean 0.0, Std. Dev. 1.0 (Actual data); Mean 0.0, Std. Dev. 1.4 (Baseline model).
  - Inflation: Mean 8.9, Std. Dev. 6.3 (Actual data); Mean 8.9, Std. Dev. 5.3 (Baseline model).
  - Core Inflation: Mean 7.3, Std. Dev. 4.5 (Actual data); Mean 7.4, Std. Dev. 7.1 (Baseline model).
  - Food Inflation: Mean 11.6, Std. Dev. 10.3 (Actual data); Mean 11.3, Std. Dev. 10.0 (Baseline model).
  - Nominal interest rate: Mean 7.0, Std. Dev. 3.4 (Actual data); Mean 7.0, Std. Dev. 9.6 (Baseline model).
  - Real exchange rate: Mean 1.5, Std. Dev. 12.4 (Actual data).
  - Nominal exchange rate: Mean 2.2, Std. Dev. 2.3 (Actual data).
- In-sample forecasting performance:
  - One-quarter ahead in-sample forecasts capture inflation spikes in 2008 and 2011 and track output gap dynamics.
- Out-of-sample forecasts (starting end-2014) incorporate gradual U.S. tightening:
  - Assumption: Fed Funds rate reaching 2 percent after three years.
  - Model predicts gradual closing of the output gap and inflation slowly increasing toward the 4 percent target assumed in the model.
  - Confidence bands are 95 percent intervals and leave wide margin of error, including possibility of persistently low inflation.
  - Nominal interest rate projected to increase very slowly starting towards the end of 2015; confidence bands wide suggesting policy should closely monitor inflation with bias to tighten if needed.

### Optimal monetary policy response (Chapter VI key results)
- Objective: derive an ex-post optimal monetary policy rule for Vietnam that minimizes joint variability of output, inflation and exchange rate.
- Optimization problem (functional form preserved from source):
  - Minimize E_t Σ (y'_t A y_t + e'_t C e_t + ... ) with θ the monetary policy rule parameters and W the weighting matrix; only positive weights in W are for output gap, inflation and exchange rate.
- Main comparative results (baseline vs optimal):
  - Figure 6 (described) shows relative weights on output gap, nominal exchange rate, and inflation in the monetary policy rule: baseline (blue) and optimal (red).
  - Table 2: Standard deviations in baseline and optimal models (preserve numbers exactly):
    - Output gap: Baseline 1.4, Optimal 0.9
    - Inflation: Baseline 5.3, Optimal 3.8
    - Nominal interest rate: Baseline 9.6, Optimal 12.4
    - Nominal exchange rate: Baseline 2.3, Optimal 2.4
  - Interpretation:
    - The optimal rule places relatively more weight on the output gap and inflation and relatively less weight on the exchange rate compared with the baseline.
    - The optimal rule would deliver substantial improvements in inflation stability and less accentuated business cycles at the cost of a small increase in exchange rate variability.
    - Strong focus on nominal exchange rate stability as an intermediate target leads to more inflation and output variability.
    - The optimal rule implies a more active monetary policy (larger nominal interest rate variability).

### Shock analysis: baseline vs optimal models (Chapter VII summary)
- Purpose: contrast effects of shocks under baseline and optimal monetary policy rules to evaluate policy function properties.
- Monetary transmission measure (model implication):
  - A 100 basis point increase in the nominal interest rate leads to:
    - A fall in output that reaches a peak of 0.1 percent after about 4 quarters.
    - A real appreciation of about 0.25 percent.
    - A decline in headline CPI inflation (magnitude and peak timing described in source but not numerically tabulated in provided excerpt).
  - Monetary tightening suppresses domestic demand directly through the interest rate channel and indirectly via currency appreciation.
- Shocks analyzed (described in source to be discussed in section VII):
  - Domestic demand shock.
  - Negative external demand shock.
  - Rising U.S. interest rates.
  - Increase in food prices.
- General finding:
  - Contrasting baseline and optimal rules provides insights into trade-offs: optimal rule yields lower output gap and inflation volatility but higher nominal interest rate variability and a small increase in nominal exchange rate variability.

*Source: Excerpt from the IMF working paper chapter and accompanying figures and tables in the provided PDF content.*

### 0.15 percent after two years. The results of our model for Vietnam are qualitatively similar to

### _wp15273 - 0.15 percent after two years. The results of our model for Vietnam are qualitatively similar to

### Monetary transmission and optimal vs baseline policy
- The model results for Vietnam are qualitatively similar to findings in other empirical studies on the monetary transmission mechanism in developing and emerging countries.
- Properties under the optimal monetary policy rule:
  - Deviations from equilibrium are much smaller and reversions back to equilibrium are much faster than under the baseline rule.
  - Greater responsiveness of monetary policy, particularly to output deviations, drives faster adjustment.
  - Under the optimal model the central bank reacts fast to declining output and falling inflation by lowering interest rates.
  - Short-term depreciation of the currency following a brief appreciation in response to the initial rate hike helps return the output gap and inflation to equilibrium after a few quarters.
- Numeric reference: "0.15 percent after two years" is reported in the source text.

### Domestic demand shock (interpreted as fiscal expansion/contraction)
- Shock specification:
  - Fiscal expansion equivalent to a one standard deviation increase in demand is about 0.66 percent.
- Baseline model response:
  - Headline inflation increases by about 0.35 percent.
  - Central bank responds with a slow and limited increase in interest rates.
  - Over the medium term, rising inflation leads to a real effective appreciation of the dong while the nominal exchange rate remains stable.
  - Real appreciation causes a medium-term fall in output and inflation falling below target.
- Optimal model response:
  - Central bank aggressively raises interest rates to control inflation.
  - Nominal exchange rate is allowed to appreciate, dampening inflationary pressures.
  - Output gap returns relatively quickly to a neutral level.
  - Shocks dissipate faster with the optimal monetary policy rule than under the baseline.

### External demand shock
- Context:
  - Vietnam is one of the most open economies in the world; the sum of exports and imports is about 160 percent of GDP.
  - External demand shocks (positive or negative) significantly affect Vietnamese exports and growth.
- Baseline model response to a negative external demand shock:
  - Output reduces, leading to a decline in inflation.
  - Central bank slowly cuts interest rates.
  - Nominal exchange rate remains broadly stable, while low inflation leads to a real appreciation.
- Optimal model response:
  - Nominal exchange rate allowed to depreciate and the central bank promptly cuts interest rates.
  - Depreciated dong and supportive monetary policy dampen output deviation from equilibrium and keep inflation close to target.

### Tighter U.S. monetary policy
- Background:
  - Easy U.S. monetary conditions benefited emerging markets through low external borrowing costs; a gradual tightening in the U.S. becomes likely as the U.S. economy moves closer to potential.
  - The 2013 taper tantrum exemplifies possible dislocations from shifts in U.S. policy.
- Shock specification:
  - A one-standard deviation increase in U.S. interest rates is 0.21 percentage points (in the data).
- Baseline model response:
  - Authorities let the exchange rate depreciate in response to higher U.S. interest rates.
  - Dong depreciation supports output, more than offsetting negative impacts from lower external demand and higher domestic interest rates.
  - Result: positive output gap and depreciation keep inflation elevated for an extended period.
- Optimal model response:
  - Authorities initially allow greater dong depreciation than under the baseline in response to the negative external shock.
  - Dong depreciation stabilizes output; more active monetary policy keeps inflation relatively stable.
  - Output returns faster to equilibrium than under the baseline.
- Key policy insight:
  - Allowing more exchange rate flexibility in the face of tightening in U.S. interest rates can achieve greater macroeconomic stability.

### Food prices shock
- Shock specification:
  - One standard deviation shock in food price inflation.
- Baseline model response:
  - Central bank increases nominal interest rates by about 100 basis points initially.
  - Rate hike does not fully offset inflation; real interest rates decline leading to an initial nominal depreciation.
  - Rising nominal interest rates lead to a decline in output in the medium-term.
- Optimal model response:
  - Authorities react strongly by raising interest rates by 400 basis points.
  - This raises real interest rates and produces initial nominal appreciation followed by subsequent depreciation.
  - Combined effect: earlier contraction in output and an earlier, quicker recovery.
  - Accumulated output losses are lower than in the baseline model and inflation returns to target more quickly.

### Conclusions and policy implications
- Policy objectives:
  - Vietnamese authorities prioritize macroeconomic stability with robust sustainable growth and low inflation.
  - Monetary and exchange rate policy are essential to achieve these goals.
- Current practice and transition:
  - Recent focus of monetary policy has been on the exchange rate as the nominal anchor.
  - Maintaining a de facto exchange rate targeting regime will become increasingly difficult as Vietnam faces asymmetric shocks compared to the U.S.
  - The SBV plans to gradually implement a forward-looking monetary policy framework focused on using inflation as a nominal anchor with greater exchange rate flexibility.
- Model utility and performance:
  - A stochastic general equilibrium model for Vietnam is estimated to analyze monetary and exchange rate policies, model transmission mechanisms, measure policy stances, and allow forecasting given policy actions.
  - The model provides a good fit for Vietnamese data over the last 15 years and performs well in in-sample forecasting.
- Structural insights:
  - The inflation process is very persistent, implying monetary policy must maintain a tight stance for a prolonged period to bring inflation back to the desired target.
  - Phillips curve estimation shows monetary policy has little impact on food inflation and a larger impact on core inflation.
  - These findings imply the sacrifice ratio in Vietnam is relatively large, underscoring the importance of more active monetary policy focused on inflation stability.
- Optimal policy rule findings:
  - The optimal monetary policy rule jointly minimizes variability of output, inflation, and the exchange rate.
  - It places greater weight on the output gap as the intermediate target to achieve inflation stability while allowing greater exchange rate flexibility.
  - The optimal policy delivers greater macroeconomic stability (reduced inflation and output variability) with only a small increase in exchange rate variability.
  - Over longer periods, more flexible exchange rate regimes do not increase exchange rate variability by much.
- Overall recommendation:
  - A flexible exchange rate can play a critical buffering role to facilitate internal and external adjustment.
  - The model provides a tool to support implementation of a forward-looking inflation-centered monetary policy regime; practical implementation steps remain necessary.

*Content derived from the supplied excerpt of the IMF working paper.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15273.pdf_