The theory of open-economy monetary transmission mechanism before presenting our impulse responses Essay

We would like to discuss the theory of open-economy monetary transmission mechanism before presenting our impulse responses. Following the seminal work of Obstfeld and Rogoff (1995) there has been a considerable amount of literature on open economy monetary transmission mechanism (for example Kollmann (2001), Chari, Kehoe and McGrattan (2002) and Gali and Monacelli (2004)). These models assume stickiness in prices and wages which implies that monetary policy operates through the interest rate channel and exchange rate channel.
Therefore, in response to a contractionary monetary policy shock the market interest rate is expected to rise, leading to an inflow of foreign capital in to the domestic economy. This would create an excess demand for domestic currency and domestic currency should appreciate vis--vis foreign currency. As a result prices of domestic products may rise compared to that of foreign products leading to a fall in net exports. On the other hand, increase in the domestic interest rate leads to a reduction in interest sensitive consumption and investment which leads to a reduction in aggregate demand.
In the short run, output is determined by aggregate demand. Hence, a fall in aggregate demand following a contractionary monetary policy causes a fall in aggregate output. This slack in economic activity may lead to a fall in labor demand and can eventually reduce wages and prices even in a sticky price setting. Hence, cost of production will fall and inflation should eventually decrease. Therefore, according to the theory, a contractionary monetary policy has an immediate effect on interest rate and exchange rate but a delayed effect on output. Inflation is supposed to be affected by even further delay.
Figure (.) shows the impulse response function of the domestic variables to one unit negative money supply shock. The upper and lower dashed lines plotted on each graph are two-standard-error bands. In response to a money supply shock, initially interest rate rises. The increase in interest rate is not very persistent. This is because, as we can see from Figure(.), the monetary contraction leads to a deflation in price level. The money supply shock leads to a negative change in exchange rate which, in our case, refers to an appreciation of domestic currency since we defined exchange rate as unit of domestic currency, taka(tk) per US dollar. We also observe that after the monetary contraction initially output increases to some extent but then it falls very sharply. Therefore, the effect of the shock on output kicks in with a lag. This is quite expected as real variables do not respond to changes in nominal variables instantaneously. Inflation increases at the beginning but eventually decreases as output starts to fall. In case of all the variables the impact of monetary policy shock dies of within nine month horizon. Therefore, our impulse responses conform to the theory described above pretty well. Our results also match with that of Cushman and Zha (1997) and Kim and Roubini (2000) who found similar results of monetary contraction in Canada and non-US G7 countries respectively.