Macroeconomic Determinants Of Inflation In Vietnam Economics Essay

Real world problem

Inflation is considered a serious threat to economic well-being, since it causes the cost of living to rise and the value of investments to fall. In the case of Vietnam, the country incurred high level of inflation during a long period 1995-2010, on average 7%/year, which is more persistent and more volatile than those of other countries in the Southeast Asia. As a result, controlling inflation has been a high priority of the Vietnamese government. In order to fight against inflation successfully, discovery of its determinants is of great importance. Understanding the causes of the issue is essential for updating current policies to dampen inflation and stabilize the macro economy.

Scientific problem

There have been many empirical studies on the determinants of inflation in Vietnam. These studies cover different time spans. However, most of them were conducted for the period before 2005. Therefore, this paper fills a time gap. Moreover, the study also utilizes a longer time span, which will give a more precise insight into the issue.

Moreover, recent events such as the joining WTO of Vietnam in 2007, the global financial crisis 2007-2008, sharp fluctuation in the world oil and gold price, and the exchange rate problem have posed the demand for further study on inflation in the new context.

2. Research questions

Main question:

What are the determinants of inflation in Vietnam over the period 1995-2010?

Sub-questions:

What are the short-run determinants of inflation in Vietnam over the period 1995-2010?

What are the long-run determinants of inflation in Vietnam over the period 1995-2010?

3. Literature

Theory

Demand-pull inflation

Demand-pull inflation happens when the level of aggregate demand grows faster than the underlying level of supply.

Aggregate demand is made up of all spending in the economy.

AD = C + I + G + (X-M)

Where:

C stands for consumer expenditure.

I stands for investment.

G stands for the government expenditure.

X and M respectively stand for exports and imports.

Figure 1: demand-pull inflation

Source: http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories1.htm

Demand-pull inflation may begin with any factor that increases aggregate demand. Consumers may spend more, perhaps because interest rates have fallen, taxes have been cut or simply because there is a greater level of consumer confidence. Firms may invest more with expectation of future profit. The government may spend more on infrastructure, health, education, defence, etc. It may also be a boom in export overseas.

Cost-push inflation

Cost-push inflation is an inflation that results from an initial increase in costs.

There are two main sources of increased costs

An increase in wage rate

An increase in the price of raw materials, such as oil.

Figure 2: Cost-push inflation

Source: http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories2.htm

Monetarist view

Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They emphasize the role of monetary policy better than fiscal policy in controlling inflation. According to the famous monetarist economist Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.”

This theory begins with the equation of exchange:

MV = PQ

where

M is the nominal quantity of money.

V is the velocity of money in final expenditures;

P is the general price level;

Q is an index of the real value of final expenditures;

Monetarists assume that V is unaffected by monetary policy (at least in the long run), and Q is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of P is changes in M. In other words increases in the money supply would lead to inflation. The message is simple; control the money supply to control inflation.

Figure 3: Relationship among money supply, quantity of money, value of money and price level.

Source: http://www.sparknotes.com/economics/macro/money/section2.rhtml

Empirical study

There have been many empirical studies on inflation in Vietnam. In the most recent research “Macroeconomic Determinants of Vietnam’s Inflation 2000-2010: Evidence and Analysis”, Nguyen Thi Thu Hang and Nguyen Duc Thanh have developed a hybrid model of inflation determinants that comprise both the structural approach and the monetarist approach as well as employed Vector Error Correction Model (VECM) econometric technique to come to the following results

(1) Public’s memory and expectation play a crucial role in shaping the current inflation. Memory about a period of high inflation in the past seems only to begin to fade away after 6 months of consistently low and stable inflation.

(2) The speed of adjustment of the foreign exchange market and the money market to disturbances is very low or even near zero.

(3) Stimulating the real economy through increasing productivity and output growth has better impact on controlling inflation in the longer run than monetary and nonmonetary measures.

(4) In contrast to previous study results, the model found considerable role of exchange rate, a devaluation in particular, on increasing pressures on inflation.

4. Conceptual framework

Inflation = f(GDP, previous inflation, exchange rate, interest rate, money supply, credit, world oil price, world rice price, cumulative budget deficits, wage rate)

3 channels:

Price level

Aggregate demand

1. Interest rate

2. M2

3. Credit

4. GDP

5. Budget deficit

Aggregate supply

1. Wage rate

2. World oil price

3. World rice price

4. Exchange rate

Expectation

1. Previous year inflation

Data

Monthly secondary data covering the period from January 1995 to December 2010 are used for this study. These data are collected from the General Statistics Office (GSO), State Bank of Vietnam (SBV), Ministry of Finance (MOF), International Monetary Fund (IMF), and World Bank (WB)

Variables

Sources

CPI

monthly inflation data are collected from GSO. The index is rebased to January 1995

Money supply (M2)

International financial statistics (IFS), IMF statistics data base

Credit

IMF

Interest rate

monthly data on lending rates from SBV

Exchange rate

daily official exchange rates (VND/USD) are collected from SBV. Monthly official exchange rates are calculated by taking the average of the daily official exchange rates within each month.

Cumulative budget deficit

MOF

GDP

GSO

Wage rate

World oil price

America’s Energy Information

Administration (EIA)

World rice price

International Rice Research Institute (IRRI)

5. Research method

The study uses quantitative method to identify the determinants of inflation in Vietnam. The study includes the following steps

Unit root testing: The first step is to check the set of data series whether they are stationary. Augmented Dickey-Fuller (ADF) test is used to derive the accurate conclusion on unit roots of the variables. The number of lags in ADF test is selected based on Akaike Information Criterion (AIC) and Schawarz Information Criterion (SIC).

Cointegration analysis: Johansen cointegration test is used to check for long run relationships among variables of the model.

Vector error correction model (VECM):

VECM is used to study the short-run dynamics of the series. The VECM is a restricted form of VAR that incorporates co-integration restrictions. This specification restricts the behavior of co-integrating variables to converge to their long-run equilibrium. Furthermore, this specification allows for a wide range of short-term dynamics. VECM is used to test the determinants of monthly percentage change in domestic inflation.