Monetary policy transmission and Bank of Russia monetary policy

The present study analysed monetary policy transmission mechanisms in Russia in the period of July 1995-September 2004. Bank of Russia officially implements inflation targeting and in its "General foundations of monetary policy" declares monetary base and monetary aggregate M2 as its operational and intermediate targets and policy instruments, insisting that using interest rate as a policy tool would be inefficient due to underdevelopment of financial system. Such position assumes controllability of monetary base, stability of money multiplier, and existence and stability of money demand function. In order to check the implicit assumptions of the monetary policy conduct of the Bank of Russia the SVECM model was constructed, involving monetary aggregate M2, price level, real total trade as a proxy for output, interbank interest rate and average monthly exchange rate, with one cointegrating relation estimated. The estimated cointegrating relation was recognised to be a long-run money demand function. The hypothesis of price homogeneity was not rejected, and the resulting cointegrating relation describes money demand function for the real M2 money balances. The analysis demonstrated that using monetary aggregate as a tool of monetary policy leads to greater variability in output and prices, though the time period of reaction is somewhat shorter as compared to the situation with interest rate as a policy instrument. The role of interest rate and exchange rate channels in monetary policy transmission is evident in both cases of monetary policy instrument choice. The major policy recommendation from the results received is for the Bank of Russia to introduce interest rate management practice simultaneously with further development of financial system.