The Interest Rate and Bank Lending Channels in a Small, Open and Euroised Economy with Fixed Exchange Rate – the case of Macedonia

ABSTRACT
This thesis explores the possibility of conducting a more independent monetary policy through the adoption of an inflation targeting regime in a small, open and Euroised transition economy where banks are dependent on foreign financing. The major aim of this research programme is to investigate the effectiveness and determinants of the interest rate and bank lending channels in the case of Republic of Macedonia, since their effectiveness is seen as one of the preconditions for adoption of an inflation targeting regime. This thesis contributes to the existing literature for transition economies in two main ways. Firstly, it investigates the size and determinants of individual bank‟s lending rate adjustments to changes in the „cost of funds‟ rate. Secondly, it examines two loan functions according to the currency disaggregation of loans, and investigates what bank-specific characteristics are the major determinants. The findings with respect to the first research contribution indicate that the size of the short-run adjustment of lending rates to changes in the „cost of funds‟ rate is quite sluggish and heterogeneous among Macedonian banks. Moreover, bank-specific characteristics and macroeconomic variables play different roles in individual bank‟s lending rate setting decisions. These results are consistent with the presence of aggregation bias in previous research that uses sector-level data, due to the suppression of banks‟ heterogeneous behaviour. The results regarding the second research contribution imply that the bank lending channel in Macedonia works mainly through foreign currency loans and the foreign reference rate, whereas the responsiveness of domestic currency loans to the changes in the domestic reference rate is quite low. Moreover, different banks react differently to changes in the domestic and foreign reference rates due to their specific characteristics. These findings suggest that the impact of domestic monetary policy on the Macedonian economy through the interest rate and bank lending channels is quite limited. Therefore, the current monetary policy regime of a fixed exchange rate may be more effective in achieving the price stability aim than adoption of an inflation targeting regime in economies like Macedonia.