An analysis of the impact of the non-standard monetary policy measures of the ECB on the Maltese economy

Abstract

Before the emergence of the global financial crisis of 2007/2008, central banks all around the world used to conduct standard practices of monetary policy, which involve adjusting the shortterm nominal interest rate to affect the real interest rates which in turn effects demand. These practices were disrupted by the emergence of the global financial crisis, following the burst of the housing price bubble. Business and consumer confidence decreased drastically with the emergence of this crisis, so the European Central Bank (ECB) and other central banks started lowering interest rates to decrease the cost of borrowing, hence encouraging consumption and investment. The lowering of interest rates was complemented by a series of non-standard monetary policy (NSMP) measures to steer the economies in the right direction. However, the interest rates reached the zerolower bound and thus could not be lowered anymore, so NSMP could only be used to stimulate the economy. This study analyses the impact of the non-standard monetary policy measures of the ECB on the Maltese economy. Its goal is to find out whether an increase in the total assets of the central bank of Malta (CBM), reflecting NSMP of the ECB, has caused an increase in the economic activity and the inflation level of Malta, whether such increases are significant or not and whether they are permanent or not. To answer this research question, this study makes use of a Vector Autoregressive Model (VAR) and a Vector Error Correction Model (VECM). These two models are estimated two times, the first time utilizing 5 variables, which are the 3 variables mentioned in the research question and two other control variables, which are; the real effective exchange rate and the equity price index of Malta. In the second estimation of the VAR and VECM, the two control variables are dropped, to see if there are any changes in the result they give. This study does find evidence of causality in the VECMs estimated from the increase in the total assets of the CBM (TA) to the inflation level in the long-run, but not to the real economic activity. The VARs show no causality between these variables in this direction. The variables are used in their natural log form throughout this study. The effectiveness of NSMP on the real economic activity and the inflation level of Malta was mainly found to be insignificant. With regards to the sign of the relationships, the results are mixed, some results show a positive relationship between TA and RGDP as well as between TA and HICP, which is what one would have inferred, whilst others show a negative relationship. The insignificance of these relationships is reflected in the Variance Decompositions (VDs) which show that a shock in lnTA explains a very small percentage of the movement in lnRGDP and lnHICP and it is also reflected in the Impulse Response Functions (IRFs) which show that the response of lnRGDP and lnHICP, following a one standard deviation shock in lnTA is very weak, thus not considered as permanent. The weak relationship which emerges from the model might be attributed to the econometric limitations of the model which are identified throughout the study, the main one being the degrees of freedom problem.