Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
Monetary Policy, Institutions and Governance in Major
SAARC Countries
Tariq Hussain
The aim of this paper is to evaluate either the monetary policy is counter or pro
cyclical in major SAARC countries. Monetary guidelines are considered as a foremost
foundation to acquire economic stability. This policy can execute competently as the
institutions are well built and governance is excellent. Therefore, advanced economies
take on counter type monetary strategy however developing economies agree to pro
cyclical type monetary strategy. Developing economies take on pro cyclical type
monetary strategy owing to fragile institution and reduced level of governance. In order to
develop indices for economic, political and governance indicators, Principal Component
Analysis (PCA) technique, a common approach, is applied. 2SLS and GMM techniques
are applied to appraise the cyclicality of monetary strategy either it is counter or pro
cyclical. Thus, this is established that procedure of monetary guidelines is pro cyclical in
these economies. The role of both the institutions is not effective and governance in
these economies is too poor. So as to acquire stability in Major SAARC economies,
counter cyclicality among monetary strategy is required.
1. Introduction
Stability is a significant goal of nations in this global world. So as to accomplish this
aim, definite passageways and strategies are required. Acemoglu et al (2003) explained
that growth policies have considerable role in attaining the growth stability.
Growth policy is a significant source towards achieving growth stability. It is found
that the countries where growth policies are implemented, the growth stability is gained
(IMF, 2000). The functions and responsibilities of the growth policies is part and parcel
in attaining growth stability. However, after financial crisis in 1999, by applying growth
policies, the growth stability in the world is regained. The economies of the world which
gave growth stimulus to other parts of the world are those where growth policies are
maintained domestic and local demand growth (TDR, 2012). Though, the monetary
policy is not implemented fully in the developing world. So, the developing countries still
face hurdles like low GDP, low saving rate, low investment rate, increasing
unemployment, rising government’s expenditures especially non development
expenditures, agrarian background and poor tax collection. With all these factors, the
dream of economic stability is becoming more difficult. Coupled with these corrupt
bureaucracy and inefficient government machinery makes the implementation of growth
policies complicated and difficult. One of the robust sources of success is monetary
policy which is elaborated below.
In monetary policy, appropriate transmission of money helps to accelerate the
economic growth. Therefore, one of the purposes of monetary strategy is to organize
and standardize the supply of money. Friedman and Hahn (1990) explained the focal
role of central bank. Monetary power adjusts the money accretion. This can simply
achieved via open market approach. In classical economics, role of money is just as for
_________________________________________________________
Dr. Tariq Hussain, Assistant Prof and Visiting Faculty Member, Assistant Prof. Imperial College of
Business Studies and University of Central Punjab, Lahore, Email: thussain_eco@yahoo.com
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
transaction. It has no significant role in economy. But thoughts about money change;
increase in money will affect the prices and interest rate. As the supply of money
increases economic activities enhances and output increases.
The monetarists consider that monetary policy put forth larger affect on economic
activity whereas Keynesians consider that fiscal policy has greater impact on economic
action. However, in order to attain economic stability; supply of money is adjusted by
the central bank of a country and this helps in achieving the price stability. In monetary
policy, interest rate is also used as a tool to increase output level in the economy. By
lowering interest rate, investment increases and vice versa. Therefore, interest rate and
money balance support to economic stability. But, the developing economies have not
utilized these tools judiously.
Therefore, monetary policy is not effectively used by the developing countries
and these economies are still in a fix. Developed countries gain stability and control the
cyclicality of business cycle.
The impression undoubtedly exists that developing economies are frequently
tightening and hardening the monetary policy in bad times (Lane, 2003b). It is common
phenomenon that developing countries increase interest rates through recessions and
decrease in expansion. It is also found that procyclical monetary policy is the main
source to create the economic fluctuations in emerging countries (Lane, 2003b and
Kaminsky, et al, 2004). However, the economies of OECD countries generally execute
counter type monetary approach (Lubik and Schorfheide, 2007).
Thus, monetary approach acts as pro cyclical or counter cyclical in developing
and developed countries respectively. Generally, two major reasons are put forward
about the cyclicality (procyclical) of monetary strategy in developing economies. One of
two is shortage in international credit providing marketplaces to defer underdeveloped
economies to find credit in awful circumstances; the other reason is political that good
times support hasty expenditure and rent-seeking performance. The first thought is prop
up by Guerson (2003), and the other opinion is supported with Talvi and Vegh (2005)
and Alesina and Tabellini (2005). For the implementation of monetary policy, certain
institutions like economic and political have significant role. Therefore, institutions’
function is noteworthy to gain the stability.
But, different countries have the different pattern and sources of growth. The
difference can be seen in the institutional pattern of both developed and developing
economies. Institutions of any country are taken as key mainstay of economic stability.
Growth differences among countries are viewed differently by economists. Neo classical
economists viewed the difference in per capita income, is due to the accumulation of
different factor of production. The main elucidation for proportional growth is disparity in
their institutions. Therefore, institutional organization is also fundamental in explaining
its effect on growth stability.
Hence, institutions have vital place to gain stability. Institutions are essentially in
charge for the advancement of any country. There are three foremost classifications
about institutions of any country. First, institutions be taken as the rules of the game
(North, 1990). After that, the players of the sport status is given to institutions (Nelson,
1994) lastly, institutions are the harmonizing result for a sport (Schotter, 1981).
In the same way, from a procedural viewpoint, the analysis of the association
presented among institutional structure and economic growth is commenced through
the establishment of a special tuft of investigation which is known as New Institutional
Economics. In accordance with a number of scholars and researchers, Coase (1937)
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
work can be declared as pioneer work, whose most vital importance is as the cost of
transaction raises, hence institutions matter.
As, institutions acquire a major role in the upgrading of a state. Likewise, state
gives a hand to build up these institutions. How the institutions are created and
developed, there are diverse ideas. North (1981) elaborated the difference among
contract theory and predatory theory about state’s role regarding the evolution of
institutions. In accordance with the first theory, the government and related institutions
offer the legal structure that permits private contracts to assist economic dealings and
transactions which minimize the transaction expenditures. However, the predatory
theory narrates that the state is a device for shifting resources from one set of people to
another. It is elaborated that superior institutions are those which at the same time
support and help private contracts and give check and balance in opposition to
expropriation through the state official either bureaucracy or political influential clusters.
In institutional construction amid developing economies, the function of colonial
supremacy is too foremost. The colonial powers of Europe have developed gigantic
colonial kingdom. The colonial governments established institutions in keeping their own
individual benefit. The region, in which the death rates are lofty, the colonial
governments’ decide not to inhabit in these countries eternally and establish pull out
institutions like African country, Congo. These pull out institutions are not interested in
providing security of property right and no system is there in disagreement to the
government expropriation. Alternatively, the region where weather is supportive, like
USA, the colonial governments establish superior institution resembling the institutions
of Europe. Such institutions are functioning in ex colonial countries (Acemoglu et. al,
2001). This is apparent that such high-quality institutions as in USA formulate it the
developed country and in developing economies, the institutions are the root reason of
their sluggish development.
Diverse kinds of institutions function jointly, for growth stability. This disparity in
both advanced and less advance economies may be owing to discrimination within
institution like economics. History of economic institution is very old. As Smith (1976)
elaborated that commerce, trade and manufacturing activities cannot grow in an
economy where there is no proper system of justice. In other words rule of law is
essential for the progress of a country. Property rights are an important element in
economic institutions. Property rights are customs and rules that guarantee the profits to
the invested capital. When there is security of property rights, the society will prosper
due to increased level of investment by the people.
The economic institutions of developing countries are not functioning well.
Property rights are not safe and contract enforceability is hardly seen in society, so
these economies are still lagging behind. Though, there is conflict about the distribution
of income and resource allocation among people. Strong conflict of interest may create
disaster in society. In this serious situation, political institution presents different options
to resolve this issue. Power full political party plays ultimate role in taking economic
decisions like resource allocation and contract enforcement.
Political institutions and the country’s economic system are closely associated.
The rules and regulations come from the side of political parties. Generally, political
leaders give direction to economies. Yet, the causality functions on both ways.
Specifically, the law of property rights and enforcement of contracts laws are precise
and imposed through the prominent political leaders (North, 1990). Political institutions
are significant and utmost need for both developed and developing countries. Political
institutions enable the economic institutions to work efficiently. It is essential that the
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
political institutions should be efficient and effective to implement the rules. These
political institutions have their strong impact on growth stability.
Acemoglu (2005) explained that structure of political organizations lay down the
arena for the institutions of economy. Their function is not direct. Political organizers
offer the structure to economic organizations of a country. Persson and Tabellini (2006)
examined the impact of democracy on diverse economic aspects. First democratic
system and economic liberalization, second, democracy has influenced the trade policy
and third, the impact of anticipated political restructuring on expected political reform. It
is found that there is major association among democracy and economic growth
regression. In this global village, the decisions of political leaders have strong impact on
the growth stability of the countries. Besides this governance has significant role in
improving the performance of these institutions.
Institutions hand out as key to indicators of governance. The prospect of conflicts
is decreased and assists to apply the contracts at some stage in the legal and official
organism. Institutions present obvious and clear equipments to administer big
businesses, therefore reduce corruption and ceremonial obstacles (WB 2002; Grigorian
and Martinez 2000).
Now a day’s governance develops into central point of economic researchers
and representatives of different world institutes. The spokespersons of different world
organizations currently give full attention on governance circumstances of under
developed economies. Though, good governance has achieved the place of chant for
sponsor organizations and donor economies (Nanda, 2006). There is a pioneering
application of governance indicators since the last twenty years. These indicators are
frequently used to evaluate the efficiency of developed and developing countries. As the
use of these indicators increased, the number of indicators is also increasing. A huge
work on governance indicators is done in a number of institutions as World Bank and
Development Assistance Committee (DAC). Therefore, the first generation governance
indicators are prepared by the key persons of World Bank and numerous economists as
Hall and Jones (1999), Rodrik (1997) and Isham et al (1997). The first generation
governance indicators show the importance of governance indicators. These indicators
draw our attention to the right issue of governance problems in both developed and
developing countries. However, the creation of first generation governance indicators
has difficulty to adjust with practical problems and do not give any superior grip on
reform goals. The second generation indicators have certain procedure and try to cover
the shortcomings of first generation governance indicators. Second generation
indicators are characterized as transparent, accurate and specific (Knack and Manning,
2003). The indicators of Civil liberties and Political Rights are developed by data centre;
Freedom House is applied in this study, as governance indicators. The economists as
Scully (1998) and Levine and Renelt (1992) used these indicators in their studies.
These indicators started from 1973 which assist researcher to capture long period of
time.
The most common world governance indicators (WGI) are developed by
Kaufmann et al (2007) of World Bank. At macro level, governance has to change the
vision and methodology of building of the society overall. Being a part of this global
village, every society accepts changes and set new aims and objectives for them. In the
same way, at micro level individual and firm change their style of working.
In general the purpose of monetary policy is to get stability in the economy.
Counter and pro cyclical monetary strategy is taken on by developed and under
developed economies respectively. One rationale is that underdeveloped economies do
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
not have significant approach to Finance providing institutions in international markets
and second logic is that these economies have weak institutions. These weak
institutions are robust cause of poor performance of under developed countries.
Besides this, governance is also not so good in these economies.
The structure of this paper is like. Section II comprises review of significant
literature; methodology of the paper is explained in the next section III, empirical
findings are given in section IV and in section V conclusion are elaborated and policy
suggestions and implications are also suggested.
2. Literature Review
Monetary policies are generally planned to stable business-cycle fluctuations,
which are commonly known as optimal policy (Woodford, 2001). Monetary procyclicality strategy is followed by central or state banks to gain integrity (Calvo and
Reinhart, 2002; Mendoza, 2002). However, countercyclical and procyclical policies are
adopted by developed and developing countries respectively.
Dolado and Dolores (2001) elaborated the outcome of monetary strategy over
the economy of Spain. This study uses simple Vector Autoregressive Model (VAR)
model and the time period is 1977-1997. The study explains the nature of monetary
policy either procyclical, countercyclical or acyclical. Besides this monetary policy
shocks impact is also evaluated and sectoral analysis is also performed. Construction
and services sectors show greater cyclical impacts of monetary policy.
The
monetary policy shows the tendency of procyclical.
Calvo and Reinhart (2002) elaborated that emerging economies do not
implement the countercyclical monetary policies as when the domestic economic
situation contracts, then capital outflows takes place and the central banks favors to
increase interest rates.
Gerrard et al (2003) examined a model of Kenyian economic growth from 1965 to
1997 with two purposes. The first one is to show the cyclical shocks which are faced by
developing economies. In order to estimate these shocks, the local nominal adjustments
are needed under both irreversibly fixed and free exchange rates. An evaluation of
these counterfactual nominal adjustments recognizes the short-run inferences for an
economy. The second major aim is to estimate the consequences of the economic
growth of Kenya in the absence of the lack of a rational monetary order. The monetary
policy is found procyclical.
Duncan (2010) elaborated that as the institutions of a country have less worth,
decreases the country’s overseas requirement in favor of exterior legal responsibility. It
shows that an affirmative exterior demand upset, lessening the worth of external liability
due to the genuine switch over rate appreciation. As a result of a little wealth outcome,
the genuine approval guides to lesser spending and advanced labor provision. The rate
of wages and price rises fell. Therefore the policy rate is minimized to keep inflation
steady by implementing a pro-cyclical monetary policy.
Institutions’ role is vibrant in gaining growth goals. Institutions are foremost
source in acquiring growth stability. The existing literature has authenticates role of
institutions in the progress of a country. As Mauro (1995) and Roderik et al (2004)
elaborated the function of a country’s institutions is vital for economic growth. Rodrik
(2008) exactly stresses the requirement of institutions “Getting the institutions right first”
to attain the stability.
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
Numerous robust empirical studies like Goldsmith (1997), Dawson (1998),
Heckman and Strong (2000) and Bangoa and Robels (2003) explained that economic
liberty has noteworthy connection to enhance the per capita GDP. Similarly political
based institutions have major responsibility in acquiring economic stability. A handsome
number of empirical studies explain that political based institutions have significant role
to increase the rate of economic growth. Barro (1990) explained encouraging
association between growth and political based institutions. But, this is also brought into
being that politically organized institutions have no foremost function in growth, like
World Bank (2000). In under development economies, the role of institutions is not
satisfactory; the major cause is poor performance in the field of governance in such
countries.
Governance is now becoming an indispensable subject matter of research in the
present world, particularly in the under developed countries. In 1970s, Word
governance is gone off from shadows to brighter shining day in the history of
economics. This word, governance is used just five times in the decade of 1970s. In
1980s, it is used 112 times and in the decade of 1990s it is used 3,825 times (Dixit,
2009). Chaudhry (2009) examined the affect of different noteworthy economic and
social variables on indicators of governance. The paper explained the influence of
significant variables on the issue of governance. The time period of the study is 1972 to
2007. The simple OLS method is applied. The findings of the study propose that
societal and economic (fiscal and monetary) variables have actually sturdy affects on
the issue of governance. Sharma (2007) explained the affects of poor governance on
economy which holds back the economic growth procedure.
3. Data Collection Sources and Appropriate Methodology
3.1 Sources of Data
Panel data is used in this study and it captures the time period from 1981 to
2010. The data is gained from different sources like WDI (2012), KOF Globalization
Indices, Polity iv, Freedom House data set, Government Institute Quality data set and
Human Right Indices (Cingranelli and Richards, 2010).
3.2 Methodology
The focal idea of this study is to examine that monetary policy in SAARC region,
either it is procyclical or countercyclical. The role of institutions is center of attention;
well-built institutions lend a hand the government in putting into service the growth
policies (fiscal and monetary). Though, data on different types of institutions along with
additional growth variables can cause the issue of endogeniety (Falcetti et al, 2002).
Likewise the statistics on a number of institutions might be the source of
multicollineraity. Therefore, Principal Component Analysis (PCA) is applied to decrease
the issue of multicollineraity.
3.2.1 Principal Component Analysis (PCA)
The major function of this approach is to diminish dimensionality problem from the
given data. Preisendorfer and Mobley (1988) explained the work of Beltrami (1873). The
design and approach of singular value decomposition (SVD) is developed by Beltrami. It
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
is formed like our present PCA. While, it is traditionally elaborated that early
explanations of current PCA are explained by Pearson (1901) and after that by Hotelling
(1933). This approach is a linear amalgamation of unsystematic variables as X1 to Xn.
This approach is a statistical process which is employed in order to examine
association among a variety of quantitative variables. Plainly, as in mathematics, when
there are “n” interrelated variables, the approach expands uncorrelated ingredients.
Each part is a linear combination of “n” variables. Like a group X1 to Xn
PC1  a11 X1  a22 X 2 ...........a1n X n
(3.1)
PCm  am1 X 1  am 2 X 2 ...........amn X n
(3.2)
As mn are used like weight up to mth prime constituent and the variable of nth number.
Certainly these are known as eigenvectors. This eigenvalue is known as the variance for each
major part. Therefore, first principal constituent explains the major possible dissimilarity in
given dataset. (Johnson and Wichtern, 2007).
3.2.2 Panel Data Model
Panel data is a generally used approach. Panel data possesses both time and cross section
components. Time series provides information regarding the changes inside subject while cross
section element explains variations among the subjects.
3.2.2.1 Generalized Method of Moment (GMM)
GMM technique is commenced by Hansen (1982). The conventional Instrumental Variable
(IV) technique is undoubtedly steady but unproductive in the incidence of heteroskedasticity.
This common approach is used to surmount this issue in GMM. In other word, this technique
provides reliable result in the existence of non identical and independent (i.i.d) errors (Baum,
2003).
3.2.2.2 Two Stage Least Square (2SLS)
A major part of theory is constructed on sets of association. If the attention is simply in a
specific fraction of the given system or in whole system all together, so, interface of different
variables in our model might have vital proposition in order to explain and judge the restrictions
of the model. Thus, inferences of simultaneity for evaluation in the field of econometric are
documented since long (Working 1926 and Haavelmo 1943).
The zero mean hypothesis must hold so as to utilize linear regression. However there are
three common instances in economic research work: endogeneity, misplaced variable bias, and
imprecision in variables. There are diverse causes for these troubles but the answer is same i.e.
instrumental variable approach (Baum, 2006).
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
4. Selection of Model and Empirical Results
Monetary Policy, Institutions and Governance
4.1
Selection of Model
In order to assess the monetary cyclicality, monetary reaction is evaluated through the
money balance, output gap and other control variables. Output breach is evaluated by applying
the Hodrick-Prescott (HP) filter, as Kaminsky et al (2004). It is elaborated by Hodrick and
Prescott (1981). In order to smooth annual data, the constraint put at 6.25 since recommended by
Ravn and Uhlig (2002). Since counter cyclicality or pro cyclicality issue remains among
variables which provide a major thought that guides to comprehend the path of monetary
strategy. The subsequent model is used to estimate the cyclical aspect in monetary strategy.
LM 2it  0  1LYit  2 LX it   it
(4.1)
Where L is log, M2 is real money balance, Y is taken as output gap to estimate as the
cyclicality element of amount produced divided by real output, X is the control variables,  it
error term,  0 show intercept and the other  s show coefficients of the variables and subscript i
shows countries and subscript t show the time.
X it  ECOit , Kit , M 2it 1, GVit , PIit , OPit , FAit , TTit EXPit , EGVit , PGVit , POPM it , DCPit , REVit ,
ECOit = Economic Institutions
Kit , = Gross Investment
M 2it 1 = Lagged value of Money
GVit = Governance variable
OPit= Trade Openness
PI it = Political Institutions
FAit= Foreign Assests
TTit = Terms of Trade
EXPit= Exports
EGVit=Economic Governance
PGVit= Political Governance
POPMit= Population
DCPit= Domestic Credit to Private Sector REVit= Revenue
The above mentioned model is also used in numerous pragmatic studies, as Calderon et
al (2012) and Clarida et al (1999). In order to estimate the monetary strategy, this is cyclical,
procyclical or acyclical, the study applies M2 as dependent variable as Reinhart (2004)
elaborated it as a cyclical component. In this study, 2SLS and GMM approaches are used to
assess the monetary policy cyclicality. The following are the models for the study of monetary
policy, institutions and governance.
4.2
i) Monetary Policy Models
4.2.1 Monetary Policy and Economic Institutions
LM 2it   it 1LYit  2 LM 2it 1  3 LECOit  4 LDCPit
( LPOPM it  LINFit , LREVit )
(4.2)
Proceedings of 7th Annual American Business Research Conference
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4.2.2
Monetary Policy and Political Institutions
LM 2it   it 1LYit  2 LM 2it 1  3LPIit  4 LPOPM it  5LOPit
( LDCPit  LKit , LREVit )
4.2.3
(4.3)
Monetary Policy and Governance
LM 2it   it  1LYit   2 LM 2it 1   3 LGVit   4 LINFit   5 LOPit
( LKit  LFAit , LREVit )
4.2.4
(4.4)
Monetary Policy, Economic Institutions and Interaction Variable
LM 2it  it  1LYit  2 LM 2it 1  3 LECOit  4 LEGVit  5 LDCPit
( LPOPM it  LINFit , LREVit )
4.2.5
(4.5)
Monetary Policy, Political Institutions and Interaction Variable
LM 2it  it  1LYit  2 LM 2it 1  3LPIit  4 LPGVit  5LDCPit
( LKit  LFAit , LREVit )
4.2.6
(4.6)
Monetary Policy, Economic Institutions and Governance
LM 2it  it  1LYit  2 LM 2it 1  3 LECOit  4 LGVit  5 LDCPit
( LPOPM it  LINFit , LREVit )
4.2.7
(4.7)
Monetary Policy, Political Institutions and Governance
LM 2it  it  1LYit  2 LM 2it 1  3LPIit  4 LGVit  5LIMPit
( LKit  LREVit , LFAit )
(4.8)
The first two models explain monetary policy in the perception of institutions (economic
and political), in the third model governance variable is evaluated with monetary policy, model
four and five evaluate monetary policy with institution and interaction variables and model six
and seven presents combined study of monetary policy with institutions and governance variable.
 ,  ,  ,  ,  ,  and are coefficients.
In above mentioned equatios all
ii)
Principal Component Analysis
Prior to presenting all empirical findings, the technique of institutional and governance
indicators is explained. So as to calculate the institutional variables, numerous problems and
issues are there. (Glaser et al. 2004). For this issue, a common technique PCA is used by
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
economists. Havrylyshyn et al. (2000) used PCA to develop institutional indicators. For present
study, there are three indices, i) for economic institutions ii) for political institutions iii) for
governance, are prepared. There are numerous indices are prepared by different organizations,
researchers and economists like KOF developed the economic globalization indicator, this
indicator has the values between is 0 to 100, as 0 shows the low type institutions and for high
quality institutions, the highest value is 100. For economic institutions, the indicator, government
expenditure (GS) is used in this study, the government expenditures are taken as percentage to
GDP. M2, growth of money is also used to economic institutions indicator. These two variables
are also used by the Fraser Institute. The variable inflation has significant place in
macroeconomic stability. Therefore, the inflation (standard deviation) indicator is used in the
study, as it is also prepared by Free the Economic World indicators (FEW). According to the
method of International Country Risk Rating (ICRG), the risk ranking indicator is arranged. By
following the guidelines of ICRG, the Score indicator is prepared for the SAARC countries. In
this way, by using different indicators, an index of SAARC region is prepared with the help of
PCA. Likewise, in order to evaluate the political institutions, an index is arranged. For political
institutions, index is prepared by using 7 indicators as Legislative competitiveness for electoral
environment (LIEC), Executive competitiveness for electoral environment (EIEC), Political
globalization (PG), Polity2 (PL), Executive constraints (EC) and Total summed magnitudes of
all Major Episodes of Political Violence (ACTOT). These common indicators are applied by
numerous economists in their studies, as Gleaser et al (2004). For the index of governance, two
major indicators like civil liberties (CL) and political rights (PR) are used. Freedom House has
prepared these indicators. These indicators are used by number of researchers, like Isham et al.
(1997) and Levine and Renelt (1992). In order to assess, the capability of data set prior to
applying the PCA. Kaiser-Mayer-Oklin (KMO) indicator is applied in this study. All three
indices fulfill the required targets of KMO. The KMO values between 0.5 to 1.0 indicate that
factor investigation is appropriate (Leech et al., 2005).
The subsequent equations from 4.9 to 4.11 show the values of required indices.
PC1it  0.62GSit  0.49 INFSit  0.25SCit  0.55M 2it
(4.9)
PC2it  0.40LIECit  0.44EIECit  0.36PGit  0.46PLit  0.45ECit  0.31ACTOTit
PC3it  0.70PRit  0.70CLit
(4.10)
(4.11)
4.3 Empirical Results
4.3.1 Monetary Policy and Economic Institutions
With the aim of investigating the monetary policy 2SLS and GMM approaches are used
in this paper. In this model, Economic institutions are applied to examine their function in
monetary policy. The empirical results are shown in the following Table 4.1.
Proceedings of 7th Annual American Business Research Conference
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Table 4.1 Monetary Policy and Economic Institutions (LM2 is Dependent Variable)
Variables
2SLS
1st Stage
LY
LM2t-1
LECO
LDCP
CONS
Anderson
(0.000)
CraggDon
(26.07)
Redundant
(0.000)
0.7889
(0.000)*
0.6658
(0.000)*
-0.3483
(0.000)*
-0.1830
(0.011)**
-10.3515
(0.000)*
Wu. Hausman
(0.6706)
Hetro
(0.1053)
Auto
(0.0076)
GMM
2nd Stage
0.1045
(0.019)***
0.9120
(0.000)*
-0.0089
(0.420)
0.0544
(0.001)*
0.2871
(0.361)
Sargan
(0.8233)
Hansen. J
(0.8122)
0.1068
(0.022)**
0.9108
(0.000)*
-0.0091
(0.410)
0.0558
(0.003)*
0.2810
(0.393)
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The 2SLS and GMM results show about the monetary strategy in SAARC, which is
procyclical since LM2t-1 is noteworthy in 2SLS and GMM models and coefficient sign is
according to theory. The variable LY is significant which also explains the cyclicality of
monetary policy. The economic institution is insignificant and negative coefficient sign. The
results are same as in study of Reinhart (2004) and Calderon et al (2012). It elaborates that the
underdeveloped economies take on procyclical monetary strategy. This is due to poor institutions
(Duncan, 2012). The variable LDCP is noteworthy in 2SLS and GMM models.
For model specification, Ramsey Reset test is used. The result of the test shows that the model is
according to the requirement of Ramsey Reset test. Cragg-Donald (1993) assessment is generally
used to check the weak identification. The F statistic explains that above mentioned model is
appropriate. Stock and Yogo elaborates that this usual significance analysis is strictly distorted, if
the Cragg-Donald values is less than seven (Carstensen and Gundlach, 2006). In order to
evaluate the issue of over-identification in the models, the Sargan and Hansen J tests are carried
out. The P-values elaborates the over-identification issue. The redundant preference allows an
assessment of whether a compartment of excluded or debarred instruments is unnecessary. The
result shows that the required condition is fulfilled. So as to check endogeniety, Wu hausman
assessment method is applied and it is found that endogeniety be present. Besides this,
autocorrelation problem a test is applied which explain no auto problem and heteroskadsity
analysis too elaborate heteroskadsity issue is not in the data.
4.3.2
Monetary Policy and Political Institutions
In order to analyze the monetary policy 2SLS and GMM techniques are used in the study.
Political institutions are also employed to examine their function in monetary policy. The results
are given in the Table 4.2.
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
Table 4.2 Monetary Policy and Political Institutions
Variables
2SLS
1st Stage
LY
LM2t-1
LPI
LPOPM
LOP
CONS
Anderson
(0.000)
CraggDon
(10.73)
Redundant
(0.000)
-0.0592
(0.785)
0.9503
(0.000)*
0.4427
(0.000)*
-0.5894
(0.000)*
0.1793
(0.000)*
-7.1072
(0.000)*
Wu. Hausman
(0.8801)
Hetro
(0.1100)
Auto
(0.000)
(LM2 is dependent variable)
GMM
2nd Stage
0.2462
(0.000)*
0.7516
(0.000)*
-0.0354
(0.154)
0.0183
(0.110)
-0.0397
(0.000)*
0.9297
(0.000)*
Sargan
(0.1956)
Hansen. J
(0.3715)
0.2612
(0.000)*
0.7366
(0.000)*
-0.03881
(0.179)
0.0199
(0.044)**
-0.0420
(0.000)*
0.9748
(0.000)*
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The results of 2SLS and GMM tests show that monetary strategy in the SAARC area is
procyclical, the variable LM2t-1 is important in both models and comprise positive coefficient
symbol. The variable LY is significant which as well explains the cyclicality of monetary policy.
The political institution is insignificant and negative coefficient symbol. The findings are similar
as in the paper of Calderon et al (2012). It elaborates that the underdeveloped economies adopt
procyclical monetary stratgies. This is due to poor institutions (Duncan, 2012). The variable
LPOPM and LOP is vital in both 2SLS and GMM models as both are significant. All the tests’
result shows that model fulfills the requirements.
4.3.3 Monetary Policy and Governance
So as to examine the monetary policy 2SLS and GMM techniques are used in this paper.
Governance variable is also applied to analyze the function in monetary strategy. In the
following Table, the results are elaborated.
Table 4.3
Monetary Policy and Governance
Variables
2SLS
1st Stage
LY
LM2t-1
LGV
LINF
LOP
CONS
Anderson
(0.000)
2.8656
(0.001)*
-1.2000
(0.085)***
-0.2818
(0.877)
0.3821
(0.114)
0.2479
(0.162)
-2.0014
(0.495)
Wu. Hausman
(0.7156)
(LM2 is dependent variable)
GMM
2nd Stage
0.1856
(0.000)*
0.8436
(0.000)*
0.0562
(0.034)**
-0.0197
(0.123)
-0.0347
(0.000)*
0.5299
(0.001)*
Sargan
(0.1473)
0.1834
(0.000)*
0.8455
(0.000)*
0.0603
(0.043)**
-0.0199
(0.236)
-0.0350
(0.002)*
0.5152
(0.003)*
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
CraggDon
(14.008)
Redundant
(0.0000)
Hetro
(0.1803)
Auto
(0.000)
Hansen. J
(0.1825)
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The results of 2SLS and GMM tests show so as to the monetary strategy in this area are
procyclical like LM2t-1 is noteworthy in both models and possess affirmative coefficient symbol.
The variable LY is significant which as well explains the cyclicality of monetary policy. The
governance variable is significant at 5 % conventional level. In the same way, variable trade
openness (LOP) is noteworthy in equally 2SLS and GMM approaches, therefore trade is
important in improving the conditions of SAARC countries but the variable LINF is insignificant
in both models.
4.3.4 Monetary Policy, Economic institutions and Interaction Variable
For the analysis of monetary policy, 2SLS and GMM approaches are applied. The robust
index about Economic institutions along with interaction variable (economic
institution*governance) is also estimated. The findings are elaborated in the following table.
Table 4.4 Monetary Policy, Economic Institution and Interaction (LM2 is dependent variable)
Variables
2SLS
GMM
1st Stage
2nd Stage
LY
LM2t-1
LECO
LEGV
LDCP
CONS
Anderson
(0.000)
CraggDon
(27.63)
Redundant
(0.000)
0.7649
(0.000)*
0.7159
(0.000)*
-0.5393
(0.000)*
0.1803
(0.063)***
-0.1850
(0.010)*
-11.035
(0.000)*
Wu. Hausman
(0.8840)
Hetro
(0.2021)
Auto
(0.0103)
0.1008
(0.021)**
0.9148
(0.000)*
-0.0240
(0.380)
0.0150
(0.504)
0.0546
(0.001)*
0.2515
(0.446)
Sargan
(0.8272)
Hansen. J
(0.8149)
0.1029
(0.020)**
0.9138
(0.000)*
-0.0251
(0.395)
0.0159
(0.492)
0.0560
(0.003)**
0.2791
(0.444)
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The results of 2SLS and GMM tests show with the purpose of explaining the monetary
policy in the these countries which is procyclical as LM2t-1 is noteworthy in both models and
have correct coefficient symbol as per theory. The variable LY is significant which also explains
the cyclicality of monetary policy. Both the economic institution and the interaction term are
insignificant in both models. The result is similar to the study of Reinhart (2004) and Calderon et
al (2012). It elaborates that the underdeveloped economies take on procyclical monetary
strategies. The variable LDCP is significant in both 2SLS and GMM models.
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
4.3.5 Monetary Policy, Political institutions and Interaction Variable
So as to analyse the monetary policy, 2SLS and GMM techniques are used. The index of
Political institutions and interaction variable (political institution*governance) is also evaluated.
The findings are given in the following table.
Table 4.5 Monetary Policy, Political Institution and Interaction
(LM2 is dependent variable)
Variables
2SLS
GMM
1st Stage
2nd Stage
LY
LM2t-1
LPI
LPGV
LDCP
CONS
Anderson
(0.000)
CraggDon
(24.32)
Redundant
(0.000)
2.3317
(0.000)*
-0.1898
(0.739)
-0.9326
(0.028)**
-0.1413
(0.329)
-0.6848
(0.072)***
-2.5849
(0.204)
Wu. Hausman
(0.1122)
Hetro
(0.3373)
Auto
(0.000)
0.1620
(0.000)*
0.8663
(0.000)*
-0.0267
(0.268)
0.01004
(0.185)
0.0782
(0.000)*
0.3138
(0.002)*
Sargan
(0.5421)
Hansen. J
(0.5435)
0.1636
(0.000)*
0.8653
(0.000)*
-0.0294
(0.260)
0.0107
(0.097)***
0.0802
(0.001)*
0.3111
(0.006)*
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The results of 2SLS and GMM techniques show about the monetary strategy in the major
South Asian economies and it found that policy is pro cyclical. The variable LM2t-1 is significant
and possesses correct coefficient symbol. The variable LY is significant which also explains the
cyclicality of monetary policy. Both the political institution and the interaction term are
insignificant in both models except LPGV which is significant at 10 percent. It explains that
governance has no major role in monetary policy. The finding of this study is in resemblance
with the work of Reinhart (2004) and Calderon et al (2012). The variable LDCP is significant in
both 2SLS and GMM models.
4.3.6 Combined Result: Monetary Policy, Economic institutions and Governance
Combined results are evaluated in this model. For this purpose, 2SLS and GMM
techniques are used. The results are presented in the following table.
Table 4.6 Monetary Policy, Economic Institution and Governance (LM2 is dependent variable)
Variables
2SLS
GMM
1st Stage
2nd Stage
LY
LM2t-1
LECO
LGV
LDCP
0.7643
(0.000)*
0.7172
(0.001)*
-0.3587
(0.000)*
0.1840
(0.058)***
-0.1854
0.1010
(0.020)**
0.9147
(0.000)*
-0.0090
(0.414)
0.0145
(0.519)
0.0546
0.1030
(0.020)**
0.9137
(0.000)*
-0.0092
(0.406)
0.0153
(0.507)
0.0559
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
CONS
Anderson
(0.000)
CraggDon
(27.65)
Redundant
(0.000)
(0.010)
-11.0547
(0.000)*
Wu. Hausman
(0.7323)
Hetro
(0.1982)
Auto
(0.0018)
(0.001)*
0.2520
(0.446)
Sargan
(0.8280)
Hansen. J
(0.8159)
(0.003)*
0.2444
(0.490)
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The results of 2SLS and GMM approaches elaborated about the monetary strategy in
these economies and it is found that the policy is procyclical. The variable LM2t-1 is significant
in both 2SLS and GMM approaches and has coefficient symbol as per theory. The variable LY is
significant which as well explains the cyclicality of monetary policy. Both the economic
institutions and the governance variables are insignificant in our models. The variable LECO has
negative coefficient symbol. The variable LDCP is significant in both 2SLS and GMM models.
4.3.7 Combined Result: Monetary Policy, Political institutions and Governance
Monetary policy, political institutions and governance are evaluated collectively. For this
purpose, 2SLS and GMM techniques are used. The findings are elaborated in table 4.7.
Table 4.7 Monetary Policy, Political Institution and Governance
(LM2 is dependent variable)
Variables
2SLS
GMM
1st Stage
2nd Stage
LY
LM2t-1
LPI
LGV
LIMP
CONS
Anderson
(0.000)
CraggDon
(19.93)
Redundant
(0.000)
2.6854
(0.002)*
-0.5860
(0.379)
-1.4211
(0.003)*
-0.4768
(0.362)
-0.0131
(0.932)
-1.7037
(0.503)
Wu. Hausman
(0.9045)
Hetro
(0.1083)
Auto
(0.000)
0.2071
(0.000)*
0.8437
(0.000)*
0.0207
(0.295)
0.0550
(0.039)**
-0.0263
(0.001)*
0.3353
(0.010)**
Sargan
(0.2257)
Hansen. J
(0.2632)
0.2107
(0.000)*
0.8415
(0.000)*
0.0206
(0.352)
0.0602
(0.028)**
-0.0275
(0.000)*
0.3237
(0.0025)**
Note: The values are coefficient and in parenthesis are P values. *, ** and *** show the significance level at 1, 5 and 10 percent respectively.
The results of 2SLS and GMM tests explain so as to monetary policy in these
underdeveloped economies is of procyclical nature. The variable LM2t-1 is significant in
combined results models and has correct coefficient symbol. The variable LY is significant which
too explains the cyclicality of monetary policy. The political institutions variable is insignificant
in both models and the governance variables are significant in both 2SLS and GMM at 5 percent
level. The variable LIMP is significant in both 2SLS and GMM models.
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
5. Conclusion of the Study and Policy Connotation
5.1 Conclusion
This paper has explained the cyclicality association among monetary strategy, institutions
and condition of governance in major SAARC countries. There are six significant developing
economies of South Asia and the time period covered in this paper is 1981 to 2010. It is found
that these major economies of SAARC are taken on pro cyclical monetary strategy. In spite of
the fact that in developed countries countercyclical monetary policy is adopted in peak time of
the economy. However in the developing countries monetary policy is procyclical in peak time.
Monetary strategy is of procyclical nature in underdeveloped economies whereas in
advanced economies it is countercyclical (Lane, 2003b). In this study, monetary strategy is
evaluated in the perspective of institutions and governance. So as to evaluate the cyclicality of
monetary strategy, LM2 variable is used. In above models, the variable LM2t-1 and LY is
significant and robust and has positive coefficient symbol which shows that the monetary
strategy in SAARC area is of procyclical nature. The variable Log Economic institutions and
Log Governance Indicator is not significant which show that in monetary policy, these indicators
has no vital role. The different diagnostic tests are performed, as model specification,
autocorrelation, heteroskadacity, Anderson, CraggDonald and Sargan which shows that the
results fulfilled the required conditions.
Procyclical policies hinder the economic growth. It has deep effects on the economy.
Procyclical policy will cause reduction in the collection of revenues (Eichengreen and
Hausmann, 2004), the level of poverty raises (Laursen and Mahajan, 2005) the level of new
investment fall (Bernanke, 1983).
5.2
Policy Implications
From a policy viewpoint, the implications of the study seem to be of grand practical
magnitude. The following policies should be taken for conducting the appropriate growth
policies in SAARC countries.
There is a need to adopt counter cyclical monetary policy in SAARC region. The balance
of money must decline in good and favorable times and increase in bad and shocking times
(Kaminsky, 2004). Central banks must perform significant role in adopting counter cyclical
monetary policy as open market operation.
Domestic credit to private sector and trade openness play significant role in the
economies of SAARC countries. There is need to enhance the credit to private sector, economic
activities increase and people get more jobs and the governments’ earn more revenue. It is
required to increase exports and decrease imports.
Institutions have significant and robust function to take on appropriate growth policies.
The economies of SAARC area are still lagging behind due to weak institutions. These countries
must get rid of colonial based extractive institutions. Therefore, it is essential for SAARC
countries to renovate institutions according to their local requirement.
Poor governance is common phenomena in the SAARC economies. Governance is
essential element for growth stability. The governments of SAARC region should increase the
performance of civil service employees. Corruption must be minimized.
Proceedings of 7th Annual American Business Research Conference
23 - 24 July 2015, Sheraton LaGuardia East Hotel, New York, USA, ISBN: 978-1-922069-79-5
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