Impact of Excess Reserves on Monetary Policy Transmission in Papua New Guinea

The accumulation of excess reserves in the banking system of PNG may have undesired implications on the effectiveness of monetary policy transmission. Hence, this paper employs a structural VAR model to measure the flow-on effects of positive shocks to excess reserves and the lending rate on private sector loans, the exchange rate, the CPI and real GDP using quarterly time-series data from March 2001 to December 2020. The study uses quarterly data since high frequency data for some variables are not available. The shocks are measured by the orthogonalized innovations to the monetary policy variables. The impulse response results show that the lending rate and excess reserves shocks have unanticipated effects on the exchange rate and the CPI in the short run. Similarly, in the long run, the response of GDP to the shocks is not consistent with monetary theory. Furthermore, the variance decomposition results indicate that excess reserves account for minimal components of the shocks to all variables in the short horizon. The historical decomposition results suggest that the excess reserves shock contributes weakly to the fluctuations of the CPI and GDP over the sample period. The findings determine that excess reserves reduce the effectiveness of monetary policy transmission mechanism in PNG. The study suggests that in order to promote an effective monetary policy transmission, the central bank should consider improving the monetary policy framework and modernizing the financial market system.