Agric. Econ.

– Czech, 64, 2018 (11): 499–507 Original Paper

https://doi.org/10.17221/295/2017-AGRICECON

Assessing the effect of monetary policy on agricultural

growth and food prices
Zulfiqar Ali WAGAN1*, Zhang CHEN1, Hakimzadi SEELRO2,
Muhammad Sanaullah SHAH1
1
School of Management, Hefei University of Technology, Hefei, Anhui, China
2
Faculty of Social Sciences, Sindh Agriculture University, Tando Jam, Sindh, Pakistan
*Corresponding author: [email protected]

Wagan Z.A., Chen Z., Seelro H., Shah M.S. (2018): Assessing the effect of monetary policy on agricultural growth
and food prices. Agric. Econ. – Czech, 64: 499–507.

Abstract: Agricultural growth is closely associated with sustainable economic development. This is especially true from
the perspective of developing countries, such as India and Pakistan, where significant portions of the labour force are
dependent on agriculture for their livelihood. This study analysed the impact of macroeconomic policy (i.e. monetary
policy) on employment, food inflation, and agricultural growth by analysing to what extent monetary policy is effective
in controlling food price inflation, the effect of contractionary monetary policy on the agricultural sector’s employment
and productivity, and the extent of monetary policy transmission to money market rates and 10-year interest rates. We did
so by applying a factor-augmented vector autoregressive model proposed by Bernanke et al. (2005) to agricultural data from
1995 and 1996 to 2016 for India and Pakistan, respectively. We found that tight monetary policy significantly reduced food
inflation and agricultural production while increasing the rural unemployment rate. Short-term and 10-year interest rates
increased owing to the contractionary monetary policies pursued by both countries. An inclusive monetary policy whereby
policymakers work alongside governments to achieve price stabilisation and reasonable employment rates is recommended.

Keywords: agricultural growth, food inflation, monetary policy

Increased agricultural production is vital to the of the agricultural sector’s share of GDP growth about
reduction of poverty and the growth of the over- 50% (Joshi 2015). Similarly, the agricultural sector
all economy (Thirtle et al. 2003; Färe et al. 2008; comprises 21% of Pakistan’s GDP and employs 45%
Christiaensen et al. 2011; Pauw and Thurlow 2011; of its workforce (Akbar and Jamil 2012). Monetary
Pauw and Thurlow 2012; Baldos and Hertel 2014; policy plays a major role in agricultural develop-
Dorosh and Thurlow 2016) ment both directly (e.g. providing resources) and
Moreover, a recent surge in international food prices indirectly (e.g. decreasing food prices). Through
(concentrated primarily in South Asian countries) has interest rates, monetary policy affects the availabil-
stirred discussion about the importance of domestic ity of money and, consequently, the level of demand
agricultural production to national food security. for agricultural output. Alagh (2011), for example,
While growth in the agricultural sector is neces- found that monetary policy effects rise/fall in money
sary to sustain the rural population, food security income and significantly affected India’s agricultural
requires availability of sufficient amounts of food sector. Akbar and Jabbar (2017) examined the effect
at reasonable prices. of decisions relating to macroeconomic policy on
India’s economy is primarily based on agriculture, domestic food inflation and production in Pakistan.
which provides a livelihood to about 58% of the la- Their study suggested a considerable increase in
bour force. The agricultural sector’s share of gross terms of public expenditure to undertake the devel-
domestic product (GDP) growth declined from 54.56% opment of infrastructure; in addition, it found that
in the early years (1951–1952) after independence lowering energy prices would bring a significant
to 27.87% in 1999–2000. There has been a decline improvement in terms of accessibility and availability

Supported by the National Natural Science Foundation of China, Grant No. 71373065.

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within the theme of providing food security in the ever, when VAR has to estimate a large number
country. For a limited period, tight monetary policy of parameters, the lack of data cannot be overlooked.
may help in reining in food inflation; however, it could This is especially true when accurately modelling
also have a few adverse impacts with regard to food macroeconomic relationships, where the number
production. Over the years numerous studies have of dependent variables can be more than the two
contributed to the field of agricultural productivity or three usually found in VAR models. The main
and these studies provide those working in the sector challenge faced by the researchers is to build an em-
such as business forecasters, economists for decision pirically appropriate model that can not only cap-
analysis with additional information on which to make ture the key characteristics of the data but also not
decisions (Huffman and Evenson 2006; Eyo 2008; be over-parameterised.
McCarl et al. 2009; Akbar and Jamil 2012; Traboulsi Building a model by using hundreds of time series
2013; Siftain et al. 2016). Measures taken by central variables is a challenging task, raising problems related
banks to control inflation may indirectly affect out- to the potential proliferation of parameters and the
put and employment in this sector. Although a small need for methods to reduce the dimensionality of the
number of researchers (Frankel 2006; Hye 2009) have model. Factor methods provide a solution by analysing
studied the impact of monetary policy on the price the information contained in hundreds of variables
of goods in developing economies, the effect of tight and replacing them by a few factors.
policy on agricultural sector productivity has hardly Later on, static factor models were developed into
been analysed. Recently, Indian and Pakistani mon- dynamic factor models (DFMs) to resolve the issue
etary authorities have frequently adjusted interest of identification. With the help of DFMs, researchers
rates keeping economic conditions in view. can explain the changes in a large set of cross-sectional
Vector autoregression (VAR) has been used to ana- data with the help of only a few common shocks, such
lyse policy transmission and its impact on macroeco- as monetary policy, news, technology, fiscal policy,
nomic variables for decades. Over the past 35 years, and oil shocks, which depict the key dynamics. The
there has been a great deal of advancement in the pioneering work was done by Geweke (1977), and
area of stationary VARs 1 (Giordani 2004; Brissimis the applications were suggested by Stock and Watson
and Magginas 2006; Castelnuovo and Surico 2010; (1999, 2002). Combining factor methods with VARs
Krusec 2010; Jääskelä and Jennings 2011; Rusnák leads to factor-augmented VARs (FAVARs), which
et al. 2013). Despite this, there are limitations to the were introduced by Bernanke et al. (2005). The ba-
practical use of VAR models. In addition to the sic idea was to resolve the dimensionality problem
identification problem, one of their most apparent by imposing restrictions derived from the DFM.
shortcomings is their use of an insufficient number In general, the FAVAR approach is superior to VAR
of variables (usually three or four, but occasionally because it provides a comprehensive view of the effects
more than ten). 2 While monetary policy makers use of monetary policy, and may be more intuitive for policy
more variables than those normally used in VAR makers due to the following reasons. First, standard
models. As their predictions are not based on formal VAR requires an explicit connection between the vari-
methods, replicating these is not possible. This has able used and the theoretical concept it represents.
two consequences. Firstly, monetary policy forecast- For example, it is common practice to use industrial
ing is no longer considered an entirely scientific production or GDP as the measure of ‘economic activ-
process (Orphanides 2003). Secondly, VAR models ity’. However, there may be a mismatch between the
have little impact on everyday monetary policy deci- variable for which data are available and the theoreti-
sions (Rudebusch 1998). cal construct it measures or represents. Hence, some
To answer the questions of interest to them and variables need to be treated as unobserved at the
others, macro econometricians work with hundreds time of deciding monetary policy interventions. The
of time series variables and have to rely on just a FAVAR approach allows this. Second, it allows central
few hundred observations for every variable; how- bankers to analyse the rich data set at the time of

1
VAR was initially proposed by Christopher Sims (Sims 1980) three decades ago to address four macro-econometric
tasks: data description and summarisation, macroeconomic forecasting, structural inference, and macroeconomic
policy analysis.
2
A study by Bańbura et al. (2009) that used a Bayesian VAR with up to 130 variables is an exception.

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monetary policy making. Third, standard VAR allows monetary policy on agricultural sector productivity
the observation of impulse responses for only the lim- in India and Pakistan.
ited variables included in the model, whereas in the
FAVAR approach, one can work with hundreds of the
variables and observe the impulse response functions EMPIRICAL MODEL
for each of them. To date, the effect of tight policy on
agricultural growth and employment in South Asia Data and description
has been neglected by researchers. Although food
insecurity is a global concern, South Asia is particu- The data for this analysis were taken from the
larly susceptible. For example, about 48% of people in Reuters EcoWin database (2016), the Pakistan
Pakistan are food insecure (Khan and Ahmed 2011). Bureau of Statistics (2016), the Food and Agriculture
Additionally, food is the primary driver of persistent Organization of the United Nations (2016), the Asian
inflation in India, which has resulted in widespread Development Bank (2016), and Organization for
food insecurity. Food accounts for 47.6% weight in Economic Cooperation and Development, General
India’s consumer price index (Anand et al. 2014). Statistics (OECD 2016). We have examined similar
In this study, we have employed FAVAR to analyse the variables for both India and Pakistan. Eighty variables
effects of public policy on inflation, rural employment, for each country were included in Xt, all of which were
and agricultural productivity in India and Pakistan. stationary and subject to transformation. All data
Five factors interest rates (long and short-term inter- were standardised (i.e. every variable had zero mean
est rate), employment, food inflation, and agricultural and unit standard deviation).
production were considered in our benchmark model. The following transformations were conducted: four
We were primarily interested in answering the represents (logarithm) and one (levels). We divided
following questions: the variables into fast- and slow-moving groups
– How does agricultural productivity react to con- (represented by *). Further details regarding the
tractionary monetary policy shocks? transformation and variable categories used are
– To what extent is monetary policy effective provided in Table 1.
in controlling inflation to the price of food?
– What is the extent of monetary policy transmis-
sion to money market rates and 10-year interest rates? FAVAR model
– How does contractionary monetary policy affect
the level of agricultural employment? We u s e d t h e FAVA R ap p r o a c h i nt r o d u ce d
This study contributes to the existing literature by Bernanke et al. (2005). Let Y t be a (M × 1) vector
in several ways. Firstly, by extending the analytical of observable time series macroeconomic variables
scope of our study using a FAVAR model. Secondly, assumed to have persistent effects on the economy.
we have documented the effect of monetary policy However, in many instances additional information
shocks on a broad range of variables, including em- is required to depict the dynamics of the series not
ployment, food inflation, and agricultural productivity. fully explained by Y t. As Y t contained the policy in-
Finally, we have described the effect of contractionary strument and it can be considered a subset of X t. A

Table 1. Data description and transformation

Serial Data span

Description Code
number India Pakistan
1 agricultural GDP* 1995:1–2016:12 1996:1–2016:12 4
2 employment rate in the agricultural sector* 1995:1–2016:12 1996:1–2016:12 1
3 short-term interest rates 1995:1–2016:12 1996:1–2016:12 1
4 long-term interest rates 1995:1–2016:12 1996:1–2016:12 1
5 consumer prices: food indices* 1995:1–2016:12 1996:1–2016:12 4
6 central bank rates 1995:1–2016:12 1996:1–2016:12 1

*the variables were divided into fast- and slow-moving groups (represented by *); codes – four (logarithm), one (levels)

Source: described in chapter Empirical model

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limited number of variables (normally four to eight) monthly, we used twelve lags; however, eight lags
is usually used for estimation in VAR analyses, and provided the same results. In the figures below, the
additional variables are required to depict the dy- dotted lines represent the 10 th and 90 th percentiles
namics, which can be written as F t, where F t is the and the posterior median is given by the solid line.
(K × 1) vector of unobserved factors. To identify Innovations in central bank rates were standardised
monetary policy shocks, we employed the following to one standard deviation; the figures were therefore
FAVAR approach: interpreted in terms of standard deviation units.
Our principle component analysis employed Gibbs’s
Ft  Ft  1  16 000 related iterations from which we rejected the
 Y  = φ(L)  Y  1 + vt   (1)
 t   t  initial 5 000 to draw for the accuracy of outcomes.
In our FAVAR framework, we considered Yt to con-
where φ(L) is a lag polynomial of finite order d and tain only central bank rates, which means that it was
the error term v t is identically and independently the only variable that had an effect on the economy.
distributed with mean zero and covariance matrix Q. The results showed that under the five-factor FAVAR
It is possible to reduce the above system to standard framework, 100 basis points tightening of monetary
VAR if the terms of φ(L) that relate Yt to Ft are zero. policy in each country led to an initial decline to output
The system described above enabled us to assess the in India. According to conventional wisdom, the ef-
marginal contribution of additional information in Ft. fects of a monetary policy shock to output commence
Unlike the FAVAR models, the standard VAR suffers within months. However, the most significant nega-
from omitted variables bias; hence, FAVAR is a more tive impact on agricultural output was noted during
realistic depiction of economic dynamics and produces the fifth and seventh months in India and Pakistan,
better results than the VAR model. The results were respectively. There was a persistent decline to the
analysed as impulse response functions. The responses GDP of both countries over the medium term, which
were considered significant at horizons where the me- is evident in Figures 1–2.
dian and percentile bands of the impulse response func- Our finding is in line with the theoretical constructs
tions of selected variables did not fall on the baseline. and qualitatively supports the findings of Kazi et al.
(2013), who found that the negative response in output
is because it is a slow-moving variable. This finding
RESULTS AND DISCUSSION can be supported by the relationship between the high
interest rates and a reduction in employment rate and
Our results are presented in Figures 1–10, for level of agriculture production in these countries.
India and Pakistan for major agricultural variables While Figures 3–4 show that agricultural sector
encompassing our broad dataset. We used five factors employment decreased in both countries, the impact
for each country in the form of impulse responses was more persistent in Pakistan. Previous research
in order to investigate the effects of monetary policy emphasises the government support to increase ef-
on interest rates, employment, food inflation, and ficiency, output and employment in agriculture sector
agricultural production. As the data were collected in India. Epstein and Yeldan (2009) study different

1.0
Impulse response function

0.5

0.0

–0.5

–1.0

–1.5
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 1. Impulse response function of India‘s agricultural GDP to India’s monetary policy shock
Source: authors‘ own calculation

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Impulse response function

0.2

0.0

–0.2

–0.4

–0.6
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 2. Impulse response function of Pakistan’s agricultural GDP to Pakistan’s monetary policy shock
Source: authors‘ own calculation

1.0
Impulse response function

0.0

–1.0

–2.0
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 3. Impulse response function of India’s employment rates in agricultural sector to India’s monetary policy shock
Source: authors‘ own calculation
Impulse response function

0.0

–0.2

–0.4

–0.6

–0.8
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)

Figure 4. Impulse response function of Pakistan’s employment rates in agricultural sector to Pakistan’s monetary policy shock
Source: authors‘ own calculation

economies of Asia including India and supports the effectiveness of recent monetary policy in both India
view that central banks target should be beyond and Pakistan. Das (2015) found slow transmission
inflation targeting. Felipe (2009) proposes holistic of loose monetary policy and quick transmission
approach of monetary policy beyond inflation target- of tight monetary policy to bank rates in India. Long-
ing post global financial crisis in Pakistan. term interest rates increased as a result of increases to
Figures 5–8 demonstrate that short-term interest short-term interest rates, and increases to borrowing
rates tend to rise when monetary authorities raise costs resulted in a decline in investment demand for
policy rates. This is because money market rates agricultural output. Hence it confirms that long-
closely follow policy rates. Although money market and short-term interest rates have risen significantly
rates immediately increased by 100% in both countries, in response to contractionary monetary policy shocks
this was nullified after 19 months, which affirms the in both countries.

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Impulse response function

2.0

1.0

0.0

–1.0

–2.0
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 5. Impulse response function of India’s short-term interest rate to India’s monetary policy shock
Source: authors‘ own calculation
Impulse response function

1.0

0.5

0.0

3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 6. Impulse response function of Pakistan’s short-term interest rate to Pakistan’s monetary policy shock
Source: authors‘ own calculation

2.0
Impulse response function

1.0

0.0

–1.0

3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 7. Impulse response function of India’s long-term interest rate to India’s monetary policy shock
Source: authors‘ own calculation
Impulse response function

0.8

0.6

0.4

0.2

0.0
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)
Figure 8. Impulse response function of Pakistan’s long-term interest rate to Pakistan’s monetary policy shock
Source: authors‘ own calculation

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3.0
Impulse response function

2.0
1.0
0.0
–1.0

–2.0

3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)

Figure 9. Impulse response function of India’s consumer prices (food indices) to India’s monetary policy shock
Source: authors‘ own calculation
Impulse response function

1.0

0.5

0.0

–0.5

–1.0
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
Time horizons (months)

Figure 10. Impulse response function of Pakistan’s consumer prices (food indices) to Pakistan’s monetary policy shock
Source: authors‘ own calculation

Additionally, we estimated the impulse response makers as they attempt to expedite growth in the
function of food inflation to contractionary monetary agricultural sector.
policy shocks. It took India and Pakistan four and six
months, respectively, to fully pass through to prices
(Figures 9–10). Furthermore, there is evidence of a CONCLUSION
price puzzle during the first three months in India.
Many studies (Romer and Romer 2004; Primiceri In this study, we examined the effects of monetary
2005) have found that inflation has a persistent posi- policy shocks by applying the FAVAR model proposed
tive response to monetary policy shocks in which by Bernanke et al. (2005) to a broad range of variables,
it takes several years for permanent aggregate shocks including employment, food inflation, and agricultural
to affect prices fully. Our findings present a challenge productivity and employment in India and Pakistan.
to existing explanations for the persistence of inflation In addition, we described the effect of contractionary
and contradict Lustig (2009), who argued that real monetary policy on agricultural sector productivity
and monetary dynamics played an important role in in both countries.
rising food inflation post-2007. The impulse response The agricultural sector is the most important source
functions discussed above provide an overview of of employment for most developing countries, includ-
the effects of monetary policy shocks on major ag- ing India and Pakistan. However, food inflation has
ricultural and macroeconomic policy variables and surged in both countries over the past several years.
demonstrate the effectiveness of FAVAR methodol- Monetary policy may be used cautiously to contain
ogy at capturing additional information. It provides this inflation so long as its impact on agricultural
a comprehensive view of the effects of monetary productivity and the employment rate is considered.
policy, which may prove more intuitive for policy Governments should invest in the agricultural sector

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Received October 18, 2017
Accepted January 2, 2018
Published online November 21, 2018

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