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Interest Rate Pass Through The Case Of Jordan Finance Essay

The paper seeks to explore empirically the relationship between short term policy interest rate and both deposit and lending rates in Jordan. Technically, we are trying to examine the speed of adjustment and pass-through from policy rate to deposit and lending rates. The empirical evidence from the Jordanian economy shows that deposit and lending interest rates follow a symmetric movement for their deviations from the long run equilibrium. This means that the CBJ has the power to control the spread between deposit and lending rates. Moreover, lending rate speed of adjustment is slow, as a result, any monetary policy action requires at least three years to be effective.

I. INTRODUCTON

The behavior of macroeconomic variables has long been an object of interest to economists. Technically, the ultimate goal is to predict the future path of these variables based on information from the past history. Nowadays, it is widely recognized that monetary policy has a real impact on the economy over the short horizon. On the other hand, economists understand the idea that the long-run effects of monetary policy fall entirely on prices. That’s why, central banks play a crucial role to steer the economy toward either more economic growth or more inflation rate or both of them in the short run. The economy final destination is in the hands of monetary authority. At the same time, central bankers recognize the significant role they have. As a result, they are working within critical restrictions which are to be more effective, accurate, transparent and accountable while conducting their policies. The effectiveness of monetary policy relies mainly on degree and speed of retail interest rate adjustment to a change in policy interest rate. For this reason, understanding channels of monetary transmission has received enormous attention on both theoretical and empirical levels. This analysis has a shortcoming which is nowadays central banks use short-term interest rates as a policy instrument i.e. overnight and certificate of deposits. Consequently, the relationship between policy short –term interest rate and banks’ retail interest rates i.e. deposit and lending rates have received modest attention in monetary theory. Economists widely agree that the control on firms’ and households’ behaviors is more related to retail interest rates rather than the policy rate. Despite that, significant theoretical economic models [1] assume lending interest rate is equivalent to policy interest rate [2] . They assume implicitly that the central bank has a full control over the interest rate. Therefore, it is untrue that the central banks have a full direct control over the aggregate demand and inflation rate because we should understand the effect of the policy short-term interest rate on the retail interest rates. Moreover, early researches on the monetary transmission mechanism assumed immediate and complete pass-through of changes in official rates to retail bank rates [3] . Recently, large numbers of empirical studies report stickiness in the retail banks’ interest rate, particularly lending rate. Put it in another way, retail banks’ interest rate has asymmetric adjustment to an increase or a decrease in the policy interest rate.

Lately, some economists develop more techniques to explore the fluctuations in depth. Technically, it focuses on the asymmetries of the macroeconomic and monetary variables. Scholars look to asymmetry from two different dimensions; persistence and influence. The former indicates, for example, the positive phases persist more than the negative phases of a series. The latter means, for example, to specify that positive shocks of money supply has a stronger effect on the real output than the negative shocks. Sichel (1993) states that the importance of asymmetries arises from a desire to understand facts about business cycles and other economic variables. Further, standard linear time series models are not capable to illustrate asymmetric behavior under certain assumptions.

Some economists noticed that some macroeconomic variables in many countries follow an asymmetry behavior, despite the fact that asymmetries have only recently been examined empirically. For example, Cover (1992) shows that an expansionary monetary policy in the U.S. economy does not affect the output, while a contractionary monetary policy affects the output. Sichel (1993) provides evidence from the U.S. shows that real GNP displays weak asymmetric adjustment [4] .

Moreover, recent studies concerning monetary variables reported asymmetric behavior. Enders and Granger (1998) present evidence showed that the movement toward the long-run equilibrium of the interest rate has asymmetric process. Peersman and Smets (2001) use data from 7 countries of the euro area and found asymmetric effect of monetary policy in Germany, France, Italy, Spain, and Belgium. Florio (2004) reviews five proposed explanations of why monetary policy has an asymmetric effect, of which credit market imperfection. This means the effect on a boom is not the same as in a recession.

Furthermore, the recent studies illustrate that the pass-through may be incomplete and that the adjustment speed may be slow. The pass-through and adjustment speed also differ across financial institutions and across financial products, implying the speed of monetary transmission may vary across different segments of the banking sector. For example, see Cottarelli and Kourelis (1994), Mojon (2000), de Bondt (2005), Hofmann and Mizen (2004) and Liu et al. (2008). Besides, some studies find that the speed of adjustment may be asymmetric. For example, see Chong et al. (2006), Kleimeier and Sander (2006) and Payne and Waters (2008). In a recent study, Ozdemir (2009) finds that retail interest rate adjusts symmetrically for an increase or a decrease in money market rate in Turkey.

The current paper seeks to investigate empirically the relationship between short term policy interest rate and deposit and lending rates in Jordan. Specifically, we are trying to examine the speed of adjustment and pass-through from policy rate to deposit and lending rates. The findings of the current paper help to understand the effectiveness of monetary policy in Jordan. Moreover, it assists to highlight on the behavior of commercial banks to set deposit and lending rate in Jordan. The paper contributes by exploring the relationship between short term policy interest rate and retail interest rates in a developing economy. Further, Jordan lacks such important studies, thus, we believe this paper helps the economic policymakers and scholars to have more knowledge about the Jordanian monetary policy. The rest of the paper is organized as follows: Section II presents the literature review of interest rate pass-through. Section III introduces monetary policy in Jordan. Section IV introduces the methodology of the current study. Section V presents the empirical results. Conclusions are presented in the last section.

II. LITERATURE REVIEW

Since the last two decades, the concept of interest rate pass-through receives more attention in monetary economics. Central banks can influence short-term money market interest rate which, in turn, affects retail bank interest rates. On the aggregate demand side, retail interest rate plays a crucial role to determine the decision of both lenders and borrowers, which will create inflation rate and/or economic growth. What is more, lending rate has a significant influence on the cost of production, aggregate supply side. Tillmann (2008) states that the cost channel of monetary transmission describes the supply-side effect of interest rates on firms’ cost structure. If firms decide to borrow from financial intermediaries to finance the factors of production in advance, then interest rates have an influence on their costs of production and, hence, on inflation rate. Additionally, he argues two significant points regarding the relationship between interest rate and inflation rate. First, the financial intermediaries play a decisive role in propagating interest rate shocks to the cost side of the economy and, finally, to inflation rate. Second, interest rate effect might reflect other factors leading to cost pressure more than labor share as a measure of marginal cost, which leads ultimately to higher inflation rate. Tillmann (2009) demonstrates that uncertainty about the cost channel reflects uncertainty regarding the role of financial markets in transmitting policy shocks to the supply side of the economy. He proves that uncertainty about the cost channel affects the strength of interest rate adjustment.

Interest rate pass-through means how a change in a policy rate influences the retail interest rates; deposit rate and lending rate. Consequently, the nature of this relationship has a direct impact on monetary policy effectiveness. We follow de Bondt (2005) and utilize the relationship between policy rate and retail interest rate to present the idea of interest rate pass-through and as follows:

(1)

where is the retail interest rate (price) set by banks. is a constant markup. denotes the market interest rate (the marginal cost price for banks). The coefficient is the response of retail interest rates (deposit and lending rates) to market interest rate. If we live in a perfectly competitive economy with complete information, then we should not worry about the response of retail interest rate to a change in market rate because we expect the relationship to be one-to-one. But, we are living in an imperfect competition economy, as a result, the relationship should be less than one in the short run, interest rate stickiness. Technically, the value of depends on all types of imperfection in the economy and the level of uncertainties. For example, the demand elasticity of deposits and loans with respect to the retail bank interest rate, market power, switching costs and asymmetric information costs (adverse selection and moral hazard). Lowe and Rohling (1992) state that there are four theories to explain loan rate stickiness, which they are; adverse selection, switching costs, risking sharing and consumer irrationality. The empirical studies focus on the value of the coefficient. Hence, we expect to find the value of is less then one in Jordan. The goal of the current paper is to examine whether the value of for deposit and lending rates have the same value of positive and negative policy interest rate shocks.

Most empirical studies focus on the question whether bank interest rates respond in asymmetric manner to policy rate or not. Sorensen and Werner (2006) shows that the previous studies [5] differ widely in terms of scope and methods. As for the scope, some studies focus on aggregate interest rate series for individual countries. Other studies use micro banks information to investigate the price setting behavior of these banks. In terms of method, the macro studies utilize single-equation error-correction models (ECM) to measure the dynamics of the pass-through. On the contrary, the micro studies employ panel data techniques. The previous studies conclude that the degree and speed of pass-through differ significantly across countries as well as across banking products, especially in the short-run.

Stiglitz and Weiss (1981) show that in an equilibrium characterized by credit rationing the lending rate may not move-up even when other interest rates in the economy increase. Their justification is that the interest rate a bank charge may itself affect the riskiness of the loan through imperfect information; adverse selection and moral hazard. In this case, higher interest rate may attract riskier borrowers, thus, the probability of not repaying back the loan is higher. Moreover, higher interest rate may incentive borrowers to engage in riskier investments. As a result, banks cannot increase lending rates even if they face higher marginal costs. In sum, the existence of asymmetric information between borrowers and lenders in loan market may create an upward stickiness in lending rates.

In the bank loan market, running the business is completely different than other markets. The bank needs to find out some information about the features of each customer. This is a costly activity for the bank and usually it passes onto the customer as fees. This fee makes it costly for a buyer to switch from one bank to another. This is known in the literature as switching cost. Klemperer (1987) shows that switching costs in a mature market lead to monopoly power, market segmentation and reduces the demand elasticity, which, in turn, result in incomplete adjustment of retail interest rate for a change in market interest rate. Thompson (2006) proves that the prime lending-deposit rate spread displays asymmetric adjustment. He argues that asymmetric adjustment in the spread is due to the information asymmetries between banks and their customers and the existence of switching cost. As a result, banks may be slow to adjust their rates for a change in market interest rate. Banks may utilize this practice of asymmetric price setting behavior even though it may not be optimal in the long run. If banks have market power, then they can widen of the spread by slowly adjusting their lending rates to the falling deposit rates. However, other competing banks would simply adjust their lending rates first to capture more customers and gain greater market share. Dueker (2000) examines the existence of an asymmetric relation between the prime rate and market interest rates. He finds two types of asymmetry in the prime rate. First, the latent prime rate moves more quickly in relation to the market interest rate, if the two rates are rising than if they are falling. This implies prime rate responds faster to positive shocks of market rate than negative shocks. Second, prime rate fluctuation is biased upward. Consequently, he argues that banks are unlikely to lower their prime rates during a recession due to the higher risk of default. This risk-averse behavior of banks and their managers may result in prime rates adjusting asymmetrically to movements in market rates.

Recently, Leuvensteijn et al. (2008) investigate the effects of bank competition on bank loan and deposit rate levels as well as on their responses to changes in market rates by using data from the euro area during the (1994-2004) period. They find stronger competition significantly lower spreads between bank and market interest rates. In addition, they conclude that in more competitive markets, bank interest rates react more strongly to changes in market interest rates. Besides, they confirm when competitive pressure is heavier in the loan market than in the deposit markets, banks compensate for their reduction in loan market income by lowering their deposit rates. Neumark and Sharpe (1992) investigate the impact of market concentration on the adjustment prices in the market for consumer bank deposits. They use panel data of consumer bank deposits interest rate from the U.S. economy. They find that banks in concentrated markets are slower to raise interest rates on deposits in response to rising policy interest rate. However, they find [6] that the same banks are faster to reduce interest rates on deposits in response to decreasing policy interest rate. This result suggests that downward price rigidity, the analogy to upward interest rate rigidity, exists and related to the marker power.

III. MONETARY POLICY IN JORDAN

Jordan is a small open economy classified as lower middle-income country with about 5.98 million inhabitants and annual per capita income at current market prices equal to $3835 in 2009. The Jordanian economy is living in an unstable region. As a result, the economy is vulnerable to external developments either political events or economic i.e. higher international oil prices and lower external grants. That’s why, the Central Bank of Jordan (CBJ) is seeking to accumulate foreign reserves to help cushion external shocks and maintain the peg. In 1988/1989, the Jordanian economy experienced bad economic shock leads to high inflation rate reached to 25.7% and negative economic growth get in touch with -16.7%. At that time, Jordan adopted an economic adjustment program in the consultation with the IMF aimed to achieve economic stability and to move toward the market-oriented economy.

Jordan has a stable banking sector; it is privately owned, growing, well capitalized, open to external investors, liquid and profitable. There are 23 banks are currently operating (13 local commercial banks, 8 foreign banks and 2 Islamic banks). The banking environment is highly competitive. The latest data shows a noticeable decline in the market concentration. Despite that, the largest three banks account for a market share of slightly over 40%.

CBJ primary announced objective is to enhance economic growth, maintain price stability and sustain a pegged exchange rate to the U.S. dollar. In September 1993, CBJ moved toward the indirect method i.e. certificate of deposits issued by CBJ to control money supply and absorb excess liquidity. The reasons behind this new policy are its convenience to the philosophy of free market economy, and its effect on both the deposit and lending rates. Prior to mid of 1995, Jordan targeted the monetary aggregate to achieve its economic goals. After the mid of 1995, certificate of deposits auction’s rate started to be the main tool to conduct monetary policy in Jordan. The new operating procedure of CBJ is to influence bank deposit and lending rates to guarantee a high demand on the Jordanian dinar relative to the U.S. dollar. Hence, the success of monetary policy to achieve its goals depends on how the certificate of deposits rate affects the bank’s retail interest rates. In March 1998, CBJ added the overnight deposit facility (ODF) as a new tool to manage the liquidity on daily basis. The interest rate of ODF is the floor of the inter-bank rate. Figure (1) shows the movement of the interest rate in the Jordanian economy and the federal fund rate from the U.S. economy during the period (1994:1-2008:3). We can see that since the first quarter of 1999, certificate of deposits rate declined. As a result, the deposit rate responds faster than lending rate and started to decline in the third quarter of 1999. However, the lending rate begun to decline since the first quarter of 2000. We can notice the same behavior happen again when the certificate of deposits rate started to hike in the second quarter of 2004.

This behavior proves the reaction of the deposit rate to a change in the certificate of deposits rate is faster than the reaction of the lending rate. CBJ is working between two edges; maintaining the attractiveness of the Jordanian dinar versus maintaining a pegged exchange rate to the U.S dollar. Therefore, it is crucial for the CBJ to be effective and have a symmetric control and effect on deposit and lending rates to keep their spread within certain margin.

Figure (1): Jordan Interest Rate Data and Federal Fund Rate

Recently, Poddar, Sab and Khachatryan (2006) seek to understand monetary transmission mechanism in Jordan. They find CBJ operating targets affect foreign reserves and bank rates successfully. However, the evidence shows monetary policy is unable to influence output. Sweidan (2008) proves that policy interest rate in Jordan displays symmetric adjustment. This indicates that the CBJ is not prejudice of either easy or tight monetary policy. Recently, Sweidan (2009) studies the preferences of the CBJ. He proves that CBJ prefers higher level of inflation rate and higher level of output.

IV. THE METHODOLOGY

We employ a univariate error-correction model (ECM) to achieve two goals. First, explore a separate dynamic interest rate adjustment between policy interest rate and deposit and lending rates in Jordan. The specification of the deposits rate dynamic is as follows:

(2)

The specification of the lending rate dynamic is as follows:

(3)

Where is the first difference, stands for policy interest rate, certificate of deposits, is the deposit rate, denotes the lending rate, and stand for stochastic error and assumed to be normally distributed, but not serially correlated. and reflect the short run pass-through parameters, and are the short-run error correction coefficients, and reveal the long run pass-through.

Second, following Scholnick (1996), Sander and Kleimeier (2000) and Ozdemir (2009), we utilize the univariate ECM is to investigate if the deposit and lending rates adjust asymmetrically to the movement of the error correction term [7] . The error correction term is divided into two components, as follows:

, if

, otherwise

, if

, otherwise

Then, we estimate the deposit short run dynamic model, which has the following form:

(4)

The asymmetric mean adjustment lag of above the equilibrium = .

The asymmetric mean adjustment lag of below the equilibrium = .

The asymmetric mean adjustment lag is the time horizon through which policy interest rate is fully passed through to deposits and lending interest rates. Put it in another way, it measures the time span during which the retail interest rates stick above and below the equilibrium.

The lending short run dynamic model has the following form:

(5)

The asymmetric mean adjustment lag of above the equilibrium =.

The asymmetric mean adjustment lag of below the equilibrium is =.

In equation (4), the parameter of the measures the speed of adjustment when rates are above their equilibrium level, whereas the estimated parameter of the computes the speed of adjustment when rates are below their equilibrium level. Likewise, in equation (5), the coefficient of the evaluates the speed of adjustment when rates are above their equilibrium level, whereas the estimated coefficient of the measures the speed of adjustment when rates are below their equilibrium level. The test of whether deposit and lending interest rates adjust asymmetrically relies on the values of,, and in equations (4) and (5), respectively. If and are statistically significant and, banks’ deposit rate adjusts downward faster than upward. For equation (5), if and are statistically significant and, banks’ lending rate adjusts upward faster than downward.

V. EMPIRICAL RESULTS

The current study uses quarterly data from Jordan during (1994:1-2008:3) period. The source of data is the International Financial Statistics (IFS) CD-ROM. The first step is to investigate whether the data on the level has a unit root or not. The three variables in the model; certificate of deposits, deposit rate and lending rate have a unit root on the level. This result is confirmed by running three unit root tests which they are: Augmented Dickey-Fuller (ADF) test, Phillips-Perron (PP) test and Kwiatkowski-Phillip-Schmidt-Shin (KPSS) test. Table (1) presents the results of augmented Dickey-Fuller unit root test. The results prove that all the series have a unit root on the level. The table shows that certificate of deposits and lending rates are stationary on the first difference with lags of zero and one. However, deposit rate is stationary on the first difference with lag of zero only. Therefore, we perform PP and KPSS tests to support ADF findings. Both tests confirm that all the series have a unit on the level. Furthermore, they prove that all the three series are stationary on the first difference.

Table (1): Augmented Dickey -Fuller

Unit Root Test

Series

Lags

ADF Test

the level

1st diff.

cdr

0

-1.11

-4.68

1

-1.79

-4.18

dr

0

-0.54

2.61

1

-1.47

-2.37

lr

0

-0.26

-5.07

1

-0.59

-2.81

Note: The critical values are 3.55, 2.91, and 2.59 at

1%, 5% and 10%, respectively.

The second step is to test if there is a univariate cointegration relationship between deposit rate and certificate of deposits from one side and between lending rate and certificate of deposits from the other side. The current study utilizes Johansen test. The results are reported in Table (2) and Table (3). From Table (2), the trace test statistics and maximum eigenvalue illustrates that there is one cointegration relation between deposit rate and certificate of deposits. Likewise, From Table (3), the trace test statistics and maximum eigenvalue prove the existence of one cointegration relation between lending rate and certificate of deposits. This result assures a univariate long run relationships exist between retail interest rates and policy interest rate.

Table (4) presents the results of the deposit rate univariate ECM [8] . The coefficients of the error correction term, short term adjustment [9] , and the long term adjustment are statistically significant

Table (2): Deposit rate – certificate of deposits cointegration test

Trace Test Statistics

Null

Alternative

Statistic

5% Critical Value

1% Critical Value

r = 0

r 1

r 1

r = 2

39.95

1.64

15.41

3.76

20.04

6.65

Maximum Eigenvalue

Null

Alternative

Statistic

5% Critical Value

1% Critical Value

r = 0

r 1

r = 1

r = 2

38.31

1.64

14.07

3.76

18.63

6.65

Table (3): Lending rate – certificate of deposits cointegration test

Trace Test Statistics

Null

Alternative

Statistic

5% Critical Value

1% Critical Value

r = 0

r 1

r 1

r = 2

31.72

1.86

15.41

3.76

20.04

6.65

Maximum Eigenvalue

Null

Alternative

Statistic

5% Critical Value

1% Critical Value

r = 0

r 1

r = 1

r = 2

29.86

1.86

14.07

3.76

18.63

6.65

different from zero and have the right sign. Besides, all the estimated coefficients are less than 1 as expected. In the short run, the deviation of deposit rate from the equilibrium is corrected by about 17 percent in the current period. Thus, the mean adjustment lag at which policy interest rate is fully passed through to deposits rate is approximately 6 quarters. The asymmetric results present the same conclusion, the speed of adjustment when rates are above and below their equilibrium levels are -16% and -18%, respectively. Further, the short-term adjustment is clearer and equal to 24% at the current time. To test if deposit rate adjusts symmetrically to the deviation from the long run equilibrium, we test if those two parameters are equal,. The Wald statistic is reported in Table (4), the symmetric adjustment hypothesis of deposit rate cannot be rejected. Moreover, the positive and negative lags mean adjustments support this conclusion, they are approximately the same and equal to 5 quarters. This implies that the deposit rate adjust in a symmetric manner to the movement of the error correction term. In the long run, the deposit rate adjustment coefficient is -1.09% which implies a complete pass through from certificate of deposits to deposit rate.

Table (4): The Results of the Error

Correction Model: The Deposit Rate

Variables

Symmetric

Asymmetric

- 0.026 (-1.4)

-0.036 (-0.94)

-1.09 (-33.23)***

-

0.07 (0.52)

-0.08 (-0.47)

0.01 (0.09)

0.02 (0.16)

0.06 (1.25)

0.24 (6.27)***

- 0.004 (-0.10)

-0.002 (-0.04)

-0.17 (-3.3)***

-

-

- 0.16 (2.08)**

-

-0.18 (-3.3)***

0.80

0.80

F-stat.

45.1

35.8

Wald stat.

Prob.

-

0.09 (0.76)

Notes:

1) The ECM estimated using 2 lags based on lag length criterion; LR, FPE, AIC and HQ.

2) */**/***: denotes significance at the 10/5/1 percent level, respectively.

3) T-statistics are in parenthesis.

As for the lending rate, Table (5) introduces the results of the univariate ECM. The Correlogram-Q-Statistics and Serial Correlation LM test reject the hypothesis of autocorrelation. The parameters of the error correction term, short term adjustment, and the long term adjustment are statistically significant different from zero and have the right sign. All the estimated coefficients are less than 1 as expected. In the short run, the deviation of lending rate from the equilibrium is corrected by about 9 percent in the current period. Hence, the mean adjustment lag at which policy interest rate is fully passed through to lending rate is approximately 12 quarters. The asymmetric results support this conclusion, the speed of adjustment when rates are above and below their equilibrium levels are -10% and -7%, respectively. Additionally, the short-term adjustment is clearer and equal to 9% at the current time. To test if lending rate adjusts symmetrically to the deviation from the long run equilibrium, we test if those two parameters are equal, . The Wald statistic is reported in Table (5), the symmetric adjustment hypothesis of lending rate cannot be rejected. Further, the positive and negative lags mean adjustments support this conclusion. They are approximately 10 and 13 quarters, respectively. This implies lending rate adjust in a symmetric manner to the movement of the error correction term. In the long run, the lending rate adjustment coefficient is -1.21%, which implies a complete pass through from certificate of deposits to lending rate.

Table (5): The Results of the Error

Correction Model: The Lending Rate

Variables

Symmetric

Asymmetric

-0.007 (-1.28)

0.007 (0.11)

-1.21 (-8.62)***

-

-0.12 (-0.91)

-0.21 (-1.49)

0.03 (0.22)

0.03 (0.23)

-0.01 (-0.32)

0.09 (2.19)**

-0.08 (-1.70)*

-0.07

(-1.58)

-0.09 (-4.88)***

-

-

-0.10 (-3.20)**

-

-0.07 (-1.95)**

0.46

0.45

F-stat.

10.3

8.25

Wald stat.

Prob.

-

0.40 (0.53)

Note:

1) The ECM estimated using 2 lags based on lag length criterion; LR, FPE, AIC and HQ.

2) */**/***: denotes significance at the 10/5/1 percent level, respectively.

3) T-statistics are in parenthesis.

Overall, the abovementioned results help to draw conclusions regarding the Jordanian economy. In the long run, there is a complete pass through from certificate of deposits to deposit and lending rates. Over the modification period, in the short run, deposit and lending rates adjust in a symmetric process to the deviation from the long run equilibrium. Further, deposits rate adjusts larger and faster than lending rate for a deviation from the long run equilibrium. These facts indicate that the Jordanian banking sector gives a priority to adjust deposit rate then it focuses on lending rate. One possible explanation of this behavior is that banks compete to affect its cost (deposit rate) because CBJ often disseminate information about the latest certificate of deposits interest rate. On the other hand, they are careful when adjusting lending rate in order to capture more customers and gain greater market share to maximize their profits. The policy implication of our finding is the ability of the CBJ to control the spread between deposit and lending rates. In addition, any monetary policy action requires at least three years, 12 quarters, to be effective.

VI. CONCLUSIONS

Central banks play a crucial role to steer the economy toward either more economic growth or more inflation rate or both of them. The effectiveness of monetary policy relies mainly on the degree and the speed of retail interest rate adjustment to a change in policy interest rate. Therefore, the channel between policy interest rate and retail interest rates polarized more attention of monetary economists over the last two decades. This is known in the literature as interest rate pass-through. Recently, some economists develop more techniques to explore the fluctuations in depth. Most empirical studies focus on the question whether bank interest rates respond in asymmetric manner to policy rate. The trend of research concentrates on either aggregate interest rate series or micro banks information. The results are mixed across countries and even across banks products.

The current paper seeks to explore empirically the relationship from short term policy interest rate to deposit and lending rates in Jordan. Exclusively, we are trying to highlight on the behavior of deposit and lending rates. The current paper utilizes a univariate error correction model. The empirical evidence based on quarterly data over the period (1994:1-2008:3). We can summarize our findings as follows: First, deposit and lending interest rates follow a symmetric movement for their deviations from the long run equilibrium. Second, deposit rate adjust faster and larger than lending rate to the deviations from the long run equilibrium. Third, in the long run, there is a complete pass through from certificate of deposits to deposit and lending rates. We believe such a behavior is driven by two motives: the competition among the banks to gain larger market share and the enthusiasm to achieve the largest profits. The policy implication of our paper is that the CBJ has the power to control the spread between deposit and lending rates. On top, any monetary policy action requires at least three years, 12 quarters, to be effective.

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