Pass-through to Bank retails rate from inter-bank money market rates
A vector error correction model is estimated with the following cointegrating relationships;
The key short-run equations of interest in the VECM are represented as follows:
where the error correction terms are:
The identifying assumptions that underlie this step of the empirical method are: (i) that the lending rate is weakly exogeneous to the WACMR, and (ii) that the deposit rate is weakly exogeneous to the WACMR. Assumption (i) is reasonable since changes in interest rates on bank loans, which will be of longer maturity, are unlikely to have feedback effects on overnight call money transactions. Assumption (ii) is perhaps more difficult in that an increase in the cost of deposits could make raising funds in the overnight market more attractive. With a preference for more stable and longer-maturity deposit funding, however, any feedback effects are likely small.