level variables. For variables integrating of order 1 (i.e. I(1) variables), their first difference needs to be used when including them in the estimation. The lag length, _m_ , is usually determined by using the Akaike information criteria (AIC).<sup>4</sup> Motivated by the theoretical framework discussed above and taking into account the variables used in Duma (2011), the VAR system in our study consists of the following variables: the US federal fund rate ( _ffr_ ), representing foreign policy interest rate; the growth rate of KHR to USD exchange rate ( _z_ )<sup>5</sup> ; trade balance as a share of GDP, money balance as a share of GDP ( _bmgdp_ )<sup>6</sup> ; domestic interest rate; output gap ( _gygap_ ) as the difference between real GDP and real potential GDP (i.e. GDP under full employment), scaled by real potential GDP; and consumer price index (CPI) inflation ( _infl_ ).

In addition to including the total trade balance as a share of GDP ( _ttbgdp_ ) as done by Duma (2011), the trade balances with main trading partners such as the EU and US are incorporated for the estimation in a separate case. They are represented by _tbeugdp_ and _tbusagdp,_ respectively.<sup>7</sup> Lacking Cambodia government bonds, the bank lending interest rate ( _lendint_ ) is used as the domestic interest rate.<sup>8</sup> Duma (2011) incorporates lending and deposit interest rates into the VAR system simultaneously. However, we include only one domestic interest rate in the VAR estimation, as indicated in Equation (4) of the theoretical framework.

Following Duma (2011), the fluctuation of the crude oil price represented by its change rate ( _goilp_ ) is exogenously included in the VAR system as a control for external shocks. Furthermore, we add another exogenous dummy variable ( _dummy_ ) to the estimation to capture the macroeconomic effects resulting from: political instability during the violent conflicts and political unrest in 1997; the 1997-98 Asian financial crisis; election periods in 1998, 2003, 2008, and 2013; and the 2008-09 global financial crisis.

As an extension to the VAR system, another variable added is international reserves. Cambodian authorities may use the international reserve adjustment as a policy tool to,

> 4 In this study, the cointegration methodology based on the vector error correction model (VECM) proposed by Johansen and Juselius (1990) that requires that all variables are I(1) is not adopted. This is because the integration order of the variables under consideration in our estimation are mixed. We have both I(0) and I(1) variables in the VAR system, as discussed later.

> 5 z illustrates the depreciation of KHR if it increases and the appreciation of KHR if it decreases.

> 6 Broad money is incorporated as a share of GDP to take into account the scale effect.

> 7 Trade balances are incorporated as GDP shares, taking into account scale effect.

> 8 The VAR estimation by using deposit interest rate as domestic interest rate is also conducted. We obtain very similar results of impulse responses and variance decompositions. Data on the deposit interest rate is obtained from International Financial Statistics (IFS) published by the International Monetary Fund (IMF). The results can be provided upon request.

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