Skip to main content
SpringerLink
Log in

China's Monetary Policy and the Exchange Rate

  • Symposium Article
  • Published:
Comparative Economic Studies Aims and scope Submit manuscript

Abstract

The paper models monetary policy in China using a hybrid McCallum–Taylor empirical reaction function. The feedback rule allows for reactions to inflation and output gaps, and to developments in a trade-weighted exchange rate gap measure. The investigation finds that monetary policy in China has, on average, accommodated inflationary developments. But exchange rate shocks do not significantly affect monetary policy behaviour, and there is no evidence of a structural break in the estimated reaction function at the end of the strict dollar peg in July 2005. The paper also runs an exercise incorporating survey-based inflation expectations into the policy reaction function and meets with some success.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Figure 1
Figure 2
Figure 3
Figure 4

Similar content being viewed by others

Notes

  1. Liu and Zhang (2007) note that there have been persistent deviations from uncovered interest rate parity.

  2. For a thorough description of China's monetary policy, see Geiger (2008); Evenett (2010) discusses China's exchange rate policy.

  3. http://www.pbc.gov.cn/english/huobizhengce/objective.asp.

  4. Although an industrial production series in levels is available in current prices, no deflator is published; hence our choice of year-on-year growth rates (in constant prices) for construction of the output gap. Moreover, during the reform period, Chinese economic cycles have been ‘growth cycles’, with slowdowns and upturns in growth rates but no fall in the levels series.

  5. The data are from the China Monetary Policy Report, from 2001 onwards (various issues). The targets prior to 2001 were obtained from the website of the National People's Congress of China (only in Chinese, link available from the authors upon request).

  6. For 1998, when both RPI and CPI targets were announced by the government, this procedure produces a CPI target equal to the officially announced target.

  7. When the Schwarz information criterion is used, a unit root can be rejected at 1% level for monetary base as well. Detailed results are available from the authors upon request.

  8. The adjusted Portmanteau test for autocorrelation yields a test statistic of 253.24 (p-value of 0.14), and the LM test for autocorrelation with 4 and 1 lags amounts to 76.11 (0.60) and 9.24 (0.90), respectively. The multivariate ARCH-LM test yields a test statistic of 510.00, with a p-value of 0.37.

  9. The result is obtained by calculating the long-run impact, that is, adding up the lagged coefficients of the output gap.

  10. Burdekin and Siklos (2008) find a procyclical response of monetary policy to movements in nominal GDP. However, they do not estimate policy reactions to movements in real output and inflation separately.

  11. According to the International Monetary Fund (2003), both transitory and long-term supply shocks contributed to deflation in China in the late 1990s and early 2000s.

  12. Dai (2006) reports that the PBoC would have adopted interest rates as the intermediate goal in 2004. Nevertheless, in 2009, intermediate targets for monetary aggregates and credit growth were announced by the PBoC. Furthermore, base money can be used as an instrument even with a change in the intermediate target by the monetary authority.

  13. The results can be obtained from the authors upon request.

  14. Restricting the coefficient on the exchange rate shock to zero is not supported by the data, judging by the test on over-identifying restrictions.

  15. This finding is confirmed by examining the accumulated impact of exchange rate shocks on monetary base in levels instead of growth rates – there is no statistically significant impact on the level of base money. In contrast, structural shocks to output and prices have a statistically significant impact on base money in levels for several quarters.

  16. The dynamics of the structural shocks do not need to seem identical to the coefficient estimates of the reduced form equations, as the structural shocks are identified by theoretical assumptions about the contemporaneous relationships between the reduced form errors. This explains why the policy reaction to the exchange rate gap is countercyclical in equation 2 but the response of base money to a structural shock in the exchange rate is largely insignificant in Figure 2.

  17. Recent estimates support an increasing weight on the euro in the basket, but since September 2008 almost all weight appears to again go to the US dollar (see Frankel, 2009, and http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/03/11/the-rmb-has-now-moved-back-to-the-dollar/).

  18. Woodford (2000) discusses problems related to excessive forward-looking reactions in monetary policy.

  19. The People's Bank's survey on inflation expectations is highly correlated with the business survey used in our study for the 2001–2008 period, where both series are available (contemporaneous correlation coefficient of 0.83).

  20. A possible alternative would be to use actual future outcomes for inflation and estimate a forward-looking reaction by GMM, as reported in Zhang (2009). However, our approach relies on surveys on inflation rather than a perfect foresight assumption.

References

  • Amisano, G and Giannini, C . 1997: Topics in structural VAR econometrics. Springer-Verlag: Berlin.

    Book  Google Scholar 

  • Breitung, J, Brüggemann, R and Lütkepohl, H . 2004: Structural vector autoregressive modeling and impulse responses. In: Lütkepohl, H and Krätzig, M (eds). Applied Time Series Econometrics. Cambridge University Press: Cambridge.

    Google Scholar 

  • Burdekin, RCK and Siklos, PL . 2008: What has driven Chinese monetary policy since 1990? Investigating the People's bank's policy rule. Journal of International Money and Finance 27: 847–859.

    Article  Google Scholar 

  • Calvo, G . 1983: Staggered prices and in a utility-maximizing framework. Journal of Monetary Economics 12 (3): 383–398.

    Article  Google Scholar 

  • Candelon, B and Lütkepohl, H . 2001: On the reliability of chow-type tests for parameter constancy in multivariate dynamic models. Economics Letters 73: 155–160.

    Article  Google Scholar 

  • Corden, WM . 2009: China's exchange rate policy, its current account surplus and the global imbalances. Economic Journal 119: F430–F441.

    Article  Google Scholar 

  • Dai, M . 2006: Inflation-targeting under a managed exchange rate: The case of the Chinese central bank. Journal of Chinese Economic and Business Studies 4 (3): 199–219.

    Article  Google Scholar 

  • Evenett, SJ (ed). 2010: The US-Sino currency dispute: New insights from economics, politics and law. Centre for Economic Policy Research: London.

    Google Scholar 

  • Frankel, J . 2009: New estimation of China's exchange rate regime. Pacific Economic Review 14 (3): 346–360.

    Article  Google Scholar 

  • Frankel, J and Wei, S-J . 2007: Assessing China's exchange rate regime. Economic Policy 51: 575–614.

    Google Scholar 

  • Geiger, M . 2008: Instruments of monetary policy in China and their effectiveness: 1994–2006 United Nations Conference on Trade and Development, Discussion Paper No. 187.

  • Granville, B and Mallick, S . 2010: Monetary policy in Russia: Identifying exchange rate shocks. Economic Modelling 27 (1): 432–444.

    Article  Google Scholar 

  • Holz, CA . 2004: China's statistical system in transition: Challenges, data problems, and institutional innovations. Review of Income and Wealth 50 (3): 381–409.

    Article  Google Scholar 

  • Holz, CA . 2008: China's 2004 economic census and 2006 benchmark revision of GDP statistics: More questions than answers? The China Quarterly 193 (March 2008): 150–163.

    Google Scholar 

  • International Monetary Fund. 2003: Deflation: Determinants, risks and policy options – Findings of an interdepartmental task force. International Monetary Fund: Washington, DC.

  • Koivu, T, Mehrotra, A and Nuutilainen, R . 2009: An analysis of Chinese money and prices using a McCallum-type rule. Journal of Chinese Economic and Business Studies 7 (2): 219–235.

    Article  Google Scholar 

  • Koźluk, T and Mehrotra, A . 2009: The impact of Chinese monetary policy shocks on East and South-East Asia. Economics of Transition 17 (1): 121–145.

    Article  Google Scholar 

  • Liu, L-g and Zhang, W . 2007: A new Keynesian model for analyzing monetary policy in mainland China Hong Kong Monetary Authority Working Paper 18/2007.

  • Ma, G and McCauley, RN . 2008: Efficacy of China's Capital controls: Evidence from price and flow data. Pacific Economic Review 13: 104–123.

    Article  Google Scholar 

  • McCallum, BT . 1988: Robustness properties of a rule for monetary policy. Carnegie-Rochester Conference Series on Public Policy 29 (Autumn): 173–203.

    Article  Google Scholar 

  • McCallum, BT . 2000: Alternative monetary policy rules: A comparison with historical settings for the United States, the United Kingdom, and Japan. Federal Reserve Bank of Richmond Economic Quarterly 86: 49–79.

    Google Scholar 

  • Naughton, B . 2007: Chinese economy: Transitions and growth. MIT Press: Cambridge, MA.

    Google Scholar 

  • PBoC. 2005: China monetary policy report, quarter one, 2005. Monetary Policy Analysis Group of the People's Bank of China. China Financial Publishing House: Beijing.

  • Rawski, TG . 2001: What is happening to China's GDP statistics? China Economic Review 12 (4): 347–354.

    Article  Google Scholar 

  • Rotemberg, JJ and Woodford, M . 1999: Interest-rate rules in an estimated sticky-price model. In: Taylor, JB (ed). Monetary Policy Rules. University of Chicago Press: Chicago.

    Google Scholar 

  • Sánchez-Fung, JR . 2005: Estimating a monetary policy reaction function for the Dominican Republic. International Economic Journal 19 (4): 563–577.

    Article  Google Scholar 

  • Svensson, LEO . 1999: Inflation targeting as a monetary policy rule. Journal of Monetary Economics 43: 607–654.

    Article  Google Scholar 

  • Woodford, M . 2000: Pitfalls of forward-looking monetary policy. American Economic Review 90 (2): 100–104.

    Article  Google Scholar 

  • Zhang, W . 2009: China's monetary policy: Quantity versus price rules. Journal of Macroeconomics 31: 473–484.

    Article  Google Scholar 

Download references

Acknowledgements

We thank Tuuli Koivu, Iikka Korhonen, participants in the 2010 American Economic Association-ASSA Annual Meetings in Atlanta, ACES session on China's exchange rate, and in the 2010 Finnish Economic Association Annual Meeting in Tampere, in particular our discussants Sushanta Mallick and Petri Mäki-Fränti, for helpful comments and suggestions. All opinions are of the authors and do not necessarily reflect those of the Bank of Finland. Any errors are our own.

Author information

Authors and Affiliations

  1. Bank of Finland, Institute for Economies in Transition (BOFIT), PO Box 160, Helsinki, FI-00101, Finland

    Aaron Mehrotra

  2. School of Economics, Kingston University, London, Penrhyn Road, Kingston upon Thames, KT1 2EE, Surrey, UK

    José R Sánchez-Fung

Authors
  1. Aaron Mehrotra
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. José R Sánchez-Fung
    View author publications

    You can also search for this author in PubMed Google Scholar

Appendices

Appendix A

See Table A1.

Table a1 Summary statistics
Full size table

Appendix B

See Figure B1

Figure B1
figure 5

Impulse responses computed using the benchmark VAR.

Full size image

Rights and permissions

Reprints and permissions

About this article

Cite this article

Mehrotra, A., Sánchez-Fung, J. China's Monetary Policy and the Exchange Rate. Comp Econ Stud 52, 497–514 (2010). https://doi.org/10.1057/ces.2010.16

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1057/ces.2010.16

Keywords

JEL Classifications

Search

Navigation