Noise Trading, Exchange Rate Dynamics And China-U.S. Open Economy Fluctuations

After several decades of rapid growth, China’s economic development has stepped into a stage characterized by industrial structure adjustment and transformation. Although overall economic growth has slowed down, accompanied with the steadily pushing forward national strategies like "One Belt, One Road", economic relations between China and rest of the world haven’t weakened, but are increasingly strengthened. Currently, China has become the largest country of trade in goods and second largest country for outward foreign investment, and has signed 14 free trade agreements with economies such as South Korea, ASEAN and Australia. Foreign trade dependence of China is close to 50% in recent years. Also, while enjoying the success of export-oriented economic development, it’s inevitable to be affected by negative factors like competitive currency devaluation, contraction in external demand and inflow of short-run speculative capital. Under this background, analysis of China’s open economic characteristics is of important practical and theoretical significance. However, there’s still little systematic study focused on open economic fluctuation features of China using New Keynesian DSGE models.Fortunately, the new open economy macroeconomics (NOEM) has achieved significant progress in recent years which offers us a useful theoretical tool for research in this direction. This paper should be a preliminary empirical study for China’s open economy features using NOEM-DSGE framework, which started with a simplified theoretical model and released some key assumptions progressively, then obtained a relatively complete two-country model for empirical study focused on topics like RMB appreciation, "re-industrialization" and optimal monetary policy with actual data of U.S. and China.Firstly, over the controversial issue of exchange rate overshooting found in a large number of empirical studies, this paper constructs a Pricing-to-Market NOEM model with the features of noise trading in exchange market and tradable intermediate goods market segmentation aiming to analyze theoretical relationships of irrational expectation, trade openness and short-term exchange rate dynamics using numerical methods. The study indicates that under incomplete capital market structure, unexpected monetary shock would cause a deviation from steady state of uncovered interest rate parity which still holds in the long run, and then results in the delayed exchange rate overshooting phenomenon. Yet, the DSGE model offers sufficient theoretical explanations for "J-curve" effect found in empirical literature of current account and monetary policy. And due to weakened expenditure switching effect caused by segmentation pricing of intermediate goods, higher trade openness would result in smaller promotion in real output and more welfare loss of monetary policy.Secondly, more realistic features have been added to the NOEM model such as productive capital, heterogeneous labor supply, prospective interest rate rules and mass exogenous shocks, which strengthened the model’s ability of describing realistic economic fluctuations. This part finds the backward exchange rate expectation is well identified by observed variables, which helped improving overall fit of NOEM model. When exogenous UIP shock is introduced into theoretical model, improvement of model fit appears to be more obvious, which proves UIP shock a necessity. Robustness analysis in this part finds no much difference in parameter evaluation under two tradable pricing assumptions of LCP and PCP, but identification of noise trading parameters and overall fit of LCP is slightly better. Counterfactual simulations indicate supply and demand shocks are key to explain output and CPI fluctuations, preference shocks help to identify real consumption changes, and UIP shock improves fitness of observed nominal exchange rate dynamics.Further, the author conducts an analysis of some realistic issues, such as impact of the RMB appreciation, re-industrialization of U.S. economy and optimal monetary policy based on the PTM-NOEM model with a non-stationary common technology shock. The model performs a better simulation for U.S. observed variables compared with those of China. Variance decomposition proves supply and demand shocks the main source of economic fluctuations for both economies. Besides, appreciation of RMB could narrow the imbalance of bilateral trade, but the stimulating effect on U.S. output is quite limited, and leads to greater decrease of U.S. consumers’ welfare. The re-industrialization strategy would surely benefit U.S. economic output, but may also incur appreciation of dollar and rising imbalance of trade with China. It seems hard to propose a perfect solution for the bilateral trade imbalance, which highlights the importance of monetary and trade policies coordination of both sides. Optimal policy analysis proves that monetary policy of China targets exchange rate to some extent indeed, but the reaction coefficient is slightly larger.Besides, by relaxing some assumptions like symmetric sticky pricing of tradable goods, the author continues to discuss fitness of asymmetric NOEM model for observed variables. The analysis finds obvious difference between some structural parameters of the two nations, asymmetric NOEM model performs better than LCP-NOEM in fitting standard deviations of observables, but worse in fitting correlations of some variables, and theoretical variance decomposition shows that inflation targeting shocks are important sources of economic fluctuations.Then, the paper finds inflation targeting a monetary arrangement that benefits domestic output and consumption, but reduces welfare of trade-partners. By conducting sensitivity analysis we show that some variables like net export and exchange rate are sensitive to the parameter of substitution elasticity of tradable intermediates, thus its value should be obtained using Bayesian estimation.Finally, based on the conclusive summary, the author proposes some policy recommendations to promote and maintain stable economic growth, and puts forward two feasible directions for future research.