Monetary Policy Rules Theory And Its Application In China

The controversy between rules and discretion in the monetary policy research has a long history. Since the seventies of the 20th century, monetary policy rule has made breakthrough progress in theoretical research, after the theory of dynamic inconsistency being put forward, people began to realize that discretionary prone to time inconsistency of monetary policy and inflation bias. The significant progress of monetary policy rules in theory and practice in the 1990s reflected in the following:Taylor (1993) put forward a Taylor rule that interest rate as policy instrument, New Zealand took the lead in the world to establish inflation targeting monetary policy in 1990. Svensson, as a representative, had been intensive studying the theory of inflation targeting. All of these greatly promoted the research in monetary policy rule theory. After New Zealand first implementation of inflation targeting, many other countries have also adopted this new monetary policy framework, The implementation of monetary policy that include rule in these countries can successfully control inflation and achieve macroeconomic stability.After 1984, the People's Bank of China to perform the functions of the Central Bank, the operation of monetary policy decisions with the discretion features, The macro-economy state had been changing between hot and cold, and macroeconomic instability faced with the threat. In the mid-90s from the 20th century, China began to implement monetary policy framework that money supply is the intermediate target, it became important for money supply in the macro-control. However, the performance of monetary policy in recent years shows that relationship between the money supply indicators and the ultimate objective of monetary policy had become instable, it is become more and more difficulty for the central bank to control money supply, the endogenous of money supply is increasing, the efficiency of central bank through controlling money supply to achieve monetary policy objectives is declining, it is an urgent for monetary authority to adjust and improve the current monetary policy framework.. Because of discretionary monetary policy being prone to inconsistency and inflationary bias, therefore, it is important for China to introduce rule in the monetary policy framework. During the design of monetary policy framework, it is necessary to clarify the following question:Which kind of monetary policy rules there is? What is the application of each type of monetary policy rules? How about effective of each type of monetary policy rules in practice? Is China's current monetary policy framework effective? If China's current monetary policy framework lack of efficient, then which monetary policy rule should be selected for the China's, future monetary policy framework design? The dissertation will study all above issue. The main content of this dissertation is:Introduction section introduces the research background and significance, overviews monetary policy rules research home and aboard, briefly describes the main contents and research methods in this dissertation, points out the major innovation and deficiencies of the dissertation.Chapter 1 gives the concept of monetary policy rules, and monetary policy rules are classified, in particular to introduce in detail about the instrument rules and targeting rules. Instrument rules not only include the traditional rules, such as Taylor rules, McCallum rules, Friedman rule, Melzer rules, but also non-traditional rules, such as exchange rate rules and monetary conditions index. Targeting rules Mainly include following rules, such as inflation targeting rule, price level targeting rules, monetary growth targeting, nominal GDP targeting rule, exchange rate targeting and hybrid inflation and price-level targeting.Chapter 2 is the starting point for monetary policy rule theory research. in general, There are two way to implement monetary policy,one way is with rules, the other way is with discretion. The question is which way is more appropriate? Various economics schools had been debating in this subject for a long time. The dynamic inconsistency theory ended the long time dispute between rules and discretion. The dynamic inconsistency theory suggest that discretionary monetary policies is easily result in time inconsistency and inflation bias. Barro and Gordon's research further verified the rules is better than discretionary; In order to overcome the inflationary bias in monetary policy, in addition to use monetary policy rules, there are other options available in theory, such as the reputation constraints, hiring a conservative central bankers to implement monetary policy, the use of the Principal-agent Theory with escape clause, design the optimal incentive contract and the implementation of inflation targeting. Chapter 3, The theory of monetary policy instrument choice is analyzed both from the perspective of graphical and from mathematical model. The research suggest that the instrument choice between money supply and interest rate depends on the stability of IS curve and LM curve. To derive the famous instrument rule:Taylor rule. There are two method can be used, one is from the perspective of the quantity theory of money, the other is from the perspective of dynamic macroeconomic models. Since Taylor put forward his famous instrument rule, the Taylor rule has been extensively used in studying and evaluating most of countries'monetary policy, in empirical study economist also modified and extended Taylor rule. About the application of Taylor rules in empirical study,this dissertation main include the following studies:Taylor rule is applied to estimate the developed economies'monetary police reaction functions; Taylor rules is applied in estimating emerging market economies'monetary policy rule; Taylor rule is applied to estimate China's monetary police reaction functions.Chapter 4 is mainly study the most popular targeting rule:inflation targeting. The main content of research include the content and features of inflation targeting, the prerequisite conditions for inflation targeting implementation, the effect of inflation targeting impact on macro-economy. It is growing important for two targeting rule (price level targeting and nominal income targeting rules) in recent years. For this reason, It is necessary to make a comparative analysis for inflation targeting and these two targeting rules.Chapter 5, we make a empirical research about the effectiveness of our current monetary policy framework. The research show that the effectiveness of the current monetary policy framework is decline, it is necessary to reform and improve the current monetary policy framework, the research suggest that the reform direction of China's future monetary policy framework is to transfer to inflation targeting. The innovation of this dissertation is mainly manifested in:Firstly, we use time-varying parameter model to estimate China's monetary policy reaction function. At present, most researchers mainly use time-invariant parameter Taylor rule to test China's monetary policy. China is a developing country in transition, the central bank's monetary policy objective is always changes and adjustment, the monetary policy framework in the gradual adjustment, the responses of central bank to the changes of macroeconomic variables is changing, using the time-invariant parameter Taylor rule to estimate China's monetary policy reaction function may not be appropriate, therefore, It may be more in line with China's actual for using state-space model and Kalman filter to estimate time-varying parameters Taylor rule.Secondly, we use smooth transition regression model to estimate the nonlinear Taylor rule. At present, most researcher use linear Taylor rule to estimate China's central bank's reaction function. In fact, the central bank in the face of different inflationary pressures and different growth conditions, the response of the central bank to macroeconomic variables are also different, it is difficult for the linear rule to describe this situation. In this paper, we use smooth transition regression model to estimate the China's central bank's monetary policy reaction function. The research shows that the China's central bank's monetary policy reaction has nonlinear characteristics.Finally, we summarize the comparative studies between inflation targeting and the other two targeting rules. Existing literature on the targeting rules have focused on the introduction of inflation targeting. Although the other two targeting rules, such as price level targeting and nominal GDP targeting, is not applied in practice, but it has important theoretical research value. The research interests about the two targeting rules has been growing in recent years abroad. Based on the existing of Foreign literature, we give a comparison between inflation targeting and two targeting rules (price level targeting and nominal GDP targeting). The aim is to attract researcher to study.the two targeting rules.