Monetary Policy Rule And Its Applicability In China

The operation norm of monetary policy is an important factor that affects its effectiveness. According to monetary economics, the operation norm of monetary policy has two fundamental types: commitment to rule or discretion. So far, there has been a debate about which one is more effective. But over the past 3 decades most researches support that monetary policy should commit to rule.By using the existing research achievements at home and abroad for references, this dissertation tries to study the monetary policy rule and its application in China from theory and empirical analysis based on mathematical modeling, statistical analysis, econometric analysis, experience analysis and comparative analysis. The theoretical part consists of three chapters. Chapter 2 reviews systematically the debate between the rule and the discretion of monetary policy. Chapter 3 introduces the three main models of the monetary policy rule in detail. Chapter 4 expatiates comprehensively on the specific meanings and characteristics of various monetary policy rules. The empirical part also consists of three chapters. Chapter 5 analyses the applicabilities of two instrument rules in China, namely McCallum Rule and Taylor Rule. Chapter 6 analyses the applicabilities of two target rules in China, namely interest rate targeting and money supply targeting. Chapter 7 explores the applicabilities in China and the concrete operation framework of inflation targeting. The main conclusions of this dissertation are as follows:(1) From the view of long-term, monetary policy should commit to rule and abandon the discretion. Because the discretion with time inconsistency will give rise to inflation bias, social welfare is inevitably worse off. Just the opposite, the monetary policy rule can acquire time consistency by making a credible commitment to follow the monetary policy arrangements which are set in advance, so inflation bias will be eliminated.(2) The fixed or passive rule and the pure discretion are two extremes of the operation norm of monetary policy, thereby they are not desirable. So it is advisable that central bank takes account of the flexibility and foresight of policy as well as pays close attention to the credibility and transparency of policy. As an active, forward-looking target rule with a discretionary character, inflation targeting has therefore become the most prevailing rule at present.(3) The McCallum Rule and the Taylor Rule are not applicable to China currently. There are at least three reasons for this. Firstly, the two rules belong to instrument rule, so their means of regulation are relatively single and their efficiencies of information utilization are fairly low. Secondly, the base money and the interest rate are procyclical and the marketization of them is at a very low levels. Thirdly, the maneuverability of the two instrument rules is quite poor because it is difficult to observe the changes in the velocity of money, to measure the gaps of the economic variables and to determine the coefficients of the policy reaction function.(4) The interest rate targeting and the money supply targeting are also not applicable to China presently. The adjustment of interest rate showed a very poor performance in steering inflation in the past. Moreover, the interest rate's controllability, measurability and relevance with the real economy are relatively weak. On the other hand, despite the fact that the relevance between money supply and the real economy is fairly strong and the function of money demand is comparatively stable, the controllability and measurability of money supply have gone wrong.(5) China already possesses the basic conditions to implement flexible inflation targeting at present. Accordingly, Chinese monetary policy operation should switch to this target rule timely for stabilizing the public's expectation more effectively, reducing the inflation rate and its fluctuations, and ultimately promoting the quick, stable and sustainable economic growth.The main innovations of this dissertation are as follows:(1) When the previous researches tested the McCallum Rule in the form of nominal income target, the constant term in the rule expression, namely the logarithm of the growth rate of nominal income was determined subjectively and casually because the potential economic growth rate is difficult to estimate. For eliminating the constant term, this dissertation uses creatively the one order difference of the rule expression to test the McCallum Rule. By this way, the research conclusion gets more robustnesses. (2) In the process of testing the Taylor Rule, for conforming to the monetary policy practices in China, setting the reaction function of monetary policy has three main distinctions from the previous researches. Firstly, the central bank's inflation target has time-variation which shows a positive correlation with the real inflation rate. Secondly, central bank's policy reaction is asymmetric because the reaction coefficients are different between the positive inflation gap and the negative inflation gap. Thirdly, the gap of economic growth rate takes the place of the gap of output.(3) For reviewing the effect of interest rate in steering inflation, this dissertation redefines the neutral interest rate from the angle of the correlation between the adjustment of interest rate and the change of inflation rate, and then constructs creatively a bivariate SVAR model which includes the first order difference of inflation and real interest rate to decompose China's real interest rate since 1997 into two components: neutral interest rate and interest rate gap.(4) When this dissertation makes an inquiry into the basic framework of China's inflation targeting, it uses the different methods from the previous researches to set the interval and the time limit of inflation targeting. Namely, the historical average of inflation rates that excluded outliers is adopted as the mid-point of target range and the width of the target range is determined by referencing the international experiences. The time limit of inflation targeting is measured by statistical analysis according to the historical datum of the changes of inflation rate.