Inflation Targeting And China’s Monetary Policy Framework Reform

Inflation targeting, which originated in Western developed countries during the early1990s, has developed as a monetary policy framework for more than20years. It hasplayed an active role to guide inflation expectations, reduce the level of inflation, enhancethe transparency and credibility of monetary policy and stabilize output during these years.Because of its strong vitality and institutional advantage, inflation targeting has become theguideline of reforming the existing monetary policy frameworks in many countries. Withthe deepening of market economy system reform, China takes the monetary aggregates asthe nominal anchor of monetary policy framework in the mid-1990s. However, with theacceleration of the process of financial innovation and opening to the outside world, theeffectiveness of China’s monetary policy framework which makes the money aggregates asthe nominal anchor is waning, and suitability has been greatly reduced. So, China’smonetary policy framework will inevitably face major reforms. How should China’smonetary policy framework be reformed? Is the popular inflation targeting suitable forChina? This dissertation, based on the analysis of inflation targeting, explores the relatedtheories and practices of successful monetary policy framework and discusses theapplicability of inflation targeting in China and the way of China’s monetary policyframework transition to inflation targeting. The dissertation includes four main parts:The first part describes the theory and practice of inflation targeting. Inflationtargeting is a rule-based monetary policy framework and its theoretical origins can betraced back to the theory of money neutrality, the theory of monetary policy dynamicinconsistency. Compared with other monetary policy frameworks, inflation targeting hasobvious systematic advantages. Inflation targeting has three main macroeconomicfunctions: guiding inflation expectations, stabling price level and slowing output volatility.The policy practice of inflation targeting countries shows that inflation targeting presentsgood policy performance, significantly reduces the degree of inflation target deviation andachieves the above macroeconomic functions successfully. In a word, it is a successful monetary policy framework.The second part analyzes the efficiency of China’s current monetary policyframework. The practice of China’s monetary policy demonstrates that in an increasinglycomplex domestic and international economic situation, the effectiveness of China’smonetary policy framework which takes the money aggregates as the nominal anchor isdeclining, and its effect of maintaining price stability and promoting economic growth isnot ideal. The result computed by stochastic frontier analysis based on transcendentalfunctions also proves that the level of monetary policy implementation efficiency underChina’s current monetary policy framework is low. Because the money aggregates, used asthe intermediate target, do not meet following standards such as: correlativity,controllability, testability as well as the stability of the money demand, the efficiency ofChina’s current monetary policy framework is low. In China’s current practice of themonetary policy framework reform, the scale of newly-introduced social financing can notplay the role of an independent nominal anchor. The crawling system pegged to the U.Sdollar will transit to a managed floating exchange rate system in the near future. Therefore,the direction of China’s monetary policy framework reform should be inflation targeting.The third part studies applicability of inflation targeting in China. Implementation ofinflation targeting requires some preconditions. Nicoletta Batini and others（2005）dividedthe implementation conditions of inflation targeting into four categories: institutionalindependence requirements, economic structure requirements, financial systemrequirements and the requirements of central bank’s technology infrastructure. Groundedon Nicoletta Batini and others（2005）who proposed the indicator system of inflationtargeting implementation conditions, this dissertation tests China’s implementationconditions of inflation targeting. The test results indicate that, except for the technologyinfrastructure of China’s central bank, China is superior to inflation targeting countrieswhen other conditions are taken into account. Although China does not meet with all theimplementation conditions of inflation targeting, it basically has a prerequisite for itsimplementation.The fourth part designs the program of China’s transition to inflation targeting. SinceChina can not meet with all the implementation conditions of inflation targeting andmonetary targeting regime will continue to play a certain role in the short term, Chinashould set a transition period before its monetary policy framework transforms to inflation targeting completely. So, China can reform its monetary policy framework progressively.At present, China’s inflation rate is low and its macroeconomic situation is stable, it is anopportunity for China to begin to transit to inflation targeting. During the transition period,China can select the consumer price index（CPI）as a main measure of the inflation targetprice index and set inflation target range of [2.5%1%]and target period of2years. Asfor monetary policy operations, The People’s Bank of China（PBC）should make equivalentuse of quantitative and price market-oriented tools and mainly follow the Taylor rule andalso McCallum rules. Meanwhile, inflation forecast should be based on qualitativejudgment and some simple models. In terms of system construction, by modifying the legalframework of the central bank, China needs to give PBC the operation independence in thelegal sense and priority to the price stability target. In addition, as one of the importantelements of inflation targeting, transparency and accountability of monetary policy needsto be improved during the transition period. To promote China transit to inflation targeting,China needs to improve the implementation conditions of the inflation targeting as follows:firstly, it should accelerate the market-oriented reform of interest rate; secondly, it shoulddeepen the market-oriented reform of the RMB exchange rate regime continuously; thirdly,it should enhance the soundness of the financial system; lastly, it should improve the fiscalsituation in a vigorous way.