Testing For Asset Price Bubbles And The Adjustment Of China’s Monetary Policy

Testing for price bubbles has always been a hot subject of great controversy and challenge for long years. Many methods have been developed but they are criticized as the wisdom of hindsight which usually yield inconsistent or even conflicting results. Theorists divide price bubbles into two categories:rational bubbles and irrational bubbles. Blanchard and Watson (1982) term it as rational bubbles that cannot be arbitraged away because they prove that this type of bubbles can even exist under the hypothesis that all investors are rational. Irrational bubbles are derived under a more general assumption that irrational investors are also an indispensable component which might lead to bubbles due to the investors’positive feedbacks. This compound structure of investors gives a more reasonable explanation for the origination and collapse of price bubbles but meanwhile it causes great difficulties in econometric testing for bubbles. Rational bubbles are theoretically less acceptable but they challenge the stereotype that price cannot deviate from the fundamental value in the long term, which denies the existence of price bubbles. A salient merit lies in that it also facilitates the econometric testing for price bubbles. For the above-stated reasons a vast majority of literature on testing for bubbles is rational-bubbles-orientated.Rational bubbles are fundamentally related to the theory of the testing for unit roots. Recent years have witnessed rapid progress in the theory of unit root tests to which Phillips and Magdalinos (2007) have made great contributions. They introduce a new set of theory for moderate deviations from a unit root which has promoted the development of tests for bubbles. Owing to their contributions, a new econometric test for price bubbles has been presented by Phillips, Wu and Yu (2011) most recently. The newly proposed statistic, sup ADF turns out to improve the testing power for periodically collapsing bubbles modeled by Evans (1991). What is more appealing is that this methodology is of real-time wisdom in that it makes it possible to detect the origination and collapse of bubbles synchronously. This improvement is of useful political implications, enhancing our ability to cope with asset price bubbles so as to keep the balance of the financial system. Some theoretical and empirical studies are conducted mainly on econometric testing of price bubble and monetary policy of China in the present thesis. We have an overview of the asymptotics of unit root related processes, consisting of stationary process, local to unity process, moderate deviations from a unit root process, unit root process and explosive process. The econometric tests of price bubbles including the most recent sup ADF test proposed by Phillips et al are also investigated. The present research shows by Monte Carlo simulations that sup ADF test is vulnerable to conditionally heteroskedastic innovations, leading to severe over-rejecting of no bubbles hypothesis. Moreover, the testing power of sup ADF for periodically collapsing bubbles proposed by Evans (1991) decreases substantially as the collapsing probability of bubbles increases. We extend PWY’s idea into an ESTAR framework introduced by Kapetanios et al.(KSS,2003) to test for bubbles. Sup KSS test allows for time-varying coefficients and indigenizes the explosive behavior of bubbles. Compared with sup ADF test, sup KSS test is less sensitive to heteroskedastic innovations. In addition, based on data generated from Evans’(1991) periodically collapsing bubbles and exponential smooth transition bubble processes, it is shown that sup KSS test obtains more robust testing powers.We apply sup ADF as well as sup KSS proposed in this paper to test for price bubbles in China’s stock markets and real estate markets as well as China’s monetary policy. It is found out that China’s stock markets including Shanghai stock market and Shenzhen stock market both experienced serious price bubbles between early2007and early2008, a period overlapping with the subprime crisis. In terms of real estate market, we fail to detect any price bubbles using price index of real estate sales which is a measure of the overall national house prices. China’s monetary policy is also examined by using two indexes, broad money M2and aggregate loan of financial institutions. It indicates that both M2and aggregate loan are exposed to an explosive growth dating back to2003and China’s stimulus package again resumed the explosive growth. In order to further explore China’s monetary policy, the opportunistic monetary policy is formulated in this study to incorporate a time-varying intermediate output target. Using a Taylor Rule with time varying threshold effect with respect to inflation and output, it is found out that the response of China’s interest rate to the gaps between inflation as well as output and their intermediate targets is basically in line with the opportunistic strategy. Interest rate gives a more sensitive response to output gap (ranging from [-2.03,2.63]) compared with that of inflation gap (ranging from [-2.65,2.25]). A more sophisticated opportunistic monetary policy strategy needs to be adopted to adjust the strength and sensitivity of the response to inflation and update the expectation of underlying negative shocks to achieve the goal of a steady and rapid development and a stable total price level during the period of the Twelfth Five-Year Plan.The synchronous detecting of asset price bubbles has substantial implications on China’s financial markets. In light of the experience of other economies including Japan and US, whose central banks "felt" but did not treat asset price bubbles seriously, asset bubbles are doomed to explode and collapse causing great harm to both the financial system and the real economy. It is necessary and feasible to establish a price bubbles warning system, making the stock markets the initiative since trading data of stock markets is fully available. This type of warning system can be further extended to other financial markets such as real estate market and so on so as to keep the balance of the whole financial system. As the development of China’s stock markets which have been playing a more and more crucial role as the barometer of the real economy will reflect better expectations of inflation and output, which meanwhile facilitates the adjustment of monetary policy as well. In all, the synchronous detecting of asset price bubbles (especial for stock market bubbles and real estate bubbles) is helpful in the establishment of price bubbles warning system and the adjustment of monetary policy (especially for broad money and aggregate loan) in order to keep the balance of the financial system for a stable economic growth.