Exchange Rate Volatility, Financial Stabilitv And Monetary Policy

Nowadays, managed floating exchange rate regime which used in China is not a judicious choice, exchange rate would realize the fully floating in the future, which led to more frequent and drastic fluctuations. Process of interest rate marketization is still unfinished and interest rates remain controls in China, affected the improvement of the system of exchange rate. At the same time, China’s capital account liberalization has been gradually deepened and the final trend is to realize fully convertible of RMB under the capital account. However, combining with the Relevant experience of foreign countries, fast speed of capital account opening and rapid marketization of interest rate will lead to unpredictable influence on exchange rate volatility, and produce adverse effect to financial stability. If not care for, the tragedy of "lost decade" in Japan will reoccur. Therefore, investigating the relationship between financial stability and exchange rate volatility is necessary for our country. Monetary policy as the main policy instrument for PBC(people’s bank of China) have an obligation to maintain financial stability and currency stability, promoting economic growth. Based on the policy goal of maintaining financial system stability, monetary policy how to realize the reasonable RMB exchange rate volatility also has important theoretical and practical significance.At first, this paper review the theory of currency crises, then we utilize others work which construct theoretical models by Diamond and Dybvig (1983) and Chang and Velasco (1999,2000,2001), The fourth chapter establish a theoretical model on exchange rate volatility and financial stability,which embed into a commercial bank in an open economy. Through the analysis of foreign creditors, short-term debt, the scale of capital inflow, and financial liberalization and boom and depression of asset prices to bank runs and exchange rate volatility, we can found that Exchange rate volatility have an impact on a country’s financial stability through a number of channels, especially for short-term capital inflow, financial liberalization and increasing of foreign capital inflow would intensify liquidity shortage of banks and raise vulnerability of financial system. Thereafter we use panel-VAR method to test that exchange rate fluctuation affects financial stability by means of international trade, capital flow and asset price. The estimated results show that the influence of exchange rate fluctuation on financial stability through three channels mentioned above is more robust than the direct connection between them, moreover, capital flow and asset price shows greater impact on financial stability. Finally, this paper analyzes adverse effect of macroeconomic on exchange rate volatility and financial instability, exchange rate volatility and financial instability lead to monetary policy deviation, and impair the effectiveness of monetary policy. But monetary policy deviation and financial instability is easy to mislead the general public’s expectations, leading to policy uncertainty, policy uncertainty and instability will promote financial instability and exchange rate fluctuations in turn.Respecting the fact that exchange rate volatility and financial instability may be adversely affected macroeconomy, the People’s Bank of China have an obligation to maintain financial stability and currency stability, monetary policy as the main policy regulation tool could realize this policy goal. According to this cognition, the article closely focuses on achieving a reasonable RMB exchange rate fluctuations and maintaining financial stability by the following parts.In fifth chapter, this paper establish a theory model of the source of exchange-rate change and monetary policy response, we can found the source of exchange-rate change come from two aspects:the changes of trade and financial market shocks. Then, we use a two-stage least square method to test the optimal monetary policy response for two types of RMB exchange rate fluctuations. Empirical results shows that the optimal monetary policy response depends on the sources of exchange rates changes; when the changes of trade led to appreciation of the Renminbi exchange rate, the optimal monetary policy response is to raise interest rates; when the changes of financial market shocks lead to the appreciation of the Renminbi exchange rate, the optimal monetary policy response is to lower interest rates. In sixth chapter, this paper explored a new monetary policy framework——flexible inflation targeting, central bank how to maintain financial stability in this framework.Then, we built a optimal monetary policy model under flexible inflation targeting frameworks, obtaining an augmented Taylor’s rule model which contain the indicators of financial stability, we conclude that central bank require to react to financial instability under flexible inflation targeting framework through augmented Taylor’s rule. Finally, we use time-varying-coefficient methods to test the effect of augmented Taylor’s rule model which contain indicators of financial stability achieve financial stability goal. While the existing research on the role of financial instability to the interest rate setting by the central bank is still in debate, but our empirical conclusions shows that PRC(the People’s Bank of Ghina) confront with financial instability, particularly in times of financial crisis, tends to adopt a looser monetary policy, lower policy rates in response to financial instability, through estimating time-varying monetary policy rules.Chapter7is the conclusions and suggestions of this paper. People’s Bank of China(PBC) require further improve the stability of the currency and to maintain financial stability in the monetary policy framework, if People’s Bank of China want to achieve the monetary policy objectives of monetary stability and financial stability. On the one hand, People’s Bank of China require to further promote RMB exchange rate formation mechanism reform and expand the floating range of the RMB exchange rate; and strengthen supervision of cross-border capital flows, especially for short-term capital flows, pay attention to the pace of capital account liberalization; and accurately identify the source of RMB exchange rate fluctuations, applied different monetary policy to maintain currency stability. On the other hand, monetary policy framework in China require to shift to a flexible inflation targeting as soon as possible, achieving from discretionary monetary policy to interest rate rules adjustment, and enhance the independence of People’s Bank of China, so that the People’s Bank of China have a independent executive right to conduct monetary policy; the People’s Bank of China require to build a macro-prudential policy framework that combine monetary policy with financial regulatory policies, maintaining financesystem stability.