A Study Of The Independence And Effectiveness Of China's Monetary Policy In The Open Economy

After the reform of the RMB exchange rate regime in July 2005,China began to implement managed floating exchange rate regime.Although the RMB exchange rate has some flexibility within a certain floating range,the central bank still actively intervenes in the foreign exchange market through purchasing or selling foreign exchange reserves when the RMB experiences substantial appreciation or depreciation pressures.Although foreign exchange market intervention can stabilize the RMB exchange rate,the cost is the monetary base will fluctuate with the fluctuations of foreign exchange reserves.To neutralize fluctuations of the monetary base caused by fluctuations of foreign exchange reserves,the central bank tends to take the opposite action on domestic assets or implement other contrary monetary policies(sterilization).Some scholars pointed out that China has constantly sterilized and at least had some effects.However,it is not straightforward to assess exactly the degree of sterilization,since China has applied different sterilization methods simultaneously(Goodfriend and Prasad,2007)?In addition,despite China having implemented sterilization policy,it may not be as effective as the central bank wishes it to be.Specifically,according to the "Trilemma",free international capital flows,stable exchange rate and independent monetary policy cannot be achieved simultaneously.Choosing the combination of stable exchange rate and independent monetary policy,China has to implement capital controls.However,China's capital controls are not entirely effective and are increasingly difficult.Under this situation,the change in domestic assets resulted from implementing monetary policy will further induce international capital inflows or outflows,which will undermine the effectiveness of sterilization policy,thereby affecting the independence of monetary policy.Thus,monetary policy and international capital flows may not be completely independent.Hence,to measure the effect of China's sterilization operations and judge the independence of China's monetary policy,it is necessary not only to measure the reaction of monetary policy on international capital flows(sterilization),but also to calculate the reaction of international capital flows on monetary policy(offset).Generally speaking,the target of the central bank's monetary policy is not only to control money supply in the face of large-scale international capital flows to achieve the independence of domestic monetary policy,but also to impact domestic economy,namely monetary policy is effective.However,monetary policy not only affects the macro economy directly,but also affects the macro economy indirectly through the monetary policy channel.In order to examine the effectiveness of monetary policy more comprehensively,it is necessary to study the direct and indirect effects of monetary policy on macro economy.Based on related concepts of international capital flows and monetary policy,this paper reviews existing literature on the independence and effectiveness of monetary policy,and summarizes the theory of monetary policy independence and effectiveness.In addition,this paper summarizes China's monetary policy after 1994,and employs the method of the Federal Reserve Bank of St.Louis to translate the change in reserve requirement ratio into the change in the monetary base,while the money multiplier remains unchanged.Then the change in reserve requirement ratio is combined with the other monetary policies that directly affect the monetary base to construct integrated monetary policy.Based on the BGT model and the ORW model,taking the change in reserve requirement ratio into consideration,this paper constructs a modified offset and sterilization coefficients model and estimates the quantitative relationship between international capital flows and China's monetary policy,and further estimates the dynamic change using the method of recursive coefficients estimation.In addition to conducting estimate over the whole sample period,this paper also divides the whole sample into several sub-samples according to the practice of China's monetary policy and conducts estimate over each sub-sample period.Besides,based on China's monetary policy regime,this paper analyzes the mechanism that monetary policy affects macro economy and constructs multi-level vector autoregressive systems to reveal the direct and indirect effects of monetary policy on macro economy.The major studies of this paper are as follows:First,before undertaking the theoretical and empirical analysis,this paper defines the concepts of international capital flows monetary policy,independence of monetary policy and effectiveness of monetary policy firstly.Then,this paper reviews the theory of the relationship between international capital flows and monetary policy,mainly including Mundell-Fleming model,and "Trilemma".Second,this paper summarizes China's monetary policy after 1994 and finds that China's monetary policy instruments have gone throughre-lending to open market operations to central bank bills and then to a mixed use of central bank bills and reserve requirement ratio.Third,this paper employs the method of the Federal Reserve Bank of St.Louis to translate the change in reserve requirement ratio into the change in the monetary base,while the money multiplier remains unchanged.Then the change in reserve requirement ratio is combined with the other monetary policies that directly affect the monetary base to construct integrated monetary policy.It shows that since 2000,ignoring the change in reserve requirement ratio generally underestimated the central bank's tight monetary policy through comparing integrated monetary policy with the original monetary base.Fourth,based on the BGT model and the ORW model and the integrated monetary policy calculated by the method of the Federal Reserve Bank of St.Louis,this paper constructs a modified offset and sterilization coefficients model.Then,using monthly data from January 2000 to December 2016,this paper estimates the quantitative relationship between international capital flows and China's monetary policy,and further estimates the dynamic change using the method of recursive coefficients estimation.The results show that the offset coefficient is-0.193~-0.252,indicating that China's international capital flows are still modest and China's capital controls are relatively successful.As can be seen from the dynamic change of the offset coefficient,after 2002,China saw a rapid economic growth,thus the pressure of international capital inflows was increasing and the degree of offset also kept increasing.After the reform of the RMB exchange rate regime in July 2005,due to the RMB appreciation weakened strong appreciation expectations and the global financial crisis broke out in 2007,international capital inflows began to reduce and the degree of offset also showed downward trend.With the impact of the international financial crisis diminishing,China's international capital flows expanded.However,due to China's economic growth slowed down in recent years,international capital mobility is relatively moderate.The sterilization coefficient is-0.888~-1.104,indicating that China's monetary policy has almost completely sterilized or even over-sterilized the fluctuation of the monetary base resulting from international capital flows.As can be seen from the dynamic change of the sterilization coefficient,China's central bank over-sterilized international capital flows from 2004 to 2007.But during this process,the degree of sterilization gradually declined.After the outbreak of the global financial crisis in 2007,to alleviate the economic downturn,the central bank implemented very loose monetary policy and the degree of sterilization declined dramatically.As the impact of the global financial crisis diminishing,the degree of sterilization began to rise slowly.However,as China's economic gradually stepped into the "new normal",the degree of China's monetary policy sterilization stayed on the level of near completely sterilization.Fifth,China chooses different monetary policies as main sterilization instruments at different stages,thus this paper estimates the relationship between international capital flows and monetary policy at each stage.The results show that both the offset effect of international capital flows on monetary policy and the sterilization effect of monetary policy on international capital flows are insignificant over the period from January 2000 to August 2002.From September 2002 to June 2006,the offset coefficient is-0.149~-0.218 and the sterilization coefficient is-0.723~-0.917.From July 2006 to December 2016,the offset coefficient is-0.188 ~-0.256 and the sterilization coefficient is-0.788 ~-1.083.In general,the degree of offset of international capital flows has slightly increased,while the degree of sterilization of monetary policy has significantly improved.In addition,the results of the entire sample period and of the three sub-sample periods indicate that ignoring reserve requirement ratio underestimates international capital mobility and the sterilization effect of China's monetary policy.Sixth,based on China's monetary policy regime,this paper analyzes the mechanism that monetary policy affects macro economy and constructs multi-level vector autoregressive systems to reveal the direct and indirect effects of monetary policy on macro economy.The results show that China's monetary policy mainly depends on money supply channels to play a role.Therefore,no matter directly or indirectly,monetary policy only has a slight positive impact on the economic growth rate.In contrast,although monetary policy cannot directly affect the inflation rate,it can affect the inflation rate indirectly through the operational objectives and intermediate objectives of monetary policy.As can be seen from the complete channel of money supply,monetary policy has a positive effect on inflation rate.Overall,the expansionary monetary policy will increase the inflation rate,while only increasing the economic growth rate slightly.The tight monetary policy will decrease the inflation rate,while will not inhibit economic growth substantially.