Capital Account Liberalization And The Effectiveness Of Monetary Policy

The trend of global economic integration and financial liberalization has been strengthened,and many countries have been completed or are in the process of capital account liberalization since the last century.According to Ito's caculation,there are 55 countries or regions' opening degree have reached 1 in 182 countries or regions to the end of 2013,which means capital account liberalization,and there are 82 countries or regions ' opening degree have reached 0.6 which account for 45.1%,while there are only 14 countries or regions have completely not opened.Capital account liberalization promotes the liberalization of international capital flows,brings complex impact on monetary policy in various countries and affects the implementation of ultimate objective of monetary policy.At present,China is also actively promoting the opening of capital accounts.In 2015,Zhou Xiaochuan,the central bank governor,proposed that China will launch a series of targeted reforms to further push forward the free convertibility of the RMB,in order to achieve the free convertibility of RMB capital account.Under this background,the environment about operation of monetary policy in China will be more complex,and the strengthening of international capital flows will also affect the effectiveness of China's monetary policy operation.Therefore,it is of important theoretical significance to study the effect of capital account liberalization on the effectiveness of monetary policy,and further analyze the impact of international capital flows on monetary policy.Meanwhile,it is of important realistic significance to study international experience from cross country evidence,for how to practice monetary policy operation more effectively under the background of capital account liberalization in China.The connotation of the effectiveness of monetary policy refers that the central bank uses policy instruments with intermediate target and how affects economic variables such as output and price,based on the assumption that monetary policy can have a substantive consequences on the economy,rather than monetary neutrality and non-neutrality.Main intermediate targets of monetary policy are money supply and interest rate,and monetary target is mainly economic growth and price stability.The effect of the capital account liberalization on the effectiveness of monetary policy is to study what changes in the impact of monetary policy on economic variables,and how these changes are produced under the background of international capital flows.Innovations: first,to analyze the impact of capital account liberalization on the effectiveness of monetary policy in many ways--combining theory model construction and cross country empirical research,and analyzing by national heterogeneity from many different angles.For example,sample countries are divided into developed countries and developing countries by economic development level in cross country empirical research,and it makes a research from direct investment opening and capital market opening by different forms of capital flows in the expansion of cross country empirical research.Second,to analyze the channels that capital account liberalization affects the effectiveness of monetary policy by conduction mechanism of monetary policy from the perspective of interest rate channel.In the background of open policy on finance,interest rates are the main conduction channel of monetary policy.Therefore,the paper analyzes that how the transmission mechanism of interest rate changes and influence the effect of monetary policy in the case of international capital flows strengthening from the view of interest rates,which includes the impact of domestic short-term policy rate on domestic short-term market rate,and the impact of domestic short-term interest rate and global interest rate on domestic long-term interest rates.Third,to analyze the impact of China capital account liberalization on the effectiveness of monetary policy by means of theoretical and empirical perspectives.At present,the opening time of China capital account is relatively short,so it is less to study the impact of China capital account liberalization on the effectiveness of monetary policy.The paper analyzes the impact of China capital account liberalization on the effectiveness of monetary policy,and analyzes affect channels from the aspect of interest rate transmission mechanism.The paper uses De Facto indicator and analytic hierarchy process to construct China capital account opening index.The overall idea of the paper is: To begin with,based on theory model,it analyses the impact of capital account liberalization on the effectiveness of monetary policy.Next,it tests from cross-country evidence perspective.Then,it analyses the mechanism of the effect of capital account liberalization on the effectiveness of monetary policy from the perspective of interest rate transmission mechanism.Furthermore,it integrates theories and demonstration,which comprehensively analyses the effect of international capital flows on the effectiveness of monetary policy nearly ten years and analyses the impact mechanism from the interest rate channel on China's practice.Finally,it finds the conclusion that the paper puts forward some policy recommendations.Some classical theories are reviewed in the paper,including M-F model,Redux model under new open macroeconomics,and model of capital flow,monetary policy and economic fluctuation.Meanwhile,it introduces the measurement methods of capital account liberalization from De Facto indicator and De Jure indicator.Regulation measurement of capital account liberalization is mainly based on Annual Report on Exchange Arrangements and Exchange Restrictions which is released by IMF(International Monetary Fund).The De Facto measurement of capital account liberalization is ex-post measurement.There are saving-investment relationship,total amount,price level measurement method and so on.In addition,the literature reviews focuses on the analysis framework of monetary policy,the effectiveness of monetary policy and conduction mechanism of monetary policy under opening-up circumstances.And the paper gives a brief review of the literature.The paper analyzes the effect of capital account liberalization on monetary policy by Keynesian model,and proposes a new simple theory model based on AS-IS-LM model.To start with,model specification and definition of related concept;then,analysis of commodity market,money market and international payments;last but not least,analysis of general static equilibrium.The result shows that the effect of monetary policy on output and price is weakened because of capital account liberalization.Using panel data,the paper empirically tests the effect of capital account liberalization on the effectiveness of monetary policy.It is found that the degree of capital account liberalization in countries have been rising constantly.Especially in developed countries,many countries have realized the liberalization of capital accounts in recent decades.In this paper,taking the US quantitative easing for an example,it briefly analyzes the influence of capital flow on monetary policy.Then it makes an empirical analysis of the effect of capital account liberalization,direct investment opening up,and capital market opening on effectiveness of monetary policy with whole sample countries,subsample of developed countries and developing countries.There are 109 sample countries and the data time-span covers 30 years.The empirical test,which is consistent with the conclusion of theory model,shows that capital account liberalization weakens the effectiveness of monetary policy.Moreover,the paper draws some more particular conclusions by general and extended empirical analysis: I.Capital account liberalization weakens the output effect of monetary policy.The impact on developing countries are larger while developed countries are relatively smaller;II.Although capital account liberalization weakens the effect of monetary policy on price,the impact on developing countries is instable;III.Direct investment opening strengthens the output effect and weakens the price effect;IV.Capital market opening has weakened the output effect and the price effect,but the effect is not obvious;V.The effects in developed countries are obvious,and the effets in developing countries are delayed.That is to say,the monetary policy transmission mechanism is smoother in developed countries.It seems contradictory that capital account liberalization weakens the output effect of monetary policy,but direct investment opening strengthens the output effect.That conclusion is related to the capital effect and spillover effect which are produced by the impact of foreign direct investment on the host country.The capital effect and spillover effect of foreign direct investment contribute to increasing output.Firstly,foreign capital inflows increase the savings for investment in host country that capital inflows expand the domestic money supply and form production capacity by funds outstanding for foreign exchange.Secondly,foreign direct investment promotes industrial complementary investment by industry-chain effects and demonstration effects,which generates investmental multiplier effects on host country and thereby promoting economic growth and output improvement.Thirdly,foreign direct investment has spillover effect which to promote output improvement by the effects on the host country's industrial structure adjustment,technology spillover,institutional change and so on.The paper analyzes the influence of capital flow on the effectiveness of monetary policy by conduction mechanism of monetary policy.According to the analysis,the interest rate and credit channel transmission mechanism weakens when capital flows strengthen,but the exchange rate and financial asset price transmission mechanism has been strengthened.It is very difficult to comprehensively and systematically combine monetary policy transmission paths,and quantitatively analyze their impact on the effectiveness of monetary policy.Interest rate transmission channel is the main and most important among them.From the perspective of interest rate channel,the paper consequently studies the impact of international capital flows on interest rate transmission mechanism by theoretical analysis and empirical research.The impact of interest rates on economic variables: on the one hand,the short-term interest rate affects the economic subject behavior,thus to affect aggregate demand and supply,and ultimately influences the output and price;on the other hand,short-term interest rates and long-term interest rates affect the medium to long-term behavior of each economic subject.There are two key links in the path.One is domestic short-term interest rates need to guide long-term interest rates effectively;the other is domestic short-term policy rates need to guide their short-term market rates effectively.Interest rate transmission mechanism plays a central role of both aspects.Therefore,the paper makes some empirical tests respectively on whether the relationships of short-term interest rates with long-term interest rates and short-term policy rates with short-term market rates change from these two key links.Findings: I.With the increasing intensity of international capital flows,the impact of world interest rates on domestic long-term interest rates has strengthened,while the impact of domestic short-term interest rates on domestic long-term interest rates has weakened.However,domestic factors still determine domestic long-term interest rates changes.II.With the strengthening of international capital flows,the impact of domestic short-term interest rates on domestic short-term market rate has weakened.Generally speaking,the improvement of capital accounts openness degree weakens the interest rate transmission channel of a country's monetary policy and further weakens the effectiveness of a country's monetary policy.The paper analyzes the influence of capital account liberalization in China on the effectiveness of monetary policy by interest rate transmission mechanism.First of all,the paper reviews the process of capital account liberalization in China,and describes the current situation.According to the analysis,no matter De Jure indicator or De Facto indicator,degree of capital account liberalization steadily improves in China.Among them,the extent of direct investment opening-up has risen steadily while the extent of portfolio investment is always at a low level.At the same time,the extent of capital account liberalization in China is lower than that in other countries of a similar level of economic development.The paper introduces the monetary policy practice since the Reform and Opening,which shows that interest rate transmission mechanism playing an more and more important role with the rapid progress of China' marketization of interest rate.Furthermore,the paper analyzes the cyclical changes of China's monetary policy by capital flow,and emphasizes the effect of capital flow on monetary policy.Secondly,it makes an empirical test about the effect of Capital account liberalization on the effectiveness of monetary policy.And the findings are as follows: I.Capital account liberalization in China weakens output effects of monetary policy in a narrow range;II.In recent decade,the relationship between Capital account liberalization and inflationary effects of monetary policy in China is not significant;III.Direct investment opening up greatly strengthens output effects of monetary policy in China,but it influences inflationary effects of monetary policy unobviously;IV.International capital flows,relating to the portfolio investment,have not visibly influenced the effectiveness of monetary policy concerning with comparatively closed situation of capital market in China.Finally,the paper analyzes the influence mechanism of capital account liberalization on effectiveness of monetary policy in China.Because of the existence of interest rate control,the main conduction mechanisms of monetary policy in China are bank credit and money supply.But with the constantly improving of China's financial system,and the deepening of market oriented reform of interest rate,the interest rate plays a more and more important role in the transmission mechanism of monetary policy in China.Ma Jun,Ji Min et al.,found that the change of short-term interest rate in China,to some extent,can be transmitted to bond yield and lending rate through bond market and banking channels by empirical test.The empirical test made by Jiang Zaiyong and others shows that: Market rate channel in the transmission mechanism of monetary policy has gone through the structural transformation during January 1996 to July 2009.And the effect is stronger and sustained that inter-bank offered rate changes stabilize the output and price fluctuation after the transformation.These demonstrate that it is feasible to study from the perspective of the interest rate transmission mechanism in China.Therefore,the paper uses VAR model to test what the interest rate transmission mechanism have altered with the strengthening of international capital flows in recent years.With the strengthening of international capital flow,it finds that the effect of short-term interest rate on long-term interest rate in China has weakened while the effect of world interest rate on China medium and long term interest rate has slightly strengthened.In addition,the impact of short-term policy rate on short-term market rate in China also weakens obviously.These findings explain the weakening influence of capital account liberalization in China on the output effect of monetary policy in some extent.Based on the conclusions of the study on theoretical analysis,cross-country evidence and China practice,the paper puts forward some policy suggestions.To begin with,strengthen policy coordination to enhance the effect of macroeconomic policy.In the process of promoting the further opening up of the capital account,China should pay attention to the coordination of macroeconomic policy.On the one hand,China needs to coordinate domestic monetary policy and fiscal policy well;on the other hand,it needs to handle international coordination of macroeconomic policy.Next,dredge the Interest rate transmission channel of monetary policy.With the advancing of finance marketization reform in China,interest rate transmission mechanism is becoming more and more important.In order to improve the effectiveness of monetary policy,it is necessary to perfect domestic financial market and to dredge the Interest rate transmission channel of domestic monetary policy.It is the main operational field in the central bank benchmark interest rate to pay great attention to the development of inter-bank market,increase market participants and enrich trading patterns.Whether volatility of interest rate in money market or money supply and demand,has high relativity with objective of central bank's monetary policy.What's more,further encourage and support direct investment opening-up.Both international experience and domestic empirical research show that direct investment and opening up strengthens the effect of monetary policy on output.Therefore,it is feasible to further relax the restrictions on direct investment so as to strengthen the effect of China's monetary policy on output and then to boost the economy on the premise of nation's economic safety in China.Eventually,promote domestic financial development.Capital account liberalization in China has sped up and the process of RMB internationalization has actively promoted so international capital flows are bound to markedly strengthen.Therefore,it is important to promote the development of China's financial market and to improve the ability to resist risks of China's financial system.Finally,the paper makes an outlook on the future study: First,with comprehensive consideration of national heterogeneity from many different angles,it analyzes the effect of capital account liberalization on the effectiveness of monetary policy,including different exchange rate system,economies of scale,financial development,whether the domestic currency is the reserve currency and so on;Second,under the unified framework of exchange rate,asset price,interest rate and other different monetary policy transmission channels,it systematically analyses the effect of international capital flows on the mechanism of the effectiveness of monetary policy;Third,considering the different directions of capital flows,it comparatively analyses the effect of capital inflows and capital outflows on the effectiveness of monetary policy.