Exchange Rate Volatility And Inflation Risk In China

Exchange rate and domestic price manifest the external and internal value of a country’s currency. Nowadays, China’s economy and the whole society become more and more open, however, at the same time, they also face quite serious inflation risk. On this occasion, to maintain the macroeconomic stability seems more important than any other periods. The paper focuses on the following two major questions:What role does the exchange rate play in the process of stabilizing the domestic price level? What dynamic characteristics does ERPT in China have? A deep analysis in the relationship between the exchange rate and the price level (that is ERPT) may help the government set proper monetary, fiscal and industrial policies.The paper summarizes previous studies on ERPT, and then retrospects the exchange rate regime changes and domestic price trends since1980s in order to find dynamic characteristics of ERPT. Fortunately, the facts confirmed my conjuecture. Based on the data from January1994to November2012, using MS-VAR model with3regimes, the paper focuses on the effects of RMB exchange rate to general price level. The empirical result reveals that, the domestic price is not sensitive to the movement of exchange rate, that is, ERPT is incomplete. Besides, the results tell us that the higher the price level is, the higher ERPT is. Moreover, the China’s macroeconomic state will enjoy long-term sustainability.To make the paper more rigorous and academic, in the last section, this paper analyzes the dynamic characteristics of ERPT further. Analysis shows that irrational import and export structure, weak pricing ability in competition, changes of the exchange rate regime and effectiveness of monetary policy can explain the above features. Relevant policy implications are proposed based on the specific empirical conclusions and theoretical analysis.