The Impossible Trinity And Chinese Monetary Independence In The Open Economy

This thesis analyzed the Impossible Trinity and Chinese monetary independence in an open economy from both the perspective of theoretical frameworks and empirical studies. The results of the theoretical analysis suggest that the growing trend of an open economy has made it more difficult for Chinese monetary authorities to achieve their ultimate objectives, intermediate targets and transmission mechanism. The results of the empirical analysis demonstrates that China’s supply of money and monetary independence has been affected by funds outstanding for foreign exchange, US consumer price index, money multipliers and Chinese national incomes. The main body of this thesis can be divided into four parts. Firstly, this thesis reviews the theories and literature relating to monetary independence in the open economy. The fundamental theories include the Mundell-Fleming Model, the Impossible Trinity theory and the extended Impossible Trinity. There is an abundance of existing literature regarding Chinese monetary independence in an open economy. Some applied pure theoretical derivation, and others used empirical analysis. The conclusions vary depending on the specific time range or model used. Secondly, this thesis further analyzes how the open economy affects Chinese monetary independence, finding that the open economy can affect Chinese monetary policy making in multiple aspects, including the objective of monetary policy, the intermediate targets of monetary policy and the monetary policy transmission mechanism. In addition, by taking into consideration exchange rate reforms and the increasingly high influx of international capital inflows, this thesis also explores monetary independence under the framework of the Impossible Trinity.Thirdly, this thesis uses the Girton-Roper model to empirically analyze the factors that may influence Chinese money supply and therefore monetary independence. By applying ADF tests, OLS estimation and its adjustments, and Granger causality tests, this thesis reached the conclusion that the changes of funds outstanding for foreign exchange, American price levels, Chinese national income and money multipliers have influenced Chinese money supply and therefore monetary policy. Among these factors, since Chinese monetary authorities are unable to control money multipliers and the U.S. price level, these two variables are the most important factors that may threaten the independence of the process of Chinese monetary policy making.Finally, I will conclude this thesis with recommendations for policy makers. This thesis will also propose suggestions on future works relating to monetary independence in an open economy.