Financial Condition Index And China’s Taylor Rule

Since Taylor rule was proposed, this simple linear rule has been treated as an important tool while studying monetary policy. The public can learn about how central bank adjusts interest rate through estimating Taylor rule, this increases the transparency of monetary policy and helps monetary authority guide public expectations, thus achieving better policy effects.However, the financial market volatility poses substantial risks to macroeconomic with the deepening of financial liberalization. The U.S. subprime mortgage crisis has made many central banks realize that they should pay much more attention to financial market in order to reduce macroeconomic dangers. In this context, scholars begin to try bringing financial condition index (FCI) into the monetary policy framework. As to the research of Taylor rule, extended monetary policy reaction function containing FCI becomes a new field of study. In addition, it’s appropriate to use the nonlinear Taylor rule to describe monetary policy considering the nonlinear change mechanism of economic itself and the nonlinear behavior of central bank.This paper carries out a comprehensive study of both traditional and improved Taylor rule. Taking the significant improvement of financial market’s importance into account, we construct a financial condition index which contains interest rates, exchange rates, real estate prices, stock prices and money supply. Then we test whether this index can forecast future information, result demonstrates that the correlation between FCI and macroeconomic is very strong. Moreover, compared with the prediction of output, FCI can better predict future inflation. In the next part, this thesis introduces two different ways to bring FCI into the linear Taylor rule:(1) Firstly, we add FCI to the set of instrumental variables while estimating traditional linear Taylor rule by using Generalized Moment Method. This improves the performance of the Taylor rule estimation, and FCI is proved to be an effective instrumental variable. (2) Refer to the previous literature, this thesis directly estimates an extended interest rate reaction function which contains FCI. Result shows that FCI’s coefficient is positive, this means interest rate adjustments are conductive to stabilizing financial market. In a word, People’s Bank of China might treat FCI as a target variable in the past practice of monetary policy. Finally, my thesis constructs a nonlinear Taylor rule based on LSTR2 model. Through empirical study, we found that the central bank has an inflation target range. When inflation is within the range, interest rate is mainly determined by the linear function; when inflation exceeds the target range, interest rate exhibit distinctly nonlinear response to inflation and output gap. Overall, the non-linear Taylor rule not only helps to explain the linear adjustment of interest rate, but also to capture the time-varying behavior of the central bank. Moreover, the nonlinear rule’s goodness of fit is higher than the linear rule’s. In summary, nonlinear Taylor rule is more in line with reality.One main policy recommendation is that PBC should construct a financial condition index to monitor financial market. Meanwhile, monetary authority should continue promoting the marketization of interest rate so as to make a preparation for the future implementation of the Taylor rule.