Financial Frictions,Economic Fluctuations,and Monetary Policy

In response to the adverse impact of the global financial crisis,Chinese government introduced large-scale economic stimulus policies.As a starting point,the rapid growth of China’s credit significantly increased the leverage rate of non-financial sector,especially corporations.Further,in recent years,prices of real estate across the country rose rapidly,and the shadow banking system expanded substantially.As a result,financial risks accumulated.These characteristics of financial markets were similar with the situation in developed economies before the financial crisis,and therefore should be considered by policy makers and market participants.Thus,it is necessary to study how the shocks of financial market will affect the real economy.In addition,changes in the structure of the financial market will have a significant impact on the transmission mechanism of monetary policy.The expansion of the shadow banking system,and the rapid development of the interbank markets gradually weakened the effectiveness of quantity-based monetary policy,but gradually strengthened the effectiveness of price-based monetary policy.Therefore,it is necessary to re-evaluate the effectiveness of the monetary policy framework,to provide a reference for monetary policy in the future.Although there are many researches on the relationship between financial market and economic fluctuation in China and on monetary policy in China,the research on financial market,economic fluctuation and monetary policy under one framework is very limited.This might be partly due to the limitation of the research tools.In recent years,financial frictions have become an important theme of macroeconomic research,and ignoring this structure of financial market will bias the analysis and evaluation of monetary policy.This paper attempts to draw lessons from the researches of Gertler and Kiyotaki,and uses a dynamic stochastic general equilibrium(DSGE)model with financial sector,to study the impact of the financial market on real economy fluctuations while considering the special financial structure.It also compares the effectiveness of quantity-based and price-based monetary policy instruments in terms of stabilizing output and price level.This paper uses the data of four macroeconomic variables from the first quarter of 2001 to the second quarter of 2017,including gross domestic product(GDP),consumer price index(CPI),interbank interest rate and the money supply(M2),and uses the methods of parameter calibration and Bayes estimation to determine the parameters in the model.Based on the identified parameters,this paper simulates the dynamic path of two macroeconomic variables,output and inflation,under the impact of the structural shocks.Specifically,this paper discusses the impact of structural shocks on real economic fluctuation under the interest rate rule and money supply rule respectively.It also compares the results of DSGE model with financial sector are the results of DSGE model without financial sector,and compares the effectiveness of the two monetary policy rules.According to the simulation results obtained in this paper,we can summarize the following main findings:First,due to the financial accelerator mechanism,the shocks of monetary and financial markets will amplify the fluctuations of the real economy,and the impact of financial market exists in long term;Second,the interest rate and money supply as instruments of monetary policy are only effective in short term,but are neutral in long term;Third,the price-based monetary policy is more effective than the quantity-based monetary policy in terms of stabilizing price level;Fourth,in short run,price-based monetary policy can respond more effectively to shocks of financial market.According to the analysis of the simulation results,this paper puts forward the following policy implications:First,the authority should continue to adopt a mixed monetary policy combining quantity-based and price-based instruments and use appropriate policy according to the economic situation to maintain economic stability.The monetary policy framework should also transit from quantity-based policy to price-based policy,to more effectively cope with the impact of financial markets.Second,we should pay attention to the relationship between steady growth and financial risks.The authority should implement robust monetary policy in the future,and gradually reduce the dependence on monetary policy to stimulate the economy,but achieve steady growth through the optimization of economic structure.We should also innovate monetary policy instruments,and improve economic structure,so that financial market can benefit real economy.The innovation of this paper is to make attempts to discuss the relationship between financial market and economic fluctuation through a new framework.This framework is widely used in the developed countries after the financial crisis for policy analysis,but is seldom applied to researches on issues in China.In addition,considering the situation in China,this paper incorporates money supply as an instrument of monetary policy in this framework,which is used to compare the effectiveness of quantity-based and price-based monetary policy.