Chinese Monetary Policy And Exchange Rate

Exchange rate overshooting theory is the basic analytical framework in analyzing the relationship between monetary policy and exchange rate,this theory propose that after a monetary policy shock,the short-term reaction of nominal exchange rate will exceed its long-run equilibrium level and the maximal reaction appears immediately after the shock.However,empirical researches based on SVARs find the “delayed overshooting puzzle”,they conclude that after a monetary shock,the nominal exchange rate reacts gradually,thereby giving a hump-shaped response.Recently,some researches find that due to the curse of dimensionality,SVARs may suffer from the problem of missing variables which bias the conclusions.Applying a st ructural dynamic factor model,in which can we contain more variables to avoid the problem of missing variables,this paper re-exams the “delayed overshooting puzzle”.This paper consists of five parts.The introduction,this part includes the background and the significance,the literature review,the main contents and the methods and the innovations and the insufficiency.Chapter one,set forth the basic idea of exchange rate overshooting theory and its evolutions.Chapter two,this part describes the structural dynamic factor model,including its setup,its estimation and identification methods and the advantages of the model.Chapter three,the empirical study,based on 73 Chinese macro-economic variables,we re-exam the “delayed overshooting puzzle” using structural dynamic factor model.Conclusions and policy recommendation,this part summarize the main findings and propose two policy recommendations: firstly,we should conduct a hedge policy immediately after the implement of monetary policy;secondly,we should retain some proper exchange rate stabilization tools while we are deepening the exchange rate reform.The main finding of this paper is that the empirical model can fully simulate Chinese macro-economy in which the delayed overshooting puzzle and the price puzzle disappear.Meanwhile,the time for exchange rate adjustment and price movement to reach a new long-term equilibrium is consistent.This result implies that the short-term fluctuation of Chinese exchange rate is really the story of the exchange rate overshooting modelThere are two contributions in this paper.Firstly,we find empirical evidence for the exchange rate overshooting phenomenon in China,this finding is distinct from existing researches based on SVARs.Secondly,we use a dynamic factor model,this model is more realistic which results in a more credible conclusion.