An Impact Study Of China’s Interest Rate Corridor On Interest Rate Volatility

The interbank market went through large swings on June 2013,with 7-day repo rate hiking 12%.Thus People’s Bank of China started the pilot of interest rate corridor since early 2014.Financial stability becomes increasingly important with the progress of China’s financial reform.Therefore,it is highly important to study the impact of interest rate corridor on volatility both thematically and empirically.The paper consists of six parts.The first part introduces the background of interest rate corridor.The second and third part contrast the international experience and Chinese practice from historical and institutional background.The fourth part builds a model to describe the mechanism.The fifth part evaluates the effect in China.The sixth part introduces the main contribution.Actually interest rate corridor was implemented by many central banks,such as Bank of Canada,Reserve Bank of Australia,Reserve Bank of New Zealand,as price monetary tool took the place of quantity tool at the early stage of 20 th century.The interest rate corridor gained attention again after the subprime crisis.The paper categorized the corridor into three models.The first is corridor with no reserve requirement,such as Canada.The second is corridor with little reserve requirement,such as ECB.The third is application of interest rate corridor,such as Fed.According to international experience,the paper proposed three challenges about China’s interest rate corridor.Firstly,high reserve requirement ratio may distort the supply and demand on the interbank market.The countries with highly effective interest rate corridors always implement zero reserve requirement regime.Secondly,China’s monetary policy regime is flexibility under “multi-goal and multi-tool”.The countries with highly effective interest rate corridors always implement rule monetary principle under “multi-goal and multi-tool”.Thirdly,China’s interest rate market is segmented,negatively effecting the transmission among different market.The countries with highly effective interest rate corridors are mostly developed countries.Theoretically,based on Woodford(2001),the paper introduced a supply curve,constructing a supply-and-demand interest rate corridor model in the interbank market.Based on the equilibrium,the paper discussed the implication and application of the model.The paper explained corridor tool under “zero reserve requirement” regime.The paper discussed the combination of open market operation and interest rate corridor.The paper contrasted the pros and cons for systematic and asymmetric interest rate corridor.Most importantly,by introducing uncertainty into the model,the paper proposed that interest rate corridor influences the demand of the banks to manage their expectation.This indicated that interest rate corridor works in the same mechanism as central banks’ communication does.Accordingly,the paper discussed how interest rate corridor influences the interest rate volatility empirically,by using EGARCH model.The empirical evidence indicates that interest rate corridor helped to decrease the interest rate volatility.The empirical result shows that interest rate corridor can reduce the interest rate volatility significantly.Also the narrower the corridor,the lower the interest rate volatility.The main contribution is introduction of a dummy variable in EGARCH model,providing a method to study interest rate volatility.