This paper investigates three aspects of monetary policymaking in China in the last two decades: the autonomy of the central bank in the presence of sustained capital inflows and a quasi-fixed exchange rate regime, the transmission mechanisms of monetary policy, and a retrospective evaluation of the appropriateness of the PBoC’s monetary policy stance. The first part of my analysis shows that, while China can control domestic interest rates in the short run, sterilization of balance of payments inflows has been incomplete, suggesting that capital inflows are posing challenges to China’s conduct of monetary policy....[ Read more ]

This paper investigates three aspects of monetary policymaking in China in the last two decades: the autonomy of the central bank in the presence of sustained capital inflows and a quasi-fixed exchange rate regime, the transmission mechanisms of monetary policy, and a retrospective evaluation of the appropriateness of the PBoC’s monetary policy stance. The first part of my analysis shows that, while China can control domestic interest rates in the short run, sterilization of balance of payments inflows has been incomplete, suggesting that capital inflows are posing challenges to China’s conduct of monetary policy.

Next, I employ vector error correction (VEC) modeling to characterize the impact of monetary policy instruments on the price level and real output; while in general no strong evidence can be found on the existence of long-run causality relationships from monetary policy instruments to economic variables, impulse response functions generated by the VEC model suggest that economic variables do react to monetary policy shocks in the short run. Finally I try to provide theoretical foundations to my findings by estimating a standard New Keynesian model and a Cagan-style money demand function for China. I find that, whilst the interest rate policy of the PBoC was generally consistent with an interest rate rule, it was probably too tight after the Asian financial crisis but was relatively loose in most of the 2000s.