The dynamic effectiveness of monetary policy in China: evidence from a TVP-SV-FAVAR model

ABSTRACT

We use a broad set of China’s macroeconomic indicators and a dynamic factor model to estimate latent factors of economic output and inflation, which are used to measure the ultimate objectives of monetary policy. The above factors and policy variables are incorporated into a TVP-SV-FAVAR model to investigate the dynamic effectiveness of Chinese monetary policy. Our results confirm that the effects of Chinese monetary policy are time-varying. By comparing the quantity rule with the price rule, we find that the price rule is more effective in managing China’s macro-economy, especially after the financial crisis. Moreover, the results can be regarded as a division of policy rules in a way that different rules are directed at different objectives.

KEYWORDS:

• Monetary policy
• quantity rule
• price rule
• time-varying effects

JEL CLASSIFICATION:

• C32
• E52

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The unreliability of an individual indicator is mainly reflected in: China’s statistical investigation is lagging, the quality of an individual indicator will directly determine the credibility of the study; it’s hard to characterize comprehensively the effects of Chinese monetary policy by using an individual one; there is also a subjective problem of variables selection, and the inconsistency of selection may sometimes subvert the empirical results.

² Referring to Fernald, Spiegel, and Swanson (2014), we consider the case of classical linearity. The rationality of its form selection can be supported by the accuracy of subsequent factor extraction.

³ Consistent with Ang and Piazzesi (2003), we divide macroeconomic indicators into two groups: one containing measures of output and the other containing measures of inflation. And then we extract the first principal component from each group to get latent factors of economic output and inflation separately, which ensures that each factor has a clear economic interpretation.

⁴ We assume a typical recursive ordering, with factors of economic output and inflation ordered first, followed by policy variables, that is, policy variables can respond endogenously to changes of output or inflation within the month, however, policy innovations affect output and inflation with a lag of one month or more.

⁵ Compared with the traditional methods of identification, sign restrictions can directly restrict the direction of shocks between variables based on economic theory.

⁶ Depending on the model, the criteria typically choose between one and three lags. Allowing more lags inherently leads to choppier and less precise results, given the relatively short sample we use and a large number of parameters to be estimated. Results are robust to allowing for three lags.

⁷ For the quantity rule and the price rule of Chinese monetary policy, we consider two observable measures, reported at the top of Table 1: the money supply, as measured by M2; and the benchmark short-term (7-day) interest rate, as measured by CHIBOR. The indicator of exchange rate is not included in our empirical model.

Additional information

Funding

This work was financially supported by the National Natural Science Foundation of China under Grant No. [71473279]; the National Social Science Fund under Grant No. [15ZDC024]; and the Research and Innovation Fund for Graduate of Central University of Finance and Economics under Grant No. [201708].