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Abstract
This paper models inflation dynamics in China from 1987 to 2014 using a Phillips curve framework. The Phillips curve is generally estimated under the assumption of linearity and parameter constancy. The existence of structural breaks in China’s inflation dynamics make standard linear models inappropriate tools for analysis however. Our results find that the Chinese Phillips curve is characterised by a non-linear relationship. The inflation/output relationship takes the form of a concave curve. This suggests that changes in the level of output effect inflation in China more strongly in periods when output is operating below its potential but the relationship is weaker when output is operating at or above potential. Based on these findings, the People’s Bank of China (PBC) could consider output cost and policy response on a case-by-case basis depending on the level of output in relation to potential.
Acknowledgements
The authors’ would like to thank Sheng Fang, Xingsheng Lu, Lingxiang Zhang, Bernadette Andreosso-O Callaghan and Brendan Walsh as well as the two anonymous referees for their comments and suggestions.
Notes
1. Studies carried out using Japanese, Euro Area and US data respectively.
2. Gerlach and Peng (Citation2006), Dickinson and Liu (Citation2007), You and Sarantis (Citation2012) and Zheng, Wang, and Guo (Citation2012) all discuss the effect of structural breaks and non-linearity’s in Chinese macro variables.
3. In order to implement the strategic planning adopted at the National Congress of the Communist Party of China, the Plenary Session of the Central Committee of the Communist Party of China discussed some major issues concerning deepening the reform comprehensively, and made a number of key decisions based on the discussions.
4. Chow (Citation2004) argues that these problems would have included a sudden increase in prices by market forces of essential consumer goods which would affect the welfare of consumers and the disruption of state enterprises who for years had been supplied with low cost inputs under the centrally planned system.
5. Oppers (Citation1997) points out however, that the late 1980s also saw great setbacks in the price reform process. For example, Chinese authorities, in response to macroeconomic imbalances, introduced a ‘rectification’ programme which included a part reversal of earlier price reforms. Naughton (Citation2007) argues that this is one of the many tensions which led to the Tiananmen Square incident of 1989, which further interrupted reform.
6. China Daily article, March 2015, accessed at http://usa.chinadaily.com.cn/business/2015-05/06/content_20638925.htm.
7. Before 1994, China was still under the ‘dual’ exchange rate regime, under which 80% of the foreign exchange trading volume was at the market rate, and only 20 % at the official rate. The 8.7 RMB per USD rate was basically the market rate at the end of 1993. On January 1, 1994, China unified the ‘dual’ exchange rate regime into a single one.
8. We are aware that results are sensitive to the method used for the measure of the output gap. Therefore, the output gap and potential GDP calculated by Oxford Economics Global Economic Databank was compared to a HP filter of China’s real GDP calculated by the authors. Both series were very similar as were estimations used with the different measures of the output gap.
9. Before beginning the estimations, Augmented Dickey Fuller (ADF) tests were applied to specify the order of integration of the variables. All variables were found to be I(0) at least at the 5% significance level. Results available by request.
10. While gradual price liberalisation has promoted convergence between international and domestic energy prices (OECD Citation2013), the price of oil and petroleum products in China are still highly regulated by the government.
11. This is defined in foreign currency unit per renminbi (RMB) such that an increase in this variable corresponds to an appreciation of the RMB. We therefore expect a negative sign for this variable in our estimations.
12. Reform was not in the form of a one off policy or a ‘big bang’ change in institutional systems. China adopted economic reforms gradually. By so doing, it has phased in market forces into an administered economy but without a fundamental ownership transformation into a privately owned economy (Yueh Citation2010). The reforms of the Chinese economy are often characterised into two distinct periods or ‘eras’ – 1978–1992 and 1992 onwards.
13. All significant lags of inflation were included in the estimation.
14. As the NEER is defined in foreign currency unit per renminbi (RMB), an increase in this variable corresponds to an appreciation of the RMB.
15. This is a test for parameter stability at each of the different points of a time series. Pioneered by Quandt (Citation1960) and developed by Andrews (Citation1993), it tests for one or more structural break points in the sample of a specific regression equation. It is prudent to test for structural breaks in this manner when the time series in question has experienced shocks and abrupt policy changes like those experienced by the Chinese economy.
16. In other words it tests for multiple breaks at unknown dates.
17. The standard deviations (S.D.) are calculated by multiplying the coefficient given for the independent variable by the S.D. of that variable divided by the standard deviation of the inflation. The calculation for example using the output gap in Period 1 is 0.68 × (2.4%/7.2%) = 0.23%.
18. Let us for example, say that at time t, the state of the economy st is classified as either high inflation in st = 1 or low inflation in st = 2. Let us also assume that the model gives us a probability of 95% of being p11 and 5% of being p21. What these values tell us is that if the economy is in a state of low inflation in the previous period, it tends to stay in a low inflation state with a very high probability of 95%. On the other had the probability of being in a low inflation state in the previous period and switching to a high inflation state is low at just 5%.
19. For more details on these technique and the maximum likelihood see Hamilton (Citation1994) and Kim and Nelson (Citation1999).
20. This is calculated by .
21. Figure gives a representation of a concave Phillips curve (Filardo Citation1998).
22. The assets monopoly is a key feature of the Chinese system. Although in theory the SOEs are publicly owned, citizens are not the shareholders. Instead, appointed government agents hold a monopoly over these assets. This phenomenon leads to inefficiencies, a lack of innovation, inequitable distribution, corruption, and imbalances in the economic structure (Duan and Saich Citation2014).