Time-varying comparison of the effectiveness of China’s price- and quantity-based monetary policy tools: an empirical analysis based on the TVP-FA-S-VAR model

Abstract

In order to compare the effectiveness of China’s price- and quantity-based monetary policy tools over time, we develop a structural vector autoregressive model with time-varying parameter and factor augmentation (TVP-FA-S-VAR model) to analyze the response of output gap to monetary policy shocks. We find that price-based regulation becomes increasingly effective as China’s interest rate liberalization proceeds, while the effects of broad money supply on output have been diminishing. Additionally, as it becomes harder to measure the effectiveness of quantity-based regulation, China’s central bank has been more prudent to rely on quantitative intermediaries. Moreover, as much as 40% residual information of the Taylor rule will be omitted using price-based intermediaries, while factor augmentation fails to increase the explanatory power of quantitative intermediaries significantly. The correlation between quantitative intermediaries and the real economy has been weakening, so that the quantity-based monetary policy tools are no longer suitable for government intervention in China.

HIGHLIGHTS

1. We develop a structural vector autoregressive model with time-varying parameter and factor augmentation (TVP-FA-S-VAR model) to analyze the response of output gap to monetary policy shocks.

2. We find that price-based regulation becomes increasingly effective as China’s interest rate liberalization proceeds, while the effects of broad money supply on output have been diminishing.

3. China’s central bank has been more prudent to rely on quantitative intermediaries.

4. As much as 40% residual information of the Taylor rule will be omitted using price-based intermediaries, while factor augmentation fails to increase the explanatory power of quantitative intermediaries significantly.

5. The correlation between quantitative intermediaries and the real economy has been weakening, so that the quantity-based monetary policy tools are no longer suitable for government intervention in China.

Keywords:

• Price-based monetary policy tools
• quantity-based monetary policy tools
• TVP-FA-S-VAR model
• residual information of monetary policy

JEL CODE:

• E51
• E52
• E61

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 We can introduce the matrix structure of the TVP-FA-S-VAR model by taking interest rate rules as an example. In the process of modeling money supply, we assume the central bank to adjust money supply according to changes in output gap, inflation and other macro factors for consistency. The specific forms can be found in Eq. (10) and the matrices of $A_t$ and $F_1.$

2 We find that the two macro factors’ goodness of fit to fundamental indicators can be 85% or higher in the process of macro factor selection. Hence, we add them into the TVP- FA-S-VAR model.

3 It may lead to biased estimation without classifying data in the process of developing the TVP-FA-S-VAR model.

4 The sample period is from 2004:01 to 2019:06. All data are collected from the CEInet Statistics Database. The proxy variable of price-based monetary policy tool is the monthly data of the 7-day weighted average interest rate for interbank lending. The proxy variable of quantitative monetary policy tool is the year-on-year growth rate of M2.

5 We use the one-unit positive shock of the nominal interest rate, which is equivalent to contractionary monetary policy that leads to the negative deviation of output gap.

Additional information

Notes on contributors

Dayu Liu

Dayu Liu (1988-) , Associate Professor, Center for Quantitative Economics of Jilin University, Changchun, 130012, China, Email: [email protected], major in macro-econometric analysis and business cycle theory

Yang Song

Yang Song (corresponding author) (1984-) , Associate Professor, School of Public Finance and Taxation at Southwestern University of Finance and Economics, 555 Liutai Avenue, Chengdu, Sichuan, 611130, China, Email: [email protected], major in development economics and financial economics

Dekai Chen

Dekai Chen (1991-) , Assistant Professor, Nanjing University of Finance and Economics, Nanjing, 210023, China, Email: [email protected], major in macro-econometric analysis, VAR models, business cycles and monetary policy theory