An analysis of Chinese money and prices using a McCallum-type rule

Abstract

This paper evaluates the usefulness of a McCallum-type monetary policy rule based on money supply for maintaining price stability in mainland China. We examine whether excess money relative to rule-based values provides information that improves the forecasting of price developments. The results suggest that our monetary variable helps in predicting both consumer and corporate goods price inflation, but the results for consumer prices depend on the forecasting period. Moreover, results using a structural vector autoregression suggest that our measure of excess money supply could be used to identify monetary policy shocks in the Chinese economy.

Keywords:

• McCallum rule
• monetary policy
• China

JEL Classifications:

• E52
• E31

Acknowledgements

The authors are grateful to Li-gang Liu, Wenlang Zhang and Jimmy Shek from the Hong Kong Monetary Authority for providing us with data on China's GDP. The views expressed in the paper are those of the authors alone and do not necessarily reflect those of the Bank of Finland.

Notes

Notes

1.  Monetary targeting was adopted in several advanced economies in the 1970s and it was widely considered successful in controlling inflation in Germany and Switzerland (see for example Mishkin 2001). However, the German Bundesbank missed its money growth targets quite frequently. Bernanke and Mihov (1997) argue that Bundesbank policy was actually better described as inflation targeting rather than money targeting.

2.  http://www.pbc.gov.cn/english/huobizhengce/objective.asp on 8 February 2008.

3.  In a former command economy, the lack of profit orientation is related to the concept of soft budget constraints, whereby an economic agent's budget does not pose a strict constraint on his spending (see Kornai 1992).

4.  We use data on nominal GDP kindly provided by Li-gang Liu, Wenlang Zhang and Jimmy Shek from the Hong Kong Monetary Authority. The data on monetary aggregates and prices are from the CEIC and IFS databases.

5.  Liu and Zhang (2007) also use a quantity-based rule in their New-Keynesian model to analyse China's monetary policy. However, the rule used in the model differs from the exact specification by McCallum.

6.  In addition, when measuring the feedback adjustment term, we use the target for the current period instead of previous-period GDP. McCallum (1999) argues that the velocity term captures the component of velocity growth that is due to institutional change. Therefore, the exact period of average velocity calculation may be, in practice, less important, as long as it captures possible structural changes in the economy. Burdekin and Siklos (2008) similarly report using the average growth rate of velocity of period t, smoothed by taking a moving average.

7.  For 1994–1997, the PBC used to specify targets only for retail price inflation and GDP.

8.  We use the variable ‘reserve money’ reported in the People's Bank of China Quarterly Statistical Bulletin. This aggregate includes currency issue as well as deposits of financial institutions and non-financial corporations held at the central bank.

9.  In this case, fast monetary growth may reflect tighter instead of looser monetary policy. As most of the frequent hikes in the reserve requirement ratio that took place in 2007 are outside our estimation sample, they do not pose a major problem for our analysis.

10.  For land prices, the sample starts in 1998 due to data availability.

11.  Dickinson and Liu (2007) identify monetary policy shocks in China by using the central bank lending rate and the quantity of credit. Mehrotra (2007) uses the central bank repo rate, while Chow and Shen (2005) capture Chinese monetary policy shocks by narrow money M1.

12.  Such a nominal target for GDP growth appears reasonable, given that since 1997 the government's real GDP growth targets have remained at 7–8%, consumer price inflation targets between 1–5% and the rise in the GDP deflator has exceeded consumer price inflation after 1999.

13.  An alternative approach would be to include real GDP and its deflator as separate variables in the estimated system, but this would require assumptions as to their weights in the policy rule – something not specified by the McCallum rule. Preliminary estimations using the same coefficient (−0.5) for both variables yield the persistent positive effects of an expansionary monetary policy shock, on both the level of real GDP and its deflator.