Testing and mechanism identification of liquidity trap in China

ABSTRACT

This paper examines the existence and mechanism of China’s liquidity trap. First, a broad money supply model is reconstructed to evaluate the effectiveness of monetary policy. Based on the observed data from 1997 to 2022 and first-order difference regression results, we find that: The relationship between the monetary base and broad money exhibits two distinct stages, with 2008 as a delineating point. Pre-2008, the money creation multiplier is significant; post-2008, it becomes insignificant. Second, by examining the asset-side and liability-side gaps of the financial system, we have identified two liquidity traps. The first occurs between 2015 and 2019, caused by funds idling within the financial system. The second occurs in 2020- and is caused by recessionary expectations. Monetary policy flexibility is waning, compelling strategic decisions for Chinese government and central bank.

KEYWORDS:

• Monetary policy
• liquidity trap
• currency trap
• China

JEL CLASSIFICATION:

• G00
• G10

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ First-order difference data are not available for 1996.

Additional information

Funding

This study was funded by National Social Science Foundation of China [Grant No. 23CJY017].