Inflation-targeting under a Managed Exchange Rate: the Case of the Chinese Central Bank

Abstract

In 2004, the People's Bank of China (PBC) is reported to have abandoned the quantity of money as its intermediate goal and to adopt some elements of the apparatus of inflation targeting, without giving up the managed exchange rate regime for the renminbi (RMB), the Chinese currency. We show in this paper, using a dynamic setting, that partially implementing the apparatus of inflation targeting by the PBC to improve the performance of monetary policy encounters various difficulties from out-of-equilibrium dynamics to macro-economic and financial instability. In this context, some macro-economic measures can be helpful for reducing disequilibrium. Further development of internal monetary and financial markets and assigning balanced weights by the PBC to inflation and output targets are necessary conditions for the regime to be stable.

Keywords:

• Inflation targeting
• renminbi (RMB)
• managed exchange rate
• macro-economic and financial instability
• JEL CLASSIFICATION: E52
• E58
• F41

Acknowledgements

The author wishes to thank an anonymous referee, Michel Dévoluy, Eric Girardin, Gilbert Koenig and Moïse Sidiropoulos for their valuable comments and suggestions.

Notes

Notes

¹See a report at http://finance.sina.com.cn/g/20040209/0743622538.shtml

²Although the regime is named a managed float, China has essentially operated its system as a de facto peg to the US dollar since August 1994. The exchange rate is fixed at RMB 8.27 per dollar from the aftermath of the Asian crisis until 20 July 2005. For a review of the Chinese exchange rate policy, see Phylaktis & Girardin (2001), Lin & Schramm (2003) and Huang & Wang (2004).

³See Svensson (2000) among others.

⁴Ha et al. (2003) do not find this result mainly due to their simple output gap estimate. For a review of the literature on China's Phillips curve, see Scheibe & Vines (2005).

⁵Equation (4) is derived from the balance of payments equilibrium condition: where the trade balance BC depends on the income, Y, and the real exchange rate EP∗/P and the capital balance BK depends on the differential of yields on national and foreign bonds

⁶Assuming that the expected inflation rate is predetermined is compatible with the forward-looking nature of expectations. In effect, in dynamic rational expectations models, the adjustment of the expected inflation rate takes account, even that is not done instantly, of the impacts of any news on the long-run equilibrium. See also Buiter & Panigirtzoglou (2003) for a similar assumption concerning the inflation rate.

⁷According to Roisland & Torvik (2003), a low credibility central bank must give higher priority to achieving an inflation target than a high credibility central bank. There is then a superior limit to the degree of flexibility in inflation targeting. Without considering the credibility issue, we cannot determine the superior limit but only the inferior limit.

⁸The ECB has not acknowledged the adoption of inflation targeting. In practice, it announces an inflation target (zone), communicates regularly about its monetary policy decisions and forecasts growth and inflation in the Euro zone.

⁹When the coefficients of variables are affected by uncertainty, it is preferable according to Brainard (1967) to diversify the instruments and to reduce the intensity of utilisation of each instrument.

¹⁰For example, a lump-sum export tax rebate (τ _r ) and import tariff (τ _m ) can be explicitly modelled in integrating them in the trade balance

¹¹World Bank, in its report ‘China 2020’ published in 1997, estimated the potential growth rate of the Chinese economy at 6.9% over 2001–2010 and 5.5% over 2011–2020.