U.S. Money Supply and China’s Business Cycles

ABSTRACT

This article models the U.S. dollar as a world currency in a global DSGE framework, and investigates the spillover effects of the U.S. money supply shock on China’s economy. Exchange rate targeting and capital controls in the context of dollar hegemony are investigated. Given a positive U.S. money supply shock, both the inflation and real GDP of China will be below their steady-state levels in the medium term; while for the U.S. there is no inflation pressure. The spillover of liquidity effect exists. Cost-push effects and relative price effects are employed to discuss the transmission mechanism. Under the U.S. money supply shock, a fully liberalizing reform with no capital controls and a floating exchange rate of Renminbi is not the best reform for China.

KEY WORDS:

• business cycle
• capital control
• exchange rate, U.S. dollar
• world currency

Acknowledgments

The authors would like to thank the Editor, Professor Ali Kutan, and two anonymous reviewers for their helpful suggestions.

Supplemental Material

Supplemental data for this article can be accessed on the publisher’s website.

Notes

¹. For the spillover effects of other U.S. monetary policy shocks, such as nominal interest rate shock, on other economies, there are at least three strands of literature. One is to use small open economy DSGE models, such as Uribe and Yue (2006) and Chang, Liu, and Spiegel (2013); the second is to use GVAR models, such as Pesaran, Schuermann, and Smith (2009); and the last is to use other econometric tools, for example, structural VAR, such as Mackowiak (2007).

². In Equation (7) and hereafter for any log-linearized equation, a constant term is omitted.

³. In a later section, a Taylor-type interest rate rule will also be examined. In reality the central bank of China uses other policy instruments such as loan quota and bank’s reserve rate control. To follow the main-stream literature and also to make the model tractable and solvable, these monetary policy instruments are ignored in this article.

⁴. Imperfect asset mobility is introduced into open-economy DSGE models also for the reason to avoid an indetermination of the net foreign asset holdings at the steady state and instability of the dynamic system in absence of perfect international risk-sharing (Schmitt-Grohé and Uribe 2003).

⁵. The Federal Reserve announced to quit QE in 2014. Therefore, we only use the data before 2014. And the data sources include the Federal Reserve, World Bank and IMF. We also have tried to use the purchasing power parity converted GDP data, and our main results in this article do not change.

⁶. The average M0-GDP ratios for economies like the euro area, Japan, UK and India during the period 2008Q1–2013Q4 generally lie between 8% and 20%. If for ROW we choose another value rather than 12%, our main results in this article will not be affected.

⁷. This high depreciation rate is in line with the economic reality of China, as explained in He et al. (2005).

⁸. We have also examined the benchmark model when ${\mathrm{\Omega }}^{\mathrm{R}\mathrm{O}\mathrm{W}}$ is set to be 0.15 or 0.25, and the results for the benchmark model in this article do no change much.

⁹. In reality, due to the financial market distortions of China, as described by Song, Storesletten, and Zilibotti (2011) and Peng, Shi, and Xu (2016), this international liquidity effect of U.S. money supply shock and its influence on China’s economy may be affected, and the corresponding transmission mechanism may be more complicated.

¹⁰. Persistence can be added into the Taylor rule, but the results are nearly the same.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China [grant number 71503253]; The Fundamental Research Funds for the Central Universities, and the Research Funds of Renmin University of China [grant number 15XNI006]; National Social Science Foundation of China [grant number 15AZD004].