5. Monetary policy reforms
5.3 Foreign shock
Another important issue for the liberalization of international capital market is the risk sharing of shocks from foreign countries. In this section, we consider there is simultaneous occurrence of 0.1% negative shock to the foreign demand of home exports, 0.1% negative shock to the foreign inflation rate, and 0.25% negative shock to the foreign interest rate. The persistence of shocks is assumed to be 0.9 for the export demand and foreign interest rate, and 0.75 for the foreign inflation rate.
The results are outlined in Table 5. Not surprisingly, the results show that the welfare losses under the open capital account can be higher, reverse to the effects of domestic shocks. Under closed capital account and managed floating exchange rate regime, all the foreign shocks that result in the current account imbalances will be absorbed by the central bank. This may partially or fully influence the domestic inflation rate, depending on the magnitude of sterilization. The open capital account, however, transmits the foreign shocks to the domestic economy through the international capital flows, and leads to the greatest macroeconomic fluctuations. We may also note that, the results of the case V and Full, compared to the case IV, suggest that, the further liberalization of exchange rate management can significantly help moderate the inflation rate and nominal exchange rate fluctuations after the capital account is opened.
The optimal policy reform plans under each type of shocks are listed in Table 6.
In sum, the discussions show that the regulations on the domestic credit market and the international capital market, and the analyses have important policy implications for the progress of policy reforms. Under all types of shocks, opening the capital account appears to be the most critical stage of policy reforms. Furthermore, the exchange rate should be freely floating before the required reserve ratio adjustment
turns passively, whether or not the capital account is open. Thus, the welfare analyses may suggest that, the policy reforms would start from opening the capital account, and then liberalizing the exchange rate movements. This plan for the policy reforms can result in greatest economic stability under the home shocks. Although the economy may undertake greater fluctuations from the foreign shocks, the open capital account with floating exchange rate may help lower the adverse impacts.
6. Conclusion
In this paper, we investigate the welfare of various policy reform plans of China’s economy which is currently implementing the managed floating exchange rate regime, capital control and active adjustment of required reserve ratio. The policy reforms involve the deregulation of prevailing market regulations. The reforms would take place gradually, and the progress of reforms is critical for the economic transformation.
Thus, we propose various policy reform plans. With an open-economy DSGE model, we evaluate the welfare that each of the plans entails. The results show that these regulations on the domestic credit market such as the active adjustment of required reserve ratio, and the regulations on the international capital market are closely related, and can intensify, or dampen each other.
Furthermore, the welfare analyses show that opening the capital account is the most critical step. Under the home shocks, real or financial, open capital account helps share the risk abroad. This helps stabilize the domestic economy, and significantly reduce the welfare loss. Nevertheless, opening the capital account will transmit the foreign shocks to the domestic economy, and thus significantly exacerbate the welfare loss than the case with closed capital account. However,
together with the flexible exchange rates, the welfare loss can be lowered. This study does not imply the financial reforms should start from opening the capital account, but suggests that we should be cautious about opening the capital account which can make significant differences in the shock transmission and welfare.
There are many issues left for future study. In the current model, we assume the central bank conducts the interest rate rule as the conventional measure, similar to most countries. However, the implementation of China’s monetary policy can be closer to the money growth rate rule. The future study may take into account the money growth rate rule instead. Furthermore, this study considers the adjustment of required reserve ratio as the only regulation on the domestic credit market. The future study may include the prevailing regulations on the loan and deposit rates.
Appendix
Table 1 Parameter values (on quarterly basis)
Parameter Description Value
The importance of consumption in the utility function 0.65
Capital share in goods production 0.45
Discount rate 0.99
Depreciation rate of capital 0.025q
Capital value 1boc Real government bond / consumption bundle 0.17
V
Velocity of aggregate bank deposits 0.62rr
Reserve rate 0.09
Collateral share in loan production 0.42F
Efficiency parameter of banking sector 15k
Inferiority of capital to bonds for collateral purposes 0.75
m Ratio of import goods to aggregate consumption in the steady state 0.3
d Ratio of domestic goods to aggregate consumption in the steady state 0.7
Elasticity of substitution among different variety of goods 1.5
Elasticity of substitution between domestic goods and imported goods 1.5
Price elasticity of demand for export 10
d The degree of price rigidity 0.65
R、
pR、
YR、
qR Persistence and policy parameters of the Taylor rule 0.9, 2.5, 0, 0
e、
ep、
Ye、
qe Policy parameters of the exchange rate rule 0.8, 0, 0, 1.5
rr、
rrp Policy parameters of the required reserve ratio 0.6, 10Policy reforms
e、
ep、
Ye、
qe Policy parameters of the exchange rate rule 0.8, 0, 0, 05
rr、
rrp Policy parameters of the required reserve ratio 0, 0Table 2 Policy Reforms
Regulations BM I II III IV V Full
Interbank rate v v v v v v v
Required reserve ratio v x v x v v x
Exchange rate v v x x v x x
Capital control v v v v x x x
Note: “BM” refers to the benchmark case where all the policy tools are regulated. “Full” refers to full liberalization.
Table 3 Dynamics under the domestic productivity shock
Regimes BM I II III IV V Full
Welfare (as the percentage of the steady state consumption)
-0.3892 -0.4666 -0.2085 -0.2312 -0.1127 -0.0757 -0.0742 Standard deviations (in the percentage deviation from the steady state)
Y
0.0220 0.0223 0.0225 0.0227 0.0196 0.0203 0.0203C
0.0221 0.0233 0.0185 0.0190 0.0154 0.0161 0.0161n
0.0113 0.0120 0.0094 0.0096 0.0078 0.0075 0.0075EX
0.0340 0.0362 0.0310 0.0320 0.0178 0.0185 0.0185IM
0.0323 0.0352 0.0242 0.0257 0.0053 0.0052 0.0052 p
0.0028 0.0027 0.0030 0.0029 0.0051 0.0047 0.0047 e
0.0008 0.0008 0.0004 0.0003 0.0012 0.0004 0.0004RER
0.0159 0.0169 0.0145 0.0149 0.0083 0.0086 0.0086EFP
0.0005 0.0005 0.0004 0.0004 0.0013 0.0010 0.0010 Note: BM: active required reserve ratio adjustment, managed floating exchange rate, capital control;I: inactive (fixed) required reserve ratio adjustment, managed floating exchange rate, capital control;
II: active required reserve ratio adjustment, floating exchange rate, capital control;
III: inactive (fixed) required reserve ratio adjustment, floating exchange rate, capital control;
IV: active required reserve ratio adjustment, managed floating exchange rate, open capital account;
V: active required reserve ratio adjustment, floating exchange rate, open capital account;
Full: inactive (fixed) required reserve ratio adjustment, floating exchange rate, open capital account;
Table 4 Dynamics under the domestic financial shocks
Regimes BM I II III IV V Full
Welfare (as the percentage of the steady state consumption)
-0.2681 -0.3006 -0.1736 -0.1818 -0.0213 -0.0213 -0.0213 Standard deviations (in the percentage deviation from the steady state)
Y
0.0049 0.0052 0.0038 0.0040 0.0002 0.0002 0.0002C
0.0109 0.0116 0.0086 0.0089 0.0002 0.0002 0.0002n
0.0069 0.0074 0.0055 0.0057 0.0002 0.0002 0.0002EX
0.0207 0.0222 0.0164 0.0170 0.0001 0.0001 0.0001IM
0.0228 0.0244 0.0181 0.0187 0.0001 0.0001 0.0001 p
0.0008 0.0008 0.0008 0.0008 0.0000 0.0000 0.0000 e
0.0003 0.0003 0.0001 0.0001 0.0000 0.0000 0.0000RER
0.0097 0.0104 0.0077 0.0079 0.0001 0.0001 0.0001EFP
0.0004 0.0004 0.0002 0.0002 0.0000 0.0000 0.0000 Note: BM: active required reserve ratio adjustment, managed floating exchange rate, capital control;I: inactive (fixed) required reserve ratio adjustment, managed floating exchange rate, capital control;
II: active required reserve ratio adjustment, floating exchange rate, capital control;
III: inactive (fixed) required reserve ratio adjustment, floating exchange rate, capital control;
IV: active required reserve ratio adjustment, managed floating exchange rate, open capital account;
V: active required reserve ratio adjustment, floating exchange rate, open capital account;
Full: inactive (fixed) required reserve ratio adjustment, floating exchange rate, open capital account;
Table 5 Dynamics under foreign shocks
Regimes BM I II III IV V Full
Welfare (as the percentage of the steady state consumption)
-0.3629 -0.4463 -0.2275 -0.2587 -0.9879 -0.8082 -0.7986 Standard deviations (in the percentage deviation from the steady state)
Y
0.0070 0.0076 0.0064 0.0067 0.0109 0.0110 0.0110C
0.0148 0.0163 0.0130 0.0139 0.0301 0.0289 0.0287n
0.0099 0.0109 0.0091 0.0096 0.0156 0.0158 0.0157EX
0.0294 0.0322 0.0270 0.0286 0.0244 0.0259 0.0259IM
0.0320 0.0351 0.0294 0.0311 0.0407 0.0406 0.0404 p
0.0009 0.0010 0.0010 0.0010 0.0108 0.0103 0.0102 e
0.0007 0.0008 0.0003 0.0003 0.0023 0.0008 0.0008RER
0.0137 0.0150 0.0126 0.0133 0.0114 0.0121 0.0121EFP
0.0005 0.0005 0.0004 0.0004 0.0047 0.0042 0.0042 Note: BM: active required reserve ratio adjustment, managed floating exchange rate, capital control;I: inactive (fixed) required reserve ratio adjustment, managed floating exchange rate, capital control;
II: active required reserve ratio adjustment, floating exchange rate, capital control;
III: inactive (fixed) required reserve ratio adjustment, floating exchange rate, capital control;
IV: active required reserve ratio adjustment, managed floating exchange rate, open capital account;
V: active required reserve ratio adjustment, floating exchange rate, open capital account;
Full: inactive (fixed) required reserve ratio adjustment, floating exchange rate, open capital account;
Table 6 Optimal policy reforms
Shocks Optimal policy
Productivity shocks Full Financial shocks VI, V, Full
Foreign shocks II
Reference
Bernanke, B. and A. Blinder (1988), “Credit, Money, and Aggregate Demand,” The
American Economic Review, 78(2), 435-439.
Bernanke, B. S. and M. Gertler (1989), “Agency Costs, Net Worth, and Business Fluctuations,” American Economic Review, 79, 14-31.
Bernanke, B. and M. Gertler (1995), “Inside The Black Box: the Credit Channel of Monetary Policy Transmission,” Journal of Economic Perspectives, 9(4), 27-48.
Calvo, G. (1983), “Staggered Prices in a Utility-Maximizing Framework,” Journal of
Monetary Economics, 12(3), 383-398.
Chang, C., Z. Liu, and M. Spiegel (2014), “Capital Controls and Optimal Chinese Monetary Policy,” Working paper, Federal Reserve Bank of San Francisco.
Chen, Q., M. Fanke, and M. Patez, (2012), “Market and Non-Market Monetary Policy Tools in a Calibrated DSGE Model for Mainland China,” BOFIT discussion
papers.
Gertler, M. and P. Karadi (2011), “A Model of Unconventional Monetary Policy,”