Identifying the monetary policy transmission mechanism and evaluating the McCallum Rule as a monetary policy guideline for China

Abstract

Over the last thirty years there have been dramatic changes in the monetary policy transmission mechanisms in China. The People’s Bank of China (PBC) began functioning as the central bank in 1984 and since then monetary policy has been used to promote economic growth and control inflation rate. The PBC introduced the “credit growth quota system” in 1986, which was replaced by the window guidance system in January 1998. Meanwhile, financial markets (money market, bond market and stock market) have made significant progresses. During this transition, the intermediate and operating targets also switched to monetary aggregate (M2) and monetary supply respectively, with the adoption of a combination of monetary policy instruments. In this circumstance, China’s monetary policy transmission mechanisms have been one of the most studied topics.

First, we test whether an effective interest rate channel exists currently in China using a standard VAR method, because it is the core channel of policy transmission in neoclassical economics and short-term interest rates have been used as the operating target by central banks in all developed economies and most of emerging markets. We test the effects of weighted average 7-day interbank money market interest rate and 7-day repurchase rate on real output, general price level from 1996:Q1 to 2008:Q1 and find that changes in short-term interest rates could not impact on real output and general price level significantly as expected. However, an effective interest rate channel has not come into existence, though significant advancements in market-based interest rate reform have been made during the past two decades.

Secondly, we identify bank lending channel in China based on quarterly data covering 1997:Q1 to 2008:Q4. We construct a VECM model using commercial bank one-year lending rate, bank credit aggregate, required reserve ratio, inflation rate and real output. The Johansen cointegration tests identified two cointegration relationships among them. To disentangle the forces between credit demand and credit supply, which drives the changes in credit aggregate, we impose joint restrictions on the two-cointegration relationships simultaneously, and find that the PBC could affect the bank credit supply using required reserve ratio in the long-run equation. The corresponding loading matrix shows us that short-run disequilibria in the long-run relationship could be corrected through bank lending rate.

Thirdly, we evaluate the possibility of taking McCallum rule as a monetary policy guideline for the PBC using quarterly data from 1994:Q1 to 2009:Q1. A medium-term or long-term policy rule could provide a stable framework, which reduce uncertainty and increase the credibility and transparency of current and future government policies, monetary policy effectiveness would be improved if the policymaker were to follow a rule. We use a counterfactual simulation method to evaluate the original McCallum rule and an improved McCallum rule. The results show that following the McCallum rule could reduce the root mean square error between nominal GDP target and simulated nominal GDP significantly. Then, we use the historical analysis method to confirm this result. When the actual value of monetary base deviates from the rule-produced values dramatically, China’s economy encounters inflation or deflation problems. Therefore, this study argues for the McCallum rule as a policy guideline for China.