New Approach to Analyzing Monetary Policy in China

Any attempt to model monetary policy in China has to take into account two ‘specifics’ of the Chinese monetary policy: the reliance on several operational instruments, both quantitative (open market operations, discount rate, reserve requirement) and qualitative (selective credit allowances, window guidance etc.), as well as the combined strategy pursued by the People’s Bank of China, i.e. the two intermediate targets - the exchange rate and the money growth. In this paper we analyze monetary policy in China using a small, three-equation New Keynesian model, considering these issues as follows: first, the qualitative instruments are estimated by using the Kalman filter, as no data on them exist. Then, a monetary-policy index is created as a weighted average of the quantitative and the qualitative instruments, which is in turn included in the model instead of the interest rate. Finally, the two intermediate targets (monetary growth and exchange rate) are included in the monetary-policy rule. Our results suggest that monetary authorities in China consider stabilizing inflation and output gap when making their decisions. Intermediate targets, in particular the growth of the monetary aggregates, appear to be important determinants of the monetary-policy behaviour, implying that their omission might be a serious drawback of any analysis. We also find that omitting the qualitative instruments can lead to wrong conclusions about monetary-policy conduct.