Economic Growth and Deflation in China

A puzzling fact about China's experience over the past 10 years is that the rapid economic growth (between 7% and 11% a year) has been associated with decreasing rates of inflation. Such a high growth rate with deflation has puzzled many economists. Chinese economists have named this "deflationary expansion". Both Chinese and foreign economists have different opinions on solving this puzzle. In this paper, the author constructed a trivariate structural vector auto regression (SVAR) model for China to decompose inflation rate time-series into three components explained by aggregate demand (AD), aggregate supply (AS) and money policy shocks. The analysis suggests that deflation in China has been primarily driven by money policy shock, while aggregate supply shock is the main factor explaining Chinese economic growth. These results are qualitatively robust to alternative choices for the identification methodology