RMB Exchange Rate Pass-through And The Choice Of Chinese Monetary Policy

In an open macro-economy, exchange rate is a key economic variable indicating thecloseness of a country to another. The core effects of exchange rate on macroeconomicvariables is the pass-through effects of exchange rate into the price level of a country.Therefore, the research emphasis of the economic effects of exchange rate fluctuations is thepass-through effects of exchange rates into price level of a country. Meanwhile, the changingrelationship between the exchange-rate fluctuations and the variations in price levels is also akey to setting monetary policies.With the series of reforms on China’s RMB exchange rate regime, an adjustable,managed floating exchange rate regime based on market supply and demand with reference toa basket of currencies, came into force since July21,2005, which has increased thecomplexity and uncertainty of RMB exchange rate fluctuations, thereby increased theuncertainty and complexity of exchange rate fluctuations on price levels.Based on the literature review, this paper found the research literatures on pass-througheffects of RMB exchange rate were mostly based on linear hypothesis, which could not reflectthe economic reality because of the strong-constraint. Therefore, this paper took theasymmetry of the exchange rate as the starting points to study the pass-through effects ofexchange rate, and conducted the empirical study on the variation of the pass-through effectsof different exchange rates, with the changing of exchange rates’fluctuation sizes anddirections, to provide references for setting monetary policies.This paper, from the micro and macro perspectives, conducted an empirical study on thepass-through effects of RMB exchange rates.First of all, this paper, from the micro-level, studied the pass-through effects of thenominal effective exchange rate of RMB into the import prices with a classification of goods(including manufactured products and primary commodities). It applied the thresholdco-integration method to testing the pass-through effects of the nominal effective exchangerate of RMB into the price level of classified imported goods. Results show that thepass-through effects of the nominal effective exchange rate of RMB into the prices ofimported manufactured goods and imported primary commodities are different, theadjustment process that foreign manufactures’marginal costs impact on the price level ofimports (inclusive of manufactured products and primary commodities) is non-linear. Thepass-through effects of RMB exchange rate into classified import prices are different. There is an interaction between foreign manufacturers’marginal costs and the nominal effectiveexchange rate of RMB, which enhances the impacts of the nominal effective exchange rate ofRMB and the foreign manufacturer’s marginal costs on the price level of imports.Secondly, this paper, from the macro-level, had s study on the pass-through effects of thenominal effective exchange rate of RMB into the general price level of the imports and theinflation levels. This paper, taking the output gap, inflation and exchange rate volatility asconversion variables, applied smooth-transition regression models to testing the pass-througheffects of the nominal effective exchange rate of RMB into the price level of imports, theresults verifies the pass-through effects are asymmetric. This paper also applied the fixedconversion variable probability and Markov transition probability moral two district regimestransfer model to testing the pass-through effects of the nominal effective exchange rate ofRMB into different states of inflations. Research results show that under the regime of highinflation of China, the pass-through effects of the nominal effective exchange rate of RMBinto inflation is not significant; while under the low inflation regime, the pass-through effectsof the nominal effective exchange rate of RMB into inflation is significant. Output gap,change rates of import prices, change rates of money supply and change rates of foreignmanufacturer’s marginal costs all have an impact on the transition probabilities between highinflation and low inflation regime with varying degrees.Thirdly, this paper used the complete information dynamic game theory to discuss theequilibrium exchange rate variations of RMB. Government policy preferences, the coefficientof non-expectation inflation effects on economy, the tendency of speeding up economicgrowth by government, the target rate of inflation, and the inflation rates foreign countries areall the factors that affect the changes of equilibrium exchange rates.Finally, this paper, from the perspectives of incomplete and asymmetric pass-througheffects of RMB exchange rates, explored the enlightenments on China’s monetary policies byusing the normative analysis, based on the empirical study of the asymmetry of thepass-through effects of RMB exchange rates, with the considerations of China’s actualsituations.