A Study Of The Effectiveness Of China's Monetary Policy In The Open Economy

The primary purpose of the paper is to revalue the effectiveness of China monetary policy in the open economy by examining the impact of openness factors, especially international capital flows on monetary policy. The dissertation presents a deep analysis on the influence of capital flows on the transmission channels, medium target and operation of monetary policy. The relationship between openness and output effect of monetary policy, and the relationship between openness and price effect of monetary policy are also discussed in later section. The paper tries to provide a framework of analyzing the effectiveness of monetary policy in the open economy, which can explain why China monetary policy loses its effect with the enlargement of capital flow scale. According to the above, the main body of this paper consists of four parts.Firstly, the paper explores the transmission mechanism of China monetary policy in the open economy. After giving a description of CC-LM model and putting the factor of openness into IS-LM-BP model, the paper takes an empirical test on the effectiveness of the credit channel from 1997 to 2008 in China. The results show that the credit scale and money supply, as the intermediate target for monetary policy, are identical to a certain extent, and the credit channel is an effectual transmission mechanism in China monetary policy. But after taking capital flows into consideration, we find that the credit scale can't be controlled effectively. The increase in foreign exchange, making the gap between deposits and loans become large, weaken the ability of central bank to control the credit scale and money supply. In additional, a further analysis of transmission mechanism of monetary policy is given to the influence of currency mismatch. It is found that currency mismatch can affect money demand and supply, and make it hard to estimate the money supply. The serious currency mismatch, which gathered on the balance sheet of the central bank, not only make monetary authority itself take the risk of depreciation of assets, but also increase the monetary authority's liability to commercial bank. This also weakens the ability of central bank to control the credit scale and money supply.Secondly, The paper elaborates the influence of capital flows on domestic money supply.Since 2002, under the pressure of RMB appreciation, Foreign exchange assets are expanded rapidly due to the double surplus of China's balance of payments. Foreign exchange investment has been the main channel for the People's Bank of China(PBC) to put monetary base on the market. Based on the balance sheet of the People's Bank of China, the paper applies quantitative analysis methods, such as co-integration test, impulse response and Granger causality test, to explore the main source of monetary base and its dynamic relationship with the changes of monetary base around RMB exchange rate reform. The results show that after RMB exchange rate reform in 2005, the incremental change of net foreign exchange assets is the only Granger cause of the one of monetary base. Domestic credit and bond issue taken as the means of offsetting the increase of net foreign assets to avoid the excessive augment of monetary base are invalid. The monetary base supply is endogenous, so the People's Bank of China has not been able to adjust the money supply through the control over monetary base.Thirdly, the paper estimates the sterilization and offset coefficient and the degree of the relation between the Central Bank's reactions and the international capital flows. By modifying the BGT model and readjusting the changes of net foreign assets and net domestic assets, the paper applies both the ordinary least squares (OLS) and simultaneous equations methods to explore the relationship between international capital flow and monetary policy since the foreign exchange system reform started in 1994 in China. The recursive estimation method is also presented to investigate its dynamic changes. The conclusion shows that the conflicts of international capital flows and the monetary policy were on the rise in recent years. The People's Bank of China has fully sterilized the capital inflows but the offsetting effect of the capital flow is also substantial. The independence of PBC's monetary policy faces a serious challenge and the PBC has no effective tools to sterilize the accumulation of foreign reserves.In additional, the paper provides an empirical study on the effectiveness of monetary policy. By modifying the output and price model used by Karras and making a distinction between trade openness and financial openness, this paper checks the influence of opennesses on the effectiveness of the monetary policy.The results show that the China central bank has less intention to expand money supply in the open economy. Opennesses affect the results of monetary policy mainly through financial market and changing the adjustment speed of wages and prices. The increasing opennesses will weaken the output effect of monetary policy but strengthen the price effect of monetary policy. It is indicated that the price effect of monetary policy is stronger in the long run with the enlargement of openness. The monetary policy, with price stability as the single target, is good to keep the macroeconomic stability.From the above analysis, the paper concludes that China's monetary policy is facing failure in the open economy, especially under the influence of capital flows. At last, the paper tries to search fundamental causes of all the problems of monetary policy form "ternary paradox" theory. Some suggestions are put forward from the exchange rate system, capital controls and monetary policy instruments, to improve the effectiveness of monetary policy.