Astudy Of The Impact Of Foreign Exchange On Effectiveness Of China's Monetary Policy

In recent years, with the rapid increase of China's foreign exchange reserves, foreign exchangesare increasingly becoming an important issue, and seriously influneces the effective implementationof monetary policy. In this paper, starting on the historical reasons for the formation of China's foreignexchange and the background of reform of monetary policy mechanism, we study the relationship offoreign exchange and the money supply, monetary policy transmission channels and the monetaryoperation, and analyze the stability of China's money demand function in an open economy. Thepurpose of this paper is to construct an analysis framework of the effectiveness of monetary policy, toexplain the reasons why effectiveness of monetary policy is falling under the increasing foreignexchange, and to make policy recommendations. The major work includes the following aspects:First, the paper analyzes the impact of foreign exchange for the money supply. Since2002, thedual surplus on balance of international payments makes rapid accumulation of foreign exchange inour country. Foreign exchange has become our main source of reserve money, and also constitutes animportant part of broad money. As the broad money M2and the real economy most closely linked,the papers, from the banking system balance sheet and the central bank's balance sheet, through ananalysis the monetary write-off measures of central bank bills and deposit reserve ratio, studies offoreign exchange for the dynamic effects of M2from2002to2010. Then use the MS-VAR,generalized impulse response, variance decomposition and Granger causality test and other methodsof quantitative analysis, empirical studies the sources of growth of M2and the dynamic relationshipof its and M2changes before and after the2007financial crisis. The results show that, before thefinancial crisis, the effective hedge of central bank on reserve money and broad money, directlylimiting the scale of credit growth, making the foreign exchange become the direct drivers of growthin M2; After the financial crisis, the loose monetary policy and large-scale bank credit allows therapid growth of M2, but the fundamental point of view, foreign exchange provide effective support,for domestic credit, so in fact, foreign exchange indirect promote for the growth of M2throughsupporting expansion of domestic credit. This shows that China's foreign exchange is the essencereasons of the macro excess liquidity.Secondly, the paper analyzes China's foreign exchange impact of monetary policy transmissionchannels. Since1990, China's monetary policy has been changed from direct to indirect control changes, the intermediate goals has been shifted from the credit to money supply, while the centralbank also actively promote the interest rate market to build a modern system of monetary policy. Inthe above context, the paper analyzes the traditional transmission channels of monetary policy-interest rate channel, credit channel and monetary channel, and use the variable parameter vectorautoregressive model (TVP-VAR model) to dynamic analyze three channels from1990to2010. Theimpulse response shows that China's monetary policy transmission mainly through monetary andcredit channels, the interest rate channel is not perfect. Subsequently, in the open economy framework,the paper discusses the increase in foreign exchange making the gap between deposits and loans ofcommercial banks in China, thereby weakening the central bank's ability to control the size of moneysupply and credits. Next, the paper analyzes in depth the currency mismatch influences monetarypolicy transmission channels. As China's mandatory exchange settlement system and the expectedappreciation of the Renminbi, most foreign exchange assets have been acquired by central banks,which led to currency mismatch risk be almost concentrated in the central bank, the central bankalone must bear the exchange rate fluctuations of foreign exchange risk of devaluation of assets, whilecurrency mismatch reduces the efficiency of monetary policy transmission in the asset price channeland the credit channel, distorts transmission signal.Third, the paper analyzes the dynamic relationship between foreign exchange and monetarypolicy, namely the sterilization effects of monetary policy on foreign exchange and the offset effectsof international capital flows on monetary policy. On the one hand, the central bank sterilizes theforeign exchange through the issuance of central bank bill; on the other hand, in the context of gradualliberalization of capital controls, international capital flow partially offset the effect of monetarypolicy operations. The papers, by adding the country's macro-economic quantitative targets into thecentral bank's loss function, expands the modified BGT model, and constructs an offset andsterilization model for China, and the use of simultaneous equations to estimate the quantitativerelationship between the international capital flows and monetary policy from1999to2010, and theuse of recursion coefficients method to estimate its dynamic process. The empirical results show thatinternational capital flows and monetary policy in China presence a conflict, but benefiting from thestrict supervision on "hot money", the degree of conflict is not serious. Monetary policy offsets veryhard on capital flows, but not completely, while capital flows plays a certain degree of sterilization onmonetary policy.Fourth, the paper studies China's money demand function in an open economy. In China, as money supply is the intermediate target of monetary policy, Central bank may effectively implementsmonetary policy provided that the money demand function is stable and predictable. The foreignexchange problem is actually the performance of China's strategy of export-oriented economy, so asthe improvement of China's foreign dependence; the study of money demand function must take intoaccount international factors. The Paper introduces international interest rates and exchange ratefactors into China's money demand function, respectively using error-correction model and thevariable parameter model to estimate money demand function. Stability tests show that the fixedcoefficient of error correction model has the model specification error. Kalman filter estimates suggestthat China's money demand function is not stable, dynamic changes over time. Therefore, the demandfor money is unstable, difficult to predict, so monetary policy effectiveness will be reduced.The above analysis shows that with the continued increase in foreign exchange, the effectiveimplementation of monetary policy is increasingly difficult, the central bank faced with how to solvethe problem of monetary policy failures. Finally, starting from the"impossible trinity", the paper givesthe policy recommendations of RMB issue. Based on the analysis of money supply of the U.S., UK,Hong Kong and China, we provide a theoretical basis for the choice of the currency issues throughthe"impossible trinity". Subsequently, by contrast, we analysis the major limitations of RMB issue.At last, we propose the reform proposals of buying government bonds to issue RMB through"impossible trinity".