Quantitative Study On Incomplete Pass-through, FDI And Monetary Policy Effects Of Fluctuation In Exchange Rate

As the degree of opening up continuously increases, the connection between Chineseeconomic growth and the economy of each country is closer. The exchange rate becomes the bondfor Chinese economy linking the economy of other countries. As the relative money price of twocountries, exchange rate fluctuation has influenced the changes in domestic price level so thatother macroeconomic variables are influenced through changing trade balance byexpenditure-switching effect. The exchange rate plays a vital role in maintaining internal andexternal balance of a country and thus becomes a core instrumental variable under open economicconditions. Since July21,2005, Central Bank announced to implement exchange rate systemreform, changing original exchange rate system keeping a close watch on single USD to apackage of managed floating exchange rate. This makes RMB exchange rate system to becomemore flexible and rich in flexibility. After this exchange rate system reform, RMB-USD exchangerate started to ceaselessly appreciate. But, China’s export does not fall as RMB exchange rateappreciates, and current-account trade surplus continues to increase, hitting a record highrepeatedly. Traditional macroeconomics can not offer a reasonable explanation for this economicphenomenon. The root cause lies in ignoring the fact that exchange rate fluctuation passes throughthe price level incompletely.Foreign scholars paid attention to exchange rate pass-through early, so their relevantresearches are rich. The research contents develop to investigation of the factors influencing theeffects of exchange rate pass-through from initial examination of the pass-through degree ofexchange rate fluctuation to price level; the research perspectives change to macro-level includingselection of money of account, inflation environment and the scale of a country from micro-levelincluding industrial organization, market structure and price discrimination. Existing domesticliteratures mainly rest on examination of the pass-through degree of RMB change rate fluctuationto import price, producer price and consumer price. Few literatures comprehensively exploreincomplete pass-through, FDI and monetary policy effect of fluctuation in RMB rate. So, thispaper starts with incomplete exchange rate pass-through and studies the influences of exchangerate fluctuation on import price index, consumer price index, foreign direct investment andmonetary policy. The specific theoretical and empirical analysis is as follows: Firstly, analyze theoretically the pass-through effect of exchange rate fluctuation on importprice level and propose the asymmetry in the process of exchange rate pass-through; summarizedomestic and overseas progress of studies on pass-through asymmetry of exchange ratefluctuation to import price level; put forward the starting point and entry point of this study.Firstly, the model developed by Pollard and Coughlin (2004) is used for reference to set up atheoretical model used to study the asymmetry of incomplete exchange rate pass-through. Theasymmetry theoretical base of exchange rate fluctuation on import price pass-through is providedto supply theoretical basis for empirical analysis. The asymmetry of import price pass-through isexplained from the direction and range of exchange rate fluctuation. It is considered that thedegree of manufacturers’ emphasis on market share, conversion cost between domesticintermediate input products and imported intermediate input products, the restraint of importingcountries on import quantity and domestic market structure will in some extent make exchangerate fluctuation cause asymmetry to import price pass-through. The empirical result showsexchange rate fluctuation passes through import price incompletely; the pass-through degreeshows U shape (first drop and then rise). The change trend of exchange rate pass-through effect isexplained in the aspects of inflation environment and the changes in imported product structurerespectively. Finally, it is found through introducing dummy variable to study the differences ofexchange rate depreciation and appreciation on import price index pass-through, the pass-throughdegree of exchange rate depreciation is higher than that of exchange rate appreciation. Theproportion of resource-intensive and capital-intensive imported products in China is large, withsmall import alternative and strong import dependence. Foreign export enterprises have strongspeaking right. Thus, different price adjustment policies will be made during exchange ratedepreciation and appreciation.Secondly, in recent years, foreign exchange reserve has increased sharply. The Central Bankis forced to issue a great quantity of basic currency, which aggravates the flood of market liquidityand further induces inflation. Besides, due to RMB appreciation expectation, large quantities ofhot money swarm into China, forming so-called “imported inflation” effect. Therefore, it isnecessary to reach a balance between the interest rate and exchange rate and provide a reasonablepolicy to govern the inflation. Domestic researches on RMB exchange rate pass-through effectstarted late, mainly focused on discussions of the influences of RMB exchange rate fluctuation onimport and export price and less considered consumer price pass-through. Firstly, this paper pointsout through theoretical analysis that imported input products and non-trade services (includingtransport cost and distribution cost) reduce the pass-through effect of exchange rate fluctuation toconsumer price with different degrees. Then, starting from nonlinearity of exchange ratefluctuation to price transmission, this paper sets up STR model to seize time-dynamic characteristics of mechanism transformation. The research result shows inflation is related to thelagged variable, output gap, nominal effective exchange rate and excess money change; thechange in nominal effective exchange rate has significant nonlinear effect on inflation; RMBappreciation has no inhibition effect on inflation.Thirdly, aiming at the degree of the influences of RMB exchange rate fluctuation on foreigndirect investment (FDI) in China and the mechanism of action, there is no unified resultdomestically. In addition, most researches aim at the influences of exchange rate fluctuation onoverall FDI inflow and few researches aim at FDI classification according to investors’ demands.This paper sets up two types of theoretical models about the influences of exchange ratefluctuation on market-oriented FDI and export-oriented FDI. Through analysis, the followingconclusion is gained: RMB appreciation can promote market-oriented FDI inflow and hinderexport-oriented FDI inflow. In empirical analysis, the correlation between RMB Real EffectiveExchange Rate and overall FDI inflow as well as between market-oriented FDI inflow andexport-oriented FDI inflow is analyzed through co-integration analysis, Granger causality test andimpulse response. The research results show RMB appreciation can promote market-oriented FDIinflow, but hinder export-oriented FDI inflow; the influence on overall FDI inflow is notsignificant; this maybe because two opposite effects offset mutually. Meanwhile, the results showthe market size and cheap labor force of a country will attract FDI inflow. So, the expectedobjective can not be reached through attracting FDI inflow only by depending on RMBappreciation or depreciation. In the long run, stable FDI inflow can be reached only throughcreating favorable marketing environment, promoting technical progress and raising laborproductivity so as to promote internal and external balanced development of the economy.Fourthly, CPI and GDP serve as the test variables after implementation of monetary policymeasurement. According to the characteristics of existing exchange rate system reform, the dataduring managed floating exchange rate system are selected to analyze the influences of China’smonetary policy on the price and output by use of BVAR modeling. The main conclusions aredrawn as follows: under managed floating exchange rate system, the effects of the monetarypolicy implemented by Central Bank through changing monetary supply are not significant. Thisindicates under existing exchange rate system, implementation of monetary supply can not reachthe expected effects. It is required to further perfect exchange rate system, increase transparencyof monetary policy and reduce policy uncertainty faced by the public. Under existing exchangerate system, the lag of loan interest rate imposes negative influences on the price and output inBVAR model. This indicates “price” effect of monetary policy is greater than “quantity” effect.Such phenomenon complies with current monetary policy reform direction–changing to interestrate guidance from money quantity control. At the same time, the exchange rate appreciation can not curb rising prices, and the exchange rate depreciation also can not significantly promoteaddition of the total output. Only precisely knowing the moving process of the exchange raterelative to the price level, can we design a more reasonable monetary policy, and keep promotingthe internal and external development of our national economy.