Marshall Digital Scholar

Monetary Policy in China: A Factor Augmented VAR Approach

Marshall University

We use a Factor-Augmented VAR (FAVAR) model to investigate the effectiveness of monetary policy in China. As the Chinese economy is an open economy, our FAVAR model divides the macroeconomic variables into three groups. The first group contains measures of external shock to Chinese economy while others groups contain the measure of output and price. This approach allows factors to have an economic interpretation. We estimate our model with the maximum likelihood technique and that an increase in the change of money supply "Divisia M2"has substantial and direct impact on Chinese economic activity and inflation. Our results also find that the change in change in interest rate has substantial impact on Chinese economy and on inflation with a delay of eight and twelve months respectively. Moreover, the impact of an increase in money supply "Simple Sum M2" on economic activity is economically and statistically significant with a delay of four months. However, its impact on inflation is weak with delay of twelve months. In addition to the previous instruments, we use the Dollar-Yuan nominal exchange rate as monetary policy instrument and find that an increase in nominal exchange rate (depreciation of Yuan) has a substantial impact on both output and inflation with a delay of eight and eleven months. The latter is the main contribution of our paper. In contrast with the current literature on Chinese economy such as Fernald et al. (2013), our paper found that the monetary aggregates are still strong instrument of monetary in China if they are measured correctly by the central bank. The measure proposed by Barnett (1978 and 1980), Divisia monetary Aggregates, is statistically and economically significant which confirms the literature on developed economies (Belongia and Ireland (2012), Barnett et al. (2016)).