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Two monetary policy rules, the money supply (quantity) rule and interest rate (price) rule, are explored for China in a dynamic stochastic general equilibrium model. The empirical results seem to indicate that the price rule is likely to be more effective in managing the macroeconomy than the quantity rule, favoring the government’s intention of liberalizing interest rates and making a more active use of the price instrument. Moreover, the economy would have experienced less fluctuations had interest rate responded more aggressively to inflation

Compared with advanced economies, China’s monetary policy appears to be more complicated, as can be seen at least in the following two aspects. First, although the Law of People’s Bank of China (PBoC) states that the objective of monetary policy is to maintain price stability so as to promote economic growth, in reality China’s monetary policy seems to have been assigned more goals than mandated by the law. According to a speech of the PBoC governor published in a recent issue of Caijing Magazine (in Chinese, December 25, 2006), not only should monetary policy ensure price stability and promote economic growth, it is also supposed to maximize employment and achieve balance of payments equilibrium. In addition, it is expected to help promote financial liberalization and reforms. Second, unlike advanced economies which employ mainly one policy instrument, short-term interest rate recently and money supply in the earlier period, China’s monetary authority usually applies instruments of both quantity and price in nature in view of imperfect monetary policy transmission mechanism. Take the recent episode as example, in order to rein in fast growth in investment, the PBoC has raised benchmark interest rates, increased the reserve requirement ratio several times and issued a certain amount of one-year bills to selected banks whose loans were considered to have grown too fast since April 2006. The main reason that money supply gave way to interest rate as a policy instrument in numerous countries is that the latter is usually difficult to control by monetary authority. The quantity rule is rooted in the Fisher quantity theory of money and the assumption that velocity of money is relatively stable in the short run. But, as shown by Mishkin (2003, chapter 21)), the velocity of money has fluctuated too much to be seen as constant in the US from 1915 to 2002. China’s velocity of money (M2) also seems to be unstable and has increased remarkably since the early 1990s. Another assumption of the money-supply rule is that there exists a close tie between inflation and nominal money growth. But this linkage has become looser because money demand may experience large volatility. Numerous papers have addressed this issue, see Wolters et al. (1998) for example. In fact the tie between money and inflation in China has also become looser in the past few years, mainly as a result of financial deepening. In addition, as shown in Laurens and Maino (2007), the gaps between actual and targeted money growth have been relatively large between 1994 and 2004. Evidence in this line seems to indicate that money supply should be assigned a less important role than interest rate. Indeed, as stated in the monetary policy implementation report of 2006 Q4, the PBoC is inclined to make a more active use of price-based policies and interest rate liberalization has become a main task of monetary authority. Ha and Fan (2003), for example, find that China’s investment was more sensitive to real lending rate during 1994–2002 than during 1981–1993. The research below aims at exploring two important monetary policy instruments in China, quantity and price, studying their impacts and providing some advice for policy makers. Unlike most papers on China’s policies in the literature, we will employ a dynamic stochastic general equilibrium (DSGE) model. A few macro models have been set up for China, most of which are macroeconometric models paying little attention to micro-foundations, see He et al., 2005 and Scheibe and Vines, 2005 for instance. One may argue that DSGE models might not capture China’s economy well since it is not yet a perfect market economy. As argued by Scheibe and Vines, 2005 and Chow, 2002, however, the Chinese economy has become marketised to such a degree since 1978 that it is not inappropriate to model China’s economy in a framework of the advanced economies. In addition, as mentioned by Chow (2002), a theoretical-quantitative approach is as important as a historical-institutional one for China. The remainder of the paper is organized as follows. The second section presents some empirical evidence on China’s monetary policy. Section 3 presents the DSGE model and shows the consequential first order conditions engendered by households’ and firms’ optimization behaviors. The fourth section undertakes some numerical study of alternative monetary policies, and section five concludes the paper

Monetary policy with money supply as instrument seems to become more difficult to conduct in China than before, as money multiplier and velocity have been increasing noticeably and the linkage between money supply and inflation becomes weaker over time. Experiments in a DSGE model based on data in the past decade indicate that effects of a price rule on the economy seem to have become more significant than those of a quantity rule. Moreover, the economy may experience less fluctuations in the presence of shocks from main macroeconomic variables when the price rule is employed to manage the macroeconomy. The findings seem to favor the government’s intention of liberalizing interest rates and making a more active use of the price instrument in recent years as the economy becomes more market-oriented. We have also conducted a counterfactual study assuming that the monetary authority had reacted more aggressively to inflation than estimated with data. The experiments seem to indicate that the economy would have experienced less fluctuations had interest rate been more aggressive.