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Impacts of monetary, fiscal and exchange rate policies on output in China: a Var approach.

Article Excerpt
Abstract. Applying the VAR model and using the interest rate as a monetary policy variable, we find that in the long run, output in China responds negatively to a shock to the interest rate, the real exchange rate, government debt, or the inflation rate, and it reacts positively to a shock to government deficits or lagged own output. When real M2 is chosen as a monetary policy variable, long-term output in China responds positively to a shock to real M2 or lagged own output, and it reacts negatively to a shock to the real exchange rate, government debt, or government deficits. Its response to a shock to the inflation rate is negative when government debt is used and is positive when government deficits are considered. In the short run, fiscal policy is more important than monetary policy in three out of four cases. In the long run, monetary policy is more influential than fiscal policy in three out of four cases. Therefore, the government may consider conducting monetary and fiscal policies differently in the short run and long run. The government needs to be cautious in pursuing deficit spending as its long-term impacts depend on the monetary variable employed. The policy of maintaining a relatively stable exchange rate is appropriate as the depreciation of the Yuan may hurt the economy in the short run.

JEL Classifications: E5, F4, H6

Key words: exchange rates, government debt and deficits, impulse response functions, monetary policy, VAR, variance decompositions

1. Introduction

In recent years, China's economic performance has been better than most of less developed countries (LDCs) or newly industrialized countries (NICs). Its real GDP grew at an enviable annual rate of 8.0% in 2000 and 6.74% in 2001. The inflation rate was a major concern in 1994 when it was as high as 24.24% but dropped to a low of 0.34% in 2001. The exchange rate in terms of the Yuan per U.S. dollar has been quite stable at 8.28 in 2001 compared with 8.29 in 1997 when the Asian financial crisis caused several other currencies to depreciate substantially. The unemployment rate was at 3.1% in 2000 and has been quite stable in the last five years. Exports have been greater than imports since 1994. Large trade surpluses in recent years have brought in adequate foreign exchange reserves that are used to stabilize exchange rates and import needed technology and equipment to enhance productivity and reduce costs. Gross fixed capital formation rose by 12.84% in 2001, adding more productive capacity to the economy. To stimulate economic activities and to counter a worldwide economic slowdown, the central bank in China has lowered the lending rate from a high of 12.06% in 1995 to 5.85% in 2001.

There are some concerns about the Chinese economy. The last time that the government had a budget surplus was the year of 1985. Since then, government budget deficits have been on the rise and reached 247 billion Yuan in 2001 compared with a small government deficit of 14.65 billion Yuan in 1990. To finance budget deficits, domestic debt increased from 21.47 billion Yuan in 1990 to 256 billion Yuan in 2001. Foreign debt was kept at a low level of 3.62 billion Yuan in 2001. Another concern is that the money supply increased at an annual rate of 13.1% for M1 and 15.04% for M2 during 2000-2001. Because the economic growth rate in 2001 was 6.74%, the quantity theory of money suggests that there may be potential inflationary pressure.

The purpose of this paper is to examine the impacts of several major macroeconomic variables on real GDP in China. This paper differs from most of previous studies in several aspects. This study attempts to explore how output responds to different monetary policy variables and to find if the interest rate or the quantity of money may serve as a better monetary policy tool. Furthermore, the...