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Demand for money in transition: evidence from China's disinflation.

Article Excerpt
Introduction

Since the mid-1990s, the People's Bank of China (PBoC) has emphasized the role of money growth and credit targets in its formulation of monetary policy. A prerequisite for a meaningful monitoring or targeting of monetary aggregates is a stable relationship of the money stock with the variables of policy interest, generally considered to be output and/or inflation. Similarly, as changes in the monetary stance may affect the economy with considerable lags, a formal investigation of the dynamics between money and other macroeconomic variables is imperative for a successful policy of monetary stabilization.

The paper examines the demand for domestic broad money M2 in Mainland China during 1994-2005. Our focus is on the possible existence of a stable money demand function during the notable process of disinflation, including outright deflation, and a structural change from a command to a market economy. Given the persistence of low inflation during the recent years, the possible inflationary consequences of broad money shocks are of interest. Finally, we are interested in the role of the exchange rate in the demand for Chinese broad money. In a transition economy with restrictions on capital flows and imposed ceilings on domestic residents' holdings of foreign currency, traditional currency substitution effects may be limited. However, expectations of domestic currency appreciation may still increase (unauthorized and authorized) capital inflows and thus potentially increase the domestic money supply.

We find a stable money demand relationship in a cointegration framework for the Chinese economy. No interest rate is included in the money demand system due to lack of data on market-based interest rates. Inflation rate as an opportunity cost of holding money obtains the wrong sign in the money demand relation, in line with some of the previous literature on Chinese money demand. Interestingly, the nominal effective exchange rate is found to be a significant determinant of money demand. Excess liquidity leads to both higher output and consumer price inflation. Similarly, broad money shocks have inflationary consequences. As such, our findings lend support to the policy of closely monitoring M2 growth by the PBoC. Notably, our results suggest that the development of the nominal effective exchange rate should not be ignored in the analysis of Chinese monetary developments.

Most of the work on Chinese money demand functions focus on the period prior to the emergence of low inflation. To our knowledge, the effects of the exchange rate on money demand in the Chinese case have not been investigated. A pioneering work on Chinese money demand is generally considered to be Chow (1987). As examples of other studies, Portes and Santorum (1987) estimated both real and nominal money demand systems for MO during 1954-1983, while Girardin (1996) focused on the demand for currency during 1988-1993. Huang (1994) estimated an error correction model during the reform period of 1979-1990. Xu (1998) studied three sub-components of M2. More recently, Gerlach and Kong (2005) established a stable trivariate money demand system for M2 for 1980-2004. Cargill and Parker (2004) examined the possible deflation-induced discontinuity in monetary policy. The authors, using a single equation approach, did not find any asymmetry in Chinese money demand that could be attributed to deflation.

This paper is structured as follows. The next section discusses the use of monetary aggregates in the formulation of monetary policy in China. This is followed by a presentation of theoretical issues and details on the time series used. In the next section the empirical model is estimated, and the results discussed. The final section concludes.

Some Observations on Policy

Prior to the economic and financial reforms of the late 1970s, macroeconomic policy-making was the responsibility of the State Council. The central bank was only founded in 1983 to conduct monetary policy. Its objective is to maintain the stability of the value of the currency and thereby the promotion of economic growth. Monetary aggregates were adopted as intermediate targets in 1996, and the basic objective of the operation of policy in recent years has been to maintain an appropriate growth in money and credit (Yu and Ming 2001; Dai 2002, p. 16). The PBoC has claimed that such a rate of money growth will promote "economic growth positively and contribute to preventing both inflation and deflation" (PBoC 2005, p. 27).

We examine the demand for broad money M2--consisting of currency in circulation, demand, time and savings deposits--since relatively liquid household and enterprise deposits represent an important part of Chinese financial wealth. The high broad money to GDP ratio in China (184% in 2003)...