The Identification & Economic Effects of Multiple Shocks of Monetary Policy in China
LIN Jianhao, CHEN Liangyuan, Huang Yingping
Lingnan College, Sun Yat-sen University; International School of Business & Finance, Sun Yat-sen University; People's Bank of China Guangdong Provincial Branch
Summary:
As one of the most important policies, the key for scientific evaluation of the effectiveness of monetary policy lies in identifying the shocks that monetary policies generate and how the macroeconomic and financial market react. However, when examining the regulatory effect of interest rates on inflation, empirical research has found a price puzzle, that is, contractionary monetary policy actually leads to inflation or price level increase. On the one hand, research is mainly based on a single interest rate indicator, ignoring the market expectation implied by changes in interest rates over different term structures. On the other hand, studying the economic impact of monetary policy can be disrupted by information effects. Therefore, identifying multiple shocks helps to provide a more comprehensive understanding of the impact of China's monetary policy. This paper designs an identification scheme for monetary policy shocks based on the market expectations and the information effects. First, monetary policy interventions not only adjust current short-term interest rates, but also change market expectations for future policy through longer term interest rates. Thus, we can use interest rate term structure to identify immediacy shocks and expectation shocks to monetary policy. Second, based on the information effect, stock returns are introduced as a constraint to identify policy expectation shocks that are negatively correlated with stock returns which reflect expectations about future monetary policy operations, and economic expectation shocks that are positively correlated with stock returns which reflect expectations about future economic conditions. Empirical research finds that multiple shocks of monetary policy have different effects on macroeconomic variables. The tightening immediacy shocks lead to a decrease in inflation levels, and there is no price puzzle anymore; The tightening policy shocks can lower market expectations for output, leading to a decrease in real output; Positive economic expectation shocks can lead to an increase in output expectation and inflation expectations, as well as an increase in real output and inflation levels, verifying the expectation channel of monetary policy. At the same time, there is heterogeneity in the information effect of interest rates with different maturities. As the interest rate term lengthens, the relative importance of immediacy shocks weakens, with the highest relative importance for overnight lending rates being 73.39%, while the relative importance for one-year lending rates is only 3.04%. The relative importance of economic expectation shocks is gradually increasing, with the one-year interbank lending rate having a relative importance as high as 52.32%. The biggest impact of policy expectations shock is the 3-month interbank lending rate, which is as high as 79.02%. Therefore, the public can infer potential shocks through observable changes in interest rates, providing empirical evidence for the central bank to guide public expectations through policy tools such as open market operations and medium-term lending facilitation. Finally, by comparing the multiple shocks of monetary policy presented in this paper with those of Chen et al. (2018), it is demonstrated from the effects of impulse response and variance decomposition that multiple monetary policy shocks can better explain macroeconomic fluctuations and comprehensively capture the impact of monetary policy shocks. Based on the above research conclusions, we obtain the following two research inspirations: First, there are differences in the economic effects of monetary policy shocks with different attributes. Identifying multiple monetary policy shocks helps to explain the price puzzle, which is an important basis for scientifically evaluating the economic effects of monetary policy. It provides factual support for precise policy regulation in the future, and plays a key role in maintaining financial market stability and macroeconomic regulation through monetary policy. Second, multiple shocks of monetary policy are potential factors driving changes in all term interest rates. As the interest rate term increases, the relative importance of immediacy shocks weakens, while the relative importance of economic expectation shocks gradually increases. The central bank can influence long-term or short-term interest rates through open market operations and medium-term lending tools, guiding the public to form reasonable expectations based on observed changes in market interest rates, thereby exerting the expectation management function of monetary policy and improving its effectiveness.
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