Risk Preference and Macroeconomic Effects of China's Monetary Policy: Quantitative Analysis Based on A DSGE Model
ZHUANG Ziguan, JIA Hongjing, LIU Dingming
School of Finance, Zhongnan University of Economics and Law; Economics and Management School, Wuhan University; Wang Yanan Institute for Studies in Economics, Xiamen University
Summary:
China's economy has faced greater risks in recent years due to factors such as high debt levels, an aging population,and increasingly trade disputes. These developments have made the risk preferences of households an important issue when analyzing China's economy. This paper aims to investigate whether risk preference is an important transmission channel for China's monetary policies. When risk aversion increases, households tend to hold more money and induce price adjustments on financial and real assets, thereby altering aggregate demand. The interest rate alone is thus insufficient to explain the impact of monetary policy. However, in the New Keynesian dynamic stochastic general equilibrium (DSGE) framework, the roles of risk preference and of monetary aggregates are generally neglected. To address these questions, this paper introduces an explicit role for money balances by incorporating non-separability of preferences into a classical Keynesian DSGE framework, as based on the work of Ireland (2004), Andres et al. (2006), and Benchimol and Fourcans (2012). In addition, we use a Taylor rule with a real money gap, nominal money growth, and real money growth, as a tool to investigate the mixed monetary policy rule used in China. We estimate our model by applying Bayesian techniques to China's quarterly macroeconomic data, such as GDP deflator, nominal GDP, interest rate, and money supply, as collected from the People's Bank of China, the National Bureau of Statistics of China, and the Wind database. Then we investigate the macroeconomic effects of China's monetary policies under different levels of households' risk preferences. This paper presents several findings. (1) The mixed Taylor rule with nominal money growth is the best suited to China's monetary policy at this stage of economic transition. Therefore, the growth rate of the money supply is still an important policy target. (2) A model that assumes non-separability between consumption and money fits China's macroeconomic characteristics better than models with separable utility functions. (3) With a non-separable utility function, the real money balance directly affects the economy's output gap and its rate of inflation, which means that risk preference has an important impact on the macroeconomic situation. When households are less risk-averse, the impact of monetary policy becomes stronger. Therefore, it is important for central banks to create a neutral financial environment, and to fully consider households' risk preferences during their policy-making process. The paper makes four main contributions to the literature. First, it is one of the first papers to investigate the relationship between risk preference and the effects of monetary policies in China. The findings demonstrate an important new transmission channel for China's monetary policies, which has notable policy implications. Second, unlike most studies on China's monetary policies, this paper introduces a money-in-the-utility function with an assumption of non-separability between consumption and money, and it incorporates this function into a classical DSGE model framework. This approach enriches previous research on model structures in the domestic DSGE literature, and suggests a model that is more in line with China's realistic macroeconomic characteristics. Third, this paper conducts an in-depth study on the rules of monetary policy, and attempts to construct a variety of mixed policy rules. It seeks to identify the optimal rule that best aligns with the characteristics of China's current monetary policy. To some extent, this effort improves the state of theoretical research on China's monetary policy reform.
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