Sterilized Intervention and Optimal Chinese Monetary Policy

38 Pages Posted: 6 Dec 2016  

Wukuang Cun

USC Dornsife Institute for New Economic Thinking

Li Jie

Central University of Finance and Economics (CUFE)

Date Written: November 15, 2016

Abstract

Since the early 2000s, China's central bank has been intervening actively in foreign exchange markets to prevent sharp appreciation of Chinese Yuan. At the same time, it issued central bank bills, a type of short-term central bank debt, to absorb the increase in monetary base caused by its intervention. This should have neutralized the effects of intervention if the money multiplier were invariant. However, M2 and bank credit increased significantly during the period of sterilized intervention even if the monetary base remained almost unaffected, which implies an increase in the money multiplier. We reproduce these facts in a calibrated DSGE model in which banks hold central bank bills issued as sterilization tools as part of their liquidity management. Banks reduce holdings of excess reserves as they hold more central bank bills, which raises money multiplier and leads to expansion of banks' balance sheets. Our DSGE framework allows us to study the optimal choice of monetary policy instruments. Compared to open market operations, raising required reserve ratio can directly freeze the excess liquidity and more effectively counter the effects of intervention. Allowing the central bank to use reserve requirement as an additional policy instrument can significantly reduce fluctuations in related macro-economic variables.

Keywords: Currency Intervention, Sterilization, Reserve Requirement, Monetary Policy, China

JEL Classification: F31, E51, E52

Suggested Citation

Cun, Wukuang and Jie, Li, Sterilized Intervention and Optimal Chinese Monetary Policy (November 15, 2016). USC-INET Research Paper No. 16-29. Available at SSRN: https://ssrn.com/abstract=2880873 or http://dx.doi.org/10.2139/ssrn.2880873

Wukuang Cun (Contact Author)

USC Dornsife Institute for New Economic Thinking ( email )

3620 S. Vermont Avenue, KAP 364F
Los Angeles, CA 90089-0253
United States

Li Jie

Central University of Finance and Economics (CUFE) ( email )

39 South College Road
Haidian District
Beijing, 100081
China

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