Capacity Reduction Policy Under the Interest Rate Peg in China

Bing Tong ()

No 2020/2, CFDS Discussion Paper Series from Center for Financial Development and Stability at Henan University, Kaifeng, Henan, China

Abstract: Capacity reduction has been a recurrent theme in China’s economic policy. This paper proves in a New Keynesian model that the effects of the decapacity policy depend on its persistence and monetary policy regime (interest rate flexibility). Under an interest rate peg, a temporary policy is ineffective and even expansionary, whereas a permanent policy is effective due to a negative wealth effect. When the nominal interest rate is pegged, the real rate moves oppositely with inflation, which adds positive feedback to the economy. Thus the de-capacity policy has greater uncertainty under the interest rate peg. As a policy tool, it may easily deviate from its target and bring about excessive volatility. Last, long-run price stability and a gradually advanced de-capacity policy are helpful to the achievement of policy targets.

Keywords: Chinese economy; Capacity reduction; De-capacity; New Keynesian Model; Supply shock; Interest rate peg (search for similar items in EconPapers)
JEL-codes: E12 E31 E42 E43 E52 E61 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2020-04
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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