Navigating the trilemma: Capital flows and monetary policy in China

Reuven Glick and Michael Hutchison

Journal of Asian Economics, 2009, vol. 20, issue 3, 205-224

Abstract: In recent years China has faced an increasing trilemma--how to pursue an independent domestic monetary policy and limit exchange rate flexibility, while at the same time facing large and growing international capital flows. This paper analyzes the impact of the trilemma on China's monetary policy as the country liberalizes its good and financial markets and integrates with the world economy. It shows how China has sought to insulate its reserve money from the effects of balance of payments inflows by sterilizing through the issuance of central bank liabilities. However, we report empirical results indicating that sterilization dropped precipitously in 2006 in the face of the ongoing massive buildup of international reserves, leading to a surge in reserve money growth. We also estimate a vector error correction model linking the surge in China's reserve money to broad money, real GDP, and the price level. We use this model to explore the inflationary implications of different policy scenarios. Under a scenario of continued rapid reserve money growth (consistent with limited sterilization of foreign exchange reserve accumulation) and strong economic growth, the model predicts a rapid increase in inflation. A model simulation using an extension of the framework that incorporates recent increases in bank reserve requirements also implies a rapid rise in inflation. By contrast, model simulations incorporating a sharp slowdown in economic growth such as that seen in late 2008 and 2009 lead to less inflation pressure even with a substantial buildup in international reserves.

Keywords: Trilemma; Capital; flows; Monetary; policy; China (search for similar items in EconPapers)
Date: 2009
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (32)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S1049-0078(09)00013-X
Full text for ScienceDirect subscribers only

Related works:
Working Paper: Navigating the trilemma: capital flows and monetary policy in China (2008)
Working Paper: Navigating the Trilemma: Capital Flows and Monetary Policy in China (2008)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:asieco:v:20:y:2009:i:3:p:205-224

Access Statistics for this article

Journal of Asian Economics is currently edited by C. Wiemer

More articles in Journal of Asian Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().