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Interest Rate Pegging, Fluctuations, and Fiscal Policy in China

Bing Tong () and Guang Yang
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Bing Tong: Center for Financial Development and Stability at Henan University, and School of Economics at Henan University, Kaifeng, Henan
Guang Yang: School of Economics, Nankai University

No 2020/3, CFDS Discussion Paper Series from Center for Financial Development and Stability at Henan University, Kaifeng, Henan, China

Abstract: This paper proves in a New Keynesian model that interest rate pegging can explain the unusual business cycle fluctuations in China. It is traditional wisdom that when the nominal interest rate is inflexible, there is no unique equilibrium in macroeconomic models. We prove that a unique equilibrium exists if the nominal rate is pegged for a limited period, after which it switches to a flexible rate regime. The peg alters the propagation of external shocks, magnifies volatility of endogenous variables, and leads to instability of the economy. Besides, the model becomes more unstable when the peg duration extends, and when the pegged rate deviates from steady state. At the same time, fiscal multiplier increases under the peg, indicating fiscal policy may be more effective in mitigating economic fluctuations when monetary policy is restricted by interest rate pegging.

Keywords: New Keynesian model; Chinese economy; Interest rate peg; Fiscal policy; Rational expectation (search for similar items in EconPapers)
JEL-codes: E31 E32 E43 E62 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2020-05
New Economics Papers: this item is included in nep-cna, nep-dge, nep-isf, nep-mac and nep-tra
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Persistent link: https://EconPapers.repec.org/RePEc:fds:dpaper:202003

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