Is China's Monetary Policy Effective? Evaluating the VAR Evidence

Confronted with rapid economic growth and large structural changes in the economy, China's monetary authority has managed to influence the economy with its policy actions since 1983. This paper conducts a rigorous empirical test on the effect of China's monetary policy actions on its economy by properly identifying and estimating two vector autoregression (VAR) models. To identify exogenous monetary policy shocks, two identification approaches are considered in this paper: A recursive approach and the Bernanke and Mihov [Bernanke, B. S. and I. Mihov. 1998. "Measuring monetary policy." Quarterly Journal of Economics, 113(3): 869–902] procedure. We find that (i) monetary policy has unambiguous impacts on both output and prices; (ii) the relative effectiveness of policy instruments differs, i.e. money growth is an effective policy instrument but not the interest rate; (iii) changes in nominal exchange rate affect both output and prices; (iv) the liquidity effect is present. Our results favor the need to continuously reform the financial system to make it commercially driven and to have a more flexible exchange rate regime.