Modeling the Effect of Exchange Rate Liberalization on China’s Macro Economy
Xiaowen Hu, Duanming Zhou†, Chengchen Hu, and Fei Ai
School of Economics and Management, Anhui Normal University
Wuhu, Anhui, China
The empirical characteristics of domestic and foreign interest rate shocks are obtained by using VAR method: the domestic interest rate regulation is counter-cyclical, and the increase of foreign interest rate leads to the increase of domestic output and inflation. On this basis, we construct a small open dynamic stochastic general equilibrium theory framework which reflects the empirical characteristics, including exchange rate control, to analyze the macroeconomic effects of exchange rate liberalization reform. By volatility simulation, impulse response and social welfare loss function analysis, the empirical results show that: firstly, exchange rate reform would increase volatility of output and exchange rate, but reduce volatility of inflation and interest rate. Secondly, exchange rate reform enhances the impact of domestic interest rate shocks on output and inflation. Which means the reform would improve the control ability of interest rate as a monetary policy tool. Moreover, the reform increases loss of social welfare. The conclusion shows that the exchange rate liberalization should be implemented step by step. The government should accelerate the reform when the external macro economy is stable. Otherwise it will cause a larger economic volatility.
-  M. Baxter and A. Stoekman, “Business Cycle and Exchange Regime: Some International Evidence,” J. of Monetary Economies, Vol.23, pp. 377-400, 1989.
-  A. Ghosh, A. Gulde, D. Ostry, and H. Wolf, “Does the Nominal Exchange Rate Regime Matter?,” NBER Working Paper, 1997.
-  B. Eichengreen, A. Rose, and C. Wyplosz, “Speculative Attacks on Pegged Exchange Rates: An Empirical Exploration with Special Reference to the European Monetary System,” NBER Working Paper, No.4895, 1996.
-  G. Calvo, “Capital Markets and the Exchange Rate,” NBER Working Paper, 2000.
-  E. Prasard, K. Rogoff, W. Shang-Jin, and M. Kose, “Financial Globalization, Growth and Volatility in Developing Countries,” NBER Working Paper 12, 2004.
-  S. Edwards and E. Yeyati, “Flexible Exchange Rates as Shocks Absorbers,” European Economic Review, Vol.49, pp. 2079-2105, 2005.
-  G. J. Escudé, “The Possible Trinity: Optimal Interest Rate, Exchange Rate, and Taxes on Capital Flows in a DSGE Model for a Small Open Economy,” The Open-Acess, Open-Assessment E-J., Vol.8, pp. 1-59, 2014.
-  J. Gali and T. Monacelli, “Monetary Policy and Exchange Rate Volatility in a Small Open Economy,” Review of Economic Studies, Vol.72, pp. 707-734, 2005.
-  A. Justiniano and B. Preston, “Monetary Policy and Uncertainty in an Empirical Small Open Economy Model,” J. of Applied Econometrics, Vol.25, No.1, pp. 93-128, 2010.
-  S. Yuan, P. Chen, and L. Liu, “Exchange Rate System, Financial Accelerator and Economical Undulation,” Economic Research J., No.1, pp. 57-70, 2011.
-  G. A. Calvo, “Staggered prices in a utility-maximizing framework,” J. of Monetary Economics, Vol.12, No.3, pp. 383-398, 1983.
-  E. Parrado, “Inflation Target and Exchange Rate Rules in a Open Economy,” IMF Working Paper, 21, 2004.
-  B. Liu, “Dynamic Stochastic General Equilibrium Model (DSGE) and its Applications,” China Financial Publishing House (1st Ed.).
-  J. B. Taylor, “Discretion versus policy rules in practice,” Carnegie-Rochester Conf. series on public policy, Vol.39, pp. 195-214, 1993.
-  M. Woodford, “Optimal Monetary Policy Inertia,” NEBR Working Paper, No.7261, 1999.
This article is published under a Creative Commons Attribution-NoDerivatives 4.0 Internationa License.