Digital finance, channel effect differentiation and the effects of monetary policy

ZHAN Minghua TANG Yanfei LI Shuai

【Abstract】As a transmission mechanism, financial structures bridge monetary policy and the real-economy targets of monetary policy. The evolution of the financial structure influences the way that microeconomic agents respond to the monetary policy and alters the mechanism for the amplification and propagation of monetary policy shocks. Hence, changes to the financial structure can dramatically alter monetary policy effects. The financial structure is important to monetary authorities because it affects whether they should implement monetary policy more actively or passively and which channels they should pay attention to. Digital finance has developed rapidly since the launch of Alipay in 2004 and has had an impact on China’s financial structure. Online lending reached CNY 2804.85 billion in 2017, with an annual growth rate of 35.9%. The ratio of third-party payments to GDP has been as high as 187%. Like most financial innovations in history, digital finance matters not merely because of the risks it brings, but also because of its profound impacts on the financial structure. It is important to ask how this evolution affects Chinese monetary policy effects. How does digital finance reshape the interest rate and credit channels of monetary policy transmission? A convincing conclusion relies on a thorough theoretical and empirical examination. We constructed an extended IS-LM-CC model to illustrate theoretically how digital finance affects the interest rate and the credit channels of monetary policy transmission, leading to two hypotheses. The first hypothesis is that digital finance reduces the financial frictions and increases the completeness of the financial market, altering the monetary policy effects but with the direction of the effect ambiguous. The second hypothesis is that digital finance weakens the credit channel but enhances the interest rate channel of monetary policy transmission. Empirically, we tested the first hypothesis and examined the overall effects of digital finance on monetary policy effects by applying the conditional-impulse-response IVAR technique with Chinese macroeconomic time series data. We further investigated the ways that digital finance influences monetary policy transmission channels as stated in the second hypothesis by applying the difference-in-differences technique with panel data on Chinese listed firms and by testing the interest rate channel and credit channel separately. We drew two conclusions from our analysis. First, digital finance enhances the overall effects of monetary policy by increasing the magnitude of the impulse responses of output to monetary policy shocks, reducing the time-lag of policy effects and weakening the “price puzzle.” Our results are present for both expansionary and contractionary monetary policies. Our findings imply that the influence of financial development on monetary policy effects is in line with the characteristics of developing economies instead of those of developed economies. Second, in terms of mechanisms, the improvement in the interest rate channel dominates the weakening of the credit channel. The weakening of the credit channel is due to the competition that digital finance places on traditional banks and not the variety of sources it provides for firm financing. Several policy implications can be drawn from our results. Improving monetary policy transmission requires a long-term development in the financial structure instead of short-term policy adjustments. A transition from a quantity-based to a price-based monetary policy framework relies on the proper risk regulations along with financial innovations such as digital finance that improve the financial structure and reduce financial frictions. We have made four contributions to the literature. First, we introduced the influence of digital finance into a standard IS-LM-CC model and illustrate two theoretical channels for how it works. Second, we applied the IVAR method to allow for interaction effects and identity the overall effects. Third, we used the difference-in-differences method to test how digital finance works through the interest rate channel to affect firm investments. Finally, we tested the difference between the two types of market failures under credit channels based on the assumption that digital finance is uncorrelated with these two market failures.

【Keywords】 digital finance; transmission channels; monetary policy effects;

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ISSN:0577-9154

CN:11-1081/F

Vol 55, No. 06, Pages 22-38

June 2020

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