Monetary policy, exchange rate fluctuation and the causes of inflation’s time-varying volatility
(2.School of Economics and Business Administration, Chongqing University)
(3.University of Nottingham Ningbo China)
【Abstract】This paper develops a new Phillips curve with the inclusion of monetary policy and exchange rate, then applies TVP-VAR to investigate the causes of inflation’s time-varying volatility throughout the period spanning from 1992 to 2017, and finally derives a Phillips curve with time-varying parameters via back-stepping. The results show that the central bank’s interest rate policy of inflation targeting is effective. However, due to the relatively weak impact of quantitative monetary policy on the nominal interest rate, quantitative monetary policy only has a short-term effect in regulating inflation. From the time-varying perspective, fiscal expansion would lead to price increases and supply shock-driven inflation (e.g. the periods of 1992–2001 and 2008–2013). However, once the government implements prudent fiscal policies and deals with inflation from the supply side, the market cost then becomes a major driving force for inflation (e.g. the periods of 2002–2007 and 2014–2017). Therefore, inflation shows a significant absorption effect in response to fiscal policy. Furthermore, due to the fracture of the transmission channel from the exchange rate to the interest rate and the producer price index, no imported inflation via the exchange rate can be seen in the recent period.
【Keywords】 Taylor rule; interest rate; exchange rate; inflation; TVP-VAR;
(Translated by MA Shujun)
. ① Setting , we herein adopt πPPItas the proxy variable of function f (Kt, wt). [^Back]
. ① The proof process of Equation (17) is available upon request. [^Back]
. ① In combination with Equation (16), a structural time-varying parameter vector auto-regressive model, due to reversible matrix Γ1, we can hereby transfer the structural model into a simple time-varying parameter vector auto-regressive model (TVP-VAR):. Here, we have: . This paper adopts the TVP-VAR model to conduct estimation for the simple model system and obtains the structural time-varying parameter vector auto-regressive model system by reverse deduction based on estimation parameters, namely Equation (17). [^Back]
. ① Due to limited space, the impulse response of the constant coefficient benchmark model and the estimation results of the nonlinear test are available upon request. [^Back]
. ① Due to limited space, the model parameter estimation and test results are available upon request. [^Back]
. ① Fiscal policy (e.g. government consumption, government investment bond issuance and government taxation) can directly affect inflation’s path and effect measurement, which is also a direction of follow-up research. [^Back]
. ① One of the major reasons is probably that although the value of the impulse response of inflation to production cost shock has shown a declining trend since 1992 (Fig. 2), its average value is still greater than the values of the impulse responses of inflation to the other five types of shocks. Hence, the estimated value of forecast error variance decomposition based on impulse response function is relatively greater. Especially, the production cost index was negative during most quarters between 2013 and 2016, while the time-varying response value corresponding to that period is also negative in the time-varying impulse response results. Hence, production cost has an inhibitory effect on inflation, and further causes inflation to stay at a low level. Therefore, although the transmission to inflation via the cost channel is relatively weak, it is still a major influencing factor during the low inflation period. [^Back]
. ① After the Asian financial crisis in 1998, China began to implement proactive fiscal stimulus policy to boost economic growth and expand domestic demand. After many years of fiscal expansion accumulation, signs of excessive investment and inflation started to appear. The central government began to strengthen macro-control by implementing prudent fiscal policy between 2004 and 2007. [^Back]
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