Monetary policy, exchange rate fluctuation and the causes of inflation’s time-varying volatility

CHEN Chuanglian1 LONG Xiaoxuan1 YAO Shujie2,3

(1.Financial Research Institute of Jinan University)
(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;


【Funds】 National Natural Science Foundation of China (71771093) Humanities and Social Science Research Planning Fund of the Ministry of Education of China (17YJA790009) Guangdong Natural Science Fund (2017A03033417)

Download this article

(Translated by MA Shujun)


    [1]. ① Setting , we herein adopt πPPItas the proxy variable of function f (Kt, wt). [^Back]

    [2]. ① The proof process of Equation (17) is available upon request. [^Back]

    [3]. 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]

    [4]. 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]

    [5]. ① Due to limited space, the model parameter estimation and test results are available upon request. [^Back]

    [6]. 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]

    [7]. 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]

    [8]. 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]


    Cao, W. & Shen, Y. Journal of Financial Research (金融研究), (10) (2013).

    Chen, C., Zheng, T. & Yao, S. Economic Research Journal (经济研究), (8) (2016).

    Fu, Q., Zhu, Y. & Yuan, C. China Industrial Economics (中国工业经济), (5) (2011).

    Jiang, C. & Wang, W. Finance & Economics (财经科学), (3) (2017).

    He, L., Fan, G. & Hu, J. Economic Research Journal (经济研究), (11) (2008).

    Hu, J., Guo, F. & Long, S. China Economic Quarterly (经济学(季刊)), (4) (2013).

    Liu, J. & Zhang, X. Economic Research Journal (经济研究), (12) (2015).

    Ouyang, Z. & Wang, S. Economic Research Journal (经济研究), (9) (2009).

    Ouyang, Z. & Qian, L. Economic Research Journal (经济研究), (6) (2015).

    Peng, F., Fan, H. & Lian, Y. et al. Economic Research Journal (经济研究), (8) (2012).

    Su, J. Economic Perspectives (经济学动态), (1) (2011).

    Sun, J., Cui, X. & Cai, Y. Economic Research Journal (经济研究), (10) (2016).

    Tian, X. & Wu, X. China Industrial Economics (中国工业经济), (12) (2012).

    Xiang, H. & Pan, X. Statistical Research (统计研究), (5) (2011).

    Wang, X., Wang, Q. & Chen, Z. Economic Research Journal (经济研究), (2) (2016).

    Yang, Z., Zhou, L. & Li, G. The Journal of World Economy (世界经济), (5) (2014).

    Yang, Z., Li, G. & Zhang, N. Journal of Financial Research (金融研究), (6) (2016).

    Zhao, J. & Gao, H. China Economic Quarterly (经济学(季刊)), (1) (2004).

    Zhang, Y. Economic Perspectives (经济学动态), (1) (2010).

    Zhang, T. Economic Perspectives (经济学动态), (6) (2014).

    Zhu, Z. & Deng, X. The Journal of World Economy (世界经济), (7) (2017).

    Aye, G. C.; Balcilar, M. and Gupta, R. “The Effectiveness of Monetary Policy in South Africa under Inflation Targeting: Evidence from a Time-Varying Factor-Augmented Vector Autoregressive Model.” University of Pretoria, Department of Economics Working Paper No. 201653, 2016.

    Besancenot, D. and Vranceanu, R. “Credibility Costs in the Monetary Integration Game.” Economics of Transition, 2003, 11(4), pp. 727–741.

    Calvo, G. A. “Staggered Prices in a Utility-Maximizing Framework.” Journal of Monetary Economics, 1983, 12(3), pp. 383–398.

    Campa, J. M. and Goldberg, L. S. “Exchange Rate Pass-through into Import Prices.” The Review of Economics and Statistics, 2005, 87(4), pp. 679–690.

    Castillo, C. “Inflation Targeting and Exchange Rate Volatility Smoothing: A Two-Target, Two-Instrument Approach.” Economic Modelling, 2014, 43, pp. 330–345.

    Choudhri, E. U. and Hakura, D. S. “Exchange Rate Pass-through to Domestic Prices: Does the Inflationary Environment Matter?” Journal of International Money and Finance, 2006, 25(4), pp. 614–639.

    Clarida, R.; Gali, J. and Gertler, M. “The Science of Monetary Policy: a New Keynesian Literature.” Journal of Economic Literature, 1999, 37(4), pp. 1661–1707.

    Clarida, R.; Gali, J. and Gertler, M. “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory.” Quarterly Journal of Economics, 2000, 115(1), pp. 147–180.

    Devereux, Michael and Genberg, Hans. “Currency Appreciation and Current Account Adjustment.” Journal of International Money and Finance, 2007, 26(4), pp. 570–586.

    Eichenbaum, M.; Johannsen, B. K. and Rebelo, S. “Monetary Policy and the Predictability of Nominal Exchange Rates.” NBER Working Paper No. 23158, 2017.

    Geweke, J. “Evaluating the Accuracy of Sampling-Based Approaches to the Calculation of Posterior Moments.” Federal Reserve Bank of Minneapolis Staff Report, 1991, 4, pp. 169–193.

    Ghosh, A. R.; Ostry, J. D. and Chamon, M. “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies.” Journal of International Money and Finance, 2016, 60(1), pp. 172–196.

    Giannellis, N. and Koukouritakis, M. “Exchange Rate Misalignment and Inflation Rate Persistence: Evidence from Latin American countries.” International Review of Economics & Finance, 2013, 25(1), pp. 202–218.

    Freund, C. “Current Account Adjustment in Industrial Countries.” Journal of International Money and Finance, 2005, 24(8), pp. 1278–1298.

    Haque, Q. “Monetary Policy, Target Inflation and the Great Moderation: An Empirical Investigation.” University of Adelaide, School of Economics Working Paper No. 10, 2017.

    Hegerty, S. W. “Inflation Volatility, Monetary Policy, and Exchange-Rate Regimes in Central and Eastern Europe: Evidence from Parametric and Nonparametric Analyses.” Eastern European Economics, 2017, 55(1), pp. 70–90.

    Hossain, A. A. “Inflation Volatility, Economic Growth and Monetary Policy in Bangladesh.” Applied Economics, 2015, 47(52), pp. 5667–5688.

    Jooste, C. and Jhaveri, Y. “The Determinants of Time-Varying Exchange Rate Pass-Through in South Africa.” South African Journal of Economics, 2014, 82(4), pp. 603–615.

    Kim, C. J. and Nelson, C. R. “Estimation of a Forward-Looking Monetary Policy Rule: A Time-Varying Parameter Model Using Ex Post Data.” Journal of Monetary Economics, 2006, 53(8), pp. 1949–1966.

    McCarthy, J. “Pass-through of Exchange Rates and Import Prices to Domestic Inflation in Some Industrialized Economies.” Eastern Economic Journal, 2007, 33(4), pp. 511–537.

    Mihaljek, D. and Klau, M. “A Note on the Pass-through from Exchange Rate and Foreign Price Changes to Inflation in Selected Emerging Market Economies.” BIS Papers, 2001, 8, pp. 69–81.

    Mumtaz, H. and Surico, P. “Evolution International Inflation Dynamics: World and Country Specific Factors.” Journal of the European Economic Association, 2012, 10(4), pp. 716–734.

    Primiceri, G. E. “Time Varying Structural Vector Autoregressions and Monetary Policy.” Review of Economic Studies, 2005, 72(3), pp. 821–852.

    Shintani, M.; Terada-Hagiwara, A. and Yabu, T. “Exchange Rate Pass-through and Inflation: A Nonlinear Time Series Analysis.” Journal of International Money and Finance, 2013, 32, pp. 512–527.

    Taylor, J. B. “Discretion Versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy, 1993, 39(1), pp. 195–214.

    Yamada, H. “Does the Exchange Rate Regime Make a Difference in Inflation Performance in Developing and Emerging Countries? The Role of Inflation Targeting.” Journal of International Money and Finance, 2013, 32, pp. 968–989.

This Article


CN: 11-1138/F

Vol 41, No. 04, Pages 3-27

April 2018


Article Outline


  • 1 Introduction
  • 2 Theoretical model and testing framework
  • 3 Data sources and explanations
  • 4 Empirical results and analysis
  • 5 Conclusion and implications
  • Footnote