Monetary policy in China: A Factor Augmented VAR approach

This paper investigates the effectiveness of Chinese monetary policy. We employ the data-rich Factor Augmented VAR (FAVAR) model to address the paucity of Chinese data. We find that the Divisia monetary aggregate M2 (DMA2) that considers both the quantity of monetary assets and the user-cost of the money/forgone interest rate is more effective in boosting economic activities and prices than other instruments (e.g., interest rate, simple money supply M2, and required reserve ratio). These other instruments produce outcomes that contradict theoretical predictions in at least one area. Therefore, we suggest the use of the DMA2 to steer the performance of the Chinese economy effectively.

Automated summary

This paper investigates the effectiveness of Chinese monetary policy using the data-rich Factor Augmented VAR (FAVAR) model, and finds that the Divisia monetary aggregate M2 (DMA2) is more effective in boosting economic activities and prices than other instruments such as interest rate, simple money supply M2, and required reserve ratio. The use of DMA2 is recommended to effectively steer the performance of the Chinese economy.