Chapter 47
Examining China: Monetary Policy, Inflation Potential, and the Organization of the Monetary System Under a Floating Exchange Rate System
Abstract
When it comes to monetary policy and inflation, we are quite fond of making two complementary statements. The first one is that we believe that inflation is a monetary phenomenon. To get a sense of the inflation rate, all we need to determine is the growth rate of the monetary aggregates relative to the demand for these aggregates. The second statement that we are also fond of making when discussing monetary matters is that the organization of the monetary system determines the inflation potential of an economy. The reason for this is that the organization of the monetary system may impose some constraints and rules that can, under some circumstances, limit the rate of growth of the monetary aggregates. Hence, if we know these rules, we can determine the inflation potential of a monetary arrangement. These two simple concepts go a long way to explain a country’s inflation rate, the behavior of its monetary aggregates, and international reserves. China is no exception.
Keywords
Chinese inflation rate
convergence of the inflation rate
floating exchange rate
inflation potential
price rule
quantity rule
When it comes to monetary policy and inflation, we are quite fond of making two complementary statements. The first one is that we believe that inflation is a monetary phenomenon—too much money chasing too few goods. Hence, to get a sense of the inflation rate outlook, all we need to determine is the growth rate of the monetary aggregates relative to the demand for these aggregates. The second statement that we are also fond of making when discussing monetary matters is that the organization of the monetary system determines the inflation potential of an economy. The reason for this is that the organization of the monetary system may impose some constraints and rules that can, under some circumstances, limit the rate of growth of the monetary aggregates. Hence, if we know these rules, we can determine the inflation potential of a monetary arrangement. These two simple concepts go a long way to explain a country’s inflation rate, the behavior of its monetary aggregates, and international reserves.
China is no exception. In fact, during its floating exchange rate period, China was almost a perfect textbook example of a floating exchange rate. The analysis of a floating exchange rate traditionally assumes that the country in question only uses its domestic currency for transaction purposes and that the rest of the world does not use the local currency in their transactions. That appears to be the case in China before the Chinese decided to fix their exchange rate to the US dollar. The lack of use of foreign currencies at home is easily attributable to legal tender requirements where the authorities made it difficult, and in some cases illegal, to use foreign currencies. The use abroad is much more pedestrian. Foreigners had no use for the Chinese currency—a currency that was very difficult to take out of the country—outside of China.
Given the regulatory apparatus, the Chinese had a great deal of control over the monetary aggregates. If one is willing to go that far, then it seems reasonable to assume that the Chinese central bank controlled these aggregates. At the very least, it controlled exactly the narrowest of the aggregates, the monetary base.
As we already mentioned, the textbook representation assumes that the central bank controls the quantity of money precisely and that the local currency is used only in the local economy. That is, the demand for the local currency is determined solely by local factors. If inflation is too much money chasing too few goods, inflation will be observed when the money growth/creation by the monetary authorities exceeds the growth in the demand for money. Viewed this way, one can see that there is no limit to the inflation potential of this economy. Fig. 47.1 presents evidence in support of the monetarist proposition under the conditions outlined in this section. The money growth is closely correlated to the Chinese inflation rate.
Figure 47.1 China’s inflation and money growth rates.
We have not specified a mechanism that may limit the central bank money creation process, which could evolve into a hyperinflation if unchecked. Monetarists who advocate a floating exchange rate argue that central banks should keep the monetary growth rate at a constant rate that approximates the country’s underlying growth rate. The assumption is that the growth rate is a proxy for the demand for money and that, over the long term, if the money grows at the real GDP growth, the money demand and supply will be in balance and there will be no excess inflation. The constant money growth at the rate of real GDP will, in the long run, produce price stability. The only problem will be in the short term, over the business cycle, when real GDP deviates from its long-run trend.
Political pressures may force the central bank to abandon the constant money growth. If the central bank sticks to the quantity rule, then the inflation rate will deviate from trend, and that may not be politically acceptable. But doing so leads to a countercyclical inflation rate. During periods of rapid growth, all else the same, the demand for money will rise and that would lead to a decline in the underlying inflation rate. In contrast, during periods of economic decline, the demand for money will fall relative to the constant growth in money supply and that will lead to a rise in the underlying inflation rate. Under an inflation targeting regime, the central bank would then reduce the quantity of money to keep the inflation rate constant.
Notice that this is the opposite of what Keynesians believe. The countercyclical response could get into trouble if unanticipated shifts in the demand for money occur. For example, during periods of rising inflation, people may switch to other currencies or other commodities, and that will reduce the demand for money and lead to an even higher inflation. Also, budgetary pressures may force the central bank to abandon the constant money growth rule. Once the central bank departs from the strict quantity rule, there is no real constraint that may prevent the excess demand from steadily rising. Whether it is because the demand for money is less than forecast, or because of budgetary issues, the central bank is forced to print money in excess of the target rate due to budgetary and/or political reasons.
The bottom line here is that there is no constraint or limit on how high the inflation rate can go under a floating exchange rate system. At that point, only a crisis brings about an abrupt change in the organization of the monetary system. On the other hand, as we will argue later on, the adoption of a price rule or fixed exchange rate amounts to the Chinese central bank outsourcing its monetary policy. The results of these experiments were quite remarkable and in line with the purchasing power parity (PPP) view of the world. Once the fixed rate system was implemented, from 1995 on, China’s inflation rate collapsed and converged to that of the United States (Fig. 47.1).
China’s Monetary Policy and the Floating Exchange Rate Experience
In spite of the presumed control over the monetary aggregates, the outcome in China was not a pleasant one. As shown in Fig. 47.1, during the early 1990s, the inflation rate accelerated and peaked at around 25%. One is hard pressed to justify such a high inflation rate. Either the Chinese did not exert complete control over the demand for money, or budgetary pressures forced the central bank to print too much money. Either way, the inflation rate exploded. We can see that the year-over-year growth rate in the monetary aggregate also rose to better than 30% during most of the first half of the 1990s.
The monetary data certainly fits the view that inflation was too much money chasing too few goods. Under a floating exchange rate, when China’s inflation rate was in the double-digit range and the rest of the world (i.e., most of China’s trading partners) was experiencing single digit inflation rates, PPP theory would suggest that China’s currency depreciated against the rest of the world. It did. In 1990, it took 4.96 yuan to get a dollar. By 1994, it took 8.51 yuan (Fig. 47.2). That is a 71.6% depreciation over 4 years or approximately 17.6% per year. The yuan’s annual depreciation roughly matches the growth in China’s monetary aggregate.
Figure 47.2 Yuan/dollar exchange rate.
The Central Bank Reaction to the Floating Exchange Rate Experience
China experienced an annual double-digit excess money creation, inflation during the 1990–94 time periods. The Chinese experience also shows that under the floating exchange rate, the excess money growth less the US inflation rate does a pretty good job of explaining the yuan’s fluctuations (Fig. 47.3). The close fit between the two variables in Fig. 47.3 during the floating exchange rate is consistent with the PPP view of the world.
Figure 47.3 Yuan/dollar exchange rate fluctuations versus the Chinese money growth net of China GDP growth and US inflation.
If inflation is an undesirable outcome, it should not surprise anyone that the Chinese authorities reacted to the deteriorating monetary situation and rising inflation rate. However, the big surprise was the action they took. They fixed China’s exchange rate to the US dollar. The floating exchange rate experience shows that even in a command performance economy, the central bank has a tough time controlling the underlying inflation rate.
Under a fixed exchange rate system, in absence of transportation costs, the dollar price of freely traded goods and services will be the same across the world. Also, if the broadly defined transportation costs are constant, the rate of change of the dollar price of the traded commodities will be the same across localities. The implication is fairly clear: by fixing the exchange rate to the US dollar, the traded goods’ inflation rate in China had to converge to that of the US dollar. If tradable goods make up the bulk of the price index, one would expect to see the Chinese inflation rate converge to that of the US inflation rate. The data reported in Fig. 47.4 shows that is the case. PPP is the proper framework to evaluate and analyze the Chinese inflation and exchange rates policies.
Figure 47.4 China and US inflation rates.
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