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Empirical Review of China’s Monetary Policy


One of the main issues scholars debate over is whether monetary policy should be conducted in accordance with a uniform rule, or whether the policy should be conducted in a discretionarily fashion by central banks. Two types of monetary policy rules can be found in the literature. One is the purely theoretical derivation of the optimal monetary policy rule, which can be obtained by analysing the optimal behaviour of central banks in subject to the loss function and macroeconomic restraints. The second type of policy comprises setting the monetary policy rule exogenously. This type of monetary policy rule includes the Taylor rule. The Taylor rule was introduced by Stanford economist John Taylor in order to set and adjust interest rates in such a way that it stabilizes the economy in the short-term, and still maintain long-term growth. To a large degree, the estimated Taylor rule can be considered as a benchmark for the central banks to follow when conducting monetary policies.

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Many central banks’ conduct of monetary policy, including the Federal Reserve, Bank of England, Bank of Japan, the Bundesbank, and European Central Bank, has been examined according to the Taylor rule (McCallum 1993, Judd, Rudebusch 1998, Gerlach, Schnabel 2000, McCallum 2000, Nelson Edward E 2000) Although the research about the monetary policy conduct in major industry countries has proliferated, little English written literature can be found on the monetary policy analysis, using the Taylor rule, in transition economies and emerging market economies, like China.

The lack of studies in the literature could reflect the obstacles we came across in conducting our research. In the first place, the monetary policy in a transition and emerging market economy often lack consistency. This may be due to the fact that the economy in these countries is under reconstruction or major reform. Indeed, many of these countries are in the course of major market-oriented reforms. Moreover, the financial market in those economies is far from fully developed. These practical obstacles could prevent scholars from doing research in these areas. This paper we tried to overcome these boundaries and therefore this paper’s its main purpose is to estimate how well the Taylor rule estimates China’s monetary policies, during the period 2000:1 – 2015:1.

The remaining includes 5 sections. Section 2 will provide a brief overview of the literature. Section 3 describes the data used. Section 4 will provide the econometric model used. Section 5 covers the results obtained. Section 6 will conclude this empirical paper with a summary.

2. Literature overview

As mentioned in the introduction a substantial amount of research has been focussed on monetary policy in macroeconomic and monetary economics. In terms of Chinese monetary policy rule, there is has been little English literature on the application of the Taylor rule to China. On the other hand, the Chinese literature on studyingregarding monetary policy effectiveness and monetary policy rule is increasing after 2000. Ping and Xiong (2002) is the first Chinese paper, we could find, to conduct the empirical study of Taylor rule with Chinese data and their viewpoint is that the Taylor rule is a good measure of the Chinese monetary policy. Regarding the little English written literature there is, the overall consensus is that the Taylor rule can accurately describes the People’s Bank of China (PBC) monetary policy (Fan, Yu & Zhang 2011). However, no recent English literature can be found, which is slightly odd considering that China wants to grow into a more consumer driven, rather than an investment driven, economy, which has to be achieved via political policy and monetary policy. An important piece of information from the literature is that the PBC claims that its main monetary policy tool is the money supply, while other instruments, such as the benchmark interest rates, open market operations are used as complimentary tools to protect the money supply target (Fan, Yu & Zhang 2011).

  1. Data

3.1 Data description

The data used in our analysis are quarterly, which span from 2000:1 to 2015:1. The Peoples’ Bank of China (PBC)PBC has used, and is still using, multiple policy instruments which include benchmark interest rates, required reserve ratios and refinancing banks. In China, interest rates decisions are taken by The Peoples Bank of China Monetary Policy Committee. The PBC administers two different benchmark interest rates: one year lending and one year deposit rate. In this paper we focus on the lending rate, for three reasons: since the two rates are highly correlated due to data availability, data about the latter rate is more available, and because of the fact that it has been continuously used as an instrument since 1986.

Real GDP, potential real GDP and the output gap We obtained the real GDP data from the National Bureau of Statics of China (NBS), which is the accumulated GDP per quarter in 100 million current Yuan. This data was converted into quarterly GDP by subtracting the accumulated GDP in quarter 2 from the GDP quarter 1 etc. We estimated the potential real GDP by using the linear trend estimate, as has been used by Ping and Xiong (2002). Since the output figures we have demonstrate potential quarter-related varied characteristics, we implemented three dummy variables.

The potential output can be based on the following equation


(t)(547)(89.2) (-16.0) (-12.0) (-11.0) Sample period: 2001Q1-2015Q1 Oberservations:61 :0.99 F-statistic2082.84

In accordance with equation (1), the potential GDP can be estimated using


Using this information we can estimate the output gap with the following expression:


Inflation rate and inflation target

The inflation rate used is measured by using the CPI. This CPI data can be found in consulting the database of the Federal Reserve Bank of St. Louis. Information regarding the inflation rate target was collected by reading “The Report on Plan Implementation for National Economic and Social Development of the year and the Draft plan for National Economic and Social Development of the following year”. This report is composed is was published annually by the State Development and Reform Commission of China. However, in this paper quarterly data is used, while the inflation targets are annual, therefore, we set the quarterly target equal to the annual target.

Interest rate and long run real interest rate

The official interest rate used is the average of the 1-year lending rate, this rate is set by the PBC and can be found on their website. The long run equilibrium real interest rate posed a dilemma, the literature does not provide a clear cut answer to which rate should be used. In the literature both the median and the average real interest rates are used as the long run equilibrium real interest rate (Ping, Xiong 2002). We chose to go with 4.7%, since this is the most recent data we could find in the literature concerning the equilibrium long real run interest rate (He, Wang 2012).

3.2 stationarity tests

The Augmented Dickey-Fuller (ADF) test was used to test the variables used in the Non-Linear Least Squares (NLS) regression. The outcomes of those tests can be found in table 2.

4. Establishment of model

The original Taylor rule states that the interest rate determined by the central bank can be described by Taylor (1993):


Where is the interest rate set by the central bank, LRRI is the long run equilibrium real interest rate,  is the realized inflation as measured by the Consumer Price Index (CPI) on a quarterly basis, is the information available to the central bank at time t,  is the inflation target set by the PBC,  the output gap. We expect the parameters  and , since this is in line with the Taylor (1993). What’s more,  would represent an active interest rate policy towards the CPI gap, whereas  would indicate a more passive policy. Furthermore, a higher value for  would indicate a more responsive interest policy towards the output gap. The inflation rate is highly persistent, therefore  can be applied (Fan et al. 2011).

However, in reality central banks apply a degree of smoothness to the rate. In the literature a weighted average method is used which comprises of the target interest rate, , the existing interest rate , and an error term, . This can be summarized in the following expression:


The  conforms the original Taylor rule, furthermore, . When (4) and (5) are combined we obtain the following definition for the Taylor rule for the benchmark interest rate, :


5. Results

This section presents our findings based on the Taylor rule (6) from section 4. We faced substantial heteroskedasticity in the error term. Interestingly this seemed to be due to the observations from 2008:3 to 2009:1. This period is especially interesting, since on 9 November 2008 the State Council of the People’s Republic of China announced a $586 billion (current dollars) stimulus package, before this period the PBC already cut the interest rate three times in an effort to bolster economic growth[1]. Furthermore, the PBC cut interest rates for the fourth time that year with 108 basis point, the biggest drop in 11 years, on 26 November 2008[2]. In the literature we could not found similar mentions of the heteroskedasticity issue, which causes the test statics to be incorrect and overstate precision.

At first, we tried to get rid of the heteroskedasticity by applying White heteroskedasticity-corrected standard errors. However, this did not remove the heteroskedasticity issue. What’s more, when these observations are removed we found that the  increases from 0.81 to 0.92, that the output-gap(y) becomes more significant, and that the long run equilibrium real interest rate and the CPI-gap become less significant after the removal of these observations (see (7) and (8)). Furthermore, we found no serial correlation issues or correlation between variables (see table #).


(t) (2.21) (3.57) (2.11) (18.03)

Sample period: 2000:1 – 2008:2 2009:2-2015:1


:0.92 White (F):1.20 White Prob (F):0.32


Sample period: 2000:1 – 2015:1 Observations:60 :0.81 White (F):9.18 White Prob (F):0.00

During the sample period the benchmark interest rate responds passively to the CPI gap (). What’s more, the set interest rate shows a positively to the output gap (y). The CPI-gap and the output gap are statistically significant at the 1% and 5% level, respectively.

6. Conclusion

In this empirical paper we analysed how well the Taylor rule can describe the PBC’s monetary policy during the period 2000:1 to 2015:1. The recent developments in China’s monetary policies, lack of literature regarding our topic, and the fluctuations in macro-economic variables provided a challenging opportunity to see whether the benchmark interest rate set by the PBC is accurately described with the Taylor rule. We found that the interest rate reacts positively, but passively to the CPI-gap. What’s more, the interest rate also reacts positively to the output gap. Furthermore, all our variables were statistically significant. What’s more, we pointed out that the literature fails to mention a heteroskedasticity issue caused by the period 2008:3-2009:1. This heteroskedesticity in the error term is likely to be caused by the stimulus package initiated by Chinese government around that period. Although the PBC explicitly states that money supply is its primary monetary tool, the Taylor rule does fairly accurately describe the PBC monetary policy.


Fan, L., Yu, Y. & Zhang, C. 2011, “An empirical evaluation of China’s monetary policies”, Journal of Macroeconomics, vol. 33, no. 2, pp. 358-371.

Gerlach, S. & Schnabel, G. 2000, “The Taylor rule and interest rates in the EMU area”, Economics Letters, vol. 67, no. 2, pp. 165-171.

He, D. & Wang, H. 2012, “Dual-track interest rates and the conduct of monetary policy in China”, China Economic Review, vol. 23, no. 4, pp. 928-947.

Judd, J.P. & Rudebusch, G.D. 1998, “Taylor’s Rule and the Fed: 1970-1997”, Economic Review-Federal Reserve Bank of San Francisco, , pp. 3-16.

McCallum, B.T. 2000, “Alternative monetary policy rules: a comparison with historical settings for the United States, the United Kingdom, and Japan”, No. w7725. National Bureau of Economic Research, 2000.

McCallum, B.T. 1993, “Specification and analysis of a monetary policy rule for Japan”, No. w4449. National Bureau of Economic Research, 1993.

Nelson Edward E 2000, UK monetary policy 1972-97 : a guide using Taylor rules“, No. w120. Bank of England, 2000 .

Ping, X. & Xiong, L. 2002, “Taylor Rule and Its Empirical Test in China’s Monetary Policy [J]”, Economic Research Journal, vol. 3, pp. 3-12.

Taylor John B. J 1993, “Discretion versus policy rules in practice.”, Carnegie-Rochester Conference Series on Public Policy, vol. 39, pp. 195-214.

Data sources

CPI Data

Organisation for Economic Co-operation and Development,Consumer Price Index: Total All Items for China©[CPALTT01CNQ659N], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/CPALTT01CNQ659N/, May 4, 2015.

GDP data

National Bureau of Statistics of China, Quarterly Gross Domestic Product, Accumulated (100 million Renminbi, current), retrieved from NBS, National Bureau of Statistics of China http://data.stats.gov.cn/english/easyquery.htm?cn=B01, may 4, 2015


Table 1: inflation target 2000-2015; Source: the State Development and Reform Commission of China

Year CPI target
2000 4%
2001 1.5%*
2002 1.5%*
2003 1.0%
2004 3%
2005 4%
2006 3%
2007 3%
2008 4.8%
2009 4%
2010 3%
2011 4%
2012 4%
2013 3.5%
2014 3.5%
2015 3%

* In 2001 and 2002 the inflation target was 1-2%, we chose to go for 1.5%

Table 2: Augmented Dickey-Fuller Test Results

Variable ADF Test Value 1% Critical Value 5% Critical Value 10% Critical value Stationary
CPIgap -5.914 -3.550 -2.914 -2.595 Yes*
Interest -2.696 -3.546 -2.912 -2.594 Yes***
y -0.586 -3.544 -2.911 -2.593 No

Note: *,*** denote rejections of the null hypothesis of the unit root at the 1%, and 10% significance levels, respectively.

Heteroskedasticity tests

2008 out vs 2008 in

Covariance Analysis: Ordinary
Date: 05/12/15 Time: 12:29
Sample: 2000Q1 2015Q1
Included observations: 61
INTEREST 1.000000
CPIGAP 0.529487 1.000000
Y1 0.546691 0.266719 1.000000
Covariance Analysis: Ordinary
Date: 05/14/15 Time: 11:30
Sample: 2000Q1 2015Q1
Included observations: 58
Y1 1.000000
CPIGAP 0.281842 1.000000
INTEREST 0.548022 0.521436 1.000000



[1] http://www.economist.com/node/12585407

[2] http://www.theguardian.com/business/2008/nov/26/global-recession-china-banking

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