Inflation in China

Microfoundations, Macroeconomic Dynamics, and Monetary Policy

Chengsi Zhang

• Publisher: Routledge
• Year: 2020
• Print ISBN:
  9780367898823
• eBook ISBN:
  9781000166200
• Topic: Economics
• Subtopic: Finance
• Index: Economics

Inflation plays a central role in macroeconomic and financial policy regulation, and its dynamic formation has gradually become a popular research topic in this field. This book comprehensively studies the dynamic mechanism of inflation in China from the perspective of New Keynesian economics.

By combining the dynamic trajectory of price changes since China's reform and opening-up under Deng Xiaoping as well as the underlying economic operating characteristics, the book deploys a multifaceted approach to understand the mechanism of inflation dynamics. The author explores the microfoundations of inflation dynamics, and underlines their importance in the context of modern monetary policy. In particular, he builds upon the traditional New Keynesian Phillips curve to include factors of globalization and financialization within the inflation formation regime of modern China.

As the book explores the dynamic mechanism of China's inflation from different perspectives including inflation cycle theory, price index internal conduction, price index chain transmission, capital rotation, and industry inflation mechanisms, international readers will gain a full understanding of China's inflation, monetary policy, and economy.

1 Introduction

Inflation is a core element related to the harmonious and sound development of the national economy and the effective implementation of monetary policy. It is also an important reference indicator for macroeconomic and financial policy regulation. Since there is some time lag in terms of the macroeconomic policy of all countries from its formulation and implementation to its impact on inflation, understanding the mechanism of inflation dynamic formation is of great significance to the timeliness and effectiveness of macroeconomic policy. As a result, the dynamic formation of inflation has gradually become an important research topic in the analysis of macro finance, especially modern monetary policy.

Although the inflation rate of all countries in the world has shown a steady declining tendency after the 1990s, the inertia or persistence of inflation is still strong. For example, it is shown in some studies that there is still strong persistence or inertia in terms of the inflation rates of the United States and most countries in Europe.¹ According to the studies on the persistence of China’s inflation by Liu (2007) and Zhang (2008a), there is also strong persistence in China’s inflation. By definition, inflation persistence refers to the time it takes for inflation to deviate from its equilibrium state after being hit by random disturbances. Therefore, the longer it takes, the more persistent the inflation is and the more obvious the lagging effect of monetary policy will be.

These dynamic characteristics of inflation rate have attracted many economists and experts of monetary policy to continuously update and improve their dynamic mechanism theory. Relevant theories have evolved from the early dynamic model based entirely on macroscopic perspectives (e.g. Gordon, 1982) to the dynamic mechanism of short-term inflation rates with a microfoundation of the modern New Keynesian school. The latest inflation dynamic mechanism theory is based on the staggered contract model of Taylor (1979, 1980) and Calvo (1983) and the quadratic price adjustment model of Rotemberg (1982), which describe the dynamic process between the current inflation rate and the rational expectations of inflation rates, and between historical inflation rates and real output gaps. Woodford (2003) elaborates and explains this classic theoretical framework.

In the past 20 years, many outstanding monetary policy experts in China have continuously studied and explored the importance of the dynamic mechanism of China’s inflation rate in current monetary policy analysis, including the important literature of Liu (1997a, 2007a), Yu (1999), Xie and Shen (1999), Hu (1999), Lu (2001), Fan (2002), Liu and Xie (2003), Zhang (2007a), Zhang (2010), and Yang (2011). The existing research is mainly based on the traditional macro-inflation dynamic model, but research on the dynamic mechanism theory of micro inflation in modern times is rarely seen. In addition, the research is seldom expanded by relating it to the realities of China’s inflation dynamics.

At the same time, it is worth noting that after the 1980s, China’s inflation seems to show similar dynamic trends to major Western countries. Namely, after high price fluctuations from the mid-to-late 1980s to the mid-to-late 1990s, it has shown a steady and low trend in a dozen years recently since 2000. However, since there is still strong persistence of inflation, the cost of inflation (or deflation) has not decreased significantly, and the monetary policy authorities are still very concerned about the trend of inflation. In this context, it is of great practical significance to portray the dynamic formation mechanism of China’s inflation scientifically and accurately. At the same time, on the basis of the theory of inflation dynamic mechanism, the research methods of rational expansion, meticulous characterization, and scientific modeling are conducive to the improvement and development of relevant theories.

In view of this, this book attempts to comprehensively study the dynamic mechanism of inflation from the perspective of existing theories, combining the dynamic trajectory of price changes since China’s reform and opening up and the economic operating characteristics hidden behind it to develop multiple logics to understand the mechanism of China’s inflation dynamics. Next, we will sort out the theoretical framework of the macro-inflation dynamic mechanism based on microfoundation, clarify its importance in the framework of modern monetary policy analysis, and summarize the latest research on this theory, so as to provide a research basis for us to study the dynamic formation mechanism of China.

Reviewing the development of related academic research, we can find that the theoretical framework of the latest inflation dynamic mechanism gradually established its vital importance in the analysis of modern monetary policy after the publication of some far-reaching articles written by Roberts (1995), Clarida et al. (1999), and Gali and Gertler (1999). Classical works in modern macroeconomics and monetary economics (e.g. Walsh, 2003a; Thomas, 2006; Romer, 2006; Mishkin, 2007) emphasize the role of the inflation dynamics model in monetary policy analysis, highlighting its importance in macro theory and monetary policy analysis mechanisms. The monograph by Woodford (2003) demonstrates the core position of the dynamic mechanism of inflation in the transmission mechanism of modern monetary policy. Although Woodford’s monograph is mainly based on mathematical language, and many of the proof processes feature bound thinking, we can still feel the author’s preference for the theory of inflation dynamics if we read his book carefully, and this love comes from the author’s deep understanding of the importance of the dynamic mechanism of inflation.

In fact, after Roberts (1995) proposed the concept of the New Keynesian Phillips curve based on micro-pricing for the first time, the academic community rekindled its enthusiasm for researching the dynamic mechanism of inflation. This can be confirmed from the fact that a series of important documents were published in the world’s top academic journals after the mid-1990s.² Although the focuses and researching methods of these studies vary, a broad consensus is reached that the theory of inflation dynamics plays an indispensable role in the transmission framework of modern monetary policy.

This consensus complements the important research on the scientific analysis of modern monetary policy proposed by Clarida et al. (1999) The 50-page article published on QJE elevates the monetary policy analysis framework of the New Keynesian Phillips curve to a scientific monetary policy analysis for the first time, which marks the core status of the inflation dynamic mechanism model in the framework of modern monetary policy analysis. In essence, the scientific analysis method proposed by Clarida et al. (1999) is a modern monetary policy transmission mechanism based on the dynamic general equilibrium model, which embodies the cutting-edge research methods in modern macroeconomics. John Taylor (1999a), a well-known economist at Stanford University, elaborated on the close relationship between the inflation dynamic mechanism based on the dynamic general equilibrium model and macro-monetary policy analysis in a comprehensive and detailed manner and collected micro-level data such as prices and wages. He demonstrated with the application of rigorous econometric analysis that the inflation dynamic mechanism model with expected factors is most consistent with the actual data in explaining the dynamic relationship between monetary policy, economic growth, and inflation.

Because of this, the micro-based macro-inflation dynamic model has gradually become a core element in the transmission mechanism of modern monetary policy. In summary, this transmission mechanism is mainly manifested in three segments. The first segment is the central bank’s monetary policy. For example, the central bank’s adjustment of short-term interest rates impacts on the total output by affecting investment. This segment is based on the classical Euler equation after logarithmic linearization. If we use i_t to represent the nominal interest rate, then the actual interest rate r_t should be equal to the nominal interest rate minus the effect of inflation, i.e.

r t = i t − E t π t + 1

(1.1)

So the first segment can be formulated as

y t = − α r r t + E t y t + 1 + ε y t , α r > 0

(1.2)

E t y t + 1 represents the rational expectation of the total output gap, and ε_yt is used to capture the influence of random factors such as demand shocks on the total output gap y_t. Obviously, with other conditions being the same, the higher the actual interest rate is, the smaller the total output gap will be.

Although according to early macro theory the change in the total money supply will affect the aggregate demand, and the change in aggregate demand will further impact on the total output, the role of the monetary aggregate has gradually been weakened by the analysis of modern monetary policy. The main reason is that it has been proved in plenty of literature in recent years, especially the work of Clarida et al. (1999) which is of watershed significance, that using monetary aggregates as the central bank’s monetary policy tools generates more volatility in the macro economy than using the policy of interest rate adjustment. In fact, the People’s Bank of China has gradually revealed its tendency to use interest rates as a major monetary policy tool in the process of continuously improving its central bank functions. The central bank’s increases and cuts of interest rates have become the weathervane for people to observe in order to understand the change of monetary policies.

Among the major developed countries in the world, especially the United States, the first aspects mentioned above have been fully demonstrated in the actual operation process. Of course, for China, although the People’s Bank of China has gradually paid attention to the role of interest rate indicators as an intermediate target of monetary policy in recent years, the regulation of monetary aggregates has been an important measure for a long time. Therefore, when examining China’s monetary policy and inflation interaction mechanism, the monetary aggregate indicator cannot be ignored. Chapters 4 and 8 of this book will explain this aspect in detail.

The second segment of the modern monetary policy transmission mechanism is achieved through the dynamic mechanism of inflation. In the first segment, changes in total output will affect the current inflation rate. For example, larger GDP gaps caused by the growth of real output will put upward pressure on the current inflation rate. At the same time, the second segment highlights the impact of people’s expectations of future inflation rates on current inflation rates. Of course, the over-emphasis on the expectation of inflation rate and the neglect of inflation inertia (i.e. persistence) in the inflation dynamic mechanism is precisely a shortcoming of modern inflation dynamic mechanism theory, which will be explained further.

Finally, the third segment portrays the response of monetary policy tools to total output and inflation. Specifically, changes in total output and inflation rates in the first two segments have an impact on monetary policy makers, prompting the central bank to adjust its monetary policy tools (such as short-term interest rates), i.e.

i t = ρ π π t + ρ y y t + ρ i i t − 1 + ε i t

(1.3)

ε_it stands for the variables of monetary policy shocks. The reason the lagging nominal interest appears on the right side of the equation is because of the existence of interest rate smoothing which is widely accepted (e.g. Rudebusch, 2002b). This segment is often referred to as the currency response equation. If interest rates are used as a monetary policy tool, then this reaction equation is known as the famous Taylor Rule, which is named after the important study of John Taylor in 1993 (Taylor, 1993). Since then, Taylor (1995, 1999b), Judd and Rudebusch (1998), and Clarida et al. (2000) have conducted further empirical research on the application of the Taylor Rule in monetary policy analysis. The basic conclusions are relatively consistent, that is, the Taylor Rule works well in reflecting the central bank’s monetary policy response mechanism.

In this way, monetary policy acts upon total output, total output affects inflation, and inflation and changes in total output impact on the formulation and regulation of monetary policy, thus forming a dynamic transmission mechanism of monetary policy. Since the interest rate is the major monetary policy instrument in Western developed countries, the above-mentioned transmission mechanism weakens the function of monetary aggregates, so it is often referred to as the “currency-free” monetary policy transmission mechanism (e.g. McCallum, 2001).

Since the 1990s, the “currency-free” monetary policy analysis framework has gradually become the basis for studying the interactions between monetary policy, inflation, and economic growth. For example, based on this framework, McCallum and Nelson (1999) studied the effects of monetary policy and the US economic cycle. Boivin and Giannoni (2002) studied the stability of the transmission mechanism system of monetary policy. Rudbusch (2002a) analyzed the impact of the uncertainty of model and macro data on the implementation of nominal income target systems. Roberts (2006) and Stock and Watson (2002) compared the monetary policy shocks and the unobservable random disturbance factors in terms of their influence on the total output and the fluctuatio...

Table of contents

• Cover
• Half-Title
• Series
• Title
• Copyright
• Contents
• List of figures
• List of tables
• 1 Introduction
• 2 Dynamic evolution of inflation in China
• 3 Inflation dynamics: Internal transmission perspective
• 4 Inflation dynamics: Upstream and downstream transmission perspective
• 5 Inflation dynamics: Industry tide perspective
• 6 Inflation dynamics: Goods financialization perspective
• 7 Inflation dynamics: Equilibrium of goods and asset markets perspective
• 8 Inflation dynamics: A compromise perspective between monetarism and New Keynesianism
• 9 Target mismatch and dynamic mechanism of inflation
• 10 Inflation expectations and its dynamic mechanism
• 11 External shocks, monetary policy, and the structural change of inflation dynamics
• 12 Excess liquidity and inflation dynamics in an open environment
• 13 Exchange rate parity relation change and inflation dynamic mechanism
• 14 Globalization and inflation dynamics
• 15 Disparities and consistencies
• References
• Index