This paper addresses the issue of endogeneity in the monetary policy of mainland China. A reaction function approach is discussed and implemented for the sample period 1951–1985.
Since 1979, the dominant economic concern has been the reform of the banking system. The monobanking system in mainland China represents a financial control mechanism for carrying out economic planning. The economic grounds for centralized monetary control in mainland China are generally applicable to other LDCs, because they reflect the desire to increase the growth of the economy.
In 1979, the Chinese Communist Party’s leaders approved various major changes in the banking system and subsequent banking reforms have followed. They targeted the banking system to become an important intermediary linking state planners with economic agencies in a more decentralized economy in which economic levers would play a growing role in guiding state planning. These reforms changed the organization of the banking system and expanded the banks’ power.
To examine the relationship between monetary policy and the goals of macroeconomic stabilization, a monetary policy reaction approach is employed. The reaction function approach assumes that the monetary authorities’ actions are based on macroeconomic goals, with, overall economic growth, price stability, balancing the budget deficit, and balancing the trade deficit being the main targets. That is, an assumption is made about how the monetary authorities will react to disturbances in reaching their goals in the Chinese economic system; hence, a “reaction function”.
Three alternative monetary aggregates, M1, M2, and M3, are used as a measure of the effectiveness of monetary policy. The Almon polynomial lag estimate and the Theil’s residual variance are employed to determine the proper lag structure of the reaction function equation. The empirical results show that the most narrowly defined monetary aggregate (cash) reflects the endogeneity of monetary policy. Hence, the monetary policy is significantly influenced by the overall economic growth, budget deficits, and trade deficits. The price level only has a short-term delayed effect.
