Monetary Policy Effects on the Stock Market in China: Comparing Two Restriction Schemes in the SVAR Model

Abstract

This paper analyzes and compares the effects of the monetary policy on the stock price in China based on SVAR models with two different restriction schemes. As suggested by existing literature, there are four major monetary policy instruments used by the People’s Bank of China. They are the seven-day repo rate, the one-year benchmark lending rate, the M2, and the total loan. We run SVARs with the monetary policy instrument, the stock index, and the macroeconomic variables and show the impulse responses of the stock index to the monetary policy shocks. After comparing two restriction schemes, the short-run Cholesky restrictions and the short-run and long-run combined restrictions for identification, we conclude that the latter restriction method leads to better estimation than the former one. In general, a contractionary monetary policy shock lowers the stock price, appreciates the Chinese currency, reduces the output gap, injects deflation, and shrinks the commodity price gap. We find that the benchmark lending rate is more effective in regulating the Chinese stock market than the other monetary policy instruments. In addition, a combination of price-based and quantity-based monetary policy instruments is suggested for impacting the stock market and stabilizing the economy in China.