Monetary Regime Choice in China: Policy Rules for Navigating in Dark Corners

Abstract

This paper examines the performance of monetary policy rules when the economy finds itself in dark corners. An economic dark corner can occur when the real sector experiences a sequence of negative shocks from world demand, while the central bank faces prolonged low world interest rates on its foreign reserve holdings. We examine variations of the current policy rules, based on variations of the Taylor rule with interest-rate instruments, in the context of strong restrictions on capital flows and a fixed exchange rate, and in the context of less restricted capital flows and a more flexible managed exchange rate. Our results show that a more flexible exchange-rate system with a more open capital account acts as a shock absorber when the economy is in a “dark corner”, thus reducing the fall in real GDP and consumption. However, this benefit comes at a cost. Under the more flexible exchange-rate regime with the more open capital account, during dark corner episodes, employment is much lower than in the more restricted fixed-rate environment. In the more open environment, the real exchange rate appreciates, with an increase in imported inputs, leading to a large loss of foreign exchange reserves and lower employment.