Monetary transmission and government investment in China

Abstract

The quantity measure of money supply—the M2 growth, in particular—has been used as the intermediate target of monetary policy in China since 2000. We document three findings on the transmission of money supply shocks to firm investment and financing over the period from 1998 to 2016. First, positive money supply shocks have significant negative effects on firm investment and do not have consistent impacts on firm financing, contradicting the standard monetary transmission mechanism. Second, using short-term global capital flows as an exogenous money supply factor, we recover the standard positive effect of money supply shocks on firm investment and financing, suggesting that M2 growth contains confounding factors and it is inappropriate to use it directly as an intermediate target or indicator of monetary policy. Third, we show that removing the government investment-related component from M2 growth leads to a monetary supply measure that conforms to the standard monetary transmission mechanism. Overall, we argue that our refined measure of M2 growth can serve as a superior indicator for the intermediate target of monetary policy in China.