The Interest Rate as a Monetary Policy Instrument in China: Applications, Challenges and Latest Reforms

Abstract

The interest rate is a vital tool of monetary policy and is taken into account when the central bank and the government deal with variables such as capital flows, inflation, unemployment and investment. In the context of financial crises, central banks are equipped with the key task of growing the national economy and maintaining financial stability. Formulating monetary policy, ie, lowering or increasing interest rates, therefore is under close scrutiny. This article first discusses how China’s central bank has been using interest rates as a key policy tool in and after the financial crisis. Against this background, some “domestic” challenges of adjusting interest rates will be discussed. China’s latest decision to let banks set lending rates freely by removing an artificial floor is a new policy move which has triggered tremendous market reactions. However, it will be argued in this article that this move is probably simply another gesture from the new leadership to deepen economic reform without touching upon vested interest groups.