The Overshooting and Coordination of Monetary Policy and Financial Regulation in China: Money Multiplier Redux

Abstract

From 2017 to 2018, to prevent the accumulating financial risks, the Chinese government used strict financial regulation and tight monetary policy to constrain the growth of the banking innovative businesses. It seems that there is no target conflict, however, the above policies resulted in a sharp drop of M2 growth, which drag down the economy growth further. I call this phenomenon as policy overshooting. I find the policy overshooting mechanism can be explained by money multiplier theory: Because there is a high required reserve ratio (RRR) for traditional deposit while none for innovative deposit, hence strict financial regulation will decrease the money multiplier growth. Combine with the decline in monetary base growth derive from the tight monetary policy, will lead to a sharp drop of M2 growth. To test this hypothesis, I calculate the exogenous monetary base growth and the correspondent real money multiplier growth. The former measures the monetary policy stance of the People’s Bank of China accurately. To solve the overshooting problem, I propose a new policy tool called differential reserve ratio based on money creation mechanism (DRRMCM), which set a low RRR on traditional deposit while a high RRR on innovative deposit. Then strict financial regulation will increase the money multiplier growth to offset the decline in monetary base growth due to the tight monetary policy. I call this phenomenon as policy coordination. At last, I give a discussion about how to use DRRMCM in practice.