TIME-VARYING COEFFICIENT TAYLOR RULE AND CHINESE MONETARY POLICY: EVIDENCE FROM THE TIME-VARYING COINTEGRATION

Abstract

(ProQuest: ... denotes formulae omitted.)1.INTRODUCTIONThe Chinese economy, known as the miracle, has maintained steady and fast growth for three decades, and attracts much attention from scholars and practitioners. Unlike Eastern European countries, China undergoing a gradual market-oriented reform in which its economic structure and regime are changing slowly and smoothly. For this reason, it is of great importance to study whether existing economic theory can be applied to China. In macroeconomics, the proposed by Taylor (1993), is an important monetary policy that specifies how the US Federal Reserve should adjust its targeted interest rate to the inflation and output gaps. Studying the validity of the Taylor rule for China is theoretically and practically important.There is a vast literature on the Taylor rule. For example, Taylor (1999) studied the validity of the Taylor rule using historical data covering 1897 to 1914 and 1955 to 1997, finding that the deviation of the actual interest rate from the targeted interest rate could help reflect the effectiveness of monetary policy. Kim and Nelson (2006) proposed a time-varying parameter forward-looking monetary policy rule and provided an efficient estimation using the Kalman filter. Yuksel, Metin-Ozcan, and Hatipoglu (2013) introduced an interest rate pass-through specification of the monetary transmission process in a general Taylor model. Xie and Luo (2002) were the first to check the validity of the Taylor rule for China, finding that it was a good measure for Chinese monetary policy and provided a reference for Chinese monetary policy implementation. However, Bian (2006) showed that the Taylor rule was unstable in China by using the GMM and cointegration test approach. Zheng and Liu (2010) developed a regime-switching Taylor rule with a time-varying inflation target, and showed that the Chinese monetary policy rule could be significantly divided into passive and active regimes.As Osterholm (2005) pointed out, however, previous studies ignored the nonstationarity of the variables in the Taylor rule model, despite the enormous body of literature. On one hand, the variables might not be stationary processes. Given the variable's unit root behavior, the cointegration relationships among them become essential for regression modeling. In the absence of cointegation, the model would be a spurious regression. On the other hand, the traditional fixed coefficient cointegration approach assumes a constant long-run equilibrium relationship among the variables, thus failing to capture the dynamic structure of the equilibrium relationship. China's gradual reform process is leading to a smooth structural change in the relevant economic variable and market, such as stock markets (Huang et al., 2000) and interest rate. For example, China is gradually carrying out interest rate liberalization. First, inter-bank lending and bond markets were deregulated in 1996; then, the ceiling on deposit rates and the floor on lending rates of commercial banks were relaxed; then, the Shanghai Interbank Offered Rate (Shibor) became China's benchmark rate in 2007; and then, the lending interest rate was completely decontrolled in 2013. Accordingly, this paper considers the smooth and gradual structural change occurring in China rather than abrupt structural breaks.This paper develops a time-varying coefficient Taylor rule to study China's monetary policy. Given the nonstationarity of the model's variables, the paper employs the time-varying cointegration approach of Park and Hahn (1999). To the best of our knowledge, this paper is the first to examine the Taylor rule through the time-varying cointegration approach. Kim and Nelson (2006) also considered the time-varying coefficient Taylor rule, but failed to consider the nonstationarity of the variables. By using several unit root tests, we found that the interest rate, the inflation gap and the output gap are indeed nonstationary. …