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The Open-Economy Trilemma in China: Monetary and Exchange-Rate Policy Interaction under Financial Repression

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  • Ying Wu

Abstract

type="main" xml:lang="en"> This paper models China's monetary-cum-exchange rate policy, in which sterilization measures insulate base money from the full effects of capital inflow while the accumulation of net foreign assets (NFAs) limits exchange-rate appreciation. I find that the negative-risk premium in the interest rate—which compensates NFA holders for exchange-rate risk with a higher relative rate of return on their NFAs—plays a pivotal role in influencing the magnitude of sterilization and in inducing endogenous change in the exchange rate. I show that a feedback loop between the exchange rate and capital inflow exists in the form of a multiplier mechanism that jeopardizes both monetary autonomy and exchange-rate stability. The findings testify to the open-economy trilemma challenging the effectiveness and sustainability of China's monetary-cum-exchange rate policy and point to a flexible exchange rate as a solution that can enhance monetary sovereignty, reduce financial repression and improve economic efficiency.

Suggested Citation

  • Ying Wu, 2015. "The Open-Economy Trilemma in China: Monetary and Exchange-Rate Policy Interaction under Financial Repression," International Finance, Wiley Blackwell, vol. 18(1), pages 1-24, March.
  • Handle: RePEc:bla:intfin:v:18:y:2015:i:1:p:1-24
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    Cited by:

    1. Maosheng Ye & Jim H. Shen & Eric Golson & Chien‐Chiang Lee & Yuting Li, 2022. "The impact of Sino–US trade friction on the performance of China's textile and apparel industry," International Finance, Wiley Blackwell, vol. 25(2), pages 151-166, August.
    2. Kerry Liu, 2017. "China's Interest Rate Pass-through to Commercial Banks Before and After Interest Rate Liberalisation," Economic Affairs, Wiley Blackwell, vol. 37(2), pages 279-287, June.
    3. Moumita Basu & Jonaki Sengupta & Ranjanendra Narayan Nag, 2018. "Exchange Rate Dynamics, Endogenous Risk Premium and the Balance Sheet Effect: An Effective Demand Model," South Asian Journal of Macroeconomics and Public Finance, , vol. 7(2), pages 212-239, December.
    4. Ying Wu, 2023. "Monetary sterilization response to the movements in exchange rates and official net foreign assets: a case of China," Review of Quantitative Finance and Accounting, Springer, vol. 60(2), pages 821-838, February.
    5. Andre Varella Mollick, 2016. "Adoption of the Gold Standard and Real Exchange Rates in the Core and Periphery, 1870–1913," International Finance, Wiley Blackwell, vol. 19(1), pages 89-107, April.
    6. Helder Ferreira de Mendonça & Igor da Silva Veiga, 2017. "The open economy trilemma in Latin America: A three-decade analysis," International Finance, Wiley Blackwell, vol. 20(2), pages 135-154, June.

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