Optimal Monetary Policy Instruments and Rules: Evidence from China

This chapter explores optimal monetary policy rules using a stochastic macroeconomic framework for China's economy. Since the People's Bank of China uses the money supply, rather than the interest rate used by many countries, as its primary monetary policy instrument, this chapter first employs Granger-causality tests to select the optimal monetary policy instrument, which proves to be the money supply for China. It then examines the optimality of different money supply rules by the minimization of quadratic loss functions. In order not to a priori assume specific forms of the loss function and its policy rule, alternative loss functions incorporating volatilities of the exchange rate and money supply, in addition to those of the output gap and inflation, are investigated. The optimality of the alternative forms of the monetary policy rules derived from the loss function are then evaluated by comparing the inflation output volatility frontiers.