Capacity Reduction Policy Under the Interest Rate Peg in China

Capacity reduction has been a recurrent theme in China’s economic policy. This paper proves in a New Keynesian model that the effects of the decapacity policy depend on its persistence and monetary policy regime (interest rate flexibility). Under an interest rate peg, a temporary policy is ineffective and even expansionary, whereas a permanent policy is effective due to a negative wealth effect. When the nominal interest rate is pegged, the real rate moves oppositely with inflation, which adds positive feedback to the economy. Thus the de-capacity policy has greater uncertainty under the interest rate peg. As a policy tool, it may easily deviate from its target and bring about excessive volatility. Last, long-run price stability and a gradually advanced de-capacity policy are helpful to the achievement of policy targets.