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Interest Rate Pegging, Fluctuations, and Fiscal Policy in China

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  • Tong, Bing
  • Yang, Guang

Abstract

This paper proves in a New Keynesian model that interest rate pegging can explain the unusual business cycle fluctuations in China. It is traditional wisdom that when the nominal interest rate is inflexible, there is no unique equilibrium in macroeconomic models. We prove that a unique equilibrium exists if the nominal rate is pegged for a limited period, after which it switches to a flexible rate regime. The peg alters the propagation of external shocks, magnifies volatility of endogenous variables, and leads to instability of the economy. Besides, the model becomes more unstable when the peg duration extends, and when the pegged rate deviates from steady state. At the same time, fiscal multiplier increases under the peg, indicating fiscal policy may be more effective in mitigating economic fluctuations when monetary policy is restricted by interest rate pegging.

Suggested Citation

  • Tong, Bing & Yang, Guang, 2020. "Interest Rate Pegging, Fluctuations, and Fiscal Policy in China," MPRA Paper 100930, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:100930
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    References listed on IDEAS

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    More about this item

    Keywords

    New Keynesian model; Chinese economy; Interest rate peg; Fiscal policy; Rational expectation;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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