Factor-augmented VAR analysis of the monetary policy in China

- A factor-augmented VAR method is used to measure the effects of monetary policy.
- Market-based instruments are mildly effective when exchange rate is more flexible.
- The non-market-based measures of the PBC are effective in affecting Chinese economy.
- China may continue employing the non-market-based instruments in the near future.

We investigate the transmission mechanism of monetary policy in China over the past decades with emphasis on the post-Asian crisis period. A factor-augmented VAR method is used to study the effectiveness of monetary policy instruments in stabilizing the Chinese economy. We find that repo rate, benchmark lending rate, and a market-based monetary stance have little impact on the Chinese economy, and are only mildly effective when the exchange rate is more market-determined. The non-market-based measures of People's Bank of China, such as growth rates of total loan and money supply, are effective in adjusting the real economy and price level. Given the slow pace of exchange rate reform, China is likely to continue employing non-market-based policies in the near future.