Estimating forward-looking rules for China's Monetary Policy: A regime-switching perspective

This paper introduces a regime-switching forward-looking Taylor rule to describe the monetary policy behavior and considers its estimation using a two-step MLE procedure due to Kim and Nelson (2006), Kim (2009) and Zheng and Wang (2010). By doing an empirical analysis on quarterly data for China over the period 1992-2010, our results show that the actual reactions of China's monetary policy can be well characterized by a two-regime forward-looking Taylor rule. Furthermore, it is also suggested that the interest rate policy in response to inflation and output gap is asymmetric, behaving a significant characteristic of regime-switching nonlinearity. Specifically, in the first regime the People's Bank of China targets inflation, but not focuses on the output gap; while in the second regime the central bank targets the output gap and the policy rule is not a stable framework.

► Generalize linear forward-looking Taylor rule to a rule with regime-switching. ► Realize the consistent estimation of this model via the two-step MLE procedure. ► Find that interest rate reacts to inflation and output gap asymmetrically in China. ► In the first regime the PBC targets inflation, but not focuses on output gap. ► In the second regime the PBC targets output gap and the policy rule is unstable.