A financial CGE model analysis: Oil price shocks and monetary policy responses in China

Most CGE models are real and cannot be easily used to study monetary policies. This paper develops a financial CGE model with interaction between real and financial side of the Chinese economy and applies the model to study oil price shocks and monetary policy responses. Unlike macro models in the current literature, the financial CGE model can be implemented to look into industrial details of effects of oil shocks, the responding interest rate and reserve ratio policy. We then identify the optimal monetary policies aiming at each inflation target. We found that when tolerance for inflation is high, it is best to implement interest rate policy alone. On the other hand, when tolerance for inflation is low and the government is more focused on social stability and household welfare, reserve ratio policy should also be implemented in addition to interest rate policy. In a scenario where world oil price increases by 100% and the inflation rate is to be targeted at below 2%, the monetary authority should raise the interest rate and reserve ratio by 2.5 percentage points and 3.0 percentage points, respectively.