China’s Central Bank Monetary Policy and how it will affect the Economy
http://fortune.com/2016/03/13/china-central-bank-monetary-policy/
The article states that the economy is facing a slowdown, but this only means that
economic growth is slowing but still is in growth. China’s CB adopted a loose
(expansionary) monetary policy (MP) to help achieve their goal of economic growth by
increasing AD, in turn increasing real GDP. So they are able to counter possible shocks
from structural reform in the economy. It also mentions the use of fiscal policy by the
Chinese government to boost the housing market. China’s CB will try to counter possible
shocks from structural reform to the market by adopting an expansionary MP. These
policies include altering interest rates (IR) and/or the level of money supply in China.
Where the Long Run Aggregate Supply (LRAS) curve meets the AD curve, the economy
is operating at the equilibrium level of output, which according to Keynesian principles
can occur below the full employment level of national income (Yf).
Figure 1. Shows how AD is affected by the expansionary MP employed by the CB. The
application of expansionary demand side policy, also known as demand push policy,
means the AD curve, (AD1) will shift to the right towards (Yf) to (AD2), in turn average
price level (APL) would increase from (P1) to (P2). Hence yield increase in turn there is an
increase in inflationary pressure, as the available factors of production in the economy
are scarce and their prices are bid up.
One of the advantages of MP is that they are flexible as stated in the article. CBs can
easily reverse policies, without political pressure. Which allows CBs to adapt policy
according to economic conditions. However, excessive expansionary MP has negative
consequences because it creates downward pressure on the Chinese currency (RMB).
This is partly because when IR fall, the demand for domestic currency falls with it, in
other words the nominal value of the currency decreases relative to other countries.
In theory lowered IR increases investment. Consumer incentive to invest is increased
because, returns on savings are lessened and the opportunity cost for consumers of an
investment is reduced as it would be more affordable to take a loan. Also a lower interest
rate will usually result in a decrease in mortgage payments for consumers which means
households have more disposable income, increasing money flow in the economy.
However, the effectiveness of MP depend on consumer confidence. Low ir mean that the
expansionary policy employed would be less effective due to market bias. The market
would lean towards a contractionary bias instead. Keynesian economists would argue
that increases in the reserves of commercial banks do not necessarily lead to a multiple
expansion of money flow, as banks might still refuse to lend from reserves. Moreover,
low IR may not necessarily increase investment and consumption expenditure, as the
demand of firms and households may be unresponsive to lowered IR.
Figure 2. Shows the new-classical perspective of the impact of an AD increase in the
short run and long run. Initially, at point (A) the economy is in long run equilibrium at
(Yf), but as AD is increased from (AD1) to (AD2), in the short run the economy
experiences an inflationary gap at the new equilibrium point beyond (Yf), at (Y) point (B).
At point (B), AD has been increased resulting in an increase in real GDP. Consequently,
so does APL from (P) to (P2), because firms are competing for increasingly scarce FoPs
(i.e. capital and labour). Production at point (B) is only possible in the short run as there
are no unutilized resources. New classical economists believe that the economy can only
be in equilibrium at the full employment level of output and therefore, in the long run this
type of policy results in inflation, increasing price to (P3) at the new equilibrium point (C)
at max output (Yf).
The disadvantage of expansionary policies in this case is that rapid growth is
unsustainable, it increases inflation, creates negative externalities. Growth may damage
social welfare and ultimately lead to market failure. There would be increased
consumption of de-merit goods as households have more disposable income, and there
would be an increase in household and industrial waste. Also, China’s high growth rate
means they also face environmental issues in the form of increased pollution and waste
levels. Furthermore, depletion of raw materials hastens.
The slowdown may have been caused by China’s rapid growth, because there is limited
demand in foreign markets, and demand might be stagnating. Growth in China may have
to be absorbed by increases in domestic demand, which might be why China’s Central
Bank (CB) is making use of demand side policies to increase aggregate demand (AD). In
this case Keynesians would argue that the government and CB must find a way to
increase AD components and therefore the policies employed are correct, even though
they induce inflationary pressure.
On the other hand Monetarists argue that the economy is self-righting ‘ceteris parabus’
and should be uninfluenced by the government or CB and will return to equilibrium at
max output, without an increase in inflation. If anything Monetarists would argue to
employ supply side policies to increase AS and yield, as they argue it determines the
long run rate of growth.