Articleidicec.1999.1607,availableonlineathtp://www.idealibrary.comonIdeAl Monetary Growth and Inflation in China A Reexamination T Mohammad s Hasan School of Financial Studies and Law, Sheffield Hallam University, City Campus Pond Street, Sheffield, S 1WB, United Kingdom Received September 24, 1996, revised June 8, 1999 Hasan, Mohammad S -Monetary Growth and Inflation in China: A Reexamination Using the notion of cointegration theory and its implied vector error correction mod- eling strategy, this paper reexamines the relationship between monetary forces and inflation in mainland China. Contrary to most recent research in this area, these results based on unit root and cointegration tests indicate a reliable long-run relationship between the general price level and the money stock, as well as between inflation and mone wth, Our findings also suggest a bi-directional or feedback relationship between inflation and monetary growth. J. Comp. Econ., December 1999, 27 (4), pp. 669-685 School of Financial Studies and Law, Sheffield Hallam University, City Campus, Pond Street, Sheffield, SI IWB, United Kingdom. 0 1999 Academic Press Journal of Economic Literature Classification Numbers: P24, P52, Oll L INTRODUCTION The nature of the relationship between monetary aggregates and inflation in mainland China has been the subject of ongoing debate among researchers. Chow (1987) contends that the quantity theory of money appears to be a plausible explanation of the inflationary process in China over the period 1952-1983. In contrast, Peebles(1992), while recognizing the institutional differences of the Chinese economy from other highly developed market economies, argues that the quantity theory is no help in understanding the historical association between money and prices in China. The situation became more clouded when Huang (1995)reported that monetary forces explain price movements in China in the The author thanks John Bonin and two anonymous referees for providing useful criticisms and Press All rights of reproduction in any form reserved
Monetary Growth and Inflation in China: A Reexamination1 Mohammad S. Hasan School of Financial Studies and Law, Sheffield Hallam University, City Campus, Pond Street, Sheffield, S1 1WB, United Kingdom E-mail: m.s.hasan@shu.ac.uk Received September 24, 1996; revised June 8, 1999 Hasan, Mohammad S.—Monetary Growth and Inflation in China: A Reexamination Using the notion of cointegration theory and its implied vector error correction modeling strategy, this paper reexamines the relationship between monetary forces and inflation in mainland China. Contrary to most recent research in this area, these results based on unit root and cointegration tests indicate a reliable long-run relationship between the general price level and the money stock, as well as between inflation and monetary growth. Our findings also suggest a bi-directional or feedback relationship between inflation and monetary growth. J. Comp. Econ., December 1999, 27(4), pp. 669–685. School of Financial Studies and Law, Sheffield Hallam University, City Campus, Pond Street, Sheffield, S1 1WB, United Kingdom. © 1999 Academic Press Journal of Economic Literature Classification Numbers: P24, P52, O11. 1. INTRODUCTION The nature of the relationship between monetary aggregates and inflation in mainland China has been the subject of ongoing debate among researchers. Chow (1987) contends that the quantity theory of money appears to be a plausible explanation of the inflationary process in China over the period 1952–1983. In contrast, Peebles (1992), while recognizing the institutional differences of the Chinese economy from other highly developed market economies, argues that the quantity theory is no help in understanding the historical association between money and prices in China. The situation became more clouded when Huang (1995) reported that monetary forces explain price movements in China in the 1 The author thanks John Bonin and two anonymous referees for providing useful criticisms and suggestions. Journal of Comparative Economics 27, 669–685 (1999) Article ID jcec.1999.1607, available online at http://www.idealibrary.com on 669 0147-5967/99 $30.00 Copyright © 1999 by Academic Press All rights of reproduction in any form reserved
MOHAMMAD S HASAN prereform perio reform economy. In contrast, the empirical work of Blejer et al. (1991)on the demand function in the m documents the existence of a relatively stable relationship between a range of regates, inflation, and real lr v After its inception, the Chinese economy experienced relative price stabilit more than 30 years. Following the economic reform in 1979, price increases remained a substantial and common phenomena almost throughout the 1980s and mid-1990s. Inflationary pressure rose to its first postreform peak of 6%per annum in 1980: in the second half of the 1980s. inflation continued to accelerate and reached double digits with a peak of 18.5% in 1989. Inflationary pressure subsided concurrent with faltering growth for the next three years. But ar inflationary upsurge again hit the economy in 1992 and reached its historical apex of 21.7% in 1995 as fast real growth resumed, e.g., 13.5% in 1994 Contemporaneously, the stock of broad money increased by 268% during the period from 1979 to 1985. Broad money rose by 30% in 1992 and at a similar rate in 1993, narrow money and currency in circulation were growing at a rate of% and 46%, respectively, by the end of the first quarter of 1993( Harrold and Lall 1993). Although reserve requirement, credit ceiling, variable interest rates, and other administrative levers have been introduced to control monetary and credit aggregates in the postreform period, their role and effectiveness were problem atic. The postreform economy has experienced insufficient control over monetary and credit aggregates. The activities of nonbank financial institutions(NBFls) and disintermediation have loosened the link between the credit plan and mon- etary aggregates. Unbridled monetary growth in the postreform period was blamed as an important contributor to this inflationary upsurge The aim of this paper is to delineate both the short-run and long-run monetary dynamics of inflation in the Chinese economy. This approach has significant differences from others both theoretically and methodologically, First, this study adopts the theoretical framework of a conventional monetarist model( Chen 1989, Chow, 1987; Huang, 1995)but extends the analysis by incorporating a more general model of inflation to capture the institutional features of the Chinese economy. Second, the study uses the cointegration ogy with However, the exception applies during the period of the Great Leap Forward(1958-1961)when infiation achieved a peak of 16. 2% Harrold and Lall (1993)have noted that the postreform credit explosion outside the credit plan as induced by diversion of funds from the specialized banks to a variety of fast growing NFBls and into the direct hands of enterprises through the interbank market See, for example, Country Profile: China Mongolia, The Economic Intelligence Unit, 1994-1995, p. 17. The country report also suggests that the government often had to resort to printing noney to cover the budget deficit as selling treasury bonds to state employees through paro deductions became an unpopular practice
prereform period reasonably while they have no predictive content in the postreform economy. In contrast, the empirical work of Blejer et al. (1991) on the money demand function in the postreform period from 1983QI to 1988QIII documents the existence of a relatively stable relationship between a range of monetary aggregates, inflation, and real income. After its inception, the Chinese economy experienced relative price stability for more than 30 years.2 Following the economic reform in 1979, price increases remained a substantial and common phenomena almost throughout the 1980s and mid-1990s. Inflationary pressure rose to its first postreform peak of 6% per annum in 1980; in the second half of the 1980s, inflation continued to accelerate and reached double digits with a peak of 18.5% in 1989. Inflationary pressure subsided concurrent with faltering growth for the next three years. But an inflationary upsurge again hit the economy in 1992 and reached its historical apex of 21.7% in 1995 as fast real growth resumed, e.g., 13.5% in 1994. Contemporaneously, the stock of broad money increased by 268% during the period from 1979 to 1985. Broad money rose by 30% in 1992 and at a similar rate in 1993; narrow money and currency in circulation were growing at a rate of 41% and 46%, respectively, by the end of the first quarter of 1993 (Harrold and Lall, 1993). Although reserve requirement, credit ceiling, variable interest rates, and other administrative levers have been introduced to control monetary and credit aggregates in the postreform period, their role and effectiveness were problematic. The postreform economy has experienced insufficient control over monetary and credit aggregates. The activities of nonbank financial institutions (NBFIs) and disintermediation have loosened the link between the credit plan and monetary aggregates.3 Unbridled monetary growth in the postreform period was blamed as an important contributor to this inflationary upsurge.4 The aim of this paper is to delineate both the short-run and long-run monetary dynamics of inflation in the Chinese economy. This approach has significant differences from others both theoretically and methodologically. First, this study adopts the theoretical framework of a conventional monetarist model (Chen, 1989; Chow, 1987; Huang, 1995) but extends the analysis by incorporating a more general model of inflation to capture the institutional features of the Chinese economy. Second, the study uses the cointegration methodology with an 2 However, the exception applies during the period of the Great Leap Forward (1958–1961) when inflation achieved a peak of 16.2%. 3 Harrold and Lall (1993) have noted that the postreform credit explosion outside the credit plan was induced by diversion of funds from the specialized banks to a variety of fast growing NFBIs and into the direct hands of enterprises through the interbank market. 4 See, for example, Country Profile: China Mongolia, The Economic Intelligence Unit, 1994–1995, p. 17. The country report also suggests that the government often had to resort to printing money to cover the budget deficit as selling treasury bonds to state employees through payroll deductions became an unpopular practice. 670 MOHAMMAD S. HASAN
MONEY AND INFLATION N CHINA 671 error correction model(ECm) to identify short-run and long-run interdependen cies and the causal linkage between prices and money stock. This approach avoids the spurious regression problem and offers a parsimonious time series approach based on a more general inflation model with a rich dynamic structure Third, it is a well known fact that the official price indices in China do not provide a proper yardstick for measuring the overall extent and character of inflation due to inflationary repression over a long period of time. Previous studies concerning the money-price relationship have focused on the official price indices(Chow, 1987; Huang, 1995). In contrast, we use a measure of the true price index to explore an otherwise hidden relationship between money and prices. Despite the institutional differences between the Chinese economy and other Western market economies, the statistical techniques, when supplemented with the true price index, unravel the monetary dynamics of the inflationary process in China The paper is organized as follows. Section 2 presents a more general model designed to estimate the monetary dynamics of inflation and discuss the institu- tional issues in China that affect the application of the monetarists'modeling strategy. Sections 3 and 4 present the estimates, while the final section offers a 2. THE MODEL We start with a simple and transparent quantity theory model to explain the monetary dynamics of inflation in China. Irving Fishers(1911)celebrated quantity equation of exchange was responsible for assigning monetary forces the principal role in the determination of the price level where M,v, P, and y are the quantity of money, the income velocity, the price level, and real income, respectively. Classical, monetarist, and new classical economists invoke several assumptions to convert this simple identity to rticulated theory. The classical assumptions of full employment equilibrium fully flexible price and wages, Friedman's statement of the natural rate of unemployment, and the rational expectation hypothesis of the New Classical economists characterize a time path where long-run monetary growth only determines the rate of inflation. If we interpret the quantity theory as a long-run equilibrium and supplement it with a short-run error correction mechanism obtain a dynamic path of the inflation rate that cannot deviate too far from the path of long-run solution values. More specifically, combining the notion of tegration and the error correction mechanism, we specify the following del to capture the dynamic essence of the inflation rate
error correction model (ECM) to identify short-run and long-run interdependencies and the causal linkage between prices and money stock. This approach avoids the spurious regression problem and offers a parsimonious time series approach based on a more general inflation model with a rich dynamic structure. Third, it is a well known fact that the official price indices in China do not provide a proper yardstick for measuring the overall extent and character of inflation due to inflationary repression over a long period of time. Previous studies concerning the money–price relationship have focused on the official price indices (Chow, 1987; Huang, 1995). In contrast, we use a measure of the true price index to explore an otherwise hidden relationship between money and prices. Despite the institutional differences between the Chinese economy and other Western market economies, the statistical techniques, when supplemented with the true price index, unravel the monetary dynamics of the inflationary process in China. The paper is organized as follows. Section 2 presents a more general model designed to estimate the monetary dynamics of inflation and discuss the institutional issues in China that affect the application of the monetarists’ modeling strategy. Sections 3 and 4 present the estimates, while the final section offers a summary and conclusion. 2. THE MODEL We start with a simple and transparent quantity theory model to explain the monetary dynamics of inflation in China. Irving Fisher’s (1911) celebrated quantity equation of exchange was responsible for assigning monetary forces the principal role in the determination of the price level, MV 5 PY, (1) where M, V, P, and Y are the quantity of money, the income velocity, the price level, and real income, respectively. Classical, monetarist, and new classical economists invoke several assumptions to convert this simple identity to an articulated theory. The classical assumptions of full employment equilibrium, fully flexible price and wages, Friedman’s statement of the natural rate of unemployment, and the rational expectation hypothesis of the New Classical economists characterize a time path where long-run monetary growth only determines the rate of inflation. If we interpret the quantity theory as a long-run equilibrium and supplement it with a short-run error correction mechanism, we obtain a dynamic path of the inflation rate that cannot deviate too far from the path of long-run solution values. More specifically, combining the notion of cointegration and the error correction mechanism, we specify the following model to capture the dynamic essence of the inflation rate, MONEY AND INFLATION IN CHINA 671
MOHAMMAD S HASAN P=0o+a,M,+ a2V,,+ Er △P,= ∑n△-,+v where the growth rates of real output, money, and income velocity are assumed to be exogenously determined at time period t and E, is an identically and independently distributed error term. Equation (2) is the cointegration regression and depicts the equilibrium relationship; Eq. ( 3)is the error correction equation and describes the process of adjustment to equilibrium, with Er-I being the equilibrium error of the previous period The application of quantity theory models of inflation to a developing semi monetized economy is a somewhat controversial issue. However, Chow (1987) and Duck(1993) provide good justifications for using such models in a devel oping country, while Chow(1987) has estimated a variant of a quantity theory model for the Chinese economy. In order to alleviate the problem of omitted variable bias, we specify a general model of inflation that subsumes the aggregate demand and supply factors, as well as monetary forces(Darrat, 1994; Gordon 1982; Huang,1995).Let P1=δ+81(L)M1+82(Lg1+63(LW1+δ4(LAP1+85(LIP4+Ep,(4) where the right-hand variables are the money stock(M), economywide excess demand pressure proxied by the output gap(g), wages(), agricultural pro- ductivity(AP), and a measure of industrial productivity (IP). The 8()s are lag polynomials in the lag operator and st is a serially independent error with zero mean. Equation (4)is s-curve inflation equation augmented by the inclusion of supply-side factors(Gordon, 1982) If inflation and the right-hand variables, such as growth of monetary aggregates are cointegrated, P is proportional to M from a statistical point of view. If the variables are cointegrated, the next test seeks to ascertain whether the coefficient of E-I in Eq. (3)or the coeficient of s-l in a similar error correction equation is negative and statistically significant so as to specify the short-run dynamics of the system. Granger(1988) has shown that finding cointegration also implies the pres- ence of Granger causality between cointegrated variables, at least in one direction Several institutional issues affect the mechanical application of the quantity eory as well as the general modeling strategy and deserve discussion. First over a long period of time, retail price growth in China was slowed or even halted by administrative price controls, usually accompanied by administrative wage controls. In the postreform period, price liberalization progressed in a piecemeal fashion and with considerable delays. Previous research has attempted to mea- sure the extent and character of true inflationary or deflationary pressure in the economy( Chen and Hou, 1986, Feltenstein and Farhadian, 1987, Feltenstein and
Pt 5 a0 1 a1Mt 1 a2Vt 2 a3Yt 1 «t (2) DPt 5 2g«t21 1 O i51 s di DMt2s 1 O i51 s bi DVt2s 2 O i51 s hi DYt2s 1 vt, (3) where the growth rates of real output, money, and income velocity are assumed to be exogenously determined at time period t and «t is an identically and independently distributed error term. Equation (2) is the cointegration regression and depicts the equilibrium relationship; Eq. (3) is the error correction equation and describes the process of adjustment to equilibrium, with «t21 being the equilibrium error of the previous period. The application of quantity theory models of inflation to a developing semimonetized economy is a somewhat controversial issue. However, Chow (1987) and Duck (1993) provide good justifications for using such models in a developing country, while Chow (1987) has estimated a variant of a quantity theory model for the Chinese economy. In order to alleviate the problem of omitted variable bias, we specify a general model of inflation that subsumes the aggregate demand and supply factors, as well as monetary forces (Darrat, 1994; Gordon, 1982; Huang, 1995). Let Pt 5 d0 1 d1~L! Mt 1 d2~L! gt 1 d3~L!Wt 1 d4~L!APt 1 d5~L!IPt 1 jt, (4) where the right-hand variables are the money stock (M), economywide excess demand pressure proxied by the output gap ( g), wages (W), agricultural productivity (AP), and a measure of industrial productivity (IP). The d(L)s are lag polynomials in the lag operator and jt is a serially independent error with zero mean. Equation (4) is a Phillips-curve inflation equation augmented by the inclusion of supply-side factors (Gordon, 1982). If inflation and the right-hand variables, such as growth of monetary aggregates are cointegrated, P is proportional to M from a statistical point of view. If the variables are cointegrated, the next test seeks to ascertain whether the coefficient of «t21 in Eq. (3) or the coefficient of jt21 in a similar error correction equation is negative and statistically significant so as to specify the short-run dynamics of the system. Granger (1988) has shown that finding cointegration also implies the presence of Granger causality between cointegrated variables, at least in one direction. Several institutional issues affect the mechanical application of the quantity theory as well as the general modeling strategy and deserve discussion. First, over a long period of time, retail price growth in China was slowed or even halted by administrative price controls, usually accompanied by administrative wage controls. In the postreform period, price liberalization progressed in a piecemeal fashion and with considerable delays. Previous research has attempted to measure the extent and character of true inflationary or deflationary pressure in the economy (Chen and Hou, 1986; Feltenstein and Farhadian, 1987; Feltenstein and 672 MOHAMMAD S. HASAN
MONEY AND INFLATION N CHINA Ha, 1991). However, Feltenstein and Ha(1991)develop a measure of the true price index in China from a money demand function and this performed better in a simulation exercise. Li and Leung(1994) have updated the annual data based on this approach. We use their measure of the price index to avoid the measurement problem of price and inflation encountered in the empirical work in China. Second, the assumption of exogeneity of monetary aggregates, Mo or M3,in a reforming centrally planned economy is important in the quantity theory analysis Considering the importance of the state enterprise borrowing requirement, the nonstate enterprise borrowing requirement, and the public sector borrowing requirement in the money supply process, most studies recognize explicitly the endogeneity of money with respect to income(Chen, 1989; Gong, 1986; Li and Leung, 1994; Portes and Santorum, 1987). In contrast, Blejer et al.(1991) recommended the use of broader monetary aggregates as more suitable interme- diate targets of monetary policy. In a recent study, Hasan and Taghavi(1996) found a feedback relationship between the narrow money stock(Mo) and real income while the broad money stock(M,) is statistically exogenous in the information set that contains the money stock, price, real income, and the real interest rate. However, if we consider the fact that the cash and credit plans are assembled principally by the Peoples Bank of China(PBC)and the State Planning Commission(SPC), and the original versions of both or any modifi cations during the year have to be approved by the State Council, control of the money supply by the central authority enhances its exogenous characteristics Indeed, the central authorities in China set monetary growth to maintain price money stock, M,, as a proxy variable of m prefer to use a measure c S Feltenstein and Ha( 1991) proposed constructing a true price index on the basis of the equations logP=logP+alog(M/PR)0≤a≤1 m5-m5-1=B(mr-m-1)0≤B≤1 where Pr is the true price, P is the official retail price, R is the real volume of consumer retail sales, and M2 is the stock of currency plus household bank deposits. The true rate of infation is given by T,- log Pr-- where Ti denotes the expected rate of infiation in the true price index. a and B are parameters of repressed inflation and expectation adjustment, respectively. The first equation relates the true price index to the official price level and an index of monetary overhang Feltenstein and Ha(1991) hypothesized that if a= 0, the true and official rates of inflation would be equal. On the other hand, a= I implies that a 10% increase in the ratio of money to retail sales will cause the true rate of inflation to be 10%. The second equation hypothesized that inflationary expectations follow an adaptive pattern in which the change in the expected value of the true rate of inflation is proportional to the deviation between actual and expected inflation in the last period Feltenstein and Ha(1991)suggest a simultaneous search process to find the optimal values of a and B using a log-likelihood criterion that maximizes the log-likelihood function. Li and Leung(1994) found the values of a and B to be 0.49 and 0.61, respectively. Using these parameter values and yearly data over the period from 1952 to 1989, they generated a true price index b Under the traditional central planning model, the amount of currency in circulation, in the economy, Mo, was viewed as the principal determinant of inflation(Chow, 1987; Portes and
Ha, 1991). However, Feltenstein and Ha (1991) develop a measure of the true price index in China from a money demand function and this performed better in a simulation exercise. Li and Leung (1994) have updated the annual data based on this approach.5 We use their measure of the price index to avoid the measurement problem of price and inflation encountered in the empirical work in China. Second, the assumption of exogeneity of monetary aggregates, M0 or M3, in a reforming centrally planned economy is important in the quantity theory analysis. Considering the importance of the state enterprise borrowing requirement, the nonstate enterprise borrowing requirement, and the public sector borrowing requirement in the money supply process, most studies recognize explicitly the endogeneity of money with respect to income (Chen, 1989; Gong, 1986; Li and Leung, 1994; Portes and Santorum, 1987). In contrast, Blejer et al. (1991) recommended the use of broader monetary aggregates as more suitable intermediate targets of monetary policy. In a recent study, Hasan and Taghavi (1996) found a feedback relationship between the narrow money stock (M0) and real income while the broad money stock (M3) is statistically exogenous in the information set that contains the money stock, price, real income, and the real interest rate. However, if we consider the fact that the cash and credit plans are assembled principally by the People’s Bank of China (PBC) and the State Planning Commission (SPC), and the original versions of both or any modifi- cations during the year have to be approved by the State Council, control of the money supply by the central authority enhances its exogenous characteristics. Indeed, the central authorities in China set monetary growth to maintain price stability (Chen, 1989). Given these facts, we prefer to use a measure of the broad money stock, M3, as a proxy variable of monetary aggregates.6 5 Feltenstein and Ha (1991) proposed constructing a true price index on the basis of the equations logPT 5 logP 1 alog~M2/PR! 0 # a # 1 p T e 2 p T21 e 5 b~pT 2 p T21 e ! 0 # b # 1, where PT is the true price, P is the official retail price, R is the real volume of consumer retail sales, and M2 is the stock of currency plus household bank deposits. The true rate of inflation is given by pt 5 log PT 2 logPT21 where pT e denotes the expected rate of inflation in the true price index. a and b are parameters of repressed inflation and expectation adjustment, respectively. The first equation relates the true price index to the official price level and an index of monetary overhang. Feltenstein and Ha (1991) hypothesized that if a 5 0, the true and official rates of inflation would be equal. On the other hand, a 5 1 implies that a 10% increase in the ratio of money to retail sales will cause the true rate of inflation to be 10%. The second equation hypothesized that inflationary expectations follow an adaptive pattern in which the change in the expected value of the true rate of inflation is proportional to the deviation between actual and expected inflation in the last period. Feltenstein and Ha (1991) suggest a simultaneous search process to find the optimal values of a and b using a log-likelihood criterion that maximizes the log-likelihood function. Li and Leung (1994) found the values of a and b to be 0.49 and 0.61, respectively. Using these parameter values and yearly data over the period from 1952 to 1989, they generated a true price index. 6 Under the traditional central planning model, the amount of currency in circulation, in the economy, M0, was viewed as the principal determinant of inflation (Chow, 1987; Portes and MONEY AND INFLATION IN CHINA 673