Monetary policy transmission in China: A DSGE model with parallel shadow banking and interest rate control

By Michael Funke, Petar Mihaylovski and Haibin Zhu

The paper sheds light on the interplay between monetary policy, the commercial banking sector and the shadow banking sector in mainland China by means of a nonlinear stochastic general equilibrium (DSGE) model with occasionally binding constraints. In particular, we analyze the impacts of interest rate liberalization on monetary policy transmission as well as the dynamics of the parallel shadow banking sector. Comparison of various interest rate liberalization scenarios reveals that monetary policy results in increased feed-through to the lending and investment under complete liberalization. Furthermore, tighter regulation of interest rates in the commercial banking sector in China leads to an increase in loans provided by the shadow banking sector.

China is special, and the Chinese financial sector extra-special, with a heavy regulated and nudged official banking sector and an over-sized shadow banking system. How to conduct monetary policy in such an environment is a challenge, and so is understanding how undoing some of the constraints is going to impact all sectors. This paper is a nice attempt at tackling this.


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