Estimating the money demand function in China : was the Chinese Central Bank targeting too high a monetary growth rate ?

• Main Authors: Chen, Qiancai, Lin, Nanzheng, Zhuo, Xiangyu
• Other Authors: Yip Sau Leung
• Format: Final Year Project
• Language: English
• Published: 2017
• Subjects: DRNTU::Social sciences::Economic development::China
• Online Access: http://hdl.handle.net/10356/70377
• Institution: Nanyang Technological University

This report checks whether the money supply target chosen by the People’s Bank of China (PBoC) over the past twenty years contributed to higher inflation in China. Given that China’s average M2 growth was 17.6%, and China’s average real GDP growth was 9.5% during this period, the answer will depend on the magnitude of the income elasticity of money demand. As such, we estimated the money demand function in China by adopting the Autoregressive Distributed Lag (ARDL) approach with several stability tests to show the existence of a robust long-run cointegration relationship among real M2, real GDP, as well as relative return between money and other assets. Our estimation results show that the income elasticity of money demand in China was 1.42 during the sample period, which implies of 13.5% M2 growth for the 9.5% GDP growth during the sample period. Adding another 2% monetary growth to avoid possible slack in the economy, a 15.5% M2 growth would be more appropriate than the 17.6% M2 growth chosen by the PBoC. With China’s long-term GDP growth falling on the interval from 6.5% to 7.0%, if income elasticity of money demand remains unchanged, this would imply the PBoC should reduce the M2 growth rate to the range from 11.2% to 12%.