Economic reforms and long-run money demand in China: implications for monetary policy.

• Author: Hafer, R.W.

1. Introduction

   Although money demand equations have been estimated for many western countries, only recently have researchers investigated the demand for money in centrally planned economies like China. Chow |7~, who helped pioneer the analysis of Chinese macro data, estimates a simple money demand function derived from the quantity theory. Using annual data from 1952 through 1983, he concludes that the quantity theory "provides a reasonable first approximation in explaining the demand for money in China." |7, 325~ Portes and Santorum |27~ use real and nominal adjustment specifications and test for the homogeneity of money demand with respect to the price level and real income.(1) Feltenstein and Farhadian |11~ estimate a money demand function based on Cagan's |3~ work, and Blejer et al. |1~ estimate an error correction model using data for only the 1980s. Both studies find that the demand for real balances is explained by real income and an opportunity cost measure.

   A common feature of such studies is the use of a standard lagged-adjustment specification to capture the short-run dynamics of money demand. Such dynamic specifications have been the subject of much recent work, the bulk of which suggests that they fail on theoretical and econometric grounds.(2) Another feature is the presumption that a long-run equilibrium relationship underlies the short-run dynamic models being estimated.(3) If such an equilibrium relationship does not exist, attempts to measure the short-run dynamics of a given specification are misdirected.

   The purpose of this study is to determine if there exists a long-run, equilibrium relationship between nominal money balances, real income, prices and interest rates using data for China. We do so by applying the tests for cointegration due to Johansen and Juselius |20~. While most previous applications of such tests to money demand have focused on advanced market economies |15; 18; 20~, this study represents an exploratory attempt to determine if such basic economic forces also hold in centrally planned economies like China. While the limited sample (1952-88) affects the power of our test statistics, the results are informative and provide a basis to which future studies can be compared.

   Our analysis also allows us to consider which monetary measure is preferable in determining the long-run effect of monetary policy actions. Previous work by Portes and Santorum |27~ and Chen |5~, for example, indicates that currency in circulation is preferable to a broader measure. Such conclusions, based on estimates of short-run money demand functions, may not hold when considering the long-term equilibrium relationship. Moreover, the issue of which aggregate to use has become increasingly important in light of continuing economic reforms in China.

   The format of the paper is as follows. Section II provides an overview of economic and financial reforms in China. Section III provides a brief discussion of the cointegration test procedures. A description of the data is in section IV followed by our empirical results in section V. Concluding remarks close the paper in section VI.

2. Reforms

   Economic and financial reforms since the late 1970s in China have brought about major changes in the conduct of Chinese monetary policy.(4) Before the reforms, currency in circulation was considered the nation's money supply since cash was used mainly for transactions between the state and household sectors of the economy. Macroeconomic policy was determined solely by the State Council: Independent monetary policies conducted by a central bank did not exist, and ". . . the role of monetary policy was essentially to support the implementation of the physical output targets contained in the |central~ plan . . ." |1, 12~ The economic reforms emphasized the use of market forces for the allocation of resources.

   The banking system was reformed in order to separate banking functions and create new policy instruments to achieve better control over the economy. In particular, the People's Bank of China (PBC) was created in 1984 with its own monetary policy instruments. The PBC controls the total volume of credit in the economy and works closely with the State Council in making important macroeconomic policy decisions. The commercial aspects of banking are controlled by the Industrial and Commercial Bank of China. Although this bank competes with specialized banks and others established at the province level, the government credit plan continues to influence monetary policy decisions.(5)

   Financial reforms gave state enterprises more freedom in decision-making and permission to retain some of their profits. These earnings were allowed to be put in special time deposit accounts (in the form of trust deposits) and used to finance investment expenditures. Most state enterprises also were allowed for the first time to use checking accounts for many financial transactions |28~. Financial reforms promoted household savings by introducing new financial instruments and services. New institutions were created for this purpose, including credit cooperatives and special savings banks. The role of the specialized savings banks is to raise sufficient funds consistent with the desired investment level set by the State Council. Naughton |23~ observes that these institutional developments brought about a substantial increase in the volume of bank deposits, the greatest growth being in enterprise deposits and urban savings deposits, followed by rural deposits.(6)

   A potential implication of these financial reforms is the increased importance of monetary aggregates in policy decisions. De Wulf and Goldsborough note that ". . . together with the need for greater emphasis on developments in household bank deposits, which are a fairly close substitute for cash, the greater autonomy of enterprises and local governments implies that broader monetary aggregates than household currency holdings should become increasingly important in setting targets for monetary policy . . ." |8, 233~ Thus, China's policy makers must address the choice of currency in circulation (M0) or the broader monetary aggregate that includes savings deposits (M2) in setting policy. In this vein, others have compared the relationship between economic activity and M0 or M2 using a variety of models. Portes and Santorum |27~ use Granger-type causality tests, and Chen |5~ a vector autoregressive (VAR) model to study the empirical link between the monetary aggregates and economic activity. Both studies conclude that currency (M0) is better related to economic activity and, hence, the preferable policy measure. In contrast, Hafer and Kutan |16~ provide support for both M0 and M2 in setting monetary policy. By establishing whether there exists a long-run relationship between either monetary aggregate and income, prices and interest rates, this...