Economic/Monetary Policy in China Free Essay

A monetary policy is understood as something that a central bank or government uses to manage liquidity to create economic growth in the country. The autonomous monetary policy, free in-flow and out-flow of capital, and exchange-rate management are not compatible. The objectives of all of them represent a policy trilemma for any central bank or government around the globe since out of these three, only two can be used simultaneously (Aizenman 448). Thus, there is a need to discuss why a country has to choose among the three monetary policy objectives. The example of China is utilized since the Chinese government has adopted independent monetary and exchange-rate management policies.

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Any country has to choose between two of the three monetary policy goals. It represents an impossible trinity or the Mundell-Fleming trilemma. Two of the three policy objectives have to be pursued given that a nation cannot simultaneously guarantee exchange rate stability, have an autonomous monetary policy, and ensure free capital mobility (Rey 6). Thus, the policy trilemma helps in understanding the constraints faced by policymakers in an open economy setting.

To illustrate this, one should suppose that the world interest rate is at seven percent. If the central bank of a particular open economy attempts to set the domestic interest rate at four percent or any rate below seven percent, the home currency would experience depreciation pressure. It is because the country’s investors would most likely purchase the foreign currency that yields higher returns and sell their domestic currency that yields lower returns. Given that a central bank has limited foreign currency reserves, the domestic currency would depreciate as soon as the foreign currency reserves are depleted (Aizenman 450). Therefore, all three policy objectives can’t be pursued at the same time. The case demonstrates that any government around the globe can only choose two out of the three policy objectives.

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Apart from that, assuming that country A is open to foreign capital and decides to fix its exchange rate against the pound sterling of the United Kingdom. If the central bank of country A keeps the interest rates higher than the interest rates in the United Kingdom, foreign capital would flood into country A, thus searching for higher returns. Due to these inflows, demand for country A’s local currency would increase (Weeks 57). In the end, the peg with the pound sterling would break. On the other hand, capital would leave country A and its local currency would fall if its central bank keeps the interest rates lower than the interest rates set by the Bank of England. Thus, again, it proves that only two out of the three monetary goals could be pursued at the same time.

It is worth noting that there are only three policy combination alternatives that a government can choose. Firstly, it entails guaranteeing a stable exchange rate and having an autonomous monetary policy. Thus, there would be no free capital flows with this option, and the government would have to put capital controls in place (Rey 9). Secondly, it entails ensuring free capital flows and having a monetary policy that is completely autonomous. Nonetheless, with this alternative, the stability of the exchange rate cannot be guaranteed. Thirdly, it entails guaranteeing the stability of the exchange rate and free in-flows and out-flows of capital. However, the monetary policy would not be independent given that setting a domestic interest rate that differs from the world interest rate undermines exchange rate stability due to the depreciation or appreciation pressure on the domestic currency. When the exchange rate is pegged to some base country, and free flows of capital are permitted by a central bank, the domestic interest rate would be pinned down by simple interest parity (Weeks 58). In turn, this would force the country’s domestic interest rate to be equivalent to that in the base country.

History has demonstrated that dissimilar global financial systems have tried to attain combinations of two out of three monetary goals. Examples of these international financial systems are the Bretton Woods system and the Gold Standard system. The Bretton Woods system ensures monetary independence as well as stability of the exchange rate. The Gold Standard system guaranteed exchange rate stability and capital mobility. The Gold Standard system, as Frieden pointed out, was integral to the golden era of international economic integration (17). It brought predictability and stability that significantly facilitated international travel, migration, finance, investment, and trade (Frieden 17). Immigrants, investors, and businesspeople did not need to worry about any hindrances to moving money internally, any controls on currencies, or changes in exchange rates.

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Chinese Monetary Policy

China is an example of a country that has been faced with the Mundell-Fleming trilemma. In this Asian nation, the policymakers chose to maintain an independent monetary policy and stabilize the exchange rate. However, for this to work, the policymakers had to impose restrictions on the flow of international capital (Liu 172). China’s policy combination is in contrast to that pursued by the American government which maintains an open capital account and an autonomous monetary policy. Consequently, the Federal Reserve has to permit the value of its currency, the United States dollar (USD), to be determined by the market.

The Chinese government places a high priority on the stability of the exchange rate. It fixes the exchange rate. Since America is its biggest trading partner, the country sets the value of yuan within a 2% range against the USD (Liu 173). China seeks to stabilize the exchange rate and has a weaker currency compared to the dollar to control the prices of its exports and boost exports (Wu 3). Its government wants to ensure that China’s exports are priced reasonably when they are sold in America. The Chinese government has always had an independent monetary policy. The interest-rate policy in China is autonomous since it is free from any outside influences.

Nevertheless, the country imposes firm restrictions on the flows of capital into and out of its borders. Although the Chinese government has utilized various incentives, including tax benefits, in promoting inward foreign direct investment (FDI), external debt, portfolio capital, and other forms of capital inflows are discouraged (Wu 6). Capital controls have protected the banking system in China from the external competition by making it very difficult for capital to flow out of China and by restricting the entry of foreign banks into the nation (Wu 7). Exchange rate stability can result in the stability of prices, as it provides an anchor. It also mitigates uncertainty since it brings a lower risk premium. It consequently serves to encourage international trade as well as investment.


Central banks, governments, and policymakers are faced with the Mundell-Fleming trilemma when making monetary policy decisions. Thus, they can only pursue two since it is impossible to fulfill all three monetary policy goals. If a government wants monetary independence and opts for free capital mobility, it would have to let its local currency float. If the nation permits inflows and outflows of capital but then chooses to fix the exchange rate, it would be impossible for its monetary policy to be autonomous. If a government wishes to have an interest-rate policy that is free from external influence and would like to fix the value of its local currency, it cannot permit free capital flow across its borders. China is an example of a country that has been faced with a policy trilemma. It has fixed the value of the yuan, and its monetary policy is autonomous. However, there are no free capital flows.

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