Exchange market pressure in OECD and emerging economies: Domestic vs. external factors and capital flows in the old and new normal

Abstract

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. Monetary policy transmission in China: A DSGE model with parallel shadow banking and interest rate control Against this background, our paper addresses the Chinese shadow bank issue and contributes to the literature on modelling parallel shadow banks and interest rate control in micro-founded dynamic stochastic general equilibrium (DSGE) frameworks. Few theoretical analyses exist to guide policymakers in this way. This paper is most closely related and complementary to three recent papers modelling a shadow banking sector, but differs in several respects. Verona et al. (2013) consider a financial accelerator DSGE model for the US economy with investment banks investing in less risky projects while formal retail banks provide funding to riskier firms. They are mainly concerned with the adverse effects of shadow banking for boom-bust events caused by a level of interest rates that is too low for too long. Meeks et al. (2014) are concerned about financial instability due to commercial banks unloading risky loans to off-balance sheet shadow banks via securization. Mazelis (2014) has investigated the impact of monetary policy shocks on aggregate loan supply in a DSGE framework with commercial banks and shadow banks. In contrast to Meeks et al. (2014), Mazelis (2014) does not assume that shadow banks are funded by the commercial banking sector; instead, shadow banks have to acquire deposits from the markets in order to function as intermediaries. The funding market is modelled via search and matching by shadow banks for available deposits of households. Our paper differs from the existing papers in a number of ways. None of the above papers focuses on the multifaceted interactions between nonstandard monetary policy, the traditional banking sector and the shadow banking sector in China. In our DSGE framework, in contrast, we analyze monetary policy transmission with parallel shadow banking and different degrees of interest rate control. This means, as a corollary, that we also investigate the impacts of financial liberalization and regulatory change in China on shadow banking. The remainder of the paper is organized as follows. Section 2 provides a brief overview of shadow banking activities in China: the products, the range of participants, and the reasons behind their rap...

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