Empirical analysis on China’s money, income and

inflation: 1979 - 2004

Yanqun Zhang ∗
Institute of Statistics and Econometrics
Free University, Berlin

May 17, 2006

Abstract

This paper aims to analyze and assess China’s monetary policy.

Macroeconomic variables such as money aggregate, income, inflation
and interest rate are empirically analyzed as a system. Vector error
correction (VEC) model and structural VAR (SVAR) model are app-
lied as the statistical instruments. The empirical models are estimated
with quarterly and seasonally unadjusted data for the period from
1979Q1 to 2004Q4, which began from the China’s economic reforms
until the latest data are available for this study. A regime shift has
been detected at round 1995:1. The empirical models are therefore
constructed based on two sub-samples and for two definition of money,
M1 and M2. The cointegration relations between money stock, income,
inflation and interest rate, as well as the corresponding short-run dy-
namic adjustments are analyzed. In addition, the information derived
from the moving average (MA) representations are used to identify the
common stochastic trends and long-run impacts. Finally, impulse re-
sponse analysis are conducted to trace the effects of monetary shocks
hitting the system.
∗
The author is an associate researcher of the Institute of Quantitative and Technical
Economics, Chinese Academy of Social Sciences, Beijng, China, and a Ph.D. candidate in
the Free University of Berlin, Germany during 2002-2006.

1
1 Introduction

In this paper, we empirically analyze macroeconomic variables in China such

as money, income, inflation and interest rate as a system. The purposes
of the empirical analysis are to identify the existence of the steady-state
relations between money stock, income, inflation and interest rate, and to
investigate interactions within the system. In particular, we will assess the
effects of China’s monetary policy on inflation and real income.
Cointegrated VAR and structural VAR (SVAR) models are applied in the
empirical investigation. The statistical models are estimated with quarterly
and seasonally unadjusted data for the period from 1979Q1 to 2004Q4, which
began from the China’s economic reforms until the latest data are available
for this study.
During the sample period, the Chinese economy is in a process of tran-
sition from a centrally planned to a market economy. With the reforms,
the macroeconomic environment, the banking system, monetary targets and
policy instruments all have undergone significant changes. Under these cir-
cumstances, it is necessary to examine possible regime shifts in the model.
Pre-test have identified a structural shift of the system occurring around
1995. Consequently the empirical analysis is conducted for two separate
sample periods of before and after 1995.
Since 1998, the People’s Bank of China (PBC) has officially changed the
intermediate targets of the monetary policy from total credit quotas and
currency in circulation (M0) to money supply. There are two measurements
of broad money in China, namely M1 and M2. Since 1995, the movements
of M1 and M2 have displayed divergent patterns. The PBC nevertheless
has never explicitly specified which measure of broad money to be the in-
termediate target. According to the PBC’s criteria for the selection of an
intermediate target, an intermediate target for monetary policy should be
measurable, controllable and has close correlations with the ultimate policy
goals, i.e., controlling inflation and promotion of economic growth. Against
this backdrop, the empirical analysis will model M1 and M2 separately. By
means of this modelling strategy, the controllability of M1 and M2 and their
relationships to inflation and real growth can be examined, respectively.
In the present study, four models are constructed. These are models for
M1, M2 for two separate sample periods. For each model, we first investigate
the existence of cointegration relations between money supply, real GDP,

2
inflation and the interest rate. Then, the short run dynamics within the
long-run cointegration system will be examined to probe the monetary policy
effects on inflation and real economic growth, along with the interactions and
feedbacks within the VAR system.
For a better understanding of the effects of monetary policy, it is ne-
cessary to further analyze the useful information derived from the moving
average (MA) representation of the VAR model. By means of identifying
the common stochastic trends and analyzing the long-run impact matrices,
the driving and pulling forces of the economic system are to be inspected. In
addition, it is of interest to analyze how the monetary shocks affect the eco-
nomic system. The impulse response analysis obtained from the structural
VEC model is conducted with identified shocks.
The structure of the rest of this chapter is as follows. Section 2 is about
the research motivation. In section 3 the exiting literature is reviewed. In
section 4 we discuss the relevant economic theories. Section 5 is about data
description and preliminary analysis. In section 6 we estimate the models in
the full sample period and test the potential structural shifts. In section 7
at first models in the two split sub sample periods are estimated. Then we
check model specification and determines the cointegration ranks. In section
8 the single stationary relations are tested. Section 9 is about identifying the
long-run structure. Section 10 is about identifying the short-run structure.
In section 11 we analyze the impulse response functions based on a Chole-
ski decomposition. In section 12 we conduct long-run impact analysis. In
section 13 impulse response functions for transitory and permanent shocks
are analyzed. In section 14 a summary and conclusions are presented.

2 Motivation

In this section we first briefly summarize the main changes in China’s mone-
tary policy goals, intermediate targets and operational instruments. Then
we highlight the policy debate on Chinese monetary policy, against which
we set out the institutional background of the current research.

2.1 Evolution of China’s monetary policy: 1979-2004

In contrast to its passive role in the pre-reform period, Chinese monetary

policy in the reform years has been deployed as a major policy tool for

3
controlling inflation and stabilizing the economy. As a consequence, the
monetary objectives, intermediate targets and operational instruments of
the monetary policy have undergone changes.
From 1984 when the PBC was formally set up unite 1994, China’s mo-
netary policy was commissioned to achieve multiple objectives, namely sti-
mulation of economic growth, adjustment of the economic structure and
stabilization of the value of China’s currency. During this period, currencies
in circulation and total credit size have been used as the main intermediate
targets for the monetary policy. Credit quotas and cash plans were the main
policy instruments for the government to manage total demand.
With economic transition, Chinese monetary policy that relied on direct
and administrative orders became increasingly ineffective in achieving mo-
netary goals, especially in controlling inflation. The high inflation in 1993
proved that the total credit size was not a suitable intermediate target. Alt-
hough the total credit size did not exceed the planned target as set in the
credit plan, inflation ran out of control. On the other hand, the money
supply grew very fast at the time, which caused investment overheating and
a two-digit inflation rate in 1993 and 1994. In 1996, the PBC formally used
the money supply instead of the credit quotas as the intermediate target
for monetary policy. In 1998, total credit size as a policy instrument for
controlling aggregate money supply was finally abandoned.
Along with changes in the intermediate target, the PBC has also tur-
ned to indirect and more market-oriented instruments, such as open market
operations, interest rate policy, required reserves, and window guidance, etc.
The Law of People’s Bank of China issued in 1995 specifies that the
goal of the monetary policy is to ensure the stability of the value of the
Chinese currency hereby to promote economic growth. This implies that
price stability is the primary goal of monetary policy.

2.2 Debates on China’s Monetary Policy

Debate 1: Which measurement of money supply should be used as the

intermediate target, M1 or M2?
Since 1996, money supply has been formally announced by the PBC
as the intermediate target for the monetary policy. But the PBC has not
explicitly specified which measurement of money supply, i.e. M1 or M2,

4
is the intermediate target, despite the fact that the velocity and supply
conditions of M1 and M2 are quite different. The PBC has published the
money supply plan for the target growth of M0, M1, M2, and total loans at
the beginning of each year since 1994. Dai (2002), who was then director
of the monetary policy department of the Chinese central bank, pointed
out that PBC’s intermediate target actually included a group of variables
including M0, M1, M2 and total loans. Among them, M1 is mainly related
to temporary price hikes and the short-run growth rate of GDP, while M2
is more related to that of the long-run inflation and economic growth (Dai,
2002).
Debate 2: Can the PBC control money supply?
Table 1 shows the targeted and realized growth rates of money supply
and inflation rate. From 1994 when the PBC started publication of the
target growth rates for money supply to 2004, the realized growth of M1
missed the target rate in seven years and M2 in five years, by a margin of
more than 2.5% for both measurements. Only in three years, the discrepancy
between the realized and target growth rates of both M1 and M2 were less
than 2%
The foundation for the PBC’s calculating the planned targets was the
quantity theory:
M ∗V =P ∗Q

where M is the total amount of money in circulation in an economy, V is

the velocity of money, P is the average price level, and Q is the total number
of items purchased with the particular kind of money represented by M .
The PBC’s planed growth rates of both narrow and broad money supply
were based on the predicted GDP growth rates and the inflation rates. The
target growth rate of money supply was then calculated as the sum of the
two rates minus changes of velocity of money aggregates. Because velocity of
money stock is hardly a constant but displays an upward trend, the average
velocity of the recent three years is taken as the predicted velocity (Monetary
Police Report 2000, PBC, 2001; Dai, 2002).
Reasons for PBC’s poor record in accomplishing money supply targets
are several. One is the fact that money supply is endogenously determined
within the economic system, which makes the PBC incapable of fulfilling the
plan of the money supply target. Another reason could be that, in practice,
the PBC does not adjust the money supply to the planned targets. Xia

5
 Table 1: Targeted and actual monetary policy objectives: 1994-2004
Year M1 (%) M2 (%) inflation (%)
Target Actual Target Actual Actual
1994 21 26.2 24 34.5 24.1
1995 21-23 16.8 23-25 29.5 17.1
1996 18 18.9 25 25.3 8.3
1997 18 16.5 23 17.3 2.8
1998 17 11.9 16-18 15.3 -2.6
1999 14 17.7 14-15 14.7 -1.4
2000 15-17 16 14-15 12.3 0.4
2001 13-14 12.7 15-16 14.4 0.7
2002 13 16.8 13 16.8 -0.8
2003 16 18.7 16 19.6 1.2
2004 17 13.6 17 14.6 3.9

Note:
1. The inflation rate is based on consumer price index.
2. Source: China Financial Yearbook, various issues.

and Liao (2002) pointed out that it seems that in actual monetary policy
operations, the PBC did not adjust money supply strictly according to the
planned targets.
This motivates the current study to systematically investigate the rela-
tions between real output, money supply, and inflation in China, which has
not been adequately discussed in the literature. Xie (2002), who was the
director of the PBC’s research division, acknowledges that there is hardly
any research that systemically investigates the relationship between Chinese
economic growth, money supply and inflation, and therefore it is questiona-
ble to use the formula that calculates the target money supply on the basis
of the predicted growth rates of GDP and target inflation rates. For the
same reason, it is debatable about the PBC’s use of money supply as the
intermediate target for monetary policy (Xie, 2002).

6
2.3 Propositions examined in the empirical analysis

The current empirical study will investigate the cointegration relations and
the shout-run dynamics of the money stock and other relevant economic
variables, in order to understand the following fundamental issues that are
relevant in understanding the foundation of China’s monetary policy.
As we have explained at the beginning of this section, after about 1995
monetary policy has undergone changes in terms of policy goals, interme-
diate targets, and instruments. In addition, the stance of monetary policy
has changed from controlling inflation to dealing with deflation and unem-
ployment. These changes suggest there could be a structural shift in the
model.
Therefore in the current research we will first examine:
1. Is there any structural break in the system? If the answer is yes,
we will split the whole sample into two sub-samples, i.e. before and after
the structural break, and construct models for the two periods separately.
Because of the different movements of M1 and M2, we also need to model
M1 and M2, respectively.
2. Whether in China there exists a long run relationship between money
stock and other macroeconomic variables in the system under examination?
This long run relationship can be interpreted as a money demand or supply
equation.
3. What are the responses of monetary aggregates, economic growth,
inflation and other macroeconomic variables to ”excess money”? Or in other
words, whether the excess money can stimulate real growth and increase
inflation in the long-run and short-run?
4. Is the money stock determined by money supply or demand?
5. How do real output and inflation respond to monetary shocks?
Because a structural break around 1995 has been identified in our model,
we have modelled M1 and M2 in two separate periods. By examining the
similarities and dissimilarities of the determination of inflation and the two
measures of money stocks in the two periods, we try to answer this question:
6. Which one should be taken as the intermediate target for China’s
monetary policy, M1 or M2?

7
3 Review of the Literature

In contrast to the large volume of empirical studies on money demand and

the monetary transmission mechanism in industrial countries (Lütkepohl
and Wolters, 1999a), the empirical analysis of Chinese money demand func-
tions or monetary transmission mechanisms is scant. The existing studies
include Yi (1993), Hafer and Kutan (1994), Huang (1994), Qin(1994), Gi-
rardin(1996), Chen (1997), Xu(1998), Qin, et al. (2004), Zhang and Wan
(2004), Chow and Shen (2004), etc.

3.1 Main findings of the Literature

Against the backdrop of China’s economic transition, some of the studies

have devoted to defining the institutional variables representative of China’s
reforms and the marketization process. Yi (1993) points out that the mone-
tization process, accompanied by rapid income increase of both individuals
and enterprise, is an important institutional variable. He uses the share of
urban population in total population as a proxy for the monetization pro-
cess. When this monetization proxy is included in the estimation of the
money demand function, the model’s explanatory ability is considerably en-
hanced. Qin (1994) chooses two institutional proxies to reflect the reform
process. With these institutional variables in the model, Qin finds that the
long run income elasticity of money demand in China is close to unit, which
is lower than what has been suggested in prior empirical research. This in-
dicates the existence of a long run equilibrium relationship between money
demand and other macroeconomic variables in China.
Most of the empirical analyses apply an error-correction model in their
econometric formulations. Some of them use single equation error-correction
models which follow the methodology of Engle and Granger (1987), others
draw on vector error-correction models which follow the maximum likelihood
method of Johansen (1995). Some models are based on quarterly data from
1978 when China started economic reforms (Qin, 1994, Huang, 1994, Girar-
din, 1996, and Chow and Shen, 2004), while in other models, annual data
are employed and the sample period starts with the beginning of the 1950s
when the People’s Republic China was just established (Yi (1994), Chen
(1997), Zhang and Wan (2004), and Chow and Shen (2004)).
The aforementioned empirical research have reached a similar conclusion

8
that, in spite of considerable economic changes during the reform years, a
relatively stable relationship of money demand can be found in China.

3.2 Main Problems and Shortcomings of Previous Research

Although prior work has made valuable contributions to the understan-

ding of the relationship between monetary variables, output and inflation in
China, problems and shortcomings do exist.
1. Most of these empirical analyses are based on single equation estima-
tion, which implicitly assumes that monetary aggregate is an endogenous
variable while other macroeconomic variables are weakly exogenous. Howe-
ver, rarely any proper statistic test were conducted in previous research to
justify this assumption. The only exception is Giradin (1996), which tests
for weak exogeneity using a multiple cointegration technique, but the sample
period from 1988-1993 in his model is rather short. The assumption that
there is only one cointegration relation among monetary variables, income
and inflation is not consistent with theoretical insights underpinning inter-
action of monetary policy and the real economy, hence is doubtful. From
a statistical point of view, to assume that there is only one cointegration
relation in the information set and that the money stock is the only endoge-
nous variable means imposition of many restrictions on the long-run matrix,
the validity of which needs to be tested. Because single equation estimation
of cointegrated vectors is problematic, if cointegrated variables are between
the regressors, the estimation results without testing for cointegration rank
and weak exogeneity are not accurate and reliable (Ericsson, et al, 1998).
2. The sample period of most existing studies is up to 1995. As we
have analyzed in the previous section, since 1995 China’s monetary policy
has undergone sweeping changes. In this sense, the previous research has
missed the critical shift in China’s monetary policy, which has lasting impli-
cations. The current research extends the sample period to 1979-2004, i.e.
from the beginning of China’s economic reforms to when the latest data are
available for the present study. The correlation between money aggregates
and the monetary policy goal after 1995 is the focus of the examination of
this research, with a view to shed light on the functioning of the Chinese
monetary policy.

9
4 Economic theoretical framework

In the current study, we apply the conventional static IS-LM model as the
framework of the economic analysis. The static comparative solution of the
conventional IS-LM model can provide useful expositional device for the
analysis of the long-run structure of a dynamic model.

4.1 Money demand function and choice of variables

Because the money demand function is in the center of interest in a mo-

netary model, in this subsection we first illustrate the standard theory of
money demand. Then we give the explicit form of a money demand function
and explain the relevant variables, which should be included in a standard
monetary model. In the end, we discuss some issues concerning the Chinese
money demand function.

4.1.1 The Standard Money Demand Function

According to conventional monetary theory, demand for money stems from

at least two sources: as an inventory to smooth differences between income
and expenditure streams, and as one of several assets in a portfolio. Both
demands lead to a long-run specification of the following form (Ericsson,
1999):
M d /P = f (I, R), (1)
where M d is the nominal quantity of money demanded, P is the price level,
I is a scale variable, and R is a vector of returns on various assets. The
function f (·, ·) is increasing in I, decreasing in those elements of R that are
associated with assets other than M d , and increasing in those elements of
R for assets regarded as M d .
Equation (1) is commonly represented with the following money demand
function (2), which is in log-linear form, with the interest rates entering in
either logs or levels (Ericsson, 1999):

md − p = b0 + b1 i + b2 Rout + b3 Rown + b4 ∆p, (2)

where b0 , b1 , b2 , b3 and b4 are coefficients, Rout and Rown are the rates
of returns on assets other than money and on money itself. So b2 should

10
be negative and b3 positive. In empirical models, the spread Rout − Rown
is usually used to measure the opportunity costs of holding money, which
implies that b2 and b3 have equal magnitudes but opposite signs. The infla-
tion rate ∆p measures the return to holding goods instead of money, so b4
should be negative.

4.1.2 The Choice and Measurement of Variables

The choice of the measurement of money and the associated economic theory
may determine the selection of the scale variable. In the portfolio theory of
asset demand, wealth is a natural scale variable, while noting that income
may be relevant as well. Thus, wealth is often included in models of the
demand for broad money. Because the narrow money is held mainly for
transaction demand, GDP is an appropriate scale variable for narrow money
equations.

4.1.3 China’s Money Demand Equation

In this study, the money demand (or supply) equation for two measures of
money, namely M 1 and M 2 are to be modelled separately. In the context
of China, M 1 and M 2 are defined as follows:
M 1 = currency in circulation + demand deposits of firms
M 2 = M 1 + time deposits of firms + saving deposits of households
The firms’ and households’ demand deposits M 1 bear interest rate for
demand deposit. The interest rates have been strongly regulated by the PBC
with only occasional changes. Among various interest rates, the one−year
deposit rate is generally regarded as the benchmark rate which plays a do-
minant role in China’s interest rate system. The PBC adjusts the one−year
deposit rate, here denoted as R, according to changes in inflationary conditi-
ons. This will be followed by adjustments of other interest rates. When the
inflation rate goes up, the PBC increases R and enlarges the gap between
R and the interest rate for demand deposits, to reduce the demand for M 1.
When the inflation rate goes down, the PBC adjusts the interest rates in
the opposite direction.
In this study, R is included in the M 1 demand equation to represent the
opportunity costs of holding M 1 rather than quasi money. The sign of R

11
in the M 1 demand equation is expected to be negative. In the M 2 demand
function, the R is the own rate of return for firms and households’ time
deposits, which is a component of M 2, and hence its sign could be positive,
if we assume that the public are willing to hold money rather than other
financial or physical assets when the interest rate increases.
In the standard money demand function, the bond rate is usually inclu-
ded to represent the interest rate on assets other than money. In the case of
China, because of the underdevelopment of financial markets, bank deposits
are the predominant form of financial assets.1 Therefore, only R is included
in the M 2 model. Because of the unavailability of data for wealth, we use
real GDP in the M 2 model as a scale variable.
In summary, the money demand functions for M 1 and M 2 in China are
expressed in what follows, where m1 and m2 are logarithm of M 1 and M 2,
respectively, y is the logarithm of real GDP, p and ∆p are logarithm of CPI
and its first difference, R denotes the one-year deposit rate. The following
empirical investigation is based on monetary models with four variables
{m1/m2, y, ∆p, R}.

4.2 Potential long-run equilibria

Within the framework of the aforementioned monetary models with four

variables, we expect to find the following potential equilibria or cointegration
relations in the current empirical investigation.

4.2.1 Money demand or supply relation

Since in the steady state md = ms , the observed money holdings can be eit-
her a realization of money demand or supply, unless adjustment takes place
immediately (Juselius, 1996). The observed money stock can be determi-
ned by demand or supply, or both. If the central bank is able to effectively
control the money stock, then the observed money stock is likely to be sup-
ply determined, and the demand for money has to adjust to the supplied
quantities (Juselius, 2005). In an economy with capital and credit controls,
this is likely to be the case. However, if the central bank cannot control
1
With the rapid development of the housing market since around 2000 when the pro-
perty market reform was launched, owning real properties has become an alternative
means for households to hold wealth.

12
the money stock, or the central bank’s money supply conforms to agents’
desired money holdings, then the observed money stock could be determined
by the demand for money. This is usually the case in open and deregulated
economies.

Demand function for M 1 If a M 1 demand function exists, it should

have the following form:

m1d − p = b0 + b1 y − b2 R + b3 ∆p, (3)

or:

m1d − p = b4 + b5 y − b6 (R − ∆p), (4)

with b1 , b2 , b5 , b6 > 0. R − ∆p represents the real interest rate. The sign

of b3 is indeterminate without further information, because on the one hand,
high inflation could drive economic agents to transform quasi money into
M 1 in order to increase liquidity. On the other hand, economic agents tend
to keep more physical goods rather than holding money.

Demand function for M 2 The M 2 demand function can be represented

in the following form:

md2 − p = b0 + b1 y + b2 R − b3 ∆p, (5)

or
md2 − p = b4 + b5 y + b6 (R − ∆p) (6)
with b1 , b2 , b3 , b5 , b6 > 0

The Central Bank’s Reaction Function During the sample period

under examination, the main policy instrument that PBC has deployed is
quantity control. According to Juselius (1996), if quantity control is adopted
as a monetary instrument, the central bank’s reaction function would include
a relation between velocity and excess inflation:

(mt − pt − yt − k) = f (∆pt − π ∗ ) + uCBm , (7)

13
 where k is a constant, π ∗ is the target inflation rate, and uCBm is a
stochastic residual. If the inflation rate is above/below the central bank’s
target rate, central bank will take contractive/expansionary monetary po-
licy. The money stock will be decreased or increased correspondingly. If
the monetary expansion effect on inflation is predominated, which means
monetary expansion always leads to inflation, then inflation will be posi-
tively cointegrated with trend-adjusted velocity. This relation results in the
following equilibrium:

(mt − pt − yt − b1 trend − k) = b2 ∆pt + uCBm , (8)

with b1 , b2 > 0.
If the central bank controls the money supply in order to keep a trend-
adjusted velocity constant, then the following long-run steady relation exits:

(mt − pt − yt − b1 trend − k) = uCBm , (9)

with b1 > 0.

Real Income Relation and the Phillips Curve If monetary expan-

sion leads to inflation through demand pressure, then inflation is cointegra-
ted with trend-adjusted real income. Based on the IS-LM model, the real
aggregated income relation can be characterized by the following function:

yt = c1 Rt + c2 ∆pt + c3 trend + uy (10)

Where a trend variable is used to approximate the linear real producti-

vity trend . Hence, the trend-adjusted real income, yt − c3 trend, represents
the cyclical part of real income. If c1 < 0 and c2 = −c1 , equation (10)
can be interpreted as an IS relation. If c1 = 0, and c2 > 0, (10) can be
interpreted as a short-run Phillips curve. In both cases, c3 represents the
average quarterly growth rate of real income for the sample period.

Relation between money expansion and real income If money stock

is dominated by money supply, and expansion of real money always causes
the increase of the domestic aggregate demand, or alternatively, if money
stock is mainly determined by money demand, and higher transaction value

14
needs more money, then the following long-run equilibrium exits:

m1t = c0 + c1 yt + um1 , (11)

or
m2t = c2 + c3 yt + um2 , (12)
with c1 > 0 and c3 > 0.
In the former case, the change of money stock is not error correcting
to the deviation from the steady-state, whereas in the later case the money
demand is negatively error correcting to the deviation from the equilibrium.

Relations between interest rate and inflation: the Fisher parity

The Fisher parity implies that the steady-state relationship between the
interest rate and the expected inflation rate is as follows:

Rt = R0 + Et (∆pt+1 ) + uRt (13)

Where R0 is the constant real interest rate. Et (∆pt+1 ) represents the ex-
pected inflation rate at time t. uRt is a stochastic residual. If the realized
inflation rate is used to approximate the expected inflation rate, then the
Fisher parity can be modified to take the following form:

Rt = b0 + b1 ∆pt + ut , (14)

Where b1 > 0, and close to 1.

The liquidity effect If the excess money supply has a liquidity effect and
causes a decrease in the short-run interest rate, then the following long-run
relation might be found in the data:

(mt − pt − yt − b1 trend − k) = −b2 R + ut , (15)

with b1 , b2 > 0.
The aforementioned steady-state relations provide theoretical underpin-
nings for the investigation and interpretation of long-run relationships in the
system. Furthermore, by analyzing the short-run dynamics of the variables
in the system, the dynamic path from one steady-state to another and the
interrelations between the variables can also be examined.

15
5 Data definition and preliminary analysis

5.1 Data definition

The definitions of the original variables is as follows:

M 1t : nominal money supply of M 1t

M 2t : nominal money supply of M 2t

GDP Ct : real GDP in 1990 prices

Rt : one-year interest rate of household’s savings deposits

Pt : consumer price index, equals to 100 in 1990

The transformed variables used in the empirical VAR models are as

follows:

m1t : the real money stock of m1t , defined as log of M 1t /Pt ,

m2t : the real money stock of m2t , defined as log of M 2t /Pt ,

yt : four-quarter moving average of log of GDP Ct :2

yt = (LGDP Ct + LGDP Ct−1 + LGDP Ct−2 + LGDP Ct−4 )/4,

∆pt : the quarterly inflation rate in terms of CPI,

R1t : the one-quarter deposit interest rate, R1t = Rt /4

5.2 Data graphs and preliminary analysis

Figure 1 and 2 display data for m1t , m2t , yt , ∆pt , R1t in levels and in dif-
ferences for the period 1978:1-2004:4, respectively. The results of HEGY
seasonal unit root tests in Table 2 show that there are unit roots at 1, -1,
and ±i in LGDP Ct . The reason for the presence of the seasonal unit roots
might be related to the way the data are compiled. China does not publish
GDP data for individual quarters. The available quarterly GDP data are
2
The reason to make this transformation is to get rid of the seasonal unit roots.

16
 Table 2: Seasonal unit root tests for the period 1978:1-2004:4

HEGY seasonal unit root tests

T
variable deter. lag length t(π1 ) t(π2 ) F : π3 π4
m1t c, t, sd n(AIQ) = n(HQ) = 1 -2.44 -6.04** 20.78**
m2t c, t, sd n(AIQ) = n(HQ) = 1 -3.49* -3.43** 7.14**
LGDP Ct c, t, sd n(AIQ) = n(HQ) = 1 -2.36 -2.33 2.93
∆pt c, sd n(AIQ) = n(HQ) = 1 -3.25* -1.24 8.52**

Notes:

1. c, t, sd denote constant term, trend and centered seasonal dummies, respec-

tively.
2. Lag order n is chosen by Akaike (AIC) and Hannan-Quinn (HQ) info criteria
with maximum lag length of 6.
T
3. t(π1 ), t(π2 ) and F : π3 π4 indicate there are roots at 1, -1 and ±i in the
data, which indicates that there is regular, semiannual, or annual unit roots
respectively.
4. * and ** denote significance at 5% and 1% level.

17
 m1 m2
6
6
5
4
4
3

1980 1985 1990 1995 2000 2005 1980 1985 1990 1995 2000 2005
y Dp
0.10
9
0.05

8 0.00

1980 1985 1990 1995 2000 2005 1980 1985 1990 1995 2000 2005
0.03
R1

0.02

0.01

1980 1985 1990 1995 2000 2005

Figure 1: Data in levels

compiled accumulatively. Therefore, we transform the real GDP data to its

four-quarter moving average to get rid of the seasonal unit roots.
The one-year saving deposits rate Rt is transformed to one-quarter rate
R1t , in order to match the quarterly inflation data ∆pt .
Several dummy variables are included in the models to capture the effects
of government intervention or regime breaks. Impulse dummies are defined
as dxxqyt = 1, where xx and y denote the year and the quarter where
dxxqyt = 1, respectively, and equals 0 anywhere else. E.g. d80q1t equals 1
for the first quarter of 1980 and 0 elsewhere. The step dummy is denoted
as Dp97t , which equals to 1 from 1997Q1 to 2004 Q4, and 0 otherwise. The
dummy variables included in the models will be described in details when
discussing individual model’s specifications.

18
 Dm1 Dm2
0.2 0.2

0.1 0.1

0.0 0.0

−0.1 −0.1
1980 1985 1990 1995 2000 2005 1980 1985 1990 1995 2000 2005
Dy DDp
0.05
0.050
0.00
0.025 −0.05

0.000 −0.10
1980 1985 1990 1995 2000 2005 1980 1985 1990 1995 2000 2005
DR1
0.005

0.000

1980 1985 1990 1995 2000 2005

Figure 2: Data in differences

6 Models for the full sample 1979:1-2004:4

6.1 The statistical model

The statistical model for the current empirical analysis is an unrestricted

vector autoregressive model (VAR) in the following form:

k
X
0 0
∆xt = Π(xt−1 , trend, st−1 ) + Γi ∆xt−i + ΦDt + ²t (16)
i=1

With
t = 1, · · · , T, ²t ∼ N (0, Ω)
where xt is a (p × 1) vector of endogenous variables, and the parameter
matrices Π, Γ1 , · · · , Γk , Φ, Ω are unrestricted. Under the hypothesis that
xt is an I(1) process, Π has reduced rank r < p and can be formulated
0
as Π = αβ , where α and β are (p × r) matrices, respectively. Meanwhile,
0
α⊥ Γβ⊥ has full rank, where α⊥ and β⊥ are the orthogonal matrixes of

19
 Pk−1
α and β, respectively and Γ = I − i=1 Γi (see section 3.3 for the VAR
representation).
In addition, in the equation (16), a trend variable is allowed to enter the
cointegration space, because money supply and GDP are trending variables.
st denotes a vector of exogenous variables, or un-modelled variables, such
as the shift dummies, and fixed and non-stochastic variables that need to
be included in the cointegration space. Dt contains a constant term and
centered seasonal dummies, intervention impulse dummies, as well as the
current and lagged differences of the variables in st . The constant term and
centered seasonal dummies are unrestricted, which means they are included
both inside and outside the cointegration space.

6.2 Model specification and estimation

We estimate the m1 and m2 models for the full sample based on the unre-
stricted cointegrated VAR model (16). For m1 and m2 models, xt contains
(m1t , yt , ∆pt ) and (m2t , yt , ∆pt ), respectively. st includes R1 and Dp97t
for both models. In the m1 model, intervention dummies consist of impulse
dummies d80q1, d84q1, d85q4, d86q4, d88q1, d88q3 and d93q1, while in the
m2 model, they consist of d80q1, d83q1, d84q1, d84q4, d85q1, d85q4, d88q3
and d93q1. The impulse dummies are chosen according to the outliers in the
residuals of the system, which have been caused by the policy interventions.
Based on the Schwarz and Hannan-Quinn information criteria with the
maximal lag length setting to be 4, the lag length for both models are set to
be 4. The residual misspecification tests turn out that there are no serious
misspecification problems in the residuals of both models.3 Based on these
results, the parameter nonconstancy tests are performed.

6.3 Stability tests and identification of structural changes

Before we conduct further empirical analysis, it is important to test whether

the model is misspecified. This includes tests for residual misspecification
and parameter nonconstancy. As we have discussed in section 2.4, the im-
plementation of China’s monetary policy seems to have undergone changes
before and after the mid-1990s. Therefore it is of interest to test whether
3
The misspecification tests of the two models for the full sample period is available on
request.

20
 Test for Constancy of the Log-Likelihood
5
X(t)
R1(t)
5% C.V. (1.36 = Index)

0
1989 1991 1993 1995 1997 1999 2001 2003

Figure 3: The recursively calculated log-likelihood for m1 model

there is evidence from the data that a structural shift has occurred in the
sample period by testing for parameter constancy. The model for the whole
period is used for the tests of the parameter constancy and whether there is
a structural shift occurring in the sample period. For this matter, various
recursive tests are first applied to the full-sample models to give us a visual
inspection of the constancy, followed by formal statistical tests to identify a
structural break.

21
 Test for Constancy of the Log-Likelihood
4.5
X(t)
R1(t)
5% C.V. (1.36 = Index)
4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0
1989 1991 1993 1995 1997 1999 2001 2003

Figure 4: The recursively calculated log-likelihood for m2 model

22
 Trace Test Statistics
2.5
X(t)

2.0

1.5

1.0

0.5

0.0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
The test statistics are scaled by the 5% critical values of the basic model

1.75
R1(t)
1.50

1.25

1.00

0.75

0.50

0.25

0.00
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
H(0)|H(3) H(1)|H(3) H(2)|H(3)

Figure 5: The recursively calculated trace test statistics for m1 model

23
 Trace Test Statistics
2.25
X(t)
2.00
1.75
1.50

1.25
1.00
0.75
0.50
0.25
0.00
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
The test statistics are scaled by the 5% critical values of the basic model

2.25
R1(t)
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0.00
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
H(0)|H(3) H(1)|H(3) H(2)|H(3)

Figure 6: The recursively calculated trace test statistics for m2 model

24
 Test of Beta(t) = ’Known Beta’

3.5
X(t)
R1(t)
5% C.V. (16.9 = Index)
3.0

2.5

2.0

1.5

1.0

0.5

0.0
1989 1991 1993 1995 1997 1999 2001 2003

Figure 7: The recursively calculated test of β for m1 model, reference sample

is 1980:1-2004:4

25
 Test of Beta(t) = ’Known Beta’

4.0
X(t)
R1(t)
5% C.V. (16.9 = Index)
3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0
1989 1991 1993 1995 1997 1999 2001 2003

Figure 8: The recursively calculated test of β for m1 model, reference sample

is 1995:1-2004:4

26
 Test of Beta(t) = ’Known Beta’

4.5
X(t)
R1(t)
5% C.V. (16.9 = Index)
4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0
1989 1991 1993 1995 1997 1999 2001 2003

Figure 9: The recursively calculated test of β for m2 model, reference sample

is 1980:1-2004:4

27
 Test of Beta(t) = ’Known Beta’

2.5
X(t)
R1(t)
5% C.V. (16.9 = Index)

2.0

1.5

1.0

0.5

0.0
1989 1991 1993 1995 1997 1999 2001 2003

Figure 10: The recursively calculated test of β for m2 model, reference

sample is 1995:1-2004:4

28
6.4 Recursive tests for parameter constancy

6.4.1 Tests for recursively calculated log-likelihood

CATs in RATS 2.0 provides a variety of recursive tests of parameter con-

stancy. Here we present graphs of some recursive tests.
Figure 3 and Figure 4 display the forward recursively calculated log-
likelihood of m1 and m2 models based on both X-form and R-form with
the line for the 5% critical value. The graphs indicate that there exists
possible instabilities in the sample period.

6.4.2 Tests for recursively calculated trace test statistics

Figure 5 and 6 contain the recursively calculated trace test statistics for the
m1 and m2 models, respectively. They show that, two stable cointegration
relations exist for both models from 1995. But before that, it seems the two
cointegration relations are not stable in both models. In general, the figures
of recursively calculated trace test statistics suggest that there might be a
structural break at around 1995:1.

6.4.3 Tests for constancy of β

Figure 7 and Figure 9 show the recursively calculated test statistics of the
m1 and m2 model, respectively. In the graphs the test statistic is scaled by
5% critical value. The reference time is chosen to be the full sample period.
Figure 7 shows that there exists a structural shift at around 1995. Because
of our interest in the more recent economic regime, we next conduct the
recursively calculated β test statistic using 1995:1-2004:4 as the reference
sample period. Figure 8 and Figure 10 display that all the parts of the
graphs are above the rejection lines, which indicates that the estimated β
based on the period 1995:1-2004:4 are different from that obtained from the
full sample period.

6.4.4 Chow tests for structural changes

In addition to nonconstancy tests by means of recursive graphs, Chow tests

offer a statistical possibility for testing structural changes. Jmulti 3.1 pro-

29
 Table 3: Chow tests for VAR models 1979:1-2004:4 for m1 and m2
Model Break point Test Test statistic p−value
m1 1994Q4 λSS 227.5154 0.0000
λBP 144.1051 0.0000
m2 1994Q4 λSS 427.9735 0.0000
λBP 180.4821 0.0000

Note: λBP and λSS denote test statistics for break point Chow tests and sample
split Chow tests, respectively. Sample range for estimation is 1980:1-2004:4

vides the program to test the sample-split, break-point and forecast Chow
tests.
Table 3 reports the break point and sample split Chow tests for the m1
and m2 models, assuming the breaking data is 1994Q4. All the tests reject
the stability in m1 or m2 model, which suggests that a structural change
occurred before and after 1994:Q4. Therefore, in the following sections we
split the sample period into two sub-periods; one is from 1979:1 to 1994:4,
and the other is from 1995:1 to 2004:4. All further empirical analysis is
applied to these two separated periods.

7 Empirical analysis for m1 and m2 models in the

two sub-samples

The finding of a structural change allows us to split the sample into two
sub-periods, i.e. before and after 1995Q1. Therefore we have four models.
Hereafter, they will be denoted as m1 model 1, m2 model 1, m1 model 2,
m2 model 2, respectively.

7.1 Model specifications

The statistical formulation for the four models are based on the unrestricted
cointegrated VAR model (16). To save space, the precise specification of the
four models are summarized in Table 4.
The interest rate variable R1 rarely changes and does not look like a
stochastic variable. We initially included it in the models as an exogenous

30
 Table 4: Model specification of m1 1,2 and m2 1,2
Variables model 1 model 2
m1 m2 m1 m2
       
m1t m2t m1t m2t
xt  yt   yt   yt   yt 
∆pt ∆pt ∆pt ∆pt

µ ¶ µ ¶
R1t R1t
st - -
Dp97t Dp97t

 
d80q1  
  d80q1
 d84q1   
   d84q1 
 d84q4   
   d84q4  ¡ ¢ ¡ ¢
 d85q2   
Dt    d85q1  d03q2 d03q2
 d85q4   
   d85q4 
 d86q1   
  d88q3
d93q1
d93q1
d94q1

variable. However, through variable exclusion tests, we find that R1 can be

excluded in m1 and m2 model 1. The exclusion test output is reported in
Table 5.
The shift dummy Dp97t is included in m1 and m2 model 2, due to the
enlargement of the measurement of money stocks since 1997Q1.

7.2 Lag length determination

The choice of the lag length is mainly based on the information criteria tests.
Table 6 contains the output of information criteria tests, where SC and H-Q
indicate Schwarz and Hannan-Quinn information criteria, respectively. The
test results show that for m1 model 1, 2, and m2 model 1, both SC and H-Q
suggest the same order, which is 2, 1, and 4, respectively. The residual and

31
 Table 5: Testing the exclusion of R1
Models
1979:1-1994:4 1995:1-2004:4
coin. rank m1 m2 m1 m2
r=1 2.264 0.019 4.631 2.645
[0.132] [0.892] [0.031] [0.104]
r=2 4.785 2.056 11.889 7.115
[0.091] [0.358] [0.003] [0.029]

Note: P -values in square brackets

Table 6: Lag length Determination Tests

m1 m2
Model k SC H-Q SC H-Q
4 -22.60 -24.13 -23.21 -24.74
Model 1 3 -22.68 -24.02 -22.82 -24.16
2 -23.21 -24.35 -23.02 -24.17
1 -22.60 -23.56 -22.03 -23.19
4 -26.18 -28.50 -29.12 -31.52
Model 2 3 -26.42 -28.31 -28.45 -30.42
2 -26.64 -28.10 -28.93 -30.47
1 -27.54 -28.57 -29.44 -30.56

Note: SC and H-Q denote Schwartz and Hannan-Quinn information criterion, re-
spectively. The maximum lag length is set to be 4

32
 Table 7: Multivariate misspecification tests
Multivariate tests: 1979-1994 1995-2004
m1 m2 m1 m2
Autocorrelation:
LM1 (9): 15.2[0.08] 11.4[0.24] 6.9[0.63] 7.7[0.56]
LM4 (9): 21.9[0.01] 9.7[0.37] 12.0[0.21] 12.4[0.18]
Normality:
χ2 (6): 6.6[0.35] 4.8[0.55] 5.6[0.46] 3.02[0.80]
ARCH:
LM1 (36): 51.3[0.05] 21.3[0.97] 32.4[0.64] 30.0[0.74]
LM2 (72): 74.7[0.38] 48.5[0.98] 66.5[0.66] 78.1[0.29]

recursive tests show that there is no problem with misspecification or non-

constancy for the models with corresponding lag length. For the m2 model
2, SC suggests order 1, but H-Q suggests order 4. The recursive estimation
indicates that both VAR(1) and VAR(4) are significantly nonconstant for
the estimated β coefficients, while the misspecification tests and recursive
estimations show that VAR(2) has good properties. Therefore, we will esti-
mate m1 model 1 and 2, m2 model 1 and 2 as VAR(2), VAR(1), VAR(4)
and VAR(2), respectively.

7.3 Model misspecification tests

Table 7 and Table 8 report residual tests for the system and for individual
equations. They are based on corresponding unrestricted VAR models. The
Multivariate tests are conducted using CATS in RATS 2.0, while univariate
tests are performed with PcGIVE 10.0. Figures in square brackets beside
the test statistics are the corresponding p-values.
There is some evidence of fourth order autocorrelation in the residuals of
the ∆pt equation in the m1 model 1 and for the whole system, which suggests
that there is probably some seasonal autocorrelation left in the ∆p equation
despite the inclusion of quarterly seasonal dummies. A graphic inspection of
∆p shows that the seasonal pattern seems to have changed since about 1987,
perhaps because of the change in the data compilation. Quarterly inflation
data before 1987 was calculated by the National Bureau of statistics of
China. However, the CPI quarterly statistics has been published only since

33
 Table 8: Univariate misspecification Tests
Autocorrelation ARCH Normality R2
AR 1-1 AR 1-4 ARCH 1-2 χ2 (2)
m1 model 1
m1 0.02[0.86] 1.02[0.40] 0.48[0.61] 0.86[0.64] 0.78
y 0.30[0.58] 1.43[0.24] 0.96[0.38] 1.38[0.50] 0.85
∆p 1.98[0.16] 3.36[0.02] 0.32[0.72] 4.48[0.10] 0.81
m2 model 1
m2 0.57[0.45] 0.18[0.94] 0.41[0.66] 0.71[0.69] 0.87
y 0.51[0.47] 1.56[0.20] 0.84[0.43] 1.47[0.47] 0.90
∆p 1.58[0.21] 0.89[0.47] 0.005[0.99] 1.80[0.45] 0.89
m1 model 2
m1 0.01[0.90] 1.15[0.35] 0.11[0.89] 0.72[0.69] 0.81
y 0.21[0.64] 0.65[0.62] 0.35[0.70] 0.36[0.83] 0.60
∆p 0.04[0.83] 1.39[0.26] 0.62[0.54] 2.97[0.22] 0.96
m2 model 2
m2 6.56[0.02] 1.51[0.24] 0.04[0.95] 0.70[0.70] 0.80
y 0.02[0.88] 1.19[0.34] 0.34[0.71] 0.08[0.95] 0.82
∆p 0.94[0.34] 0.36[0.83] 0.28[0.75] 1.57[0.45] 0.97

34
1987. Because coefficients of the recursive estimated long-run cointegration
relations and short-run adjustments turn out to be stable and constant under
the model specification, we keep this specification and further analysis will be
based on it. The F-test shows there is a problem of first order autocorrelation
in the residual of the m2 equation in m2 model 2. But the LM (1) test for
the system suggests there is no autocorrelation in the system. Except for
this minor problem, the misspecification tests show that all p-values are
substantially greater than usual significance levels, suggesting no problem
of autocorrelation, ARCH or nonnormality for the system and for individual
equations. The R2 values show that a large part of variations of the system
can be explained by the chosen information set. In general, the current
models seems to be well behaved.

7.4 Cointegration Rank Determination

The determination of the cointegration rank is equal to determine how many

stochastic trends are in the system, and it is thus crucial for the long-run and
short-run structure identification and impulse analysis. This calls for more
attention to be paid to this issue. Because of the low power of trace tests,
Juselius (2005) and also Hendry and Juselius (2001) suggest the use of diffe-
rent sources of information to determine the cointegration rank. The useful
information includes: (1) trace tests, (2) the largest roots of the companion
matrix, (3) t-values of the adjustment coefficients of the cointegration vector,
and (4) the recursive graphics of the trace statistic. In the present empirical
studies, all four information resources are applied for the determination of
the cointegration ranks.

7.4.1 Trace tests for cointegration rank determination

Table 9 shows the results of the trace test for the determination of cointegra-
tion ranks, where Trace denotes the asymptotic trace statistic corresponding
to a model without shift dummies, and Trace* denotes the trace statistic
with Bartlett small sample corrections. Because R1t and the shift dummy
Dp97t are included in the m1 and m2 models 2 as exogenous variables, the
critical values for standard trace test are not valid and need to be simulated.
CATS in RATS 2.0 automatically gives the simulated critical values when
stochastic exogenous variables are included in the cointegration space (Ju-
selius, 2005, section 8.2). In the current m1 and m2 models 2, R1 does not

35
behave like a real stochastic variable, and Dp97t is a shift dummy, therefore
we use the critical values calculated in CATS in RATS 2.0 for the trace tests,
but also check the cointegration ranks with further information. The results
of trace tests suggest that the cointegration ranks for all the four models
should be 2.

7.4.2 The graphs of the recursive trace statistic

Following Juselius (2005, section 9.1), if the cointegration rank is r < p,

then the recursively calculated components of the trace statistic should grow
linearly for all i = 1, · · · , r, but stay constant for i = r + 1, · · · , p.
Figure 11, Figure 13, figure 12 and figure 14 exhibit pronounced linear
growth in the first two cointegration relations in the R-form, but no growth
in the third one, although it seems that the second cointegration vector in
m1 model 2 is not very stable and the second cointegration vector in m2
model 2 is not very significant. The first two linearly growing trace test
components correspond to two cointegration relations, while the third one
indicates a small eigenvalue, which corresponds to a unit root or near unit
root.

7.4.3 Checking the roots of the companion matrices

Following Hendry and Juselius (1999), if the rth + 1 cointegration vector

is nonstationary and is wrongly included in the model, then the largest
characteristic root will be close to the unit circle. After restricting a reduced
rank to the model, the largest characteristic roots will be significantly smaller
than one.
Table 10 shows the three largest characteristic roots for the unrestricted
models and the models restricted with reduced rank. In m1 models 1 and
2, and m2 model 1, there is a large root for the unrestricted models. After
restricting the cointegration rank to be 2, the largest unrestricted roots have
been smaller. Although in m2 model 1 the difference between 0.95 and 0.91
is not very significant, but adjustment coefficients α are very significant for
r = 2. This result can be regarded as evidence for two cointegration relations
in these two models. For m2 model 2, this is not the case however. The
largest root becomes larger when r is reduced from 3 to 2. Meanwhile, the
0
adjustment coefficients α of β xt−1 are significant for both r = 2 and r = 3.

36
 Table 9: Trace Test for the Rank Determination
M1 model 1
p-r r Eig.Value Trace Trace* Frac95 P-Value P-Value*
3 0 0.66 102.60 90.29 42.77 0.00 0.00
2 1 0.38 35.64 32.03 25.73 0.00 0.00
1 2 0.08 5.46 4.87 12.44 0.54 0.62
M2 model 2
p-r r Eig.Value Trace Trace* Frac95 P-Value P-Value*
3 0 0.52 84.86 74.19 42.77 0.00 0.00
2 1 0.46 39.71 34.87 25.73 0.00 0.00
1 2 0.03 1.98 1.84 12.44 0.95 0.96
M1 model 2
p-r r Eig.Value Trace Trace** Frac95 P-Value P-Value*
3 0 0.77 97.88 94.05 57.31 0.00 0.00
2 1 0.54 39.58 38.67 35.95 0.02 0.02
1 2 0.21 9.20 9.13 18.15 0.55 0.59
M2 model 2
p-r r Eig.Value Trace Trace** Frac95 P-Value P-Value*
3 0 0.68 88.28 73.94 57.31 0.00 0.00
2 1 0.54 44.89 36.29 35.95 0.00 0.04
1 2 0.32 15.10 11.18 18.15 0.12 0.36

Note: trace and trace* denote standard trace statistics and the trace statistics with
Bartlett corrections for small sample, respectively. Frac95 denotes the 95% quantile
from the asymptotic table generated in CATS in RATS 2.0. The value of Frac95
for the model 1 corresponds to that in the asymptotic table generated with a trend
in the cointegration relations, while that for the model 2 is generated with a trend
and a random exogenous variable in the cointegration relations

37
 Trace Test Statistics
2.25
X(t)
2.00
1.75
1.50

1.25
1.00
0.75
0.50
0.25
0.00
1987 1988 1989 1990 1991 1992 1993 1994
The test statistics are scaled by the 5% critical values of the basic model

2.00
R1(t)
1.75

1.50

1.25

1.00

0.75

0.50

0.25

0.00
1987 1988 1989 1990 1991 1992 1993 1994
H(0)|H(3) H(1)|H(3) H(2)|H(3)

Figure 11: Recursive trace test statistic M1 1979:1-1994:4

Table 10: Modulus of the 3 largest roots of the companion matrices

Model 1
coin.ranks m1 m2
unrestricted 0.902 0.902 0.498 0.947 0.914 0.914
2 1.000 0.711 0.539 1.000 0.909 0.909
1 1.000 1.000 0.634 1.000 1.000 0.842
Model 2
coin.ranks m1 m2
unrestricted 0.993 0.534 0.0912 0.769 0.769 0.563
2 1.000 0.886 0.014 1.000 0.857 0.469
1 1.000 1.000 0.788 1.000 1.000 0.719

38
 Trace Test Statistics

2.00
X(t) = R1(t)

1.75

1.50

1.25

1.00

0.75

0.50

0.25
1999 2000 2001 2002 2003 2004
The test statistics are scaled by the 5% critical values of the basic model
H(0)|H(3) H(1)|H(3) H(2)|H(3)

Figure 12: Recursive trace test statistic M1 1995:1-2004:4

39
 Trace Test Statistics
2.25
X(t)
2.00
1.75
1.50

1.25
1.00
0.75
0.50
0.25
0.00
1987 1988 1989 1990 1991 1992 1993 1994
The test statistics are scaled by the 5% critical values of the basic model

2.00
R1(t)
1.75

1.50

1.25

1.00

0.75

0.50

0.25

0.00
1987 1988 1989 1990 1991 1992 1993 1994
H(0)|H(3) H(1)|H(3) H(2)|H(3)

Figure 13: Recursive trace test statistic M2 1979:1-1994:4

40
 Trace Test Statistics
1.6
X(t)
1.4

1.2

1.0

0.8

0.6

0.4
2001 2002 2003 2004
The test statistics are scaled by the 5% critical values of the basic model

1.6
R1(t)
1.4

1.2

1.0

0.8

0.6

0.4
2001 2002 2003 2004
H(0)|H(3) H(1)|H(3) H(2)|H(3)

Figure 14: Recursive trace test statistic M2 1995:1-2004:4

41
This can be regarded as evidence that some variables contain a near I(2)
unit root (Juselius, 1999).

7.4.4 Concluding remarks

In this subsection, various information has been applied to testing the coin-
tegration ranks of the four models. Evidence for the existence of two coin-
tegration relations in the m1, m2 model 1 and m1 model 2 are quite clear.
Whereas evidence for two cointegration relations in the m2 model 2 seems
weak, which implies that the cointegration rank in this model could be one
or two. In the following analysis, we first restrict all four models with r = 2.
After imposing restrictions on long-run cointegrations, we further examine
the plausibility of the rank choice by means of inspecting the stability of
the long-run cointegration and short-run adjustment coefficients, as well as
checking the economic meaning of the restricted long-run relations.

7.5 Weak exogeneity for the long-run parameters β

Before we further impose restrictions on the VAR models, we test for the
weak exogeneity for the long-run parameters β.
Table 11 gives the results of weak exogeneity tests for both r = 2 and r =
1. It shows that no variable is weakly exogenous in the m1 models for both
r. In the m2 model 1 and 2, the results depend on the choice of cointegration
rank. If r = 1 then m2t or yt is weakly exogenous in both models. If r = 2,
then no variable is weakly exogenous in m2 model 1. We further test the
joint weakly exogenous for m2 model 1 and 2 by setting r = 1. The results
are χ2 (2) = 29.658[0.000] for m2 model 1 and χ2 (2) = 1.562[0.458] for m2
model 2, where p-values are in square brackets. The results indicate that,
in m2 model 2, by setting r = 1, both m2t and yt would have acted as two
independent driving forces for ∆pt , while ∆pt is a fully adjusting variable.
m2t in m2 model 2 is found to be weakly exogenous independent of the
choice of r. When we examine the estimated residual correlation matrix
Ω̂ (see table 17), we find the residual correlation between equation m2t
and ∆pt is as large as -0.78, which indicates that current effects between
the variables are perhaps neglected in the reduced VAR model. Because
the identification of the short-run structure may change the adjustment
0
coefficients α of the cointegration relations β xt , we further estimate all
four models in the full system. In order to check for the robustness of the

42
 Table 11: Testing for weakly exogenous variables
Model 1
m1 m2
coin. rank m1t yt ∆pt m2t yt ∆pt
r=1 24.376 4.683 5.746 1.611 3.108 5.008
[0.000] [0.030] [0.017] [0.204] [0.078] [0.025]
r=2 24.422 22.051 19.451 33.541 32.994 21.331
[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]
Model 2
m1 m2
coin. rank m1t yt ∆pt m2t yt ∆pt
r=1 7.568 11.419 9.428 0.043 1.559 10.040
[0.006] [0.001] [0.002] [0.835] [0.212] [0.002]
r=2 12.453 24.454 29.867 0.179 12.921 13.694
[0.002] [0.000] [0.000] [0.914] [0.002] [0.001]

estimates of β coefficients, we have estimated m2 model 2 based on both

the full system and the partial system conditioning on m2t given r = 2.
The difference between the estimates of the β coefficients obtained from the
two systems is negligible, which justifies our further estimation m2 model 2
being based on the full system.

8 Identifying the long-run structure.

8.1 Testing for Single Stationarity Hypotheses

0
Before formally identifying the long-run structure β xt , we first test the
stationarity of a single hypothetical cointegration relation, and leaving the
remaining r − 1 relations unrestricted. The tests for single stationarity hy-
potheses can be regarded as a preliminary attempt to imposing restrictions
on the long-run structure, because systematically testing the stationarity
of all possible relations helps to spot relevant information for an identified
long-run structure. If a hypothetical cointegration relation is rejected by the
single stationarity test, it could never be included in the long-run structure
0
β xt (Juselius, 2005, section 10.4). On the other hand, the single cointegra-
tion relationship can be regarded as a potential equilibrium relationship in
the final long-run structure.

43
 The hypotheses to be investigated are of the form β = {Hφ1 , ψ1 }, i.e.
we test for whether a single restricted relation lies in the cointegration space,
while leaving the other relations unrestricted. The test procedure deals with
nonlinear estimation problems and is provided by CATS in RATS 2.0 (for
detailed test procedures, see Juselius, 2005, section 10.4).
Tables 12, 13, 14 and 15 show the outcome of tests for the stationarity of
the potential single relations in m1, m2 model 1 and model 2, respectively.
The null hypotheses, or the potential long-run steady-states as illustrated
in Section 4, are categorized into four groups, i.e. relations relating to real
money, real income, the velocity and the inflation rate.
In the real money group, except for m2 model 2 (H30 ), all the other
three hypotheses regarding the stationarity of trend-adjusted real money
stocks (H1 ,H9 ,H17 ) can be rejected. Tests for H2 ,H10 ,H18 and H31 show
that the real money stock is cointegrated with real income in model 1, but
not in model 2. In m1 and m2 model 1 and m1 model 2, trend-adjusted
real money is positively cointegrated with inflation rate ( see H3 , H11 , H19 ).
But this is not the case for m2 model 2 (see H32 ).4
In the group of real income, we test stationarity of trend-adjusted real
income , Phillips curve and IS type relationships. H4 , H12 , H20 and H33
show that trend-adjusted real income is nonstationary in all four models. In
m1 and m2 models 1, trend-adjusted real income is positively cointegrated
with inflation ( H5 and H13 ), which indicates a Phillips curve type relation,
while in the m1 and m2 models 2, trend-adjusted real income is cointegrated
with inflation, but with negative sign ( H21 and H34 ). In the m1 and
m2 models 2, the stationarity of the relation between trend-adjusted real
income and the real interest rate are tested by H22 and H35 . This relation
is nonstationary in m1 model 2 ( H22 ) and stationary in m2 model 2 (H35 ),
but with ’wrong’ signs for IS type relations.
In the group of velocity relations, tests for H6 and H14 show that trend-
adjusted velocity in m1 and m2 models 1 is stationary, but with relatively
small p-values. When the inflation rate is added to the relations denoted by
H6 and H14 , which indicates the relation between the trend-adjusted velocity
and inflation, the coefficients of the inflation are significant. In addition,
the p-values rise from 0.21 and 0.09, respectively, to 1, by construction (H7
4
This result should not come as a surprise, because a combination of a stationary
component (trend-adjusted real money, H30 ) and a nonstationary component (inflation
rate, see H40 ) is nonstationary.

44
and H15 ), which indicates that trend-adjusted velocity shares a common
stochastic trend with inflation in some degree, and can be cancelled out by
a linear combination. In m1 model 2, the trend-adjusted velocity is not
stationary (H23 ), but is strongly positively cointegrated with the inflation
rate (H24 ) and negatively cointegrated with the real interest rate (H26 ).
In m2 model 2, H36 is the combination of H30 and H33 . The p-values of
the tests for H30 and H33 are 0.16 and 0.00, respectively, hence it is not
surprising that the test for H36 has a lower p-value (0.06). H37 can be
regarded as a combination of H30 and H34 , or H36 and H40 .
The inflation rate in H37 is not significant, which makes H37 close to
H36 . H36 indicates the trend-adjusted velocity, which is only borderline
acceptable. The test for H38 shows that there is a negative cointegration
relation between trend-adjusted velocity and interest rate in m2 model 2.
The tests for the group of inflation and the real interest rate show that
inflation (H8 , H16 , H27 , H40 ) is not stationary in all four models. The real
interest rate (H28 , H41 ) or the relations between inflation and the interest
rate with freely estimated coefficients (H29 , H42 ) are also nonstationary in
m1 and m2 models 2, which indicates that Fisher parity does not exist in
the Chinese data, probably because the interest rate as a policy variable is
heavily regulated by the PBC during the sample period.

8.2 Restrictions on the long-run structure

In the previous section, we have tested various hypotheses of stationarity for

single relations, in order to spot the potential cointegration relations between
variables. In this section, we formally impose restrictions on the long-run
structure and test the joint stability of cointegrations in the systems.
Tables 16 and 17 report the restrictions imposed on the cointegration
spaces and the corresponding short-run adjusted coefficients for m1 and m2
models 1 and models 2. We illustrate the test results for the four models
one by one as follows.

8.2.1 m1 model 1979:1-1994:4

The restricted long-run relations are the combination of hypotheses H2 and

H5 in the table 12. The first cointegration vector represented by H5 indicates
that the expansion of m1 always leads to an increase of real income. The

45
 Table 12: Testing the stationary of single relations m1 model 1
m1t yt ∆pt trendt χ2 (υ) p − value
Real money relations
H1 1 0 0 −0.029 χ2 (1)=10.394 0.001
[−26.022]
H2 1 −1.292 0 0 χ2 (1) = 0.224 [0.636]
[−41.333]
H3 1 0 −10.156 −0.027 − −
[−12.697] [−19.513]
Real income relations
H4 0 1 0 −0.022 χ2 (1) = 24.581 [0.000]
[−24.173]
H5 0 1 −6.914 −0.021 − −
[−19.657] [−33.195]
Velocity relations
H6 1 -1 0 −0.007 χ2 (1) = 1.535 [0.215]
[−8.813]
H7 1 -1 −3.242 −0.006 - -
[−4.220] [−6.082]
Inflation
H8 0 0 1 0 χ2 (2)=12.834 [0.002]

46
 Table 13: Testing the stationary of single relations m2 model 1
m2t yt ∆pt trendt χ2 (υ) p − value
Real money relations
H9 1 0 0 −0.039 χ2 (1)= 19.115 [0.000]
[−40.521]
H10 1 −1.715 0 0 χ2 (1) = 0.826 [0.364]
[−71.713]
H11 1 0 −12.320 −0.036 − −
[−12.433] [−35.754]
Real income relations
H12 0 1 0 −0.027 χ2 (1)= 29.625 [0.000]
[−17.603]
H13 0 1 −3.829 −0.015 − −
[−4.093] [−22.825]
Velocity relations
H14 1 -1 0 −0.017 χ2 (1) = 2.840 [0.092]
[−31.953]
H15 1 -1 −3.829 −0.015 - -
[−4.277] [−23.174]
Inflation rate
H16 0 0 1 0 χ2 (2)=13.236 [0.001]

47
 Table 14: Testing the stationary of single relations for m1 model 2

m1t yt ∆pt R1t Dp97t trendt χ2 (υ) p − value

Real money relations
H17 1 0 0 0 −0.283 −0.034 χ2 (2) = 18.111 [0.000]
[−4.871] [−16.243]
H18 1 −0.501 0 0 −1.393 0 χ2 (2) = 19.074 [0.000]
[−0.868] [−4.435]
H19 1 0 −12.025 0 −0.237 −0.037 χ2 (1)= 0.159 [0.690]
[−17.038] [−5.181] [−24.190]
Real income relations
H20 0 1 0 0 0 −0.020 χ2 (3) = 28.261 [0.000]
[−37.700]
H21 0 1 2.836 0 0 −0.019 χ2 (2) = 3.585 [0.167]
[14.078] [−63.155]
H22 0 1 2.618 −2.618 0 −0.021 χ2 (2)= 7.079 [0.029]
[11.546] [−11.546] [−71.521]
Velocity relations
H23 1 -1 0 0 −0.591 −0.008 χ2 (2)=18.988 [0.000]
[−4.499] [−1.667]
H24 1 -1 −15.088 0 −0.257 −0.017 χ2 (1) = 0.418 [0.518]
[−20.677] [−4.611] [−8.955]
H25 1 -1 0 33.411 −0.046 0.001 χ2 (1) = 4.589 [0.032]
[6.373] [−0.680] [0.270]
H26 1 -1 −10.456 10.456 −0.183 −0.011 χ2 (1) = 1.960 [0.162]
[−15.523] [15.523] [−4.774] [−8.027]
Inflation and real interest rate
H27 0 0 1 0 0 0 χ2 (4) = 9.001 [0.061]
H28 0 0 1 -1 0 0 χ2 (4) = 23.492 [0.000]
H29 0 0 1 −0.082 0 0 χ2 (3)= 8.874 [0.031]
[−0.497]

48
 Table 15: Testing the stationary of single relations for m2 model 2

m2t yt ∆pt R1t Dp97t trendt χ2 (υ) p − value

Real money relations
H30 1 0 0 0 −0.102 −0.036 χ2 (2) = 3.559 [0.169]
[−7.167] [−76.836]
H31 1 −1.849 0 0 −0.085 0 χ2 (2) = 8.449 [0.015]
[−52.684] [−4.057]
H32 1 0 0.794 0 −0.089 −0.036 χ2 (1)=3.271 [0.070]
[1.121] [−4.050] [−74.155]
Real income relations
H33 0 1 0 0 0 −0.020 χ2 (3) = 19.824 [0.000]
[−83.601]
H34 0 1 1.654 0 0 −0.019 χ2 (2) = 2.773 [0.250]
[11.632] [−160.923]
H35 0 1 1.578 −1.578 0 −0.020 χ2 (2) = 2.649 [0.266]
[11.520] [−11.520] [−211.082]
Velocity relations
H36 1 -1 0 0 −0.083 −0.017 χ2 (2) = 5.603 [0.061]
[−5.389] [−33.045]
H37 1 -1 −0.986 0 −0.095 −0.017 χ2 (1) = 5.227 [0.022]
[−1.270] [−3.979] [−32.706]
H38 1 -1 0 4.397 −0.062 −0.015 χ2 (1)= 0.499 [0.480]
[2.721] [−3.625] [−17.591]
H39 1 -1 −2.011 2.011 −0.101 −0.016 χ2 (1) = 2.448 [0.118]
[−2.709] [2.709] [−5.327] [−24.238]
Inflation and real interest rate
H40 0 0 1 0 0 0 χ2 (4)= 16.983 [0.002]
H41 0 0 1 -1 0 0 χ2 (4) = 20.724 [0.000]
H42 0 0 1 −0.408 0 0 χ2 (3) = 15.813 [0.001]
[−1.927]

49
 Table 16: Identifying long-run structure: 1979:1-1994:4

m1 model m2 model
The cointegrating vectors:
β̂1 β̂2 β̂1 β̂2
m1t 1.0 0.0 m2t 1.0 0.0
yt −1.292 1.0 yt −1.715 1.0
[−41.333] [−71.713]
∆pt 0.0 −6.615 ∆pt 0.0 −8.202
[−11.237] [−8.833]
trendt 0.0 −0.021 trendt 0.0 −0.021
[−32.414] [−30.389]
The adjustment coefficients:
α̂1 α̂2 α̂1 α̂2
∆m1t −0.084 0.200 ∆m2t −0.037 0.282
[−1.828] [5.205] [−0.933] [6.825]
∆yt 0.037 −0.005 ∆yt 0.047 −0.006
[5.299] [−0.883] [6.803] [−0.913]
∆2 pt 0.075 0.098 ∆2 pt 0.114 0.020
[2.960] [4.650] [4.914] [0.816]
The residual correlation matrix Ω̂:
∆m1t 0.028 ∆m2t 0.02
∆yt 0.38 0.004 ∆yt -0.16 0.003
∆2 pt -0.42 0.004 0.015 ∆2 pt -0.34 0.23 0.012
Test of overidentifying restrictions
χ2 (1) = 0.224 [0.636] χ2 (1) = 0.826 [0.364]

Notes:
1. p − values are in square brackets.
2. in Ω̂ the standard errors are on the diagonal, cross-correlations are on the
off-diagonal elements.

50
 Table 17: Identifying long-run structure, 1995:1-2004:4

m1 model m2 model
The cointegrating vectors:
β̂1 β̂2 β̂1 β̂2
m1t 1.0 0.0 m2t 1.0 0.0
yt −1.608 1.0 yt -1.0 1.0
[−24.062]
∆pt −11.752 2.696 ∆pt 0 1.632
[−11.595] [11.711] [11.747]
R1t 11.752 0.0 R1t 5.717 0.0
[11.595] [3.535]
Dp97t −0.133 0.0 Dp97t −0.061 0
[−5.850] [−3.495]
trendt 0.0 −0.019 trendt −0.014 −0.019
[−63.876] [−16.224] [−164.134]
The adjustment coefficients:
α̂1 α̂2 α̂1 α̂2
∆m1t −0.205 −0.872 ∆m2t −0.010 0.247
[−3.387] [−4.273] [−0.096] [0.903]
∆yt 0.033 0.139 ∆yt 0.049 0.045
[5.987] [7.375] [5.034] [1.769]
∆2 pt 0.113 0.086 ∆2 pt 0.119 −0.804
[4.645] [1.041] [2.173] [−5.671]
The residual correlation matrix Ω̂:
∆m1t 0.017 ∆m2t 0.012
∆yt 0.42 0.001 ∆yt 0.533 0.001
∆2 pt -0.28 -0.058 0.006 ∆2 pt -0.782 -0.403 0.006
Test of overidentifying restrictions:
χ2 (3) = 3.686 [0.297] χ2 (3) = 2.957[0.398]

Notes:
1. p − values are in square brackets.
2. in Ω̂ the standard errors are on the diagonal, cross-correlations are on the
off-diagonal elements.

51
relation can be regarded as a money supply equation, because m1 is not
significantly error correcting to this cointegration vector. The second one
represented by H5 indicates a short-run Phillips curve relation.
The corresponding adjustment coefficients show that m1 is not error
correcting to the excess money as measured by the deviation from the money
supply relation. Whereas, excess money seems to have significantly increased
the real aggregate demand and the inflation rate.
The deviation from the short-run Phillips curve as given by the second
cointegration vector has positive effects on inflation as expected. Moreover,
m1 is significantly and negatively error correcting to the deviation from the
second cointegration vector, which can be interpreted as the monetary policy
reaction effect.
The overidentifying restrictions on the long-run structure are acceptable
with a p-value of 0.63.

8.2.2 m2 model 1979:1-1994:4

The restrictions imposed on the long-run structure and the corresponding

adjustment coefficients in m2 model 1 are similar to that in m1 model 1,
except that in the inflation equation the error correction of the second coin-
tegration vector is not significant.
The overidentifying restrictions on the long-run structure are acceptable
with a p-value of 0.36.

8.2.3 m1 model 1995:1-2004:4

In m1 model 2, the two restricted long-run relations can be regarded as

the combination of a modified relation represented by H26 with a relation
represented by H21 in the table 14. The first cointegration vector looks like
a money demand relation. Because m1 is negatively error correcting to the
deviation from this cointegration vector, we can further confirm that the
relation can be interpreted as a money demand relation. Moreover, excess
money has significant positive effects on real aggregate demand and the
inflation rate.
The second cointegration vector indicates that trend-adjusted real in-
come is negatively cointegrated with inflation, which might be interpreted

52
as a partial real income relation. In order to get an economic interpretable
real income relation, more variables need to be included in the information
set.
The adjustment coefficients show that m1 is positively error correcting to
the deviation of the second cointegration vector, which indicates a monetary
policy reaction effect. In other words, when there exists excess inflation in
terms of deviation from modified velocity, the central bank takes measures
to reduce the money supply. In addition, the deviation from the second
cointegration vector has positive effects on the real income.
The overidentifying restrictions on the long-run structure is acceptable
with a p-value of 0.30.

8.2.4 m2 model 1995:1-2004:4

The two cointegration relations in m2 model 2 are the combination of mo-

dified H38 and H34 in Table 15. The first cointegration vector indicates
that the modified velocity ( the coefficient of y is freely estimated) is ne-
gatively cointegrated with the interest rate R1t , which implies that excess
money supply has long-run liquidity effects on the interest rate, i.e. there
is a negative transmission effect between the interest rate and monetary ex-
pansion, as the standard IS-LM model would predict. The corresponding
adjustment coefficients show that the excess money measured as the devia-
tion from this cointegration vector increases the real income and inflation
significantly, whereas m2 is not error correcting to it. The second cointegra-
tion vector is similar to the second cointegration vector in the m1 model 2,
which reflects that real income is negatively correlated with inflation. Ad-
justment coefficients show that only inflation is negatively error correcting
to this cointegration vector.
The overidentifying restrictions on the long-run structure is acceptable
with a p-value of 0.40.
In Tables 16 and 17, the estimated residual correlation matrices for the
corresponding models are reported. We find that in m2 model 2, there
exists a large correlation between residuals of the equations of ∆m2 and
∆2 p, which implies that current effects may exist in this model. Hence,
although m2 seems to be weakly exogenous for the long-run coefficients in
m2 model 2, we still keep it as an endogenous variable before we analyze
the short-run structure of the model.

53
8.3 Graphs of the cointegration vectors

Figures ??-?? in the Appendix display the graphs of the identified cointe-
grations for the four models. All eight cointegration relationships seem to
be mean-reverting and stationary.

8.4 Recursive Estimation of α and β

Having estimated restricted long-run β coefficients and their corresponding

loading factors α, we now examine the constancy of these parameters using
recursive methods. Figure 21-?? in the appendix exhibit the forward recur-
sively estimated α and β for the four models. It can be seen that except
some nonconstancy occurring in the beginning of the short sample period,
the estimated α and β are in general constant. Figure ??-?? display the
recursively calculated LR-tests for restrictions on the four models, which
indicate that the restrictions imposed on the α and β are acceptable.

9 Identifying the Short-run Structure

9.1 The procedure and guideline for identifying the short-

run structure

We next impose a short-run structure on the system of unrestricted short-

run reduced-form equations, which are estimated in the previous section.
The statistical formulation takes the following form:

k−1
X
0
A0 ∆xt = α∗ β xt−1 + Γ∗i ∆xt−i + Φ∗ Dt + Bvt (17)
i=1

t = 1, · · · , T, vt ∼ N (0, Ω∗ )

In the unrestricted short-run reduced form models, A0 = I, which is

equivalent to imposing p − 1 zero restrictions on each row of A0 and hence
is exactly identified. We note that the short-run structure of the current esti-
mated unrestricted reduced form system is over-parameterized with many
insignificant coefficients. In addition, some of the correlations of standar-
dized residuals are rather large, which may be caused by ignorance of the

54
current effects. In this section we try to impose general restrictions on A0
or B, which might make the short-run structure overidentified.
The error correction terms that are calculated from the identified long-
run cointegration vectors before identifying the short-run structure are inclu-
ded as stationary components in the VEC models. This strategy is justified
by the super consistent property of estimated β (Juselius, 2005, Section
13.1).
In the models of present research, there are no prior hypotheses or theory
about the current effects. Hence we impose overidentifying short-run re-
strictions through simplification searching rather than a stringent economic
identification. The guiding principle is the plausibility of the results, in
particular plausible estimates of the coefficients of the equilibrium error cor-
rection terms α, as well as the reduction of the residual cross-correlations.
The search for the short-run structure is performed with PcGive 10.0
following the approach suggested by Lütkepohl and Wolters (1999b). First,
we eliminate the most insignificant short-run parameters according to the
lowest t-values but keep the error correction terms in the systems. Then
we try to consider the current effects of the system by including current
variables in the equations of other variables. Then we continually eliminate
the insignificant variables. If finally the error correction terms are proved
to be insignificant, they are also eliminated. The estimation of the full
system is conducted using FIML contained in PcGive 10.0. Next, we conduct
the overidentifying restriction tests to make sure that the reductions are
acceptable. By means of examining the economic plausibility of the current
effects, as well as checking whether the estimated residual cross-correlations
are reduced by including current variables, we can decide on the structural
models that are sensible to our research interest.

9.2 Estimated structural models

In what follows, we give the identified parsimonious structural models for

m1, m2 model 1, 2, respectively. To save space, constant terms and seasonal
dummies are not reported. The standard errors are in parentheses under-
neath the parameters. All reduced-form models have been tested with LR
tests of over-identifying restrictions, and proved to have no over-identifying
problem.

55
9.2.1 Structural m1 model 1

∆m1 equation in the m1 model 1

∆m1t = − 0.91 ∆2 pt + 0.31 ec2t−1 + 0.65 ∆yt−1 + 0.55 ∆2 pt−1

(0.22) (0.043) (0.38) (0.15)

+ 0.11 (d84q4t − d85q2t ) + 0.06 d85q4t + 0.11 d93q1t + ut

(0.019) (0.03) (0.03)

AR(1-1): F(1,45) = 1.75 [0.19] AR(1-4): F(4,42) = 1.42 [0.24]

ARCH(1-1): F(1,54) = 0.04 [0.83] ARCH(1-4): F(4,44) = 1.34 [0.26]
Normality: χ2 (2) = 1.43 [0.48]

∆y equation in the m1 model 1

∆yt = 0.03 ec1t−1 + 0.545 ∆yt−1 + 0.015 d80q1t + 0.039 d84q1t

(0.0065) (0.064) (0.005) (0.0047)

+ 0.016 d85q1t − 0.022 d85q4t + ut

(0.0048) (0.0053)

AR(1-1): F(1,45) = 5.31 [0.02] AR(1-4): F(4,42) = 2.52 [0.05]

ARCH(1-1): F(1,54) =0.04 [0.83] ARCH(1-4): F(4,44) = 0.66 [0.61]
Normality: χ2 (2) = 1.46 [0.48]

∆2 pt equation in the m1 model

∆2 pt = 0.07 ec1t−1 + 0.10 ec2t−1 + 0.1 ∆m1t−1 + 0.09 d80q1t

(0.025) (0.016) (0.06) (0.019)

+ 0.06 d93q1t + 0.07 d94q1t + ut

(0.018) (0.018)

AR(1-1): F(1,54) = 0.27 [0.60] AR(1-4): F(4,42) = 3.82 [0.01]

ARCH(1-1): F(4,48) = 0.72 [0.57] ARCH(1-4): F(4,44) = 0.31 [0.86]
Normality: χ2 (2) = 5.02 [0.08]

56
 where

ec1t = m1t − 1.29yt

ec2t = yt − 6.61∆pt − 0.02trend

9.2.2 Structural m2 model 1

∆m2 equation in the m2 model 1

∆m2t = − 1.3 ∆2 pt + 0.25 ec2t−1 − 0.16 ∆m2t−2 − 0.093 ∆m2t−3

(0.21) (0.032) (0.082) (0.068)

− 0.55 ∆yt−2 + 0.78 ∆yt−3 + 0.42 ∆2 p t−1 + 0.5 ∆2 pt−3

(0.45) (0.53) (0.2) (0.14)

+ 0.075 d84q4t + 0.1 d85q4t + 0.19 d93q1t + ut

(0.034) (0.03) (0.033)

AR(1-1): F(1,38) = 3.80 [0.05] AR(1-4): F(4,35) = 1.05 [0.39]

ARCH(1-1): F(1,45) = 1.24 [0.27] ARCH(1-4): F(4,39) = 1.08 [0.37]
Normality: χ2 (2) = 0.54 [0.76]

∆y equation in the m2 model 1

∆yt = 0.044 ec1t−1 − 0.038 ∆m2t−1 + 0.49 ∆yt−1 + 0.093 ∆yt−2

(0.006) (0.016) (0.074) (0.013)

+ 0.031 ∆2 p t−3 + 0.017 d80q1t + 0.039 d84q1t + 0.025 d85q1t

(0.018) (0.019) (0.0047) (0.004)

+ 0.016 d84q4t − 0.017 d85q4t + ut

(0.004) (0.004)

AR(1-1): F(1,38) = 3.22 [0.08] AR(1-4): F(4,35) = 2.71 [0.04]

ARCH(1-1): F(1,45) = 0.24 [0.62] ARCH(1-4): F(4,39) = 0.69 [0.60]
Normality: χ2 (2) = 2.27 [0.32]

∆2 pt equation in the m2 model 1

57
∆2 pt = 0.092 ec1t−1 0.43 ∆yt−1 − 0.87 ∆2 pt−1 − 0.67 ∆2 pt−2
(0.018) (0.0017) (0.075) (0.07)

− 0.54 ∆2 p t−3 + 0.084 d80q1t + 0.026 d85q1t + 0.066 d88q3t

(0.07) (0.014) (0.014) (0.013)

+ 0.069 d93q1t + ut
(0.015)

AR(1-1): F(1,38) = 4.49 [0.05] AR(1-4): F(4,35) = 1.51 [0.21]

ARCH(1-1): F(1,45) = 0.82 [0.36] ARCH(1-4): F(4,39)= 0.26 [0.89]
Normality: χ2 (2) = 0.68 [0.71]

where

ec1t = m1t − 1.71yt

ec2t = yt − 8.20∆pt − 0.02trend

9.2.3 Structural m1 model 2

∆m1 equation in the m1 model 2

∆m1t = − 0.14 ec1t−1 − 0.72 ec2t−1 + 0.083 ∆Dp97t + ut

(0.065) (0.22) (0.02)

AR(1-1): F(1,30) = 0.57 [0.45] AR(1-4): F(4,27) = 1.01 [0.41]

ARCH(1-1): F(1,31) = 0.12 [0.72] ARCH(1-4): F(4,25) = 0.39 [0.80]
Normality: χ2 0.49 [0.78]

∆y equation in the m1 model 2

∆yt = 0.028 ec1t−1 + 0.13 ec2t−1 + ut

(0.0064) (0.022)

AR(1-1): F(1,30) = 1.32 [0.25] AR(1-4): F(4,27) = 0.83 [0.51]

ARCH(1-1): F(1,31) = 0.58 [0.45] ARCH(1-4): F(4,25) = 0.55 [0.69]
Normality: χ2 (2) = 0.95 [0.62]

58
 ∆2 p equation in the m1 model 2

∆2 pt = 0.085 ec1t−1 + ut
(0.012)

AR(1-1): F(1,30) = 0.67 [0.41] AR(1-4): F(4,27) = 1.53 [0.22]

ARCH(1-1): F(1,31) = 0.16 [0.68] ARCH(1-4): F(4,25)= 0.69 [0.607]
Normality: χ2 (2) = 4.06 [0.13]

where

ec1t = m1t − 1.60yt − 11.75(R1t − ∆pt ) − 0.13Dp97t

ec2t = yt + 2.69∆pt − 0.02trend

9.2.4 Structural m2 model 2

∆m2 equation in the m2 model 2

∆m2t = − 0.69 ∆2 pt − 0.35 ec2t−1 0.013 ∆Dp97t + 0.024 d03q2t + ut

(0.33) (0.18) (0.0094) (0.012)

AR(1-1): F(1,23) = 4.88 [0.03] AR(1-4): F(4,20) = 1.51 [0.23]

ARCH(1-1): F(1,32) = 0.45 [0.50] ARCH(1-4): F(4,26) = 0.51 [0.72]
Normality: χ2 (2) = 0.78 [0.67]

∆y equation in the m2 model 2

∆yt = 0.054 ec1t−1 + 0.28 ∆yt−1 + 0.0042 ∆Dp97t−1 − 0.006 d03q2t + ut

(0.008) (0.10) (0.001) (0.001)

AR(1-1): F(1,23) = 4.08 [0.05] AR(1-4): F(4,20) = 1.88 [0.15]

ARCH(1-1): F(1,32) = 0.66 [0.42] ARCH(1-4): F(4,26) = 0.06 [0.99]
Normality: χ2 (2) = 0.22 [0.89]

59
 ∆2 pt equation in the m2 model 2

∆2 pt = 0.12 ec1t−1 − 0.61 ec2t−1 + 1.4 ∆yt−1 − 0.017 d03q2t + ut

(0.04) (0.08) (0.58) (0.008)

AR(1-1): F(1,23) = 1.94 [0.17] AR(1-4): F(4,20) = 0.88 [0.48]

ARCH(1-1): F(1,32)= 0.03 [0.85] ARCH(1-4): F(4,26) = 2.86 [0.04]
Normality: χ2 (2) = 1.58 [0.45]

where

ec1t = m2t − yt + 5.71R1t − 0.061Dp97t − 0.014trendt

ec2t = yt + 1.63∆pt − 0.02trend

The structural models show that inflation has current negative effects
on real money stock in all the models, except in the m1 model 2, where the
structure of the unrestricted VEC model is too simple to identify the current
effect of inflation on money stock. When the current effect of inflation is
taken into account in the ∆m2 equation of m2 model 2, m2 becomes error
correcting to the second cointegration vector. In general, the significance
and sign of the error correction terms in the four models are reasonable and
have not been significantly changed by imposing the short-run structures.

10 Impulse response analysis

Impulse response analyses are conducted in this section to trace the respon-
ses of variables when the system is hit by a shock. Through the impulse
response analysis we can also examine the plausibility using the current
models as framework for policy analysis.
The impulse response analyses are based on the parsimonious VAR mo-
dels, which are achieved by eliminating insignificant components on the
right-hand sides of the equations of the system. The exogenous variables
and deterministic terms are treated as fixed in the impulse response analysis,
because they are considered to be constant and not affected by the impulses
hitting the system. The residuals are orthogonalized by the Choleski decom-
position. Because the structural analysis in the previous section shows that

60
inflation seems to have an instantaneous effect on money stock, we chose the
order of the variables for the Choleski decomposition as {yt , ∆pt , m1t /m2t }.
This implies that the shock on yt has instantaneous effects on itself, infla-
tion, and money stock, the shock on inflation has instantaneous effects on
itself and money stock, while the shock on the money stock has only an
instantaneous effect on itself. Because such an assumption is relatively ar-
bitrary, we also check the sensibility of the impulse responses by means of
using other orders of variables.
The impulse response analysis is performed with Jmulti 3.1. Bootstrap-
ping method are applied to calculate the confidence intervals for the calcu-
lated responses. If zero is not included within the confidence intervals, the
responses are supposed to be significant. The number of the bootstrap re-
plications is set to be 2000. Confidence intervals for the individual impulse
response coefficients are estimated at the 95% significant level.
Graphs 15-18 are the impulse response functions of m1 and m2 model 1
and 2. The impulses are the orthogonalized standard deviations of estimated
residuals of the models. The variables in the columns indicate the equations
to which impulses are attached, while the variables in the rows indicates
the response functions to the impulses. The graphs show that almost all
the responses are in line with theoretical expectations. For example, when
an impulse hits the real money stock, it will increase real income and infla-
tion in all the four models except the insignificant response of real income
in m1 model 2. This result can be taken as evidence that money supply
is effective in stimulating the real income and controlling inflation for both
m1 and m2 during the two sub-sample periods. An impulse hitting infla-
tion tends to decrease real money stock in all four models. This suggests
that the Chinese central bank has adopted a cautious monetary policy to
prevent inflation running out of control for both periods. The impulse on
the real income increases itself, inflation and real money stock at least for
a short period, except for the response of real money stock in m2 model 2
where m2 decreases in the beginning but increases after about four quarters.
These findings are robust to other variable orders chosen for conducting the
Choleski decomposition.
In general, the impulse response functions of the four models are in
line with economic theories. Therefore, the current models can be taken
as a sensible framework for further policy analysis. The impulse response
analyses can also provide the following conclusions. First, inflation can be
regarded as monetary phenomenon in China for the whole sample period,

61
 Figure 15: Impulse responses of m1 model 1979:1-1994:4

although in the later period the Chinese economy has experienced deflation
from about 1998-2002. Second, the Chinese monetary authorities are very
cautious in controlling inflation. This is reflected in the fact that, except
for m1 model 2, in all the other models money stock decreases significantly
in response to an inflation impulse. In m1 model 2, m1 declines in the
beginning but not statistically significant, possibly due to the fact that in
the second sample period, m1 is more determined by money demand.

11 Long-run impact analysis

We now investigate the long-run impact matrices of unanticipated shocks

to the four models based on the moving average representation of the VAR

62
Figure 16: Impulse responses of m2 model 1979:1-1994:4

63
Figure 17: Impulse responses of m1 model 1995:1-2004:4

64
Figure 18: Impulse responses of m2 model 1995:1-2004:4

65
formulation.
As pointed out in Section 3.6, VAR models can be represented in the
following moving average form:

t
X ∞
X
xt = C (²i + ΦDt ) + C∗ (²t−i + φDt−i ) + A0 ,
i=1 i=0
t
X
= C (²i + ΦDt ) + C∗ (L)εt + C∗ (L)ΦDt + A0 (18)
i=1

Where:

0
C = β⊥ (α⊥ Γβ⊥ )−1 α⊥
0
(19)

and α⊥ and β⊥ are the orthogonal complements to α and β, respectively.

(α⊥ : α) and (β⊥ : β) are regular matrices. α⊥ and β⊥ can be calculated
based on the unrestricted estimates of α and β. Long-run impact matrix C
can be uniquely calculated from α⊥ and β⊥ , although α⊥ and β⊥ are not
uniquely estimated. The estimated C matrices contain useful information
about the overall effects of the stochastic driving forces in the system.
We choose the residuals ²̂it from the unrestricted VECM models as esti-
mates of the unanticipated shocks associated with variable xi , because the
0
conditional expectation Et−1 {∆xt |∆xt−1 , β xt−1 } has optimal properties
as a predictor of ∆xt (Juselius, 1999).

11.1 Long-run impact analysis for the full sample

In previous section, we have identified that there exists structural shifts in

the estimated β in m1 and m2 models for the whole sample period 1979:1-
2004:4. In order to derive constant coefficients of the cointegration relations,
we have empirically investigated the models in the split samples, i.e. before
and after 1995Q1. On the other hand, because the long-run impact matrix
is independent of the identification of α or β, the long-run impact matrix
C might be constant even if the estimates of α and β are nonconstant. In
this section, we investigate the long-run impact based on the whole sample

66
period.5
Table 18 shows the long-run impact matrices of m1 and m2 models for
the whole sample period, with the assumption that there exists one or two
cointegration relations. An interesting finding is that the cumulated shocks
in m1 are insignificant for any of the variables in the system, which means
that m1 is a fully adjusting variable. Contrary to m1, the unanticipated
shocks in m2 have significant and positive long-run impact on m2, real
income and inflation.
If the estimated residuals associated with the money stock can be inter-
preted as monetary policy shocks, this finding might imply that expansio-
nary monetary policy in terms of increasing m2 supply has long-run positive
effects on m2, real income and inflation, whereas that in terms of increasing
m1 has no such long-run effect.
In particular, the finding is robust in the sense that it is independent on
the choice of the cointegration rank.

12 Impulse response functions for transitory and

permanent shocks

12.1 Estimate of B matrices

The impulse response analysis for transitory and permanent shocks are con-
ducted based on m1 and m2 models in the full sample with cointegration
rank to be 2. The estimated matrix B (normalized at the largest coeffi-
cient in each row) defines how the orthogonalized permanent and transitory
shocks are associated with the estimated VAR residuals through the equa-
tion ut = B²t , where ut and ²t are structural shocks and VAR estimated
residuals, respectively.
The estimated B and the transformation relations between structural
shocks and estimated VAR residuals for the two models is given in equations
(20) and (21)6
5
Because of the large cross-correlations existing in the residual covariance matrices,
the long-run impact analyses based on the two sub sample periods seem not to be very
plausible and reliable
6
Because by construction the SVAR restrictions are just-identifying, there is no test
for estimated B

67
 Table 18: The long-run impact matrices for 1979:1-2004:4

m1 model, r = 2 m2 model, r = 2
P P P P P P
²̂m1i ²̂yi ²̂∆pi ²̂m2i ²̂yi ²̂∆pi
m1t 0.031 2.700 −1.295 m2t 0.194 1.477 −0.458
[0.319] [3.478] [−6.195] [3.771] [4.459] [−3.782]
yt 0.011 0.940 −0.451 yt 0.194 1.472 −0.457
[0.319] [3.478] [−6.195] [3.771] [4.459] [−3.782]
∆pt −0.001 −0.130 0.062 ∆pt 0.011 0.080 −0.025
[−0.319] [−3.478] [6.195] [3.771] [4.459] [−3.782]
m1 model, r = 1 m2 model, r = 1
P P P P P P
²̂m1i ²̂yi ²̂∆pi ²̂m2i ²̂yi ²̂∆pi
m1t −0.201 −3.595 −2.106 m2t 0.515 −0.172 0.021
[−0.781] [−1.624] [−3.798] [4.963] [−0.376] [0.251]
yt 0.107 3.552 −0.115 yt 0.359 0.619 −0.209
[1.003] [3.875] [−0.500] [4.660] [1.822] [−3.332]
∆pt 0.010 0.178 0.102 ∆pt 0.169 −0.736 0.212
[0.785] [1.647] [3.775] [4.052] [−4.006] [6.271]

Note: t-values are in square brackets.

    
us,1i −0.003 0.123 1.000 ²̂m1i
 us,2i  =  1.000 0.563 −0.624   ²̂∆pi  (20)
ul,1i 0.011 −0.480 1.000 ²̂yi
    
us,1i −0.038 0.091 1.000 ²̂m2i
 us,2i  =  1.000 1.768 −1.345   ²̂∆pi  (21)
ul,1i 0.132 −0.310 1.000 ²̂yi

Where us,t and ul,t denote transitory and permanent shocks, respectively.

68
12.2 Impulse response functions for transitory and perma-
nent shocks

Based on the estimated B matrices, the transitory and permanent shocks in

the m1 model are defined as:

us,1 ≈ ²̂y + 0.12²̂∆p

us,2 = ²̂m1 + 0.56²̂∆p − 0.62²̂y
ul,1 ≈ ²̂y − 0.48²̂∆p

and that in the m2 model are defined as:

us,1 ≈ ²̂y + 0.09²̂∆p

us,2 = ²̂m2 + 1.76²̂∆p − 1.34²̂y
ul,1 ≈ ²̂y + 0.13²̂m2 − 0.31²̂∆p

In both m1 and m2 models, there are two transitory shocks and one per-
manent shock. In order to identify the two transitory shocks, one exclusion
restriction need to be imposed on the matrix C0 , which describes the im-
mediate effect of the structural shocks on the variables. The restriction on
matrix C0 in m1 and m2 model are given as follows, respectively:
 
−0.174 2.171 0.627
C0,m1 =  0.665 0.052 −0.978 
0.321 −0.000 0.122

and  
0.496 1.453 1.501
C0,m2 =  0.192 −0.191 0.126 
0.829 −0.000 −0.753

The exclusion restriction imposed on the C0 matrix in the m1 and m2

models is equivalent to assuming that the second transitory shock has no
current effect on yt . Based on the estimated B matrix and the identification
restriction imposed on the C0 matrix, the impulse response functions for a
one standard deviation of transitory and permanent shocks in m1 and m2
models are calculated and depicted in Figure 19 and 20, respectively.

69
 Trans(1) Trans(2) Perm(1)
0.004 0.0150 0.0225

0.0125 0.0200
0.000

0.0175
0.0100
-0.004
0.0150
0.0075
-0.008 0.0125

LM1 0.0050
0.0100
-0.012
0.0025
0.0075
-0.016
0.0000
0.0050

-0.020
-0.0025 0.0025

-0.024 -0.0050 0.0000

0.0125 0.012 0.006

0.010
0.0100 0.004

0.008
0.0075 0.002

0.006

DP 0.0050 0.000

0.004

0.0025 -0.002
0.002

0.0000 -0.004
0.000

-0.0025 -0.002 -0.006

0.0042 0.0010 0.012

0.0036
0.0008 0.010

0.0030

0.0006 0.008
0.0024

Y 0.0018 0.0004 0.006

0.0012
0.0002 0.004

0.0006

0.0000 0.002
0.0000

-0.0006 -0.0002 0.000

Steps 1 to 29

Figure 19: Impulse response functions for the transitory and permanent
shocks in m1 model

By the construction of the transitory and permanent shocks, the two

transitory shocks have no long-run impact, while the permanent shock has
long-run impact on all the variables.
Figure 19 and 20 display similar pictures. The first transitory shock
consisting of residuals from equations yt and ∆pt has transitory positive
effects on real income and inflation, but transitory negative effects on money
stock. Therefore, we might interpret this shock as a demand shock. The
negative response of the money stock can be interpreted as the monetary
policy reaction. The second transitory shock, which contains residuals of
money stock, real income and inflation, seems like a money supply shock,
which increases money stock and inflation immediately, and real income
a period later. The only permanent shock has permanently increased the
money stock and real income, but initially decreased the inflation, and only
slightly increased the inflation in the long-run, which makes it much like a
supply shock, according to the Blanchard and Quah’s (1988) interpretation
of supply disturbances.
In their paper, Blanchard and Quah interpret the supply and demand

70
 Trans(1) Trans(2) Perm(1)
0.002 0.0175 0.030

0.000 0.0150
0.025
0.0125
-0.002

0.0100 0.020
-0.004

0.0075

LM2 -0.006
0.0050
0.015

-0.008
0.0025 0.010

-0.010
0.0000
0.005
-0.012 -0.0025

-0.014 -0.0050 0.000

0.008 0.010 0.004

0.002
0.008
0.006
0.000

0.006
-0.002
0.004

DP 0.004 -0.004

0.002
-0.006
0.002

-0.008
0.000
0.000
-0.010

-0.002 -0.002 -0.012

0.005 0.00175 0.012

0.00150
0.004 0.010

0.00125

0.003 0.008
0.00100

Y 0.002 0.00075 0.006

0.00050
0.001 0.004

0.00025

0.000 0.002
0.00000

-0.001 -0.00025 0.000

Steps 1 to 32

Figure 20: Impulse response functions for the transitory and permanent
shocks in m2 model

disturbance as follows (in Abstract):

If we interpret fluctuations in GNP and unemployment as due

to two types of disturbances: disturbances that have a permanent
effect on output and disturbances that do not. We interpret the
first as supply disturbances, the second as demand disturbances.

They characterize the effects of supply disturbances as follows (pp. 2):

The effect of supply disturbances on output increases steadily

over time, to reach a peak after two years and a plateau after
five years. ’Favorable’ supply disturbances may initially increase
unemployment.

Being aware that interpreting residuals in small dimensional systems

as ’structural’ disturbances is always perilous (Blanchard and Quah, 1988,
Juselius, 2005, et al.), we regard the aforementioned economic interpretation
of transitory and permanent shocks only as a very tentative attempt.

71
13 Summary and Conclusions

To conclude, we will first report the results of our empirical investigations

for the hypotheses raised in the beginning of this chapter. Then we will
summarize the main findings of the current study and discuss some related
issues.

13.1 Answers to the propositions

1. Is there any structural break in the monetary transmission mechanism in

China during 1979:1-2004:4?
We do find evidence of a structural break in the estimates of the long-run
cointegration coefficients β and the corresponding short-run loading factors
α before and after 1995Q1. When the models are separately estimated in
the split sample period, estimates of α and β turned out to be constant.
2. Are there long-run relationships between money stock, real income,
inflation and other macroeconomic variables? If yes, are they money demand
or supply relationship?
In the first period, we find cointegration relations between money stock
and real income, which can be interpreted as money supply relations. This
correlation implies that money supply and real income have the same sto-
chastic trend, and hence can be cancelled out by a linear combination. In
the second period, there exists a money demand function for m1. But in
the m2 model, there is a correlating relation between velocity and interest
rate, which seems still to be a supply relation. In other words, m1 is largely
determined by money demand in the second period, while m2 is still supply
determined.
3. How do real income and inflation adjust to the monetary expansion?
In all four models, excess money of m1 and m2 has a positive short-run
effect on real income and inflation. This is the evidence that the Chinese
monetary policy is effective in adjusting aggregate demand and in controlling
inflation by means of controlling money supply in the whole sample period.
Or in other word, inflation can be regarded as monetary phenomena during
the whole sample period.
4. How does the money supply react to excess inflation?

72
 We also find that m1 and m2 negatively respond to excess inflation in
both periods, which reflects the fact that PBC’s has taken cautionary mone-
tary policy to prevent inflation, and furthermore, the cautionary monetary
policy has not changed during the whole sample period.
5. Do unanticipated shocks of m1 or m2 have long-run impacts on real
income and inflation?
Only the unanticipated shocks of m2 have long-run positive impacts on
m2, real income and inflation. The unanticipated shocks of m1 have no
long-run impacts for any variable.
6. Which one should be taken as the intermediate target, M1 or M2?
In the short-run, both excess m1 and m2 have a positive impact on
real income and inflation, whereas only expansionary shocks in m2 have a
long-run impact on real income and inflation. This means, in the long-run
to take m2 as intermediate target of monetary policy is more relevant. In
addition, in the second period, m1 is largely determined by money demand,
which implies that the PBC cannot directly control m1 but can only indi-
rectly adjust m1 through adjusting the deposit rate. To qualify to be an
intermediate target, it is usually required to be measurable, controllable and
relevant to the monetary target. According to these criteria, m2 seems to
be more suitable as the intermediate target for monetary policy than m1,
especially in the long-run.

13.2 Other Interesting Findings

The empirical investigation also provides us with some other interesting

findings that are worth mentioning.
1. In the first period, there exists a short-run Phillips curve type rela-
tion, which suggests that excess aggregate demand pressure causes inflation.
In the second period, we find cointegration relation between trend-adjusted
real income and inflation, but with a ’wrong’ sign, i.e. they are negatively
cointegrated. Juselius (2005) has also found similar cointegration relation
in a monetary model including five variables based on Danish data. She
interprets this relation as a partial real income relation. When more infor-
mation is added to the original model, she has found a standard Phillips
curve relation between inflation, the unemployment rate and real bond rate.
In our current models, the similar relations seem to exist as well, and further

73
investigation using more information is required in this regard.
2. The PBC has adjusted the interest rate in the recent period more
frequently than it did in the first period. Our empirical investigation shows
that the interest rate variable can be excluded from the models in the first
period, but not in the second period. In the later period, the interest rate
is a indispensable component of the monetary relations, and seems to have
influenced by the monetary expansion in the long-run. This gives the evi-
dence that the interest rate policy is now playing an increasingly important
role in China.
3. The PBC has claimed to take money supply as the intermediate tar-
get of the monetary policy since 1995. The planed target of money supply
is supposed to be calculated based on the quantity theory and exchange
equation. If the PBC has controlled money supply according to the planed
target, then we expect to find a long-run relation between real money supply
and real income, and money stock should adjust to the deviation from the
equilibrium. In our empirical models in the second sample period, we didn’t
find such long-run equilibria and the corresponding short-run adjustments.
Instead, we find the growth rate of money supply m1 and m2 react signifi-
cantly negative to the current increase of inflation and the excess inflation
in the previous period. This finding might be interpreted as evidence that in
practice, the PBC has not adjusted money supply according to the planned
target but rather according to the inflation target.

74
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