Economic fluctuations, volatility changes and the role of government spending in China: A structural analysis

Date01 October 2020
AuthorJunsang Lee,Min Zhao,Minchung Hsu
DOIhttp://doi.org/10.1111/1468-0106.12302
Published date01 October 2020
ORIGINAL MANUSCRIPT
Economic fluctuations, volatility changes and the
role of government spending in China: A structural
analysis
Minchung Hsu
1
| Junsang Lee
2
| Min Zhao
3
1
National Graduate Institute for Policy
Studies (GRIPS), Tokyo, Japan
2
Department of Economics, Sungkyunkwan
University, Seoul, Korea
3
World Bank Beijing Office, Beijing, China
Correspondence
Junsang Lee, Department of Economics,
Sungkyunkwan University, Seoul, Korea.
Email: junsanglee@skku.edu
Funding information
GRIPS Policy Research Center; JSPS
KAKENHI, Grant/Award Number:
17H02537; Nomura Foundation
Abstract
We study the economic fluctuations in China by using a
standard neoclassical general equilibrium model to pro-
vide a structural analysis. We have carefully constructed
measurements for economic variables from Chinese data
to be consistent with the literature. We show that the gov-
ernment spending behaviour plays an important role in
accounting for the changes in the pattern of both absolute
and relative volatilities. Although we find that a general
moderation in economic fluctuations after 1978 can be
largely explained by the total factor productivity (TFP)
process, TFP itself cannot explain the change in the pat-
tern of relative volatilities. We show that policy changes
in government spending can account for the relative vola-
tility divergency. Counterfactual experiments are also pro-
vided to discover the role of each factor in explaining the
economic fluctuations in China.
1|INTRODUCTION
Chinas high economic growth has attracted the worlds attention. After China started its market-
oriented economic reforms in 1978, the average annual gross national product (GNP) growth rate
reached 9%. Previous studies have devoted substantial effort to examining economic growth in
China (see e.g. Chow and Li, 2002), while business cycles (economic fluctuations around the growth
trend) in China are relatively less studied. However, understanding business cycles is important.
Moreover, business cycle studies on China typically suffer from problems in data availability and
consistency. Therefore, the long-term features of Chinese business cycles are still not well under-
stood in the published literature.
Received: 4 August 2017 Revised: 2 April 2019 Accepted: 23 April 2019
DOI: 10.1111/1468-0106.12302
512 © 2019 John Wiley & Sons Australia, Ltd Pac Econ Rev. 2020;25:512538.wileyonlinelibrary.com/journal/paer
In this paper, we use a neoclassical general equilibrium growth model with aggregate shocks (or a
so-called dynamic stochastic general equilibrium model) to study economic fluctuations in China.
This framework was pioneered by Finn Kydland and Edward Prescott in 1982 and has been a work-
horse for macroeconomic studies, although research has mainly focused on the US or European
economies. We adopt a structural approach to perform the analysis within the framework. In particu-
lar, because the 1978 reform significantly affected the Chinese economy, we study how and why the
features of economic fluctuations changed after 1978.
In the present study, we attempt to improve the business cycle measurement of China and dis-
cover the long-term features of Chinas real business cycles for periods between 1954 to 2015.
1
The
data and measurements that we use in our analysis are constructed carefully such that they are consis-
tent with the real business cycle (RBC) literature using dynamic general equilibrium models. In par-
ticular, to the best of our knowledge, this paper is the first structural dynamic general equilibrium
study following the RBC literature to have household durable consumption separated from official
Chinese aggregate consumption data.
2
Based on our previous study, Zhao and Hsu (2012), which
suggests that using the official consumption data directly will lead to an overestimation of consump-
tion volatility in China, we estimate the value of consumer durables, such as housing and trans-
portation/communication equipment, which are not officially available in China. Because those
durable goods have the same properties as investment in the model, we separate the durable con-
sumption from the official consumption data so that the measure of consumption is consistent with
the model environment. Furthermore, Zhao and Hsu (2012) did not separate out the private and gov-
ernment consumption and investment. The present study further reveals the features of private and
public consumption and investments and finds that the governments fiscal policy plays an important
role. We also improve the estimates of labour supply because the data from the government are not
consistent over time. We provide the details for our estimation in the Appendix.
We find two key features of business cycles in China after 1950. First, the economic fluctuations
in China have been largely moderated since 1978. This finding is consistent with the empirical study
by Imai (1996), who examines the fluctuations in net material product from 1955 to 1994. Compared
with the volatility in the pre-1978 period, the volatility of output decreased by 78%, consumption
decreased by 60%, investment decreased by 83%, and employment decreased by 84% in the post-
1978 period.
3
Second, we find that the relative volatilities diverge over the periods in that consumption became
more volatile relative to output in the post-1978 period, while the relative volatility of investment
decreased for the same periods. The relative volatility of consumption increased from 55% pre-1978
to 102% post-1978.
4
Meanwhile, the relative volatility of investment decreased from 276% pre-1978
to 217% post-1978.
5
We use a standard neoclassical growth model with population growth, technology growth and
total factor productivity (TFP) shocks to conduct a quantitative investigation into the volatility mod-
eration and relative volatility divergence after 1978 in China. With careful calibration, we find that
this standard model can generate the moderation of volatility to some extent in the post-1978 econ-
omy and confirm Chows (1985) conclusion. However, a model with TFP shock alone cannot
explain the relative volatility changes: in the model economy, the relative volatility of every variable
does not change much from the pre-1978 to the post-1978 economy.
We further consider a model economy with government activities (consumption and investment
in particular) as shocks, as in Ohanian (1997), who studies the effects of the government spending on
war finance in the USA. We incorporate some impacts of the Chinese Governments economic inter-
ventions as a form of government spending into the economy. We find that government expenditures
HSU ET AL.513

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